Over the years, bankers have developed systems for managing risk. Some are elaborate, some are simple. But all are based on identifiable or predictable risk.
One example: Your bank runs the risk of technical regulatory errors, such as failing to correctly calculate loan disclosures or provide disclosures at the right time.
Because the possibility of error is predictable and measurable, compliance staff can design procedures and controls to minimize the risk that the errors will occur. Also, with these risks, we can predict the consequences of a violation.
With fair-lending compliance, assessing and managing risk has always been very different. There are no tricky or specific rules that can be identified, tested for, and monitored. There are no numbers to check or forms to issue. There are no underlying systems that can be examined for errors.
Fair lending is all about people, and how they treat customers. No risk management matrix can measure that risk.
But that doesn’t mean you are helpless.
Assessing your exposure
Fair-lending programs are built on policies and procedures; product design and availability; lending authorities; product delivery; and training—lots of training. Banks can establish clear policies and provide procedures that guide lenders through all aspects of taking applications and making loans. Compliance can train lenders and other staff to understand fair-lending issues and act in ways that ensure fair lending.
However, the most careful and sincere management team cannot possibly predict everything that might happen—or how it will look in hindsight.
Fair lending’s real risk challenge lies outside of the industry’s control. As long as there are differences in how different groups of people are treated, the regulatory agencies are pressured to address the problem. Reviewing and evaluating a bank’s policies and procedures is insufficient. It isn’t enough to then evaluate performance by measuring lending results. If inequities exist, regulators must dig out the cause.
Even with all the policies, procedures, and training possible, it remains impossible to evaluate the risk that a regulatory agency will later consider that a practice violates fair-lending laws. As long as there is any unfairness in the world of credit, there will be fair-lending issues.
In this respect, fair lending is much like Community Reinvestment Act performance. No amount of effort seems to be enough. How many loans should a lender make? Until all low- and moderate-income consumers have their credit needs met and no one is treated differently, there is more to be done.
Looking back, and ahead
The challenge for risk management is that fair lending is evaluated after the loan decisions are made, with the advantage of hindsight.
Loan policies, products, and procedures are based on what is known at the time. How those will work out in the marketplace is educated guesswork, which makes it particularly difficult to anticipate risk. Some notable fair-lending actions brought by the Justice Department have involved banks that had been making pro-active efforts to serve protected groups—and at least one reflected obedience to a regulatory request that went wrong.
Managing fair-lending risk is fundamentally an exercise in predicting what an agency such as the Consumer Financial Protection Bureau or the Justice Department will develop as a theory for an enforcement action. In recent years the doctrine of disparate impact, while not synonymous with fair lending, has been the focus of many of the fair-lending actions brought against lenders. The doctrine holds that a lender can be charged with discriminatory practices—even if no intent to discriminate is found—if the effect of the lender’s policies has a disproportionate effect on a protected class.
In January, a disparate impact case involving fair-housing law made it to the stage of oral arguments before the U.S. Supreme Court. News accounts indicate it was a spirited session where both sides took some hits from the Justices, and not just along their historic ideological lines. A decision in Texas Department of Housing and Community Affairs v. The Inclusive Communities Project, is expected in June or July.
The nature of the decision and its effect on disparate impact as it relates to lending remains uncertain. But fair lending as an issue won’t go away in any event.
Here are four ways a financial institution can check itself to find if it has exposure to fair-lending violations:
1. Early indicators. Pay close attention to news stories relating to credit discrimination. Many compliance issues are generated through consumer complaints. They don’t just complain to you, however. They may contact a news channel or a website or write to their Congressman. Worse yet, they may contact your state Attorney General. As these problems become news stories, they are likely to become compliance problems. Watch them closely.
Next, take any statements or guidance from regulators seriously. This includes tracking what is said in speeches. Regulators use speeches as a means of advising the industry about pending concerns. Tracking regulators’ speeches on a timely basis gives you an early warning to study the issue within your bank and get a head start.
In particular, whenever an agency such as the CFPB, DOJ, or the Federal Trade Commission says it is considering a fair-lending issue, take it as a warning and get to work.
These agencies are not going to communicate with banks in the ways prudential bank regulators do, so they require watching. When one of them mentions a new fair-lending theory, it is a safe bet that they are working on a case based on that theory.
Apply the theory to your bank and see what you look like.
2. Self assess. The only way to avoid being caught unawares is to be aware.
Know who the borrowers are, who the applicants were, and who is or is not your customer. Your CRA analysis of community credit needs is a useful foundation for fair-lending self-analysis.
Enforcement analyses have been based on who was included, who was excluded, and who was not even invited. Some agencies, such as DOJ, have made arguments of exclusion that seem to come from left field. For example, DOJ has stated that designating the bank’s assessment area in a way that fails to include a minority area—even if the designation complies fully with CRA requirements—can violate the Fair Housing Act and the Equal Credit Opportunity Act.
3. Think creatively. You must stay ahead of the curve.
Creditors must think creatively to anticipate ways in which regulators could approach fair-lending concerns.
Because fair-lending enforcement relies on hindsight, use you own version of hindsight. You actually have an advantage—because you are familiar with the inner workings of your bank. This renders a better view of cause and effect.
Base creative thinking on who doesn’t have credit and why. This means a regular evaluation of all credit products together with analysis of approvals and denials based on demographics.
It also means eliminating assumptions about what consumers probably want—they may want something entirely different—and what is profitable for
But don’t go overboard. After the burst of the housing bubble, lending policy must fall neatly between rock and hard place without hitting either one.
There is both need and desire out there that cannot be supported. Making a loan to a consumer who cannot afford it is just as bad as refusing to lend to a consumer because of the language that customer speaks.
4. UDAAP is a guide. Whether the topic is fair lending or unfair, deceptive, or abusive practices, the issues are strikingly similar.
Both fair-lending law and Unfair, Deceptive, Abusive Acts and Practices law represent “soft” rules in that there are no specific requirements to meet and no benchmarks to use. Both are based on perceived fairness and judged by results. Both are designed to protect consumers from decisions and actions over which they have no control.
A good test to subject your fair-lending program to: Run it through a UDAAP evaluation.
Scoring well on UDAAP is a good sign. Any indicators of possible unfairness or deception are bad signs and should be remedied.
The test must always be from the customer’s perspective:
• Does the marketing program communicate to borrowers of every demographic?
• Do the loan products provide the right choices for consumers in your market?
• Is information about products clear and readily available?
• Are products designed to benefit the consumer as well as the bank?
How consumers understood and responded to the bank’s offerings is the measure used in fair lending—hindsight. Risk management in the fair-lending program involves some creative work and always thinking about what things will look like later.