In most things in life a complete and honest assessment of a situation is a good place to start. Businesses and others use SWOT analysis to identify their Strengths, Weaknesses, Opportunities, and Threats. The military uses a GRAT, a Ground Risk Assessment Tool, to aid decision making for ground operations. In a similar manner, analyzing your overall fair lending program begins with a fair lending risk assessment. This assessment should include a review of:
- Marketing Activities,
- Discretion Permitted & Incentive/Compensation Programs,
- Exception Handling, and
- Use of Third Parties.
The goal of fair lending risk assessment is to identify the POTENTIAL risk for fair lending violations. It does not assess whether violations are occurring.
This assessment also assumes that policies, procedures, and automated scoring models are free of overt discrimination and the institution supports fair lending compliance at all levels of the organization, including conducting regular fair lending training.
The first part of a fair lending risk assessment is to review your marketing activities, which includes looking at your market areas and demographics, the delivery channels you use, the products you offer, and the advertising you conduct.
- Is your market area stable or evolving?
- Do you operate in areas with low or high diversity?
- Low or high competition?
- Do you have any illogical gaps in the areas in which you lend?
When giving presentations on fair lending I often get asked whether discrimination is more likely to occur in areas of high diversity or low diversity. The honest answer is probably that neither is “more likely”, but areas with high diversity and that are evolving have a greater potential for impacting more people and therefore, in my opinion, create heighted areas of potential fair lending risk.
A specific type of discrimination that needs mentioning is redlining (and reverse redlining). Redlining is the illegal practice of refusing to make loans or imposing more onerous terms on borrowers because of the racial, national origin, or other prohibited basic characteristics of the residents of a subject area. Reverse redlining is the deliberate targeting of residents of such neighborhoods with less advantageous or potentially predatory products.
If you think redlining is obsolete, think again. Are financial institutions still drawing a red line on maps in their offices where they won’t lend? No, but several recent cases brought by the Department of Justice (DOJ) have, in fact, claimed redlining discrimination. The claims are made by looking at the number of branches, ATMs, and levels and trends of lending activities in predominantly minority areas compared to non-minority areas. In many cases the DOJ has claimed that financial institutions have created “virtual horseshoe” patterns excluding minority areas. If there are illogical gaps in your lending area, you may be subject to the same claim. You are especially vulnerable if peer financial institutions don’t have similar gaps and/or metrics that show more inclusion of predominantly minority areas.
The processes and procedures around how you deliver and service your loans are another source of potential fair lending risk. Do processes (application processing, underwriting, pricing, servicing, etc.) vary depending on channel used? Do you refer certain loans to subprime subsidiaries?
Steering, in the case of lending activities, is the guiding of an applicant or a borrower to a less advantageous product on a prohibited basis rather than on the legitimate needs. Steering, in real estate transactions, refers to guiding a prospective purchaser towards or away from certain neighborhoods based on race. Offering subprime type loans or having subprime subsidiaries which you refer certain applicants to increases the risk of steering discrimination.
How and where you offer credit products are not just fundamental business decisions; they have fair lending implications as well.
Some questions to consider for you fair lending risk assessment are:
- Does your institution offer simple, traditional products or more complex products?
- Are products, especially new products, reviewed for fair lending compliance?
Advertising methods that could discourage individuals from applying for loans or in media that excludes specific regions are sources of fair lending risk.
- Do any of your advertising efforts, even subtly, have the potential to encourage or discourage certain prohibited basis groups from applying for credit? For example, are images of people in ads representative of your market area?
- Could they be construed as intimidating to certain prohibited bases groups you might not think of such as the handicapped, women, or the elderly?
- Do you advertise in a foreign language? If so are key terms and conditions also in the foreign language?
- Is your advertising broad based or targeted?
Discretion Permitted & Incentive/Compensation Programs
The next major area of a fair lending risk assessment is reviewing the level of discretion decision makers are given and the incentive and compensation programs used.
Allowing discretion has many benefits and, in fact, is usually used in the favor of the applicant or borrower. Incentives can be great motivators for a tough job.
However, the level of individual discretion permitted in certain activities, such as approvals or pricing, especially when coupled with incentives and compensation, significantly increases an institution’s fair lending risk.
In discussing Bank of America’s $335 Million discrimination settlement, Lisa Madigan, Attorney General, Illinois said, “Their compensation structure was such that a (loan officer) would make more money if they put people into a poor quality, higher priced loans.”
Centralized lending operations with clear and objective nondiscriminatory policies and procedures that are taught, followed, and monitored reduces the level of fair lending risk.
In assessing your fair lending risk consider such questions as:
- How much discretion do you give loan officers and other decision makers?
- Can they change key terms offered such as rate, term, fees, etc.?
- Can they vary the conditions for approval?
- Is compensation tied to loan production?
- Is compensation tied to higher priced or subprime type loans?
It’s probably impossible, or at least impractical, to try and have hard fast rules for every situation, but how an institution handles exceptions to policies and procedures has fair lending implications and is an important aspect of assessing your fair lending risk.
Are exceptions objective? Are they well documented? Are they few and far between? If not, consider changing the policy that is constantly being overridden. Do certain loan officers have a higher rate of requesting exceptions? Does analysis show any disparities?
Use of Third Parties
Third Party Operators (TPOs), such as mortgage brokers and auto dealers, offer legitimate opportunities to extend lending operations and enhance product offerings.
From a fair lending perspective, TPOs ARE the financial institution and if any TPO does not comply with fair lending regulations the financial institution may be as culpable as if you were the initial creditor and therefore are an important consideration in your fair lending risk assessment.
One common use of TPOS is in indirect lending. Indirect lending is when the retail establishment, such as an auto dealer or a furniture store, offers financing directly to the consumer, but uses a financial institution to fund the transaction.
Most indirect transaction will follow a 6-Step process as shown on Table 1. The potential for discrimination occurs in Step 4, where the dealer is allowed to set the actual rate.
Questions to consider for your fair lending risk assessment:
- Do you use TPOs?
- Is due diligence performed?
- Do you have written agreements addressing fair lending obligations?
- Do agreements define who is responsible and accountable?
- Do you receive regular reporting?
- Does the TPO have frequent complaints? Does the TPO conduct fair lending training?
Conducting a fair lending risk assessment focusing on marketing activities, discretion and compensation, exception handling, and the use of third parties will help identify areas of potential exposure and vulnerability. Once identified, you can then focus your efforts on ways to mitigate the risks. To view our Fair Lending Risk Assessment Scorecard click on the button below.
I think the following quote from the American Bankers Association sums things up pretty nicely, “Financial Institutions make loans to any and all qualified borrowers using sound underwriting and pricing decisions applied consistency and equally to similarly situated borrowers without regard to any prohibited basis, such as race, gender, or age. Fair Lending, then, is the natural state of bank credit operations.”