Fair Lending: What Examiners are Finding (5 Action Steps)
Note: special thanks to Mollie Newsome Sudhoff for research and assistance with this article.
Fair lending is not new. Lenders have been dealing with fair lending laws for three decades. So what's the big deal?
If fair lending was easy it wouldn't continue to be a major risk management challenge. Designing and managing a fair lending program is not easy. The rules are unchanged. What has changed are tools and the environment. Today's bankers, regulators, community groups and others have more means for identifying, tracking and analyzing patterns and practices of violations of fair lending laws than ever before. Given the regulators' mandate to refer fair lending cases to the U.S. Department of Justice where warranted, this is quite a substantial risk area for banks and other financial institutions.
What Examiners are Finding
The fastest way to predict what may be risky is to learn what examiners are finding and reporting. We spoke - off the record - with several representatives of regulatory agencies. The most frequent issues they discussed with us as troubling include the following.:
- Offering "Club Accounts" with combined credit and debit features that offer more favorable credit terms to individuals 55 and older.
- Requiring non-owner spouses to sign business loans.
- Grossing up income for some and not for others, without following a consistent practice.
- Not counting child support where the applicant has freely chosen to offer the income on the application for credit.
- Adding a hypothetical housing expense where the applicant is living with a parent or some other individual and lists no housing expense on the application.
- Aggregating married applicants' incomes, but taking the higher of the two for non-married applicants.
Where's the Beef?
In one way or another, each of these practices runs afoul of fair lending laws. In the case of Club accounts, Regulation B only allows such age based benefits to be offered to individuals 62 and older. On its face it may seem like a great product and some vendors may tell you they are selling this product to banks all over the country, but it is still a product which is in violation of the age provisions in Regulation B.
In the case of spousal signatures, requiring a non-applicant spouse to co-sign or guarantee a loan has long been a prohibited practice but commercial lenders continue to think that Regulation B does not apply to their loans and many continue to seek as many signatures as possible. Regulator concerns about this practice have resulted in changes to Regulation B and an FDIC Financial Institutions Letter 6-2004. Both issuances deal with consumer as well as commercial loans. Regulators are now requiring that joint applicants affirm their wishes to be a joint applicant and expect to find documentation in the loan file that demonstrates the applicants' intent.
Grossing up non-taxable income is designed to show the after-tax value of some types of income such as child support, workers compensation, some disability payments, some social security payments, foster care payments or other non-taxable income. When grossing up income, banks need to be consistent. It is problematic to gross up some types of non-taxable income and not others. Most troubling to regulators is the exclusion of child support where the applicant is relying on the income to support the loan.
As more and more young people live at home after high school or college a less obvious problem may result from a practice where lenders add a hypothetical housing expense to the debt-to-income ratio assuming that the applicant will not always live at home. This practice has its origins in the financing of used automobiles and other higher risk credit, but has crept into the analysis of less risky financings. This practice may have the impact of discriminating against younger applicants since it assumes that the housing expense will increase without a requisite or probable increase in income when, and if, the applicant later moves on to his or her own place. The fair lending laws prohibit creditors from making assumptions about the future living arrangements of borrowers.
While bankers rarely, if ever, specifically plan to discriminate, practices such as those above and those such as giving more weight to married applicants' incomes versus those who apply jointly but are not married, (but may be living together and sharing expenses etc.) has the same effect as discriminating against the unmarried applicant. It limits the value of their income because of their marital status. This is a practice that should be avoided just as giving less weight to part time income would also be a violation of Regulation B.
One recent case, CitiFinancial announced in May 2004, illustrates how compliance problems can happen. Someone in CitiFinancial's management (who may not have fully understood the implications of Regulation B's signature rules) made a push to increase insurance sales by increasing the number of eligible applicants. Unfortunately, this was done by requiring co-signers - which violated Regulation B. The CitiFinancial order calls for, among other things, restitution of the difference between the individual and the joint insurance policies plus any interest paid thereon. This, along with other restitution required by the Order, may cost the institution another $20,000,000.
How Does This Happen?
It is frighteningly easy for practices to emerge or products to be developed that raise fair lending issues. It happens when someone in a line of business simply copes with a situation at hand or develops a strategy to meet a goal without taking into account the possibility of compliance consequences. When examiners say they expect you to have a fair lending program, what they are looking for is a process and environment that build compliance considerations into product development and delivery - rather than finding them in an audit or examination.
Managing risk is making sure that problems don't happen in your institution. To proactively address fair lending risk, start with a critical review of polices and procedures. Look for any issues that could cause or result in discrimination. Regulators continue to be amazed by how many times they find discriminatory language right in the policies that lead lenders astray.
Next, look at how much exposure is inherent in your products and the way they are sold. Do you use brokers who may have different compliance expectations? How much control is there over lending and pricing decisions, such as using a computer based underwriting program or even a simple checklist.Be sure that your program actively includes regular and frequent employee training on fair lending issues as these relate to the types of products offered by the bank. Then there is marketing. Your marketing materials should contain fair and affirmative statements about product offerings and no negative or discriminatory insinuations. Your examiner will review all marketing for compliance with fair lending laws.
Examiners will also consider the attitude of management. While you may not be able to determine management's attitude, you can make sure that management understands the implications of fairness and how these impact the portfolio from a risk management perspective.
- Review marketing material to ensure that it presents the image that the institution is a fair and reputable lender.
- Review (or create) procedures for new product development that include an assessment of fair lending consequences. Be sure compliance is part of the process.
- Conduct regular monitoring and auditing for fair lending compliance including an assessment of business practices and business goals.
- Review existing staff incentives and determine whether they motivate fair lending or discrimination.
- Check your training calendar to be sure training is current for all staff.
Copyright © 2004 Compliance Action. Originally appeared in Compliance Action, Vol. 9, No. 9, 9/04
First published on 09/01/2004