Fair Lending Refresher
You might say that illegal discrimination is the most distasteful subject in compliance. It’s distasteful because no one wants to be biased or prejudiced. Still, it’s also the most dangerous subject in banking because the overall cost of a serious fair lending violation can be catastrophic to a financial institution, not only from a financial perspective but also due to reputation loss.
Every industry has employees that face rules about illegal discrimination, but I’m not aware of any industry that is as highly regulated on the matter as banking. The primary purpose of the Fair Lending regulations is to promote the availability of credit to all applicants in any aspect of the credit transaction. Fair Lending covers the actions of a creditor before, during, and after a credit transaction. This includes all types of credit: consumer credit, business credit, mortgages, open-end credit, closed-end credit… essentially any aspect of any credit transaction is covered by the rules imposed under the fair lending regulations.
When it comes to credit transactions, a creditor cannot discriminate against any applicant on the basis of the applicant’s race, color, national origin, sex, religion, marital status, age, the fact that all or any part of the applicant’s income is derived from any public assistance program, the fact that the applicant has in good faith exercised any rights under the Consumer Credit Protection Act, handicap, or familial status. The prohibition against sex discrimination under the Equal Credit Opportunity Act (ECOA) and Regulation B includes sexual orientation discrimination and gender identity discrimination. These categories are otherwise known as “prohibited basis” categories.
The prohibition on discrimination extends from advertising, product offering, and initial contact to servicing, loss mitigation, and extinguishing the loan. Also, keep in mind that these same types of equal treatment or “Fair Banking” concepts apply to deposit relationships as well via UDAAP and other state and federal laws.
Through the years, institutions have repeatedly been accused of discrimination in their lending practices, and in particular, with respect to mortgage lending. The Department of Justice and private plaintiffs have brought lawsuits against several financial institutions. While some of the private cases involve individual allegations of discrimination, most involve patterns of discriminatory practice. In other words, does the institution engage in a more general practice of discrimination in its lending practices?
In order to assess discrimination, the agencies have identified three types of illegal credit discrimination:
Overt discrimination. Overt discrimination occurs when the lending practice is discriminatory in its face. That is when a lender directly and intentionally turns down a qualified applicant or sets adverse loan terms based on prohibited factors like race or gender.
Disparate Treatment. Disparate treatment is when similarly qualified customers are treated differently based on a prohibited factor.
Disparate Impact. Disparate impact is the use of a policy or practice that is neutral on its face but has a disproportionately adverse effect on a protected group and that cannot be justified by business necessity.
Let’s take a deeper dive and look at these types of discrimination in more detail:
Discouraging applicants to apply for credit or offering different credit terms based on any one of the prohibited bases is overt discrimination. For example, a loan officer who tells a coworker that women are worse at repaying debt than men are, so the loan officer charges a higher rate of interest based on a female applicant’s gender has committed overt discrimination.
That would be discriminatory on its face. Now, if you have such a person within your institution, not only is this person likely unpleasant to be around, but action should be taken immediately. Another example of overt discrimination is when an institution offers a credit card with a limit of up to $750 for applicants aged 21 through 30 and $1,500 for applicants over 30. This policy violates the ECOA’s prohibition on discrimination based on age.
There is evidence of overt discrimination even when an institution expresses but does not act on a discriminatory preference. For example, a lending officer told a customer, ‘We do not like to make home mortgages to Native Americans, but the law says we can’t discriminate, and we have to comply with the law.’ This type of blatant statement violates the prohibition to discourage applicants on a prohibited basis under Regulation B.
Disparate treatment, the second type of discrimination, covers every aspect of the lending process. It can be found when a lender has neutral credit policies but applies them inconsistently in a way that adversely impacts borrowers who fall under a particular prohibited basis. In other words, an individual who falls under a prohibited basis, which we also refer to as a target group, is treated less favorably than a similarly situated individual who does not fall under a prohibited basis, which we also refer to as the control group.
For example, let’s say an institution requires auto loan customers to have monthly debt payments of less than 40 percent of their gross monthly income. If the institution denies a female applicant based on that rule but makes a policy exception and approves a male applicant in similar circumstances, this may be considered disparate treatment. Lenders often have a legitimate, business-related reason to ‘bend the rules’ for a particular applicant. If this is the case, it is possible that no violation of any fair lending laws occurred, but this is where documentation is critical. A lender should always keep a log of exceptions to policy. The details of this log should include the mitigating circumstances that persuaded the lender to make the exception. This ensures the reviewer or examiner can differentiate between the credit decisioning between the two applicants and can clearly see why one applicant was denied, and one was approved despite the general lender policy.
The last category of discrimination is disparate impact, which occurs when a lender adopts a neutral policy on its face, and applies it consistently, but the policy causes a ‘disproportionate adverse impact’ on target group applicants. Although income is not a prohibited basis, examiners have long recognized that areas with moderate to low income tend to have higher concentrations of target group borrowers. Therefore, whenever you treat borrowers differently in moderate to low-income areas, you significantly increase your fair lending risk.
For example, it is a necessity for any business to make a profit. Life would be easy if creditors could lend money interest-free, but life would not last for very long. Examples often given include policies that a creditor will not make a loan on a residence with one bedroom or one car garage or secure a loan with a residence of a certain age. The point is that examiners have determined that those residences are typically lower in value, therefore, are purchased by low to moderate-income persons, which could result in limiting financing options for target group borrowers, creating the potential for disparate impact.
It is important to note that a policy or practice that creates a disparity on a prohibited basis is not necessarily proof of a violation. The apparent disparate impact may be legal if there is a business necessity for the policy or practice and there is no alternative policy or practice that is less discriminatory. Make sure to review your institutions’ lending policies and look for the potential of disparate impact as well as monitor for disparate impact on a regular basis. If you uncover disparate impact, ensure the business justification is manifest, meaning it may not be hypothetical or speculative. Even if a policy or practice that has a disparate impact on a prohibited basis can be justified by business necessity, it still may be found to be in violation if an alternative policy or practice could serve the same purpose with a less discriminatory effect.
If you discover any fair lending issues or have any other compliance concerns and you would like to get our advice, please reach out to us through a consultation request. We are here to help!