Mitigating Fair Lending Risks: Understanding Disparate Impact

Jon Tavares
Jon Tavares – Senior Compliance Advisor

Did you know you can unintentionally engage in discrimination? Regulators recognize three main categories of discrimination concerning fair lending: Overt Discrimination, Disparate Treatment, and Disparate Impact. While many are familiar with overt discrimination and disparate treatment, disparate impact often poses challenges. Understanding and addressing disparate impact is crucial for ensuring fair lending practices. In this article, we will delve into the concept of disparate impact, its implications for financial institutions, and strategies to mitigate associated risks.

Understanding Disparate Impact:

Disparate impact occurs when a seemingly neutral policy or practice leads to disproportionately negative outcomes for a group based on a prohibited factor. For instance, setting a minimum auto loan amount at $45,000 may seem neutral but could be discriminatory if it disproportionately affects minority applicants with lower incomes who wouldn’t qualify for such a high loan amount.

Given that disparate impact can arise innocuously, courts and, subsequently, regulators have developed a burden-shifting mechanism to determine its legality under fair lending laws. Once a claimant or regulator demonstrates that a neutral policy results in adverse outcomes based on prohibited factors, the burden shifts to the financial institution to justify the policy with a legitimate business necessity. If the institution can provide such justification, the burden returns to the claimant or regulator to propose less discriminatory alternatives. If the claimant cannot show that the lender’s legitimate business necessity can be achieved in a less discriminatory manner, the lender cannot be held liable for a fair lending violation.

Defining Legitimate Business Necessity:

A key aspect of addressing disparate impact is defining legitimate business necessity. A legitimate business necessity is not quite what it sounds like; it’s a bit of a misnomer. While the term “legitimate” implies a genuine justification, “business necessity” refers to actions that achieve a business goal. It’s essential to understand that necessity doesn’t mean vital for business survival but rather serving a legitimate business purpose or advancing a legitimate business goal. For example, a lender might argue that a minimum auto loan amount of $45,000 is necessary to cover the costs associated with underwriting and lien perfection.

Identifying Potential Risks:

Creating any policy or program carries inherent risks of disparate impact. Financial institutions must be vigilant and proactive in identifying potential risks associated with their lending practices. Special loan programs targeting specific professions, such as military personnel and first responders, may inadvertently lead to disproportionate impacts on certain demographic groups, such as females. Recognizing these risks is the first step toward effective risk mitigation.

Mitigating Disparate Impact Risks:

To minimize the risk of disparate impact, financial institutions should adopt proactive measures and thoughtful strategies:

  • Rationale and Business Goals: When developing new loan products or policies, institutions should clearly articulate the rationale behind the program and identify specific business goals it aims to achieve.
  • Impact Assessment: Conducting a thorough impact assessment is crucial. Institutions must analyze the potential effects of their policies on different demographic groups to identify any disproportionate impacts.
  • Alternative Policies: Exploring alternative policies and practices can help mitigate disparate impact risks. Institutions should consider whether there are less discriminatory ways to achieve their business goals without disproportionately harming protected groups.
  • Inclusive Program Design: Expanding eligibility criteria to include a broader range of demographic groups can help mitigate disparate impact. For example, extending special loan programs to professions with diverse demographics can promote inclusivity.
  • Continuous Monitoring and Review: Regular monitoring and review of lending practices are essential for detecting and addressing any emerging disparities. Institutions should establish mechanisms for ongoing evaluation and adjustment of their policies to ensure compliance with fair lending laws.

For example, many financial institutions have a special loan program for military and first responders. Their rationale and business goal for such programs could be supporting servicemembers and first responders as a way to engage with and contribute to their communities and demonstrate their commitment to supporting those who serve and protect their communities. If the population of first responders and servicemembers in the financial institution’s lending area compared to the whole population of the lending area is disproportionately male, offering a special loan would disproportionately adversely affect female borrowers. In other words, a higher percentage of female applicants would not qualify for the special loan terms as male applicants. After considering alternative policies and considering an inclusive program design a financial institution could include professions such as teachers (a predominantly female profession) to be more inclusive and mitigate the risk of disproportionately harming female applicants. After implementing the new loan program, the financial institution would monitor and review the number of applicants and approvals under the new program compared to its entire portfolio to see if they have successfully mitigated its risks and to consider if further adjustments are necessary to ensure they achieve their business goal in the least discriminatory manner.


Ensuring fair lending practices is a fundamental responsibility of financial institutions. By understanding the concept of disparate impact and implementing proactive measures to mitigate associated risks, institutions can promote equitable treatment for all applicants while advancing their business objectives responsibly. Embracing inclusivity and diversity in lending practices not only fosters trust and goodwill within communities but also strengthens the overall integrity of the financial system.

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Jon Tavares
Jon Tavares – Senior Compliance Advisor