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A Fair Lending Compliance Update for Directors

POV 03.19.2010

This article appeared in the January issue of Western Independent Banker Director’s Digest.

Consumer protection has become a primary focus of bank regulatory agencies. This emphasis has put fair lending compliance front and center for 2010. Regulatory agencies have begun giving more specific recommendations and providing directives to banks to improve their fair lending efforts. A bad fair lending examination subjects a financial institution to extensive costs, both in potential civil money penalties and remediation expenses.

Directors are expected to provide oversight on the quality of bank’s management attention to this important area of regulatory compliance. The following is a brief overview of the fair lending regulatory structure and some essential elements of fair lending compliance.

The term “fair lending” encompasses two major laws – The Fair Housing Act and The Equal Credit Opportunity Act. Under that legal structure, the federal functional regulators issued a guidance in 1994 to further clarify their expectations. The guidance lists three types of evidence indicating that an institution is engaging in illegal discrimination. These include overt evidence – such as actual statements of discriminatory preference (i.e., “I don’t like to make loans to women”). Evidence can also be more subtle – such as disparate treatment – whereby the bank’s behavior may not be intentional, but if a protected class of borrowers is treated differently and there is no other explanation for the treatment, it will be considered discriminatory. For example if a protected class of people (i.e., women or racial minorities) have higher interest rates on their loans, and there is no apparent reason related to the borrowers’ credit histories, it will be deemed to be due to the prohibited basis and be illegal discrimination. Finally, a bank’s policy can be straightforward and applied to everyone consistently and still impact protected borrowers negatively. This type of practice is called disparate impact and it’s not always considered to be illegal if the practice is a business necessity.

Here are some fair lending hot spots to watch for:

  1. Risk Assessments
    The regulators are expecting financial institutions to conduct formal fair lending risk assessments. The risk assessment should consider the bank’s products and practices and make a determination of the institution’s level of risks across its products, branches, customer base, etc. An effective fair lending risk assessment will help an institution allocate scarce resources to the most high risk areas.
  2. Self Evaluations
    In the past some institutions have been hesitant to conduct fair lending audits. Bank management’s rationale was that a written evaluation, or audit, would just bring any problems to light and would give examiners a roadmap to an enforcement action. However, in the current environment, this position is a dangerous one. Institutions can count on having a fair lending examination at some time and any illegal behavior will be uncovered without the bank having an opportunity to remediate it in advance. It is much better to ferret out problems and fix them before examiners find them.
  3. Consumer Lending
    Consumer lending always receives scrutiny in a fair lending examination, so all practices in this bank functional area should be reviewed. One high risk practices (that is still quite widespread) is allowing lenders the discretion to set interest rates. This practice allows so much pricing latitude that it’s easy to have inconsistency in the treatment of borrowers. An effective control is the managed use of rate sheets so that lenders within the same market have a common benchmark to use in setting rates. Not only should rate sheets be distributed but policy should describe how to use them and exceptions should be approved and reported.
  4. Mortgage Lending
    Due to the requirement to report data on mortgage loans annually, these loans lend themselves to statistical analysis and therefore, can be a high risk area. Institutions should have specific, well-monitored policies governing its mortgage lending practices. Another best practice is to conduct an analysis of the bank’s Home Mortgage Disclosure Act (HMDA) data before the regulators do. Bank management should determine what these data indicate in order to make any necessary changes to its mortgage lending policies and practices.
  5. Commercial Lending
    Many bankers are not aware that all fair lending laws and regulations apply to commercial loans as well as consumer. Commercial lending is usually less regulated in policies and pricing practices, so it can be a high risk area also.

Institutions can expect fair lending scrutiny in 2010. All directors should be aware of the basic requirements of these regulations as well as how the bank manages these risks.