Fair Lending Risk - Disparate Impact

As we conclude our series on conducting a fair lending risk assessment, today's topic is the third type of discrimination recognized by the courts: disparate impact. 

As we discussed when discussing how to assess fair lending risk, there are three types of fair lending recognized by the courts that should be included in any fair lending risk assessment template:

1. Overt evidence of disparate treatment
2. Comparative evidence of disparate treatment
3. Evidence of disparate impact

Understanding Disparate Impact

Disparate impact is when a lender applies a racially or otherwise neutral policy or practice equally to all credit applicants, but the policy or practice disproportionately excludes or burdens certain persons on a prohibited basis.  In other words, a specific policy of your financial institution can not inadvertently discriminate.  

The interagency examination procedures on fair lending explain disparate impact this way:

“When a lender applies a racially or otherwise neutral policy or practice equally to all credit applicants, but the policy or practice disproportionately excludes or burdens certain persons on a prohibited basis, the policy or practice is described as having a disparate impact.”

Examples of Disparate Impact

Most cases of disparate impact result from an underwriting or product policy that has a negative effect on lower income applicants, which often include protected class individuals such as the elderly (defined as 62 or older), single women, and minorities.

For example, let’s assume that a credit union has a policy to not offer loans for single family residences for an amount of less than $60,000.00. After a period of time passes, such as ten years, this minimum loan amount policy may show to disproportionately exclude potential minority applicants from consideration because of their income levels or the value of the houses in the areas in which they live.

In addition to a minimum loan amount, disparate impact can occur from other policies.  For example, I once encountered a financial institution that had a minimum income requirement of around $40,000 for an individual credit card applicant.  As this product was only available to individuals and did not allow for co-signers, a minimum income amount of $40,000 could easily have a disproportionate effect on single women, minorities, and the elderly (not to mention many of the banks own employees).  When I discussed my concern with the financial institution, they explained that this policy had been around for years, but that they only opened one or two credit cards a year.  In this case, the fair lending risk of the product far outweighed the profits produced from the product.

An Acceptable Business Necessity        

While financial institutions must be careful that they policies do not have an adverse effect on protected class applicants, rules do allow for certain policies - such as a minimum loan amount - if there is a justified “business necessity.

For example, a minimum loan amount of $500,000 on mortgage loans would most likely have disparate impact on the elderly, young individuals, single women applicants, and minorities.  On the other hand, a minimum loan amount of $20,000 may also have some impact, but may be permitted if that is the lowest loan amount a bank can lend and still break even.  The challenge with the business necessity is to be able to document it.

The interagency examination procedures on fair lending explain a business necessity this way:

“The fact that a policy or practice creates a disparity on a prohibited basis is not alone proof of a violation. When an Agency finds that a lender’s policy or practice has a disparate impact, the next step is to seek to determine whether the policy or practice is justified by “business necessity.” The justification must be manifest and may not be hypothetical or speculative. Factors that may be relevant to the justification could include cost and profitability. 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 less discriminatory effect. Finally, evidence of discriminatory intent is not necessary to establish that a lender's adoption or implementation of a policy or practice that has a disparate impact is in violation of the FHAct or ECOA.”

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