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Fair lending is currently a hot topic with examiners and is one of the highest risk areas for any financial institution. Consequences can be devastating to a bank or credit union, as formal actions from the Department of Justice often bring huge fines and penalties. Therefore, every financial institution should take steps to mitigate and assess their fair lending risks, and the first step to do this start with conducting a fair lending risk assessment.
When conducting a fair lending risk assessment - or using a fair lending risk assessment template - there are several different approaches that can be taken, though the goal of each is the same: to identify the unique fair lending risks that apply to a specific financial institution. My goal with this article is to help you understand the elements that should be included in conducting a fair lending risk assessment.
The first step in conducting a fair lending risk assessment is to understand the big picture goal of this process. According to the FDIC, a risk assessment is “an effort to identify and measure the risk inherent in the bank’s lending process and determine what control and monitoring mechanisms are in place to protect against illegal discrimination.” So in summary, your goal should be first look at your inherent risk - the risk before any mitigating factors (such as controls) are applied - and then evaluate how the established policies and procedures reduce that risk. The result will be your residual risk of fair lending for your organization.
Put another way, you are just trying to document what a financial institution has done to reduce fair lending risk in the organization.
The next step in conducting a fair lending risk assessment is to understand how the examiners cite fair lending violations. According the the Interagency Fair Lending Examination Procedures, the courts have recognized three different types of fair lending violations:
The first type of discrimination recognized by the courts is overt evidence of disparate treatment. This type of discrimination is defined as when a lender openly discriminates on a prohibited basis.
This type of discrimination is pretty easy to identify, but should not be that common. For example, if a lender says that they won’t lend to someone just because they are over 65, this is an example of overt evidence of disparate treatment. Over the years, I have really only heard of a few stories of blatant discrimination, though my favorite experience was when a lender said that he didn’t think that women could run businesses so he wouldn’t lend to women.
You can see the problem with that statement, can’t you? Apparently, he did not and that is a perfect example of why there are fair lending laws in the first place.
The trick with overt evidence of disparate treatment is that a financial institution (or lender) doesn’t have to act on the statement, they just have to say it. For example, if a lender says something like “we really don’t like to lend to Native Americans, but the law says we have too” and then proceeds to grant the loan, this is considered overt evidence of disparate treatment even though the loan was made.
The best way to assess fair lending risks associated with overt evidence of disparate treatment is to evaluate policies and fair lending training to ensure the bank has explained their expectations (and potential consequences) with their lenders.
Comparative evidence of disparate treatment occurs through an analysis of loan files where the result is that a protected class received less favorable terms than a control group. Most often, comparative evidence of disparate treatment is not intentional discrimination, but is the result of lender discretion.
In my opinion, discretion in underwriting is the single biggest contributor to comparative evidence of disparate treatment. The problem is that when lenders have discretion, there is a lack of consistency. Even if a lender is 100% consistent in how they underwrite and approve loans, the challenge is that they won’t be consistent with the other lenders in the organization. This inconsistency leads to increased risk when comparing the credit qualification of two applicants. For example, what often happens when lenders have discretion is that a denied applicant most likely would have been approved if they had only gone to a different lender. When that denied applicant is a protected class, this is problematic because a comparable loan (one with a very similar credit posture made to a control group applicant) was approved. The result of this discrepancy is comparative evidence of disparate treatment.
The best way to assess fair lending risk by comparative analysis is to identify how much discretion a lender has in the underwriting process. If a lender doesn’t have any discretion - meaning that all applications from the financial institution are evaluated the exact same way every time, such as is the case with some automated underwriting solutions, the result is that there is no fair lending risk of comparative evidence of disparate treatment. On the other hand, however, there will be significant fair lending risk when a financial institution allows their lenders to have full discretion in the underwriting process without any guidance of credit standards.
In addition to looking for discretion when evaluating fair lending risk, it is also important to evaluate how many exceptions to the established policies are made. The idea is that the more exceptions that are made, the greater the opportunity for comparative evidence of disparate treatment. If very few exceptions are made, the risk is greatly reduced.
The final type of discrimination recognized by the courts is 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. Basically, a specific policy of your financial institution can not inadvertently discriminate. That said, the rules do allow for certain policies if there is a “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.
In conducting a fair lending risk assessment, it is important to understand that the key is to identify and prioritize risk. When examiners find fair lending violations, they are identifying areas that lack specific controls to mitigate risk of discrimination. In fact, most of the civil money penalties from the Department of Justice (DOJ) are settlements rather than actual violations because fair lending violations can only be confirmed by the courts. This means that financial institutions should be concerned about identifying fair lending risk, rather than identifying actual fair lending violations.
For this reason, a fair lending risk assessment is an essential component to a compliance management system.
In assessing risk, a financial institution should evaluate all aspects of the lending process that could have risk for fair lending purposes. Under Regulation B and the Equal Credit Opportunity Act (ECOA), discrimination can occur during any part of the loan process. This means that fair lending risk can occur from the moment an applicant inquires about the loan process and continues on until the loan is paid off and any liens or mortgages are released.
To conduct a fair lending risk assessment, there are several areas that can be focused on to determine an overall risk level of discrimination and the opportunity for fair lending violations. I have broken the most important areas to consider into the following three categories:
The Institution’s History of Fair Lending Compliance
Internal Factors Affecting Risk of Discrimination
External Factors Affecting Risk of Discrimination
In conducting a fair lending risk assessment, the first thing to evaluate is a financial institution’s past experiences relating to fair lending. The idea is that if a bank or credit union has a history of fair lending violations, the inherent risk of additional violations is increased. While a history of not having prior fair lending concerns does not ensure that a financial institution will not have any issues going forward, my experience is that organizational cultures are difficult to change. This often means that significant changes must occur to eliminate fair lending risk once it is established. Therefore, the prior history of fair lending compliance can be indicative of fair lending risk.
In assessing an institution’s history of compliance, there are a few things that should be considered.
The first thing to do in evaluating a bank or credit union’s history of fair lending compliance is to determine whether past reviews of fair lending have identified any findings. If prior deficiencies have been identified, the associated risk-level of those findings should be evaluated meaning that a large number of high-priority findings would present greater risk than just a few low-risk recommendations.
In addition to evaluating prior identified deficiencies relating to fair lending, it is important to also consider the mitigating factors that might have an effect on the residual risk of an organization. One of the main mitigating factors that should be evaluated is to determine what corrective actions were taken to both correct noted deficiencies as well as prevent future issues from occurring again. A bank or credit union that has a thorough process for correcting identified deficiencies is going to have less residual risk than one that does not make appropriate corrections and has a history of repeat findings.
A final factor to consider when evaluating an institution’s history of fair lending compliance is to review any complaints received by the organization that relate to potential discrimination and fair lending laws. In evaluating complaints, it is important to consider things like the volume and severity of the complaints received as well as management’s process for responding to complaints. Just as it is important to correct identified fair lending deficiencies discovered during a fair lending review, a lack of correcting issues noted in complaints can result in an increased risk of future discrimination.
The ultimate goal of this part of a fair lending risk assessment is to consider the organization’s history of compliance with fair lending laws and regulations.
The next step in conducting a fair lending risk assessment is to evaluate the internal factors of an organization that impact the overall risk of discrimination. Internal factors can have a significant impact on the overall risk of discrimination and violations of fair lending laws and regulations.
In looking at the internal factors that affect fair lending risk, the first thing I like to do is to look at what fair lending training has been performed in the financial institution. The reality is that an organization who conducts significant amounts of in-depth fair lending training has a reduced risk of discrimination compared to an organization that does not conduct any training. Of course, training does not eliminate fair lending risk, but I have found that a lack of any such training results in a lack of understanding of what the rules actually are, meaning that violations can more easily occur, even if inadvertently.
The next internal factor to consider in evaluating fair lending risk is the structure and complexity of the organization. By nature, large and complex organizations are going to have elevated risk while small and simple organizations are going to have reduced risk. In evaluating the complexity and structure of an organization, it is important to evaluate a few things. First, the number and complexity of loan products can increase or reduce the overall risk of discrimination. Additionally, the volume of transaction as well as the number and location of lenders in the organization can have a direct impact on the overall risk of the bank or credit union.
The depth of policies and procedures relating to certain aspects of fair lending compliance can have a significant impact on a fair lending risk assessment. Specifically, there are several controls that a financial institution can implement that, when effectively implemented, can significantly reduce fair lending risk.
First, it is important to understand how discretion in the underwriting process elevates the overall risk of an organization. Discretion can be the single biggest factor to elevate fair lending risk of an organization. Therefore, when conducting a fair lending risk assessment, it is important to evaluate how much discretion lenders have during the underwriting process. If the underwriting process is centralized and automated, fair lending risk will be significantly reduced or even eliminated all together. On the other hand, significant amount of discretion in the underwriting process will result in great amounts of fair lending risk, especially from a perspective of comparative evidence of disparate treatment.
The next internal factor to consider is the institution’s override program. Overrides are when an organization permits a deviation from the normal underwriting standard. While overrides may be appropriate in some cases, deviations from an established policy increase the risk of comparative evidence of disparate treatment. Therefore, override programs should be evaluated by looking at the volume of approved overrides, the process for submitting and tracking overrides, as well as the management and evaluation of overrides.
In conjunction with evaluating an override program, it is important to also evaluate how an institution reviews denied applications to ensure they could not have been approved another way. For example, comparative evidence of disparate treatment could occur when a loan approved based on an override/exception to policy is compared to a denied loan that was never considered for a similar exception. Therefore, a denial review process that evaluates opportunities to approve loans can help to reduce fair lending risk.
Finally, it is important to evaluate compensation agreements for fair lending impact. If a compensation agreement is designed in a way that incentives lenders to only lend to certain people or only offer certain loans, fair lending violations can result from inadvertent misdirection. Therefore, a lack of compensation incentives should reduce an institution’s fair lending risk while significant incentives should increase the fair lending risk of the organization.
The final step in conducting a fair lending risk assessment is to review the external factors that could have an affect on the fair lending risk of an organization. While external factors will vary from one organization to another, there are a few key things to be considered.
The first external factor to consider during a risk assessment is the demographics of the customer base of the institution. For example, a one branch bank in a rural town in the midwest may live in a census tract with very limited minorities. Therefore, the fair lending risk from the customer demographics is naturally going to be less than the risk of a 25 branch institution located in Chicago and its suburbs.
The next external factor to consider in evaluating fair lending risk is to look at any loans performed by affiliates or brokers. An affiliate of a bank or credit union can be evaluated the same way as the bank or credit union itself, resulting in penalties for the affiliated organization. In addition, a broker is often representing the financial institution and can ultimately have a negative effect on the fair lending risk of an organization.Therefore, it is important to consider the similarity of controls and other factors of an affiliate compared to the organization.
The final external factor to consider in evaluating fair lending risk is to determine whether the institution has any indirect lending relationships. The challenge with indirect lending relationships is that they are often set up in a way that an auto deal has discretion in pricing, which is an incentive for them to make more money and do more loans with the financial institution. The challenge with this, of course, is that the financial institution is ultimately responsible for monitoring for effects of discretion on the part of the auto deal. Therefore, indirect lending relationships should also be included in a fair lending risk assessment.
The following articles on fair lending may assist you with your risk assessment process:
On November 1, 2024, the CFPB filed a proposed order to resolve its case against Townstone Financial for discriminatory lending practices and redlining African American neighborhoods in Chicago. The proposed order would prohibit Townstone from taking any actions that violate the Equal Credit Opportunity Act (ECOA) and require the company to pay a $105,000 penalty to the CFPB’s victims relief fund.
On October 15, 2024, the CFPB and the DOJ took action against Fairway Independent Mortgage Corporation for illegal mortgage lending discrimination against majority-Black neighborhoods in the greater Birmingham, Alabama area. According to the CFPB and DOJ, Fairway illegally redlined Black neighborhoods, including through its marketing and sales actions, by discouraging people from applying for mortgage loans in the Birmingham metropolitan area’s Black neighborhoods.
On September 18, 2024, the HUD announced the approval of a Conciliation Agreement with OceanFirst Bank for engaging in redlining by restricting access to credit and mortgage lending services in majority-Black, Hispanic, and Asian neighborhoods in the New Brunswick, New Jersey area. The HUD’s investigation was conducted alongside the DOJ after a referral from the OCC.
On July 15, 2024, the HUD charged multiple entities with housing discrimination for issuing a biased appraisal and then denying a refinance loan application in Denver, Colorado. HUD charged appraiser Maksym Mykhailyna, appraisal company Maverick Appraisal Group, appraisal management company Solidifi U.S. Inc. and lender Rocket Mortgage, LLC.
On July 17, 2024, the CFPB, FDIC, FHFA, FRB, NCUA, and OCC jointly issued a final rule, pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, designed to help ensure the credibility and integrity of models used in valuations for certain mortgages secured by a consumer's principal dwelling. In particular, the rule will implement quality control standards for automated valuation models (AVMs) used by mortgage originators and secondary market issuers in valuing those homes.
On June 26, 2024, the CFPB released its Fair Lending Annual Report to Congress, describing the Bureau’s fair lending activities in enforcement, guidance and rulemaking, interagency coordination, and outreach and activities for calendar year 2023. Specifically. The Fair Lending Annual Report to Congress fulfills the Bureau’s statutory responsibility to report annually to Congress on public enforcement actions taken under the ECOA as well as the utility of the HMDA’s mortgage loan data collection requirements.
In this Compliance Clip (video), Adam explains a number of ways the examiners may identify redlining in an organization. In addition, he breaks down the different types of comparative evidence and overt evidence that could result in redlining. This video provides a great framework for understanding how redlining could appear in your financial institution.
On May 13, 2024, the HUD announced that it has entered into a Conciliation Agreement with Rocket Mortgage, LLC resolving allegations that Rocket Mortgage denied a mortgage loan application based on race because the home being purchased was located within the Tribal boundaries of a federally recognized reservation.
In this Compliance Clip (video), Adam explains what redlining is. In particular, Adam discusses the different definitions provided by the regulators as well as the different forms of redlining. A transcript of this video is now available.
In this Compliance Clip (video), Adam discusses what a protected class is under fair lending. In particular, Adam talks about the protected classes under the two fair lending laws: Fair Housing Act and ECOA., and how they differ as well as how they overlap. A transcript of this video is now available.
