Fair Lending is High on the Regulatory Radar - Are You Ready?
Fair Lending is High on the Regulatory Radar — Are You Ready?
Internal auditors can help call attention to lending discrimination and compliance issues with federal regulations.
Bruce Zaret, CPA
Partner, Advisory Services
Senior Associate II, Advisory Services
What is “fair?” Many would say the word fair is subject to an individual’s interpretation within a certain set of facts and circumstances. However, in the U.S. financial services world, bank regulators have provided guidelines to help us understand how “fair” should be interpreted. Due to current economic conditions, loan delinquencies are rising and interest rates are at their lowest levels in decades, causing many consumers to seek to have their loans either restructured or refinanced. This increase in mortgage-lending activities is exposing banks to the potential for fair lending violations.
Though fair lending laws are not new, bank officers and internal auditors may benefit from a reminder on the importance of a comprehensive and effective fair lending program. The consequences of not fully complying with fair lending regulations may be severe — not only financially, but also from a reputation perspective.
KEY ASPECTS OF COMPLYING WITH FAIR LENDING REQUIREMENTS
Understanding what should be included in an effective fair lending program begins with a working knowledge of three federal acts.
Equal Credit Opportunity Act
Enacted in 1974, the Equal Credit Opportunity Act (ECOA), prohibits creditors from discriminating against an applicant in any aspect of a credit transaction based on race, color, religion, national origin, gender, marital status, age, income derived from any public assistance program, or any exercise of rights allowed under the Consumer Credit Protection Act. The ECOA applies to all extensions of credit, including those made to small businesses, corporations, partnerships, and trusts.
Fair Housing Act
The Fair Housing Act was sanctioned in 1968 as Title VIII of the Civil Rights Act. It prohibits discrimination in housing-related transactions. Covered activities include loans, purchases and rentals, and appraisal and brokerage services. Discrimination criteria not allowed under the Fair Housing Act include race or color, religion, national origin, gender, familial status, or disability.
Home Mortgage Disclosure Act
Legislated in 1975, the Home Mortgage Disclosure Act (HMDA) requires lending institutions to annually compile and disclose information regarding home purchases, pre-approvals for home purchases, transactions related to home improvements, and refinance applications related to single-family and multi-family dwellings. Reporting requirements include the Loan Application Register (LAR), which is used to identify disparities in lending practices. One of the most noted deficiencies in recent bank examinations includes completeness of the HMDA LAR. Inaccurate collection and reporting of HMDA data has resulted in significant violations subjecting institutions to significant civil money penalties. Effective training, a strong internal monitoring system, and audit procedures that identify and address the underlying causes of violations are instrumental to ensuring that HMDA data is effectively recorded in the LAR.
WHAT IS LENDING DISCRIMINATION?
When banks, governments, or other lending institutions deny loans to people on the basis of race, ethic origin, sex, or religion, they are practicing lending discrimination. To appropriately evaluate the effectiveness of a fair lending program an auditor should have good understanding of the various forms of discrimination, of which there are three general classifications — overt disparate treatment, comparative disparate treatment, and disparate impact.
Overt disparate treatment includes instances in which applicants are treated differently in ways that violate applicable fair lending standards. Such instances include situations where lending limits, interest rates, or other terms are defined according to age, gender, race, or other prohibited discriminatory criteria.
Comparative disparate treatment occurs when analysis reveals that certain individuals were treated differently, without regard to conscious intent. Such analysis might reveal, for example, that based on race, some applicants were deemed to have unacceptable credit histories while others with essentially the same credit histories were granted loans.
Disparate impact exists when an otherwise neutral policy or practice has a disproportionate effect on certain individuals. High minimum loan thresholds might keep certain individuals within a set of age ranges or races from purchasing homes in a particular area. Such a practice may be construed to illustrate disparate treatment. Such a practice may be construed to illustrate disparate impact. Disparate impact is a prohibited discriminatory practice that may subject the bank to civil money penalties and sanctions from its primary regulator.
Evaluating whether the prescribed fair lending criteria are followed may be subject to interpretation rather than clear-cut validation of rules. Auditors evaluating a fair lending program should consider:
- Types of credit products offered.
- Credit terms offered.
- Credit markets served (consumer, commercial, and residential).
- Special programs for underserved populations.
- Demographic information regarding the institution’s credit markets.
- Decision-making processes regarding credit.
- Loan officer or broker compensation.
- Loan product documentation.
- Availability and ease of assembling relevant documentation.
Understanding these elements will help internal auditors develop focal points for a fair lending review based on the risks and vulnerabilities in the program. Some focal points may address the financial impact associated with high volumes of transactions while others may concentrate on lower volumes of transactions that present greater risk of discriminatory conduct.
Evaluating a bank’s fair lending self-assessment also will provide direction in determining the scope of the audit. Ideally, a self-assessment will include narrative comments regarding each component of risk, adverse findings from previous regulatory examinations, and the corrective action taken by management to address those concerns. A risk-based approach to reviewing potentially high-risk areas and adverse findings from previous audits and examinations should be used to ensure that primary areas of concern are adequately addressed.
Accuracy of data compiled for compliance purposes should be examined. Procedures include comparisons of internal data compiled for loan applicants and transactions against information included in the institution’s LAR.
Regulation B serves as the implementing regulation for ECOA and defines activities and practices specifically prohibited by the act. Checklists based on Regulation B also will help auditors assess whether the institution is in compliance with fair lending requirements.
An institution may have valid reasons for granting different pricing, terms, and conditions to various applicants and the auditor should evaluate whether the differences offered constitute disparate treatment. There are other areas or situations to pay attention to when thinking about fair lending.
- A loan officer or broker may have latitude to suggest a loan product that may appear more appropriate for a particular applicant. However, if prohibited factors are involved, a lender’s action could be construed as discriminatory steering, in which certain applicants are directed toward products that include less favorable terms or features specific to control group applicants.
- Redlining can take many forms but is essentially a form of illegal disparate treatment in which a bank provides unequal access to credit or unequal terms of credit, because of race, color, national origin, or other prohibited characteristic(s) in areas where residents are located or in which residential property to be mortgaged is located.
- The wording of telemarketing scripts and direct mail appeals presented to applicants may violate anti-discrimination provisions. Thus, an institution’s marketing activities also require review.
- While credit scoring can be used as a risk assessment tool, the scores may be based on prohibited factors, thus scores may not accurately reflect the risk. The auditor should evaluate what factors comprise the credit score and how such scores are used when making credit decisions. At times, a loan may be approved with terms outside of a bank’s normal policy and procedures. In these instances, the auditor should confirm the bank has included documentation in the loan file supporting the rationale for the decision made.
Suffice it to say, fair lending is high on the regulatory radar and internal auditors should have this area targeted for evaluation based on a bank’s risk profile. At a minimum, auditors should assess the current policies and procedures, training programs, quality of independent testing, and annual approval of the fair lending program by the board of directors. Auditors can provide significant value by assessing an institution’s compliance with these regulations and in helping to develop a common understanding within the credit culture of what constitutes “fair” lending.
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