How to Avoid Fair Lending Enforcement Actions

How do financial firms avoid fair-lending problems? There is a simple answer: Don't make loans. I can't figure out why financial institutions don't latch onto that brilliant solution. So, if you are one of those peculiar institutions in the business of making loans and want to keep doing so, I have other advice: prepare for the not-so-brave new world of fair-lending supervision/enforcement.

The core discrimination concepts have been around for nearly 40 years. Of course, there have been many changes to fair-lending laws on topics such as adverse action notices and credit scoring models. There is also debate about whether disparate impact claims are permissible under the Fair Housing Act.  

So, if the law really hasn't changed, what has? Well, it seems clear the Consumer Financial Protection Bureau has made fair lending a top priority. It has a dedicated fair-lending office with many attorneys whose sole purpose is to look for fair-lending issues. Recently, the CFPB stirred up a hornet's nest by issuing guidance on discretionary pricing of car loans for lenders that purchase them from auto dealers.

It seems hard to argue with the notion that an agency should ensure that institutions comply with fair-lending laws. But, nothing is simple when it comes to fair lending. First, agencies look at the results of lending decisions, and if different outcomes correlate with race, ethnicity, etc. (e.g., different approval and denial rates or interest rates), then they suspect discrimination. The burden is (literally, even if not legally) on institutions to explain the differences.

Second, what about disparate impact? Every policy could potentially have a disparate impact on some protected group. Given the economic differences of various ethnic and racial groups, many underwriting standards are likely to have a negative effect on some group.  So, what is a financial institution to do? You can't spend all your time conducting statistical analyses on each of your policies to pinpoint any possible adverse impact on a group. Even if you could, you would have to determine whether there is sufficient justification to override any disparate impact. And trying to determine if there is a disparate impact on the basis of race or ethnicity can be difficult if you don't actually know the race or ethnicity of the borrower, such as for car loans.  

So, where does one find hope in this new world?

There are things an institution can do. First, institutions should scrutinize an agency's view of the law. That is, regulators sometimes take liberties in interpreting what the law actually requires and institutions may need to discuss and even challenge an agency's reading of the law. In addition, once an allegation arises, an institution should seek to ensure that the agency is actually establishing discrimination, rather than simply asserting discrimination. 

Second: be proactive. Institutions need to take preventive steps. This involves creating clear policies, monitoring adherence to those policies, reviewing loan files and managing the use of discretion.  And, if you find a problem, fix it.

Third, there are many technical compliance issues under the Equal Credit Opportunity Act and Regulation B. For example, when can you request information about an applicant's spouse? How do you evaluate "protected" income? Are the reasons provided in adverse action notices specific and accurate? Compliance with rules on these and many other issues is critical. Failure to do so is often seen as a red flag by a regulatory agency, and typically leads to other questions.

Fourth, document matters. It's hard to lend without using any discretion. What do you do if a long-term, good customer asks you to waive a late fee? If a consumer asks and you make an adjustment, document the reason. Failure to document can cause problems with agencies.

Finally, to prepare for any allegations that practices may have a disparate impact, institutions should analyze policies to determine whether they actually do accomplish important business purposes, such as managing loan risks.

There are no secret formulas or magic bullets when it comes to fair lending. There are seldom simple solutions. There is often only difficult, tedious work.

In September 2012, the Federal Reserve Bank of Philadelphia published a paper, "Do We Still Need the Equal Credit Opportunity Act?" You can be sure that no one at the CFPB is asking that question. But when the CFPB asks other questions, financial institutions want to ensure they have robust fair-lending policies and programs to respond to those inquiries.  

Before rejoining Morrison Foerster, Leonard N. Chanin served as assistant director of the Office of Regulation of the Consumer Financial Protection Bureau.