Risk-focused fair lending examinations

• A mortgage lender tells a customer, "I'm sorry, but I don't feel comfortable lending to someone who's been through a divorce. That's why we're asking you to make a larger down payment."
• A commercial lender refuses to consider credit requests from any business located on an Indian reservation.
• A mortgage loan officer always advises minority customers to apply for an FHA loan, even if they would easily qualify for a conventional loan.

The actions of these lenders may expose their institutions to significant risk. The banks may face damaged reputations, lost business, litigation or prosecution for violating federal anti-discrimination laws.

The Board of Governors of the Federal Reserve System and other federal banking regulators recently adopted "risk-focused" fair lending examination procedures, which ensure that customers have nondiscriminatory access to credit, and that financial institutions limit their fair lending risk. In this article, we discuss analyses that examiners use to detect possible discrimination, and how the analyses are used in examinations. We also suggest resources for additional information on fair lending. Additionally, we provide an overview of federal fair lending laws, including types of illegal discrimination.

In addition to federal laws, be aware that some states have laws against credit discrimination. However, because federal banking agencies do not enforce state laws regarding credit discrimination, this article focuses only on federal fair lending laws.

New procedures: Types of analysis

The new risk-focused examination procedures assess risk exposure in underwriting decisions, credit terms and conditions, "redlining," credit scoring, and "steering." Examiners also assess lenders' policies, procedures and marketing materials.

Underwriting. Examiners compare credit-underwriting decisions to find apparent disparate treatment. For example, a lender that approves a loan to a married applicant with a two-year-old bankruptcy, but denies applications from unmarried applicants with much older bankruptcies, may have engaged in disparate treatment. Examiners focus their review on "marginal" applicants, who are neither clearly qualified, nor clearly unqualified, for credit. Lenders usually need to exercise judgment or provide extra assistance to qualify marginal applicants for credit, and discrimination may be more likely in these cases.

Terms and Conditions. If a financial institution approves a loan but imposes higher interest rates or excessive fees on a prohibited basis, the financial institution may have violated the Equal Credit Opportunity Act (ECOA) or the Fair Housing Act (FHAct). The examiner will need to investigate whether a nondiscriminatory reason, such as risk-based pricing, accounts for the difference. The Justice Department has settled several ECOA and FHAct lawsuits with lenders, often citing discriminatory credit pricing.

Fair lending laws Two federal laws forbid certain forms of credit discrimination. The Equal Credit Opportunity Act (ECOA) forbids credit discrimination based on an applicant's race, color, national origin, gender, religion, age, marital status, or receipt of public assistance income or because the applicant has exercised rights under certain consumer protection laws. ECOA applies to all types of credit, including home mortgage loans, business loans, consumer loans and even credit cards. The Fair Housing Act ("FHAct") forbids discrimination based on race, color, gender, age, religion, handicap or familial status (presence of children). The FHAct applies to housing sales, rentals and housing-related credit. Any company that makes or purchases loans for "purchasing, constructing, improving, repairing or maintaining a dwelling," or loans secured by residential real estate, is subject to the FHAct.

Redlining. "Redlining" occurs when a lender either does not lend to a certain geographic area or imposes more expensive loan terms within that area, based on the race, color or other prohibited-basis characteristics of the people who live there. For example, a bank that denies mortgage loans to qualified customers within a largely Hispanic neighborhood may be redlining. If examiners suspect redlining, they will:

• Identify areas commonly considered to have a significant minority population within the lender's market area;
• Determine if the lender avoids making loans in the area, or otherwise treats it unfavorably;
• Find any nonminority areas the lender appears to treat more favorably;
• Ask the lender for an explanation; and
• Find other information that either supports or contradicts evidence of redlining.

Credit Scoring. Many lenders make credit decisions based on automated credit scoring systems. Age may be used as a criterion under certain circumstances, but other prohibited bases may not. Examiners review credit scoring criteria to verify that disparate treatment or disparate impact are not inherent in the system. Examiners also scrutinize a lender's use of "overrides" of scoring decisions.

Steering. "Steering" occurs when a lender refers applicants to a less favorable credit product than they qualify for. Steering may raise fair lending concerns if it puts prohibited-basis customers at a disadvantage. For example, some claim that lenders steer minority customers to FHA home mortgage loans even when they should qualify for lower-priced conventional credit. Examiners review the institution's policies and practices for referring customers to various products. If individual lenders can refer customers to different credit products, examiners evaluate whether the lenders use their discretion in a nondiscriminatory manner.

New, risk-focused fair lending examinations

When examiners prepare for a compliance examination, they use the new procedures to focus the examination on the areas of greatest fair lending risk for each lender.

To determine risk, examiners consider the size of the institution, the credit products it offers, recent changes to its lending patterns or products, its credit decision-making standards and process, as well as demographic information about the community. "Risk factor" checklists help examiners decide the greatest fair lending risk for each lender.

Examiners also review the lender's overall compliance program. Small financial institutions do not need the formal, comprehensive compliance program that a superregional institution requires.

However, every lender should review its program to ensure that all customers receive fair treatment. This review significantly reduces fair lending risk. If examiners find that a lender has a thorough fair lending monitoring program in place, they may reduce the scope or intensity of their review.

What you can do (Revised May 2008)

Any consumer who wants to know more about fair lending laws or who may have experienced discrimination under ECOA or the FHAct may want to file a complaint with the federal agency that regulates the lender. Federal Reserve Consumer Help provides information on how to contact federal banking agencies. Of course, the consumer may first try to resolve the situation directly with the lender.

A lender that wants to know how to reduce exposure to fair lending risk should contact the regional office of its primary federal regulator.

Three types of illegal credit discrimination Federal law recognizes three types of credit discrimination under ECOA and the FHAct. The first type is overt discrimination, which constitutes open, blatant discrimination on a prohibited basis. For example, a loan officer who tells a female customer that he is charging a higher rate of interest based on her gender may have committed overt discrimination. Disparate treatment, the second type of discrimination, occurs when a lender has neutral credit policies and criteria, but applies them inconsistently, in a way that adversely impacts borrowers on a prohibited basis. For example, suppose a bank requires automobile loan customers to have monthly debt payments of less than 40 percent of gross monthly income. If the bank denies a female applicant based on that rule, but makes a policy exception and approves a male applicant in similar circumstances, this may be disparate treatment. Lenders often have a legitimate, business-related reason to "bend the rules" for a particular applicant. If this is the case, it is possible that no violation of fair lending law occurred. Disparate impact occurs when a lender adopts a neutral policy, applies it consistently, but the policy causes a "disproportionate adverse impact" on a prohibited basis. For example, suppose a bank adopts a minimum loan amount for home mortgage loans. This minimum is so high that few minority, single or elderly applicants qualify for loans in the bank's market area due to their incomes or the local home values. This may constitute disparate impact. It is important to note that a policy or practice that creates a disparity on a prohibited basis is not necessarily proof of a violation. The apparent disparate impact may be legal if there is a business necessity for the policy or practice, and there is no alternative policy or practice that is less discriminatory.