Fair Lending Pricing Risk: Is There A Storm Coming?

Fair Lending  »  Fair Lending Pricing Risk: Is There A Storm Coming?

All of us are familiar with the term “perfect storm.”  A perfect storm can be defined as the occurrence of a highly improbable event.   In the context of the perfect storm, the event is improbable because a combination of factors or conditions have to occur or exist either simultaneously or in a particular sequence in order to produce the event.  It is the unlikely nature of the simultaneity of multiple factors or conditions that produces the “perfect storm.” 

Hurricane Katrina which devastated New Orleans and the Mississippi gulf coast is often referred to as a perfect storm.  For New Orleans in particular, a city built below sea level but that had survived numerous storms for 300 years, it was well known what could happen with the right combination of conditions.   Katrina encapsulated most of those conditions: a slow-moving storm with a tremendous amount of rainfall, a near direct eye-wall strike on the city, and failure of the levies and city’s water pumping system.  Although unlikely, the combination of factors is what produced the catastrophic and unprecedented damage and loss of life. 

This is analogous to the discussion of today’s post, because even though the perfect storm could not have been stopped, the degree of damage could have been greatly mitigated with better preparation.  Importantly, this would have meant taking the risk of the perfect storm occurring seriously.  This does not mean waiting until the threat is imminent but as a matter of routine making sure the defenses against such an event are maintained and well-fortified. 

Sadly, however, as is human nature, avoiding the perfect storm repeatedly in previous years creates complacency.  Such complacency is an invisible villain that is typically not seen until it is too late. 

Is There A Perfect Storm Brewing?

Although storms cannot be stopped, there is a certain degree of predictability that is possible.  As with hurricanes, we can recognize the conditions conducive to produce storms, their severity, and to some degree the timing and tracking. 

The financial industry may be facing a perfect storm in relation to loan pricing risk.  There are a number of reasons (see former post), and we will not repeat all of them here.  The conditions, however, continue to prove highly conducive to increased fair lending risk with regard to loan pricing.

What To Do?

Perhaps the best way to define what TO DO is to touch on what not to do, and that is to ignore or turn a blind eye to the risk.  Another pitfall is waiting or “kicking the can down the road” to deal with another day, and usually when this happens preparation falls by the wayside until it is too late. 

The most effective thing that institutions can do is to act now and fortify their lending operations to reduce fair lending pricing risk. 

Below are some specific steps:

  1. Identify the greatest and least risks – what loan products and delivery channels produce the greatest risk? (HINT: this is usually areas where there is the greatest degree of variation in rates charged and/or areas not heavily monitored.) 
  1. UNDERSTAND loan pricing in the various areas – could it be explained to a fair lending examiner in detail how loans are priced with specificity? And for every area of the institution’s lending? 
  1. Policy versus practice – is loan pricing policy followed? If so, how is this known and how can it be proved? 
  1. Monitoring – this should be twofold in the form of ongoing regular monitoring along with comprehensive analysis on at least an annual basis. 
  1. Don’t forget disparate impact – can pricing practices be justified in terms of the parameters used? Even though this is often overlooked, it is still a risk and one that is relevant in today’s environment

If your institution is subject to the new expanded HMDA reporting, it is CRITICAL your institution have regression analysis conducted of loan pricing on a regular basis.  Although much of the impact of the new reporting on regulatory scrutiny is still evolving, these data contain critical pricing pressure points that have not been measured before.  These data also lend themselves to quantitative analysis. 

Again, using the storm analogy, although we may not know the precise details of the impact, the use of these data in fair lending reviews is predictable in general terms.  Failure to recognize the risk or failure to prepare once the risk is recognized is an easily avoidable error  that magnifies risk. 

Although the “perfect storm” may not be avoidable, a little preparation now will greatly reduce the risk and any subsequent damage. 

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