As is the case with most things in life, the regulatory environment goes through cycles. With respect to fair lending, examinations in the past few years have emphasized issues such as loan underwriting, redlining, and steering as opposed to pricing. Part of the explanation for this is cyclical, but also because examiners have perceived pricing risk as lower relative to other issues.
This, however, is very likely to change in the near term. Institutions may begin finding an increasing level of scrutiny in regard to loan pricing. There are a number of reasons for this and why this risk is likely to increase for lenders.
Loan Demand and Competition
Economic conditions have exerted downward pressure on loan demand. Irrespective of what government statistics may suggest in regard to improved economic conditions, the fact is that the economy has not yet regained momentum. The result is weak loan demand which means lenders are chasing fewer loans. This, in turn, increases competition which means lenders often face pressure to deviate in loan pricing to keep business. This, of course, elevates fair lending risk.
In addition, lenders are facing pressure from a growing alternative lending space. These lenders, often referred to as “Fintechs”, have harnessed the power of technology and have achieved tremendous growth in the past few years. Changing consumer preferences have further served as a catalyst as a new breed of consumer emerges that has an affinity for the speed and convenience of online transactions rather than the personal touch that is found at community banks.
Pricing pressure, which increases the frequency of price exceptions, increases fair lending risk. Lenders often believe that “competition matches” are benign in regard to fair lending, but they still create risk.
Rising Interest Rate Environment
Interest rates are rising today after being not only at historic lows but being static for a long period of time. The prime rate today is at 4.5% compared to 3.75% a year ago. Further, prime remained unchanged in 2008 from 3.25% until 2015; and then it only increased to 3.50%.
Rates being so low and not fluctuating produce lower pricing risk in terms of fair lending simply because there is little variation. Although competitive forces were still in play as noted earlier, there was little room for movement as lenders were essentially already at their floor in terms of covering their own costs much less profit.
The environment is different now, and rates are going up. Rates only moved 25 basis points between 2008 – 2015, whereas they have moved 3 times that much (75 basis points) just in the last year. This will create more variation in pricing, generally, and expand the sizes of pricing exceptions – all of which increase fair lending risk.
New HMDA Reporting
The new HMDA data reporting requirements that begin this year contain a large number of new data points that will be reported, many of which are designed to measure lender pricing. This is the single largest change that has taken place with regard to HMDA since the spreads reporting requirement of 2004 and, perhaps, the greatest policy change that has occurred in recent years that will directly affect fair lending. This is a “sea change” and one that has the potential to have significant implications.
With respect to pricing specifically, lenders will report data that will allow for evaluation of a number of pressure points related to pricing along with the criteria on which pricing is typically based, such as term, LTV, and credit score. This will provide examiners with a great deal of information by which to evaluate pricing with respect to prohibited bases. These data have the potential to shift fair lending focal points toward pricing.
Out-of-Sight / Out-of-Mind
Financial institutions have endured a barrage of regulatory changes since the financial crisis with the passage of Dodd-Frank. This includes not only a host of new regulations, but changes to existing ones. There has also been a much more aggressive posture by regulators and the creation of a new and powerful agency that now writes the rules for many facets of consumer compliance.
With the new regulatory challenges faced, institutions have become more reactive rather than proactive. This is largely due to the sheer volume of potential risks that they must assess, evaluate, and try to be prepared for. Hence, there tends to be more of a focus on the more pressing issues rather than a broader assessment of overall risks.
Since pricing has not been a dominant focus for most lenders (commercial banks in particular), there has been less attention paid to it. This means less monitoring and attention to pricing practices—all of which carries risk.
Pricing is Easily Measured and Quantified
Unlike other fair lending pressure points, such as underwriting or steering, loan pricing is easily quantified and measurable. Further, fair lending scrutiny from years past has caused nearly all lenders to have definitive pricing guidance for lending staff.
Factors upon which pricing can be based is also limited. Whereas with other fair lending issues (such as underwriting or steering) where an almost endless number of explanations could legitimately be offered from differences in treatment of applicants, pricing is more finite. In addition, the functional form used in regression modeling of pricing is less subject to issues in regard to the data compared to the functional form required for a discrete choice model that would be used in underwriting. Generally, therefore, a pricing analysis is much more conducive to statistical analysis and more robust.
Considering the current regulatory emphasis on quantification, examination of pricing is an appropriate and commonsensical target by which to evaluate a lender’s fair lending performance.
Although there are ebbs and flows with regard to regulatory emphasis, a financial institution’s approach to such risk should be holistic. Although the array of potential issues in regard to fair lending may seem at times overwhelming, lenders can benefit from simplification and tackling each issue systematically.
Pricing risk should be among the easiest to manage. There are a number of different approaches which can be effective, but being proactive is the key.
How to cite this blog post (APA Style):
Premier Insights. (2018, February 8). Lenders Should be Prepared for Increased Fair Lending Pricing Scrutiny [Blog post]. Retrieved from http://www.premierinsights.com/blog/lenders-should-be-prepared-for-increased-fair-lending-pricing-scrutiny.