This blog post extracts key information from three sources related to fair lending examination procedures conducted by federal regulatory agencies. These sources include: "Fair Lending Scope and Conclusions.pdf" (FLSC), "Interagency Fair Lending Exam Procedures Appendix.pdf" (Appendix), and "Interagency Fair Lending Examination Procedures.pdf" (Procedures).
In this blog we outline the core principles, processes, and risk factors considered during fair lending examinations. The goal is to provide a broad understanding of the fair lending landscape and how institutions are assessed for compliance based on regulatory guidance.
Core Principles of Fair Lending
- Prohibition of Discrimination: The fundamental principle is that lenders must not discriminate against applicants based on prohibited factors. These include, but aren't limited to, race, color, religion, national origin, sex, marital status, age, or receipt of public assistance. As the Procedures document states, "A lender may not discriminate on a prohibited basis because of the characteristics of...an applicant...a person associated with an applicant...the present or prospective occupants of either the property to be financed or the characteristics of the neighborhood or other area where property to be financed is located."
- Equal Opportunity: The Fair Housing Act (FHA) mandates reasonable accommodation for individuals with disabilities to ensure equal access to credit.
- Consistency: Lenders are expected to apply their credit standards and procedures consistently to all applicants regardless of their inclusion in a protected class. The Appendix notes that lenders should not "Use different procedures or standards to evaluate applications?" or "Use different procedures to obtain and evaluate appraisals?"
Examination Scope and Methodology
- Risk-Based Approach: Examinations are risk-based, focusing on areas where potential fair lending violations are most likely to occur. Examiners assess "inherent risk" (FLSC) and use these assessments to decide the scope of their review.
- Examiner Discretion within Agency Limits: The Procedures document clarifies that examiner discretion is limited by their own agency's priorities. "An examiner should use these procedures in conjunction with his or her own agency’s priorities, examination philosophy, and detailed guidance for implementing these procedures."
- Scoping Process (Procedures): The examination process begins with scoping to gather information about the institution, products, and markets. This includes reviewing demographics, policies, procedures, and past examination findings.
- Self-Tests and Self-Evaluations (Procedures & Appendix): Institutions may conduct self-tests and self-evaluations to identify and address fair lending issues. Examiners may streamline the examination if the institution has conducted reliable self-evaluations or self-tests. "Institutions must share all information regarding ‘self-evaluations’ and certain limited information related to ‘self-tests.’"
The Appendix details requirements for acceptable self-testing, including ensuring tests are objective, cover important decision points in the lending process, and include comparative file review of prohibited basis and control groups.
- Comparative File Review (Appendix & Procedures): A key component of fair lending exams is comparing the treatment of applicants from prohibited basis groups to that of a control group (applicants not in a protected class). This often involves reviewing loan files for consistency in application of standards in underwriting and pricing.
- Data Verification (Procedures): Examiners are instructed to verify the accuracy of data used in the examination, such as HMDA/LAR data, before proceeding with an analysis.
Key Areas of Examination Focus
The FLSC document details several areas examiners focus on:
- Compliance Management System (CMS): Examiners review the institution's CMS to assess its effectiveness in controlling fair lending risks. This includes controls in areas such as credit application and decision-making, property valuation, pricing, complaint resolution, and third-party oversight. "This should include a description of specific CMS elements that relate to fair lending, such as steps the bank takes to control risks in the credit application and decision-making process, the property valuation process, the pricing of credit, resolving consumer complaints, and oversight of third-party relationships."
- Loan Portfolio: Examiners analyze the bank's loan portfolio for inherent risks including the introduction of new products, significant growth in certain products, purchased loan portfolios, use of third parties, loss mitigation efforts, special purpose credit programs, and types of loans offered.
- Underwriting: Examiners assess underwriting methods, noting differences by product type, lending channel, or third party. They also review whether discretion is permitted, how exceptions are documented, and if automated systems use AI/machine learning. "Describe any inherent fair lending risks relating to the bank's underwriting practices."
- Pricing: Examiners investigate the method of pricing for each product type offered, including interest rates, points, and fees. Examiners will note any differences by lending channel, and any role of third parties. "Describe any inherent fair lending risks as it relates to loan officer or broker compensation."
- Steering: Examiners investigate the potential for steering to occur when a loan officer exercises discretion in referring a customer to different loan products or lending channels.
- Marketing: Examiners analyze marketing efforts, including digital advertisements and outreach, and look for any targeted efforts based on particular products or segments. "Describe any inherent risks based on the bank's market area population demographics."
- Redlining: Examiners examine the demographic composition of the bank's CRA assessment and market areas, and look for potential disparities in lending patterns based on the racial or ethnic makeup of neighborhoods.
Redlining is described as "the practice of targeting certain borrowers or areas with less advantageous products or services based on prohibited characteristics." The procedures outline detailed steps for analysis, including defining minority areas, determining demand for credit, and identifying discrepancies in lending or marketing practices.
Identifying Risk Factors
The Procedures document identifies several risk factors that may indicate potential fair lending violations, categorized as:
- Overt Discrimination: Direct expressions of bias.
- Underwriting: Inconsistencies in how underwriting standards are applied.
- Pricing: Differences in pricing that cannot be justified by cost or risk.
- Steering: Directing applicants towards certain products or channels.
- Redlining: Limiting access to credit in specific areas based on protected characteristics.
These risk factors include statistical disparities in lending, variations in branch services, and subjective or vague policies. For example, risk factors for redlining include differences in origination rates, approval/denial rates, denial rates for collateral, and availability of certain loan products in minority areas (R1-R4).
The Procedures document also notes: "Explicit demarcation of credit product markets that excludes MSAs, political subdivisions, census tracts, or other geographic areas within the institution's lending market or CRA assessment areas and having relatively high concentrations of minority residents" (R6) as a potential indicator of redlining.
Specific Examination Techniques
- Analyzing Denials: The Appendix describes detailed methods for analyzing loan denials, including ranking denied applicants by their deficiencies and comparing them to marginal approvals. Examiners will "compare each marginal control group approval to the benchmark applicant in each reason-for-denial ranking".
- Analyzing Pricing Differences: The Procedures document explains how to compare pricing and terms for control and prohibited basis groups, and to investigate differences that cannot be justified by risk or cost.
- Redlining Analysis: Examiners identify minority areas, compare lending practices in those areas to non-minority areas, and investigate whether a lender intentionally excludes or treats minority areas differently, noting that this analysis should be done to see if the "institution fails or refuses to extend credit in certain areas; an institution targets certain borrowers or certain areas with less advantageous products".
- Surrogate Analysis: The Procedures document highlights the potential use of "surrogates" for race or other protected characteristics, including Hispanic or Asian surnames or an applicant's given name. Examiners are encouraged to use these surrogates when direct data is unavailable, and the financial institution can rebut the presumption.
Corrective Action
The Appendix details potential corrective actions that an institution may need to take if violations are found, which includes: offering credit that was improperly denied, compensating for damages, notifying consumers of their legal rights, correcting policies and procedures that led to the discrimination, training and disciplining employees, and potentially implementing community outreach programs or changes in marketing strategies.
Conclusion
The three documents provide a detailed framework for conducting thorough fair lending examinations. These exams involve a risk-based approach, with specific attention to the institution's CMS, loan portfolio, underwriting, pricing, and marketing practices. Examiners use statistical analysis, file reviews, and comparative techniques to identify potential violations. The overall objective is to ensure that all individuals have equal access to credit without regard to prohibited bases and that any potential discrimination is identified, addressed, and corrected.
