Earlier this month, there was a major development that could prove to be very significant in regard to fair lending. On September 1st, the CFPB released its proposed rule regarding small business lending data collection. The rule, mandated under the Dodd-Frank Act, and, if finalized and implemented, will require lenders to collect and report information regarding small business loans.
In essence, “HMDA-like” data would be collected and reported on small business lending including key elements regarding the credit along with demographic information such as race, gender, and ethnicity. The proposed data form can be found here.
Although the Interagency Fair Lending Examination Procedure have long included a template for examining commercial loans in a fair lending review, the collection of these data may undoubtedly push the inclusion of commercial loans in fair lending examinations to the forefront. The idea of including commercial lending in a fair lending review scope has been swirling in the fair lending arena for some time, but there has not been widespread focus on it so far. (We have touched on this topic in previous posts.)
The true impact will not be known until the rule is finalized, but as of now it appears the collection and reporting requirement will apply to virtually all lenders. Although always subject to change, the current threshold only requires a lender to have originated 25 credit transactions in each of the preceding two calendar years in the proposed rule.
Special Notes for Community Banks
We are particularly concerned for community banks under the proposed rule given the prevalence of commercial loans in their lending portfolios. Specifically, we believe community banks should focus on two special considerations:
- If an exam uncovers an issue for a community bank, its ability to continue to operate and make commercial loans could be hindered, and this would have a much greater effect due to the high amount of commercial lending most community banks do.
- If a community bank faces an enforcement action requiring restitution in particular, the dollar amounts involved could be cripplingly large because the loans themselves tend to be for much higher amounts.
Fair Lending Challenges
Aside from the impact of the additional compliance burden of reporting and collecting data, this potentially has profound fair lending implications. Despite the complexities that could potentially encumber a fair lending review of business lending, this could prove very troublesome for lenders for a number of reasons.
First, non-consumer lending in general, and commercial lending in particular, have had little, if any, real fair lending scrutiny. Commercial credits are largely the focus in safety and soundness reviews but get very little attention with respect to fair lending.
Accordingly, it is unlikely that institutions have considered or implemented any fair lending risk mitigation strategies for business lending. The addition of the new data points also makes small business lending an additional compliance risk institutions will need to address.
Second, because the number of situations encountered in business lending can vary widely, most institutions (community banks in particular) do not have well defined standards for underwriting and pricing of these credits. As the foundation of fair lending is consistency, it is difficult to monitor or measure consistency without explicit, well defined, and objective policies and practices. Many institutions struggle with developing policies that will allow them to effectively serve their consumer customers, and this challenge is greatly magnified with respect to business lending.
The third major challenge is in regard to evaluation. Because the field of business lending is so diverse, it will be much more difficult than it is with consumer lending to determine compliance. These complexities likewise may also make it difficult in a fair lending examination to explain differences in loan outcomes between borrowers who appear to be similarly situated.
Finally – and further compounding all of this – is the competitive nature of small business lending and the subsequent pressures that are brought to bear. Firms and individuals are in business to make a profit and must do so to survive. As such, business applicants are more prone to negotiate, which places more pressure on lenders with respect to competition. This suggests a landscape more prone to have exceptions to policy which, of course, complicates fair lending risk.
Next Steps for Lenders
The collection and reporting of small business lending data has been on the horizon for a number of years now, but it has never materialized. This may be an area of lending that is potentially fraught with fair lending risks for many institutions.
Assuming the Bureau will move to finalize the rule and does so in the spirit of what is reflected in it today, there are steps that institutions should begin taking immediately. We summarized these in a July 2017 post, and these are still applicable today.
- Determine the primary risk areas in terms of products – Factors to consider here are volume of lending activity and do objective decision factors exist, or is the process more “free form”?
- Begin evaluating and refining policies – A good starting point here is to have lenders explain how they arrive at decisions concerning loan pricing and underwriting.
- Product segmentation – Call reporting categories would be a start, but there are likely a number of subsets within these based on loan size, collateral, and types of businesses. This would help in next item below.
- Begin evaluating, refining, and quantifying policies – Commercial loan decisions tend to be more subjective which creates challenges for fair lending assessments and increase risk.
- Start small – Select one or two products as identified in first item above and focus on them first.
The primary keys are (l) policy formulation and (2) policy quantification. Unless these two things occur, it will be impossible to manage and measure fair lending risks.
Product definitions and simplicity are also essential. A good starting point is with loans which fall under the definition of small business, which will be dictated by the final rule. Although this may somewhat unknown at this point, institutions may start with their less complex credit offerings in terms of crafting policy.
The second critical piece is to determine how controls will be put into place to enforce lending behavior with respect to policy. Essential to this process will be the handling and tracking of exceptions. Likewise, it is critical to have policy that can be followed defined before the fact rather than making decisions about exceptions after the fact or during the process. Making exceptions without clear policy directives in place can prove very problematic in a fair lending review.
Unquestionably, these are uncharted waters. They are, however, waters that lenders are increasingly likely to find themselves crossing. Now is the time to at least begin exploration and be positioned to chart a course for successful navigation as the journey unfolds.
How to cite this blog post (APA Style):
Premier Insights. (2021, September 30). Uncharted Waters: 4 Challenges Facing Small Business Lenders Under the Proposed CFPB Rule [Blog post]. Retrieved from https://www.premierinsights.com/blog/uncharted-waters-4-challenges-facing-small-business-lenders-under-the-proposed-cfpb-rule.