Understanding and managing exceptions to loan policy is a critical component of a financial institution’s fair lending risk management. It is important to understand how exceptions are defined and how they are tracked and managed. In today’s post, we focus on the former and will discuss options for management in the future.
Defining “Overrides” and Policy Exceptions
An override occurs when a decision made concerning a loan transaction falls outside of loan policy. It is imperative to note that this includes both loan applications which are approved or denied. Overrides can be policy exceptions for (1) underwriting (approval or denial) or (2) terms and conditions (such as pricing).
Both categories of overrides are further divided into two categories: (1) high-side and (2) low-side overrides. A high-side override occurs when loan policy dictates an approval or less stringent terms and conditions and a decision is made to either deny the loan or to apply more stringent terms.
For example, a loan that otherwise meets policy is denied because for another reason such as derogatory credit or other circumstance that may not be part of the core underwriting criteria. Conversely, a low-side override occurs when loan policy suggests a denial or more stringent terms and conditions and a decision is made either to approve the loan or waive the more stringent terms and conditions. This would include a loan that is approved that does not meet basic policy conditions or a lower rate is charged than otherwise would have been based on policy guidance.
Approach To Overrides
Exceptions to loan policy that take place are either (1) discretionary or (2) based on some type of compensating factor or extenuating circumstance. Discretionary overrides are decisions made that fall within a loan officer’s lending authority in which there may not be any quantifiable attributes documented that influenced the decision.
These types of overrides tend to be subjective, resulting in inconsistencies which can adversely impact fair lending over time. These may be based on valid business considerations such as competitive factors but, nevertheless, potentially increase fair lending risk.
Overrides based on compensating factors, on the other hand, tend to be less subjective, more consistent, and are generally quantifiable. Financial institutions should strive for all overrides to fall into this category and, as much as possible, avoid discretionary overrides. Unmanaged discretion, particularly at the loan officer level, will also likely draw increased scrutiny during a fair lending examination.
Another issue to be avoided is that of “selective overrides”; that is, “going the distance” for one customer in trying to work out a loan or better terms and not doing so for another. When this occurs, it serves to “lower the bar” in terms of policy requirements.
For example, let’s say Customer A has credit problems which do not meet policy. The lender, however, asks for additional information and has them settle issues on the credit report or otherwise allows the customer to strengthen the credit risk profile and then makes the loan (such as with additional collateral or adding a guarantor).
This occurs for Customer A; however, Customer B comes in the next day with similar or even better credit than Customer A but is denied strictly based on policy without any investigating alternatives as done for Customer A. Although not intended, this increases the risk of the appearance of discriminatory preferences. This often occurs when there is a significant degree of discretion regarding credit decisions.
By definition, compensating factors are attributes that offset some component of a credit transaction. A compensating factor can offset either a positive or a negative. For example, a loan that would be approved according to policy may be denied because it is discovered that the applicant’s otherwise stable employment history is not going to continue.
This is an example of a compensating factor being used for a high-side override. Equally, an applicant that would be denied because of a low credit score may be approved if the only derogatory on their credit report was a medical collection and the debt had been satisfied. This is an example of a low-side override.
Guidelines For Compensating Factors
Compensating factors should be well defined and quantifiable. In general they should relate to (i) risk, (ii) profitability, or (iii) competitive considerations. If a potential compensating factor does not affect one of these criteria, it is not an appropriate attribute.
The fair lending regulations specifically prohibit “unduly subjective standards.” Financial institutions should strive to minimize subjectivity in determining compensating factors. Our approach is that standards should be considered subjective when they are either not quantifiable or not well defined.
For example, to override a decision because an applicant is “a good customer” is not easily quantifiable and, thus, subjective. Similarly, to approve a customer for “excessive collateral” is quantifiable but not well defined. If an acceptable loan-to-value was determined (such as less than 60%) and then established as a compensating factor, it would no longer be subjective.
A managed approach is the best way to avoid issues with fair lending, and success will often be determined as to how effective an institution can be in enforcing policy discipline. Our recommendation is that discretionary overrides should be either very limited or should not occur at all.
Policy exceptions should always be applied consistently and considered on every loan transaction. Compensating factors should be employed for policy exceptions and should be objective. This, coupled with definitive policy that is closely followed, will provide a firm foundation to successfully navigate the world of fair lending.