Assessing Fair Lending Risk

Fair lending is one of the hottest topics in regulatory compliance.  As the dust has settled from TRID and the examiners haven’t quite focused their full efforts on the new HMDA rules, fair lending scrutiny is as intense as it ever has been.  In fact, it always has been a hot topic and will always be one.  

One trend new trend that I have been seeing, however, is a demand for community banks and credit unions to conduct a fair lending risk assessment as a part of their compliance management system.  While big banks have done this for years, most smaller community banks and credit unions haven’t yet completed a fair lending risk assessment.  With the continued pressure from the regulators on fair lending rules and regulations, it really is important for every financial institution to understand their risks associated with fair lending - which can be accomplished by completing a fair lending risk assessment or using a fair lending risk assessment template.

Three Types of Discrimination

In evaluating the risk of fair lending in your organization, it is important to first understand how a violation of fair lending laws would be cited against your institution.  The way this would occur is that an exam team would refer an issue to the Department of Justice (DOJ) who would either settle with your organization or take you to court.   Regardless of where the issue ultimately ended up, your regulator and the DOJ would be looking to the three types of discrimination that have been recognized by the courts:

Overt evidence of disparate treatment is a blatant statement or practice that clearly discriminates while comparative evidence of disparate treatment is evidence of discrimination that results from inconsistencies in the credit underwriting process.  Disparate impact is when a policy inadvertently has a negative effect on a protected class of applicant.

Assessing Fair Lending Risk

Once these three types of discrimination are understood, a financial institution can then conduct a risk assessment by evaluating specific policies and procedures against the three types of discrimination recognized by the courts.  In evaluating processes and procedures, there are several key areas a financial institution should look at to assess the overall risk of fair lending.  These areas include the following:

  1. The Institution’s History of Fair Lending Compliance

  2. Internal Factors Affecting Risk of Discrimination

  3. External Factors Affecting Risk of Discrimination

Prior Fair Lending Violations

The first step in evaluating fair lending risk is to look at an institution’s past history of fair lending compliance.  Evidence of prior fair lending issues naturally increases risk of future issues because fair lending issues are often systemic and difficult to fully correct.  In addition to past deficiencies, a financial institution should also consider any complaints received that relate to fair lending as they can be an indicator of larger issues.  The bottom line is that a risk assessment should take into account any prior exam and audit deficiencies as well as received complaints to understand the organization’s history of fair lending compliance.

Internal Fair Lending Factors

The second step in conducting a fair lending risk assessment is to look at the internal factors that affect the institution’s risk of discrimination.  On a high level, this evaluation will look at the organization’s policies and procedures to determine the level of (or lack of) controls that help to mitigate fair lending risk.  These controls include things like limiting lender discretion, effectively managing overrides and exceptions to policy, have a second review of denied loans, and ensuring compensation agreements don’t have the inadvertent effect of discrimination.  In addition to policies and procedures, internal factors also include training efforts and the size and complexity of the organization.

External Fair Lending Factors

The final step in conducting a fair lending risk assessment is to evaluate the external factors that could lead to a heightened risk of discrimination.  External factors include things like customer demographics and third party relationships. For example, a financial institution that has several indirect lending relationships with auto dealers would have a heightened risk of fair lending as they are ultimately responsible for the fair lending compliance of the auto dealers they have relationships with.


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