Compliance Considerations for CD Secured Loans

Compliance requirements for CD secured loans are not typically a huge topic of discussion for compliance seminar speakers or article authors.  That said, one of our members suggested this topic (you know who you are!), and I think it is a great topic to write on from the perspective of CD secured loans, rather than just bringing up these loans when discussing applicable regulations (which is usually the way it happens).

The truth is that most financial institutions (and regulators) just fly past CD secured loans because they are so low risk for a bank or credit union – from a Safety and Soundness perspective that is.  Basically, if the customer defaults…. Well, who cares?

Risks of CD Secured Loans

In reality, deposit secure and CD secured loans - sometimes referred to share loans by mutual banks and credit unions due to the fact that customers are owners and are technically pledging their “shares” of ownership - really don’t carry that much risk due to their simple nature.  For example, if a customer defaults, the financial institution is not going to be out any money as their collateral is cash.

Furthermore, underwriting is extremely simple as deposit secured loans are the definition of “collateral lending” where the underwriting is approved based on the collateral rather than other typical credit factors like an applicant’s credit score or even their debt-to-income (DTI) ratio.  Due to the low risk nature of these loans, and the lack of a need for complex underwriting, some financial institutions even permit these loans to be originated outside of the lending department, such as through the deposit side like customer service.

Compliance Concerns for CD Secured Loans

While the safety and soundness risk (or risk of a monetary loss) is minimal with CD secured loans, there are a few compliance considerations that every financial institution should be aware of.  Here is a list of some of the most common concerns found during compliance reviews of cd/deposit secured loans:

  1. CIP

  2. BSA

  3. Fair Lending

  4. The Fed Box

  5. CRA

CIP Concerns for CD Secured Loans

First and foremost, it is important to remember that CD secured loans are considered to be an account under BSA rules.  This means that when a new customer to a financial institution wants to open a CD secured loan, the financial institution must follow their customer identification program (CIP), just like they would for any other new account.  

This is something that can be overlooked when a bank is offering these types of loans to help someone, like a teenager, establish credit when a family member offers the CD as collateral to help them get the loan, which will ultimately build their credit through their payment history.  When this happens, the person opening the new account can easily get too focused on ensuring the collateral is appropriately secured and forget or overlook the need for CIP. The bottom line is that if the customer opening the CD secured loan is a new relationship to the bank, then CIP must be performed according to the financial institution’s BSA/CIP policy.

BSA Concerns for CD Secured Loans

Speaking of BSA concerns, there is another consideration relating to BSA beyond just CIP that financial institutions should ensure they have right for CD secured loans.  You see, FinCEN has told us time and time again that CD secured loans can be used as a tool for money laundering. In short, the idea is that an illicit actor would bring in cash that would be taken as collateral for a loan. When the loan is funded, those funds are essentially laundered (cleaned) and are easier to move around than the initial cash the illicit actor had in their possession.

To combat money laundering concerns, each financial institution is required to have a specific statement of purpose for any CD secured loan over $10,000.  This means that each applicable applicant must provide a very specific reason for the loan. General explanations like “personal reasons” are typically not sufficient as the rules require a “specific” reason.

While this rule is not specific to CD secured loans because it applies to any loan over $10,000 that is not secured by real estate, the rule absolutely applies to CD secured loans.  In fact, due to the low risk nature of these loans, this is something that is often overlooked by banks and credit unions during the account opening process. The best practice to ensure compliance with this BSA rule is to require a specific statement of purpose for all CD secured loans so that employees don’t accidentally forget to gather this information when such loan is over the $10,000 threshold.

Fair Lending Risks Associated with CD Secured Loans

The next compliance consideration that all financial institutions should review relates to fair lending.  The concern, of course, for fair lending is that all applicants are treated equally. For CD secured loans, this means that the application process and underwriting evaluation should be conducted in a consistent manner for all applicants.  

One of the main fair lending concerns found during fair lending audits of CD secured loans relates to inconsistencies in pulling credit reports for these types of loans.  As explained previously, CD secured and share loans are typically underwritten according to one factor: the collateral. This means that financial institutions often don’t really care about things like credit history or even income.  The challenge, from a fair lending purpose, can result if a financial institution does not have well defined procedures which all employees must follow for CD secured loans.

For example, if lenders are arbitrary pulling credit reports for some applicants, but not doing so for others, this practice could result in comparative evidence of disparate impact.  Even if there is no intention of discrimination, the courts recognize “comparative evidence” when a protected class is treated in an unfavorable way when compared to a control group applicant.  Therefore, it is important to ensure that underwriting practices for CD secured loans are consistent for all applicants.

Regulation Z Considerations for CD Secured Loans

While Regulation Z has quite a few requirements for any loan, there is one issue in particular that is a common violation for CD and deposit secured loans.  This violation relates to a requirement in Regulation Z where creditors must tell customers that the quoted annual percentage rate (APR) does not reflect the effect of the required deposit.  In other words, the APR calculation does not include considerations for the cost of having the CD or any interest earned on the CD.

Specifically, section 1026.18(r) of Regulation Z sets forth a requirement for a disclosure of “required deposit” to be included in the “Fed box” on the Truth-in-Lending disclosures (TIL) for any loan secured by a deposit.  The rule states the following:

“If the creditor requires the consumer to maintain a deposit as a condition of the specific transaction, a statement that the annual percentage rate does not reflect the effect of the required deposit. A required deposit need not include, for example:

(1) An escrow account for items such as taxes, insurance or repairs;

(2) A deposit that earns not less than 5 percent per year; or

(3) Payments under a Morris Plan.”

As you can see from this rule, there are a few exceptions to the requirement to provide the required deposit statement.  First, an escrow account held as collateral does not require this disclosure. The same is true for a qualified Morris Plan.  The other exception, found in 102618(r)(2) is a bit more complex. The way this rule works is that when a deposit earns at least 5 percent interest per year, no disclosure is required under §1026.18(r). This exception also applies whether the deposit is held by the creditor or by a third party.

What this means is not all deposit secured loans technically have to have the required deposit.  Deposit accounts which earn less than 5% per year must have the disclosure, but those earning over 5% do not.  Logistically speaking, this rule can make it very easy to have a violation if creditors don’t just provide the disclosure every time.  When rates are either very low or very high, this rule doesn’t really have much of an effect. However, when some deposit rates exceed 5% and others don’t, the opportunity for the required deposit disclosure to be missed would greatly increase if a financial institution did not require the disclosure for every loan.  

As the commentary makes it clear that the disclosure is permitted regardless of whether the disclosure is technically required, the best practice is to just provide the required deposit disclosure for every deposit secured loan.  This is by far one of the most common violations found during reviews of CD and deposit secured loans.

CRA Considerations for CD Secured Loans

The final compliance piece that each financial institution should consider for CD secured loans relates to the Community Reinvestment Act (CRA).  While not a requirement and not truly a risk for a financial institution, it is important to note that CD/deposit secured loans could provide credit to a bank during a CRA evaluation.  Specifically, we have noted where intermediate-small banks have received CRA credit during the community development test when a CD secured loan program is available to and marketed to low- and or moderate-income individuals.  

The key, of course, for getting CRA credit is to insure that the program is specifically designed for low/moderate income individuals.  This type of program can really be a win-win for both customers and a bank as the risk to the bank in offering this type of program is, well… very limited.


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