Today, we are going to continue our discusssion on conducting a fair lending risk assessment by addressing the second type of discrimination recognized by the courts: comparative evidence of disparate treatment.
As we mentioned when discussing how to assess fair lending risk, there are three types of fair lending recognized by the courts that should be included in any fair lending risk assessment template you might use:
- Overt evidence of disparate treatment
- Comparative evidence of disparate treatment
- Evidence of disparate impact
Understanding Comparative Evidence of Disparate Treatment
Comparative evidence of disparate treatment occurs through an analysis of loan files where the result is that a protected class received less favorable terms than a control group. When an auditor or examiner is looking for this type of discrimination, they will will conduct a test called a “comparative analysis.” In simple terms, a comparative analysis is when you compare the “best” denials against the “worst” approvals in an attempt to find overlap. In other terms, a comparative analysis looks at marginal applications to determine if a denied protected applicant was treated in the same manner as an approved applicant from a control group (often individual white male applicants).
The Problem With Lender Discretion
Most often, comparative evidence of disparate treatment is not intentional discrimination, but is the unintentional result of lender discretion. Discretion occurs when a bank allows a lender to use their own personal judgement during the underwriting process to determine whether or not to make a loan to an applicant.
In my opinion, discretion in underwriting is the single biggest contributor to comparative evidence of disparate treatment. The problem is that when lenders have discretion, there is a lack of consistency. Even if a lender is 100% consistent in how they underwrite and approve loans, the challenge is that they won’t be consistent with the other lenders in the organization. In other words, if Joe Lender is 100% consistent in how he makes credit decisions when a bank policy does not give him clear guidance, he naturally will not be able to be consistent with the other 15 lenders in his organization because they have also each had to make a individual determination on how to underwrite loans.
The inconsistency that results from discretion leads to increased risk when comparing the credit qualification of two applicants. For example, what often happens when lenders have discretion is that certain denied applicants most likely would have been approved if they had only gone to a different lender. If that denied applicant is a protected class, this becomes extremely problematic because a comparable loan (one with a very similar credit posture made to a control group applicant) was approved. The result of this discrepancy is comparative evidence of disparate treatment.
Discretion in Large and Small Institutions
Large banks have mitigated their risk of comparative evidence of disparate treatment by eliminating lender discretion. As large institutions have hundreds or thousands of lenders making credit decisions, the only way to manage potential discrimination as a result of comparative evidence of disparate treatment is to prohibit lender discretion. Therefore, most large banks have established centralized underwriting, or even automated underwriting that ensure consistencies in the underwriting process that cannot occur when a lender has discretion.
Community banks and credit unions often permit discretion in their underwriting process as this helps to give them a competitive advantage over large financial institutions that have centralized or automated underwriting. In fact, many community banks and credit unions even create marketing campaigns boasting their local underwriting where credit decisions are made by the lender that is working directly with them. The challenge with local underwriting and the discretion that naturally comes with it, is that the risk of comparative evidence of disparate treatment is increased.
Assessing Risk of Comparative Evidence of Disparate Treatment
The best way to assess fair lending risk by comparative analysis is to identify how much discretion a lender has in the underwriting process. If a lender doesn’t have any discretion - meaning that all applications from the financial institution are evaluated the exact same way every time, such as is the case with some automated underwriting solutions, the result is that there is no fair lending risk of comparative evidence of disparate treatment. On the other hand, however, there will be significant fair lending risk when a financial institution allows their lenders to have full discretion in the underwriting process without any guidance of credit standards.
In addition to looking for discretion when evaluating fair lending risk, it is also important to evaluate how many exceptions to the established policies are made. The idea is that the more exceptions that are made, the greater the opportunity for comparative evidence of disparate treatment. If very few exceptions are made, the risk is greatly reduced. One way to help mitigate risk of exceptions is to have a formal review of adverse actions taken.
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