"Bankers should discriminate (in pricing), provided the word means to measure and price risk properly with regard to legitimate economic characteristics of the client relationship....But bankers should be prosecuted for discriminating if the word means granting credit or setting interest rates on grounds pertaining to race, gender, or other prohibited classifications."
So said Federal Reserve Board Chairman Alan Greenspan in a speech published in this magazine in article form in January 1995. Responding to Greenspan's remarks on the same topic in an earlier speech, Assistant Attorney General for Civil Rights Deval Patrick was quoted in another publication as saying, "We agree with Chairman Greenspan that you have to take risk into account."
The article reported that Patrick went on to tell bankers that
they "simply" must show that rate disparities for minorities
result from a business necessity and not prejudice. He added that
if their methods "have the result" of treating minorities
differently from whites, then they are legally bound to see if
different methods can produce the same results.
These two seem to be saying the same thing: risk-based pricing is legal and even desirable, as long as it does not discriminate on a prohibited basis. And yet, the devil is in the details--in this case, in the little connecting phrases each official embeds in his comments.
Greenspan proscribes discrimination "on grounds" pertaining to a prohibited basis. Patrick, in contrast, warns against lending that "has the result" of limiting credit to minorities. And importantly, he puts the burden of proof on the lender, which "simply" must show that rate disparities are based on business necessity.
Bankers caught between the worlds of these two regulators know only too well that there is nothing "simple" about it. Many--maybe most--"legitimate economic characteristics" (Greenspan) that banks consider in measuring and evaluating risk also "have the result" (Patrick) of treating minorities differently from whites. For that matter, they may also impact women differently from men, the young differently from the middle-aged and old, and singles differently from married people.
As groups, in many markets, minorities, women, the unmarried, and the young--all of whom are "protected classes" under the nondiscrimination laws--tend to display the economic characteristics that accompany and therefore signal higher risk. They tend to have less wealth; a shorter or less stable employment or income track record; less experience that would presage success with a business loan; less likelihood to have a second borrower or co-signer on the loan; and more debt as a percentage of income.
In other words, the prohibited bases under fair-lending law often correlate with higher risk. The reason for the higher risk profile among these applicants may not be the applicants' fault. It may be no one's fault, or may perhaps reflect discrimination by others or overall failure of society to provide adequate education and open doors of opportunity. Neither, however, are they normally the fault of the bank, which must navigate the treacherous waters between Greenspan's warning that it "should" do risk-based pricing for compelling economic and competitive reasons, and Patrick's warning that if it does, and if doing so produces adverse effects on minorities, it must be prepared to bear the burden of proof that it has not broken the law.
The burden of proof can be crushing. Neither regulators nor courts
have yet offered useful guidance on how to distinguish between
illegal discrimination and valid risk-based practices.
Increasingly the fair-lending issue is focused on credit pricing. This is occurring at a time when the industry is both feeling new pressures and gaining new tools to do risk-based pricing (see my June 1996 column).
Look at the recent actions taken by the Justice Department in the fair-lending arena:
In other words, out of the ten fair-lending cases DOJ has brought, all of the last four have been based on pricing. Reportedly there is yet another case in the pipeline at the agency, aimed at making a mortgage company responsible for illegal pricing discrimination by third party brokers or correspondents. There have also been published reports that Justice was investigating the financing arm of the Big Three automakers--again for alleged bias in pricing.
In addition, a senior Justice official made a recent speech indicating that the Department has requested and received from the Veterans Administration comprehensive computer data on VA loans. DOJ is analyzing these loan patterns, evidently looking for pricing discrimination in the wake of news reports earlier this year that there has been great price variability on VA-guaranteed loans.
Notice that Justice's concern over pricing is on behalf of applicants whose loans were approved. The fair-lending issue has evolved beyond early questions about whether lenders were denying marginally qualified minority applicants while approving similar white applicants.
As noted above, these cases are being pursued at a time when the industry is moving rapidly toward more use of risk-based pricing for compelling competitive and regulatory reasons.
An FDIC report this spring concluded that banks are not basing enough pricing on risk factors. Chairman Greenspan said in the ABA Banking Journal article based on his speech, "...as technology increasingly facilitates the accurate measurement of risk, we should become more concerned about what happens if banks do not price their loans according to risk."
Talking about commercial lending, he said, "If credit practices are left unchanged, we can expect the experience with the best-quality large corporate clients to be repeated with the best-quality smaller business clients. The best-quality customers will seek funds elsewhere, and banks will be left with ever-higher-risk borrowers for whom loan rates would then have to be raised in any event to cover the risk."
The same argument applies to retail credit. As technology makes it possible to measure risks with far greater frequency and accuracy, lenders will be able to price credit for each borrower and across portfolios with unprecedented precision.
And Greenspan notes that it will be possible for some borrowers
to get access to credit who otherwise would not have received
it, because the lender will be confident that it can set a price
commensurate with the risk being incurred. This trend is reflected
in the recent move toward banks entering the B and C credit markets,
in an effort to increase loan volume and to get the higher margins
traditionally available there on highly priced loans (see cover
story).
Here are some ways banks can reconcile the market and regulatory forces pushing them toward more use of risk-based pricing with a regulatory climate in which civil rights advocates may challenge practices that produce outcomes suggesting discrimination:
Review and update underwriting criteria used in price decisions. Over the last few years, most banks have reviewed their traditional lending standards in light of today's fair-lending environment. Banks that have not done so should, and those that have should probably do it again, unless they have made this re-evaluation a continuous process.
At the least, banks should determine whether they are using factors in evaluating and pricing loans that are considered fair-lending red flags by civil rights advocates. For instance, the use of "time on job" rather than "time employed," or even stability of past income stream, is considered disadvantageous to minorities, who tend to experience more job turnover. The regulators have described some of these controversial practices in their joint policy fair-lending policy statement of March 8, 1994; in the FDIC's booklet Side by Side; and in the Federal Reserve Bank of Boston's publication Closing the Gap.
This review should be done even if the bank is using computerized scoring systems. Reliance on a statistically sound, empirically derived scoring process is no longer the safe harbor it once was. If, as Patrick says, the lender can use an alternative credit standard that has less averse effect, than it probably should.
Evaluate new tools being developed to do better risk-based pricing. Despite the fact that use of scoring systems is not failsafe from a fair-lending standpoint, computerized credit evaluation and pricing does have great benefits, on both the competitive and compliance fronts. Powerful new models are being created to score and price credit with great statistical accuracy. If the bank is satisfied that the model it wants has fully taken account of fair-lending considerations, it may find these advantages really compelling.
Think through how much pricing latitude to give loan officers. The DOJ pricing cases typically have involved lenders who were permitting loan officers to negotiate the best price they could get. This practice raises obvious fair-lending issues, especially when the individual negotiating for the lender can keep any overage above a target amount, or even when the person is compensated indirectly for high yields.
When wide latitude and incentives are given to negotiate the best price, the potential exists that the highest prices will disproportionately go to minorities and women. These customers may be less sophisticated about the opportunity to negotiate. They may be more easily intimidated. They may have fewer alternatives, whether due to discrimination elsewhere or to their financial situation.
This does not mean that banks must take all pricing discretion away from lenders. It means that those wanting to retain discretionary pricing, whether in mortgage, small business, or consumer lending, need to manage the process from a fair-lending standpoint.
Credit staff, for example, need to be thoroughly trained on both the rules and the subtle issues that can arise. They should be given guidelines within which to operate. Note that Fleet is still permitted to use overages under its DOJ settlement, but has agreed to limits on the pricing discretion that can be exercised.
Back-end monitoring and self-testing should be done to be sure that individual lenders and the bank as a whole are performing well on fair-lending factors.
Manage third-party relationships. While the bank's liability for third-party actions is subject to contract law and is often unclear, there is a clear move on the part of many civil rights advocates to use the bank as the lever for reaching other players. Banks, being highly regulated, frequently examined, and subject to the Community Reinvestment Act, are easier to hold accountable than are brokers, dealers, and other non-bank organizations. Banks should expect to retain some risk for the actions of these other parties.
Pay attention to how borrowers are tracked for various credit programs. As noted above, many banks are entering into the B and C credit markets in search of high volume and margins. Many are setting up separate finance companies or lending groups to pursue this niche. It is important to give thought to how borrowers will be targeted by these financing arms versus the bank itself, and also to the circumstances in which an applicant will be referred from the bank to the more highly priced B/C group.
Tie loan pricing into an ethical framework. It happens
occasionally that unsophisticated customers truly are taken advantage
of through lending that has been sold aggressively, priced at
high rates, and not properly explained. Banks need to assure that
they are not engaging in practices that they would not be comfortable
reading about on the front page of the newspaper.
 |
 |