Disparate Impact and Business Necessities
In fair lending terms, disparate impact is often evidenced by outcome and not intent. Disparate impacts often occur due to what seem to be neutral changes in bank policy. For example, a financial institution might decide not to make home mortgage loans of less than $75,000. Although this policy appears neutral regarding any of the prohibited bases and applies equally to everyone, this policy could be found to have a disparate impact if it can be shown to disproportionally exclude certain applicants from consideration.
Between the Equal Credit Opportunity Act and the Fair Housing Act, lending discrimination is prohibited on the following bases: race, color, religion, national origin, sex, age, marital status, familial status, disability, or receipt of public income.
Five conditions must generally exist for a policy to be considered disparate impact: 1) a specific policy must be involved, 2) the policy should be neutral regarding any of the prohibited bases, 3) the effects of the policy should fall disproportionately a prohibited basis group, 4) there should be a causal relationship between the policy and the adverse result, and 5) the policy either: a) has no clear rationale, or appear to exist merely for convenience, or does not meet industry standard underwriting considerations / lending practices, or b) there is not an equally effective alternative for accomplishing the same objective with a smaller adverse impact.
The existence of a disparate impact does not mean there is fair lending violation. When a regulator determines that the conditions exist to create a disparate impact, it is the regulatorâs decision whether to pursue a violation by notifying the financial institution and soliciting their response. In submitting their response, the financial institution may justify their policy to keep the policy in place, despite the disparate impact.
Disparate impact can, however, be justified by a business necessity. Although there is not much interpretation or guidance giving in-depth discussion or explanation of what a âbusiness necessityâ is, the interagency exam procedures list the five conditions which must generally exist (1-5 listed above) as things examiners should consider when evaluating whether a policy can be justified as a âbusiness necessity.â
Disparate impact can also by justified if it is the most effective method of accomplishing a legitimate business objective. As noted above, examiners can evaluate the policy to see if there is a less discriminatory alternative, or an equally effective policy that would cause less disparate impact, and if so, then the financial institutionâs policy may constitute a violation, and the institution may need to pursue the less discriminatory alternative in such an instance.
When drafting and evaluating policies, financial institutions should always be mindful of disparate impact and the prohibited bases on which even unintended discrimination can occur. To this end, Compliance Alliance can help in this process. Our Fair Lending Toolkit has more than 20 helpful tools with some focusing on fair lending in general, such as our Fair Lending Policy template, and others focusing on specific regulations, such as our HMDA Fair Lending Analysis Worksheet, or our Section 1071 Coverage Flowchart. In addition you can submit your policies to our review team through the dashboard on our website to have us review your policy for any fair lending concerns you may have. Finally, you can always reach out to us on the hotline about any fair lending or disparate impact situations you encounter.
FDIC Encourages Voluntary Diversity Self-Assessments
Last week the FDIC issued FIL 35-2023 encouraging FDIC-supervised financial institutions to voluntarily conduct and submit self-assessments of their diversity policies and practices by September 30, 2023 in accordance with Section 342 of the Dodd-Frank Act. According to the FIL, the self-assessment is not an examination requirement and results are not shared with examiners. The results of diversity policies and practices self-assessments have no impact on an institutionâs safety and soundness or consumer compliance ratings, or Community Reinvestment Act (CRA) performance evaluation.
Pursuant to Section 342 of Dodd-Frank the FDIC gathers and analyzes diversity self-assessment information based on published Interagency Standards. These standards provide a framework to create diversity policies and practices. The agencies recognize that an institutionâs size, location, and structure makes it unique, and when drafting these standards, the agencies focused primarily on institutions with more than 100 employees. The agencies acknowledge that smaller institutions or those located in remote areas face different challenges and have different options available to them compared to their larger or more urban counterparts. The interagency standards focus attention to five areas:
(1) Organizational Commitment to Diversity and Inclusion standards: Policies and practices should demonstrate an institutionâs commitment to diversity and inclusion. Standards should promote diversity and inclusion in employment and foster a corporate culture that embraces diversity and inclusion.
(2) Workforce Profile and Employment Practices standards: Many promote the fair inclusion of minorities and women in their workforce by publicizing employment opportunities, creating relationships with minority and women professional organizations and educational institutions, creating a culture that values the contribution of all employees, and encouraging a focus on these objectives when evaluating the performance of managers.
(3) Procurement and Business PracticesâSupplier Diversity standards: Institutions increasingly understand the competitive advantage of having a broad selection of available suppliers to choose from with respect to factors such as price, quality, attention to detail, and future relationship building. Many have achieved success at expanding available business options by increasing outreach to minority-owned and women-owned businesses.
(4) Practices to Promote Transparency of Organizational Diversity and Inclusion standards: Greater awareness and transparency give the public information to assess those policies and practices. Institutions publicize diversity and inclusion information through normal business methods â its own website, marketing materials, and annual reports to shareholders, if applicable. Public commitment to diversity and inclusion helps keep the general community informed about the institution and its efforts.
(5) Entitiesâ Self-Assessment standards: Institutions that have successful diversity policies and practices allocate time and resources to monitoring and evaluating performance under their diversity policies and practices on an ongoing basis. The FDIC encourages institutions to disclose their diversity policies and practices, as well as information related to their assessments, to the FDIC and the public.
The diversity self-assessment form is accessible online through the secure FDIC connect portal. If you need to obtain access to the portal, contact your institutionâs FDIC portal coordinator, and if you do not know who that is, you can email [email protected] or call the FDIC helpdesk at 703-516-1069 to find out. Should you have any questions about this FIL or diversity policies or practices, feel free to reach out to us on the hotline.
Automatic Payments – Deep in the Maze
In the labyrinthian darkness that is Regulation E lurks a potential trap of which not all adventurers are aware. One of the potential deadfalls in the regulation is the prohibition of requiring automatic debits for loans. This seemingly common forbidden practice is buried pretty deep in the text.
- 1005.10(e) Compulsory useâ (1) Credit. No financial institution or other person may condition an extension of credit to a consumer on the consumerâs repayment by preauthorized electronic fund transfers, except for credit extended under an overdraft credit plan or extended to maintain a specified minimum balance in the consumerâs account.
(2) Employment or government benefit. No financial institution or other person may require a consumer to establish an account for receipt of electronic fund transfers with a particular institution as a condition of employment or receipt of a government benefit.
When we turn this into plain language, it is stating that a bank cannot base the approval of a loan on a customer agreeing to use automatic debits for making payments on the loan.
The background to this prohibition is to protect consumers from stacking up fees from multiple sources due to one transaction. If a loan payment is debited from a checking account and there are insufficient funds to cover the payment, the customer will get a late fee from the loan and an NSF fee from the deposit account. This regulation will, at a minimum, allow the customer to have made the choice for the automatic payment and not be forced into this situation.
The commentary to this provision does, however, offer some guidance and potential relief for banks. A bank can incentivize a customer to set up an automatic payment. A bank can offer, for example, a discounted APR or a reduced origination fee for the customer setting up automatic payments. This may be both a benefit to the customer and the bank.
If you read the entire regulatory citation above, you noticed a seemingly oddly placed additional prohibition. A bank cannot dictate where an employee receives their direct deposit. A bank can require direct deposit, however the employee gets to choose where the deposit goes.
Be sure to review your loan policies and educate your lending staff about this prohibition. The penalties can be steepâup to $1,000 per individual and up to $500,000 for a class action, plus actual damages. So, as you navigate the labyrinth be sure to avoid its many dead-ends and traps ⌠the Minotaur is in there.
Section 1071 FAQs Newly Published
Undoubtedly the Consumer Financial Protection Bureau (CFPB) will continue to publish guidance for years to come as the Section 1071 rules become effective and financial institutions begin to work through implementing the small-business lending rules. Recently, however, the CFPB published a series of Frequently Asked Questions (FAQs) specifically aimed at the Section 1071 topics of Institutional Coverage (14 FAQs) and Covered Credit Transactions and Small Businesses (7 FAQs).
Among the concepts discussed in the FAQs are consumer credit used for business purposes and sole proprietorships. According to the FAQs, an extension of consumer-designated credit is not a covered credit transaction, even if the funds are used for business purposes. An extension of credit is considered to be âconsumer-designatedâ if it is extended primarily for personal, family, or household purposes. Therefore, an extension of credit used for both personal and business purposes is not considered to be for business purposes unless the financial institution designates it as business purpose credit, meaning its primary purpose is for a business purpose.
A covered credit transaction is an extension of business credit that is not excluded pursuant to the small business lending rule. For this purpose, âbusiness creditâ includes credit used primarily for an agricultural purpose as well as credit primarily used for a business or commercial purpose. Thus, covered credit transactions include loans, lines of credit, credit cards, merchant cash advances, and other credit products used primarily for agricultural, business, or commercial purposes. However, factoring, leases, and consumer-designated credit are some examples of transactions that are not covered credit transactions because they do not satisfy the definition of business credit.
An individual or sole proprietorship can be considered to be a small business pursuant to the small business lending rule, and this is true regardless of whether the individual has formed an entity under applicable state law, whether the individual is doing business in the individualâs own name, or whether the individual is doing business using a trade name, such as a DBA. An individualâs personal income is not included when calculating a sole proprietorshipâs gross annual revenue because it is not revenue earned by the for-profit business applying for an extension of credit. Gross annual revenue for these purposes is the amount of money earned by the business itself, before subtracting taxes and other expenses.
A business is a small business for purposes of the small business lending rule if its gross annual revenue for its preceding fiscal year was $5 million or less. If a new or recently started business did not operate in the preceding fiscal year (and thus did not have gross annual revenue for its preceding fiscal year) and does not have affiliates with gross annual revenue exceeding $5 million in their preceding fiscal year, the new or recently started business is considered to be a small business under the small business lending rule.
If a new business states that its gross annual revenue exceeds $5 million and the financial institution does not verify gross annual revenue, the business is not considered to be a small business. However, if the financial institution obtains gross annual revenue information or verifies gross annual revenue, it must determine if the business is a small business based on the updated or verified information.
The questions on Section 1071 do not end here, and many more questions are likely to arise as we get closer to implementation. Feel free to reach out to us on the hotline if you have any questions about Section 1071 or small business data collection.