Consumer Compliance Outlook > 2024 > Fourth Issue 2024

Consumer Compliance Outlook: Fourth Issue 2024

The Federal Reserve System’s Top-Issued Fair Lending Matters Requiring Immediate Attention and Matters Requiring Attention

By Scott Sonbuchner, Senior Examiner, Federal Reserve Bank of Minneapolis

Since 2023, Consumer Compliance Outlook (CCO) has been publishing data-driven articles on top violations and complaints for institutions the Federal Reserve supervises. In this issue, we are publishing an article on a third supervisory data point: top-issued Matters Requiring Immediate Attention (MRIAs) or Matters Requiring Attention (MRAs), which we refer to as matters. This article discusses the top-issued fair lending matters. We believe data-driven articles can help institutions assess compliance risk in their operations by identifying areas where other institutions faced challenges, how they remediated those challenges, and ways to mitigate risks.

MRIAs AND MRAs

The Federal Reserve System is the primary federal regulator for state member banks (SMBs). Communicating supervisory findings to management and the board of directors of a regulated institution is an important aspect of supervision. The report of examination is the primary way bank supervisors communicate findings. But when examiners find systemic weaknesses in an institution’s compliance management system or systemic violations of consumer laws that raise significant supervisory concerns, they can issue an MRIA or MRA or take other formal or informal enforcement actions to ensure the board and management are aware of the concerns and promptly undertake corrective actions.

MRIAs

As discussed in Federal Reserve Supervision and Regulation (SR) letter 13-13/Consumer Affairs (CA) letter 13-10, “Supervisory Considerations for the Communication of Supervisory Findings,”1 MRIAs can arise from an examination, an inspection, or any other supervisory activity that raises major concerns, including:

MRIAs must be resolved as quickly as possible. But for “heightened safety-and-soundness or consumer compliance risk,”2 they must be addressed immediately. The institution must also respond in writing to the MRIA indicating its plan for corrective action.

MRAs

MRAs raise important issues but do not pose an immediate risk and are expected to be addressed in a reasonable period of time. “The key distinction between MRIAs and MRAs is the nature and severity of matters requiring corrective action, as well as the immediacy with which the banking organization must begin and complete corrective action.”3

FAIR LENDING MRIAs/MRAs

The Federal Reserve evaluates SMBs for fair lending risk at every consumer compliance examination. For SMBs with less than $10 billion in assets, the Federal Reserve examines for compliance with both the Equal Credit Opportunity Act (ECOA) and the Fair Housing Act (FHA). For institutions over $10 billion in assets, the Federal Reserve examines for compliance with the FHA, while the Consumer Financial Protection Bureau (CFPB) examines for compliance with ECOA, as required by the Dodd–Frank Act.4

ECOA prohibits discrimination in consumer and commercial credit transactions on the prohibited bases of race, color, religion, national origin, sex, marital status, age, the receipt of income from a public assistance program, and the good faith exercise of rights under the Consumer Credit Protection Act.5 The FHA prohibits discrimination in residential housing transactions on the prohibited bases of race, color, religion, sex, handicap, familial status, or national origin.6

TOP FAIR LENDING MRIAs/MRAs FOR STATE MEMBER BANKS IN 2022

Matter #1 – Failing to Conduct Fair Lending Risk Assessments

Supervisory Expectation

An institution’s overall fair lending risk management program should be commensurate with the size, complexity, and fair lending risk profile of its lending. Supervisors expect institutions with heightened fair lending risk to conduct a fair lending risk assessment to ensure the risk is being appropriately measured and mitigated. For example, if a bank with many majority-minority census tracts7 in its assessment area is not conducting a fair lending risk assessment, its risk of fair lending violations increases.

Root Cause

Some institutions with heightened fair lending risks relied on their compliance risk assessments to measure fair lending risk. However, when an institution has elevated fair lending risk, an overall compliance risk assessment can be inadequate to measure fair lending risk because it is more general and less focused and nuanced than a fair lending risk assessment and may fail to identify risks that would have been identified in a fair lending risk assessment.

Sound Practices

Institutions with heightened fair lending risk can mitigate this risk by implementing fair lending risk assessments. These assessments are typically conducted annually, but could be updated following a major fair lending event, such as a merger or acquisition that added majority-minority census tracts to the lender’s assessment area. The assessment should be tailored to an institution’s fair lending risk profile and assess its inherent risks, controls to mitigate those risks, and the resulting residual risk. Inherent risk arises from the general conditions or the environment in which the institution operates. Factors that can inform an inherent risk assessment include:

Examiners use the risk factors in the Interagency Fair Lending Examination Procedures to scope out fair lending examinations, which may include evaluating risk for:8

Fair lending controls should be considered in conducting the fair lending risk assessment. The goal of a risk assessment is to identify and mitigate the residual risk that remains after identifying fair lending risk and the controls implemented to mitigate the risks. For example, if an institution was cited in a report of examination for failing to adequately explain the reason for taking adverse action, and it responded by requiring a second review of all notices, the risk assessment would find this fair lending risk has been mitigated. Again, the number and formality of controls vary based on size, complexity, and fair lending risk profile, but may include some combination of the following illustrative (but not exhaustive) list of controls:

After identifying and evaluating each control’s effectiveness relative to the inherent risks, the risk assessment can analyze the residual risk for each identified fair lending risk. If the risk assessment finds more than minimal inherent risk, the compliance officer may consider performing additional analysis, such as comparative file reviews. In most instances, the expectation is that the risk assessment would be updated and approved annually by the board of directors.

Matter #2 – Failing to Conduct Fair Lending Training

Supervisory Expectation

Effective, complete, and recurring training is an essential part of a fair lending compliance management program. For example, if a loan officer is aware that it can require a guarantor or cosigner when an applicant does not meet underwriting standards, but is not aware that it cannot require that it be the applicant’s spouse,9 the risk of a spousal signature violation under Regulation B increases.

Additionally, like all legal compliance risks, fair lending risks can change over time. An effective change management process includes properly training staff regarding the relevant change.

Root Cause

Compliance departments can become complacent and overlook the benefits of recurring fair lending training, especially for board members and management.

Sound Practice

Banks can provide recurring fair lending training to all lending staff, management, and the board of directors. The training should be appropriate and tailored to the position receiving the training. Training can help lending staff to understand prohibited activities, management to be aware of fair lending risk, and the board to set the correct tone. Because training is intended to emphasize values and keep risks top of mind, fair lending training is most effective when it is recurring, often annually. Training provides banks with an opportunity to promote their culture and set expectations about appropriate conduct.

Matter #3 – Failing to Gross Up Nontaxable Income When Underwriting Is Based on Gross Income

Legal and Regulatory Requirement

ECOA and the FHA prohibit discrimination in all aspects of the transaction, including when evaluating applicants for credit. Lenders’ underwriting systems typically analyze either an applicant’s gross or net income. If a lender’s system analyzes gross income and fails to gross up the income when the applicant’s income is nontaxable, the practice raises fair lending risk. It may result in discounting an applicant’s income on a prohibited basis,10 and could also result in discriminatory loan denials due to insufficient income. Suppose, for example, a lender will not approve mortgage loans for applicants with a debt-to-income ratio greater than 40 percent, and the lender analyzes gross income and does not gross up nontaxable income when computing the ratio. An applicant’s nontaxable, monthly disability income is $3,000, his monthly debt payments total $1,500, and his effective tax rate is 25 percent, showing a debt-to-income ratio of 50 percent. This applicant would be denied a mortgage loan using this lender’s standards. But if the lender grossed up his income of $3,000 based on his 25 percent tax rate, his qualifying income would be considered to be $4,000 and his debt-to-income ratio would be 37.5 percent. This applicant would have been approved under the bank’s policy but for the failure to gross up his income. A policy of not grossing up nontaxable income, such as nontaxed Social Security Disability Income received because of disability, may result in a finding of illegal discrimination, as receipt of public assistance income is a protected characteristic under ECOA, as is disability under the FHA.

Root Cause

The primary reason banks fail to gross up nontaxable income is that they do not have policies and procedures in place that require underwriters to gross up nontaxable income when underwriting is based on gross income. Banks have been especially likely to maintain this policy or practice of calculating income for products not subject to investor standards that require gross-up of income, such as the standards of Fannie Mae and Freddie Mac.

Sound Practice

Compliance departments can review loan policies to see if they properly address this issue and, if not, adjust the policies. In this example, lenders had to develop procedures to ensure that nontaxable income is consistently grossed up to an “adjusted gross income” for the initial evaluation of debt-to-income and used for the underwriting decision for all underwriting that relies on gross income.

Matter #4 – Risk Monitoring and Management Information System (Exception Monitoring)

Supervisory Expectation

Loan officer discretion can increase the risk of a fair lending violation. It is therefore important to implement controls to mitigate this risk. If loan officers have discretion, it should be monitored to ensure it is not exercised on a prohibited basis — especially in pricing or underwriting. Risk monitoring and reporting provide the board and management with the information needed to identify and evaluate fair lending risks.

Root Cause

Institutions failed to implement a control to ensure loan officers’ discretionary credit decisions do not violate fair lending laws. While having clear, written, objective pricing and underwriting criteria helps to limit lender discretion, allowing loan officers to make exceptions to those rules can increase fair lending risk. The fair lending risk can become a fair lending violation if those exceptions are applied unevenly, as the bank may be disproportionately providing accommodations, exceptions, or more favorable terms and conditions on a prohibited basis. A control is necessary to ensure the exercise of the discretion complies with fair lending laws.

Sound Practices

Banks can employ different strategies for mitigating the risk of loan officer exceptions to pricing and underwriting standards. One option is to eliminate discretion by stating in the loan policy that exceptions are not permitted. While this approach benefits from its simplicity, some banks find the solution does not fit with broader business strategies. Alternatively, banks that allow loan officers to retain discretion to make exceptions to policy can limit that risk by tracking and maintaining oversight over how loan officers use those exceptions. In this case, sound practices include establishing a written, clear policy setting forth reasons for exceptions, specifying the factors for which an exception is permitted, and retaining documentation. Another sound practice is to maintain oversight over loan officers’ use of discretion by tracking and monitoring exceptions (including frequency and amount/magnitude) to confirm that the exceptions do not result in potential disparities on a prohibited basis. Finally, lenders can train loan officers on how to exercise their discretion without violating fair lending laws.

CONCLUDING REMARKS

Fair lending MRIAs and MRAs are among the most common matters issued throughout the Federal Reserve System. While banks are responsible for all aspects of their fair lending compliance management program, compliance officers may benefit from reviewing these more frequently issued matters and comparing them to their current practices. Banks should raise specific fair lending issues and questions with their primary regulator.

ENDNOTES

1 SR 13-13/CA 13-10, “Supervisory Considerations for the Communication of Supervisory Findings” (“Supervisory Communications”) (June 17, 2013).

2 Supervisory Communications at p. 3.

3 Federal Reserve Board Commercial Bank Examination Manual at p. 21 (October 2023)

4 12 U.S.C. §5515. The CFPB enforces “federal consumer financial laws,” as defined in the Dodd–Frank Act, which does not include the FHA. See 12 U.S.C. §5481(14).

5 15 U.S.C. §1691(a); 12 C.F.R. §1002.4(a).

6 42 U.S.C. §3605(a); 24 C.F.R. Part 100.

7 In a fair lending review in a consumer compliance examination, unless otherwise noted, “majority-minority census tracts” are defined as census tracts that are more than 50 percent Hispanic and African-American.

8 Interagency Fair Lending Examination Procedures (2009).

9 12 C.F.R. §1002.7(d)(5): “If, under a creditor’s standards of creditworthiness, the personal liability of an additional party is necessary to support the credit requested, a creditor may request a cosigner, guarantor, endorser, or similar party. The applicant’s spouse may serve as an additional party, but the creditor shall not require that the spouse be the additional party.” Emphasis added.

10 12 C.F.R. §1002.6(b)(5): “A creditor shall not discount or exclude from consideration the income of an applicant or the spouse of an applicant because of a prohibited basis.”