Fair Lending Testing: Best Practices, Trends and Training
Joint Center for Housing Studies
Harvard University
Fair Lending Testing:
Best Practices, Trends and Training
Paul C. Lubin
February 2008
UCC08-4
? by Paul C. Lubin. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted
without explicit permission provided that full credit, including ? notice, is given to the source.
Any opinions expressed are those of the author and not those of the Joint Center for Housing Studies of Harvard
University or of any of the persons or organizations providing support to the Joint Center for Housing Studies.
Introduction
History has shown that self-testing and self-assessment techniques are powerful tools for
uncovering problems in business practices and policies. For the consumer seeking credit these
problems may manifest in the inability to obtain information to make appropriate credit
decisions. For the lender and financial institution it can result in unsafe business practices,
discrimination and misleading or unfair practices which in turn result in lost business, damage to
reputation and hefty financial penalties. For the nation these problems can result in inefficient
and unsound credit markets where inappropriate credit decisions are made by the consumer and
lender. These problems may ultimately limit the growth of household and national wealth.
Self-testing and self-assessment programs can help assess whether the market for credit is
functioning properly and guide government policy and enforcement activities to ensure the
allocation of credit is based on sound underwriting and sales practices that support the best long
term interests of the consumer and the lender.
The results of self-testing programs over the last 20 years have shown changes in the
credit marketplace affected the consumers¡¯ ability to make optimal credit decisions. The credit
marketplace in the early and mid-1990¡¯s was more stringent in terms of underwriting policies,
had less product alternatives and fewer delivery channels for the consumer to gather information
and apply for a loan. The approval process was longer giving the consumer more time to search
and compare loans. Ancillary products, for example credit protection, were far fewer and sales
tactics were more constrained and reflected the more rigid underwriting criteria of the time.
Starting in the very late 1990¡¯s and accelerating into the new century, commensurate with the
growth of secondary market funding and risk based pricing, consumers were faced with an
increasing number of lenders, sales personnel, delivery channels and complex product
alternatives to choose from. At the same time underwriting polices became more flexible and
less rigid reflecting the lenders¡¯ ability to source increasingly lower cost funding and then sell
loans into the secondary market. Lenders using risk based pricing and pulling credit scores and
credit information in real time required consumers to apply first before providing rate and
product information. Consumers were now faced with almost instant approval limiting the
ability to evaluate and compare products and lenders. Technology provided lenders and sales
personnel with the ability to show consumers a variety of complex loan scenarios and
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alternatives. Ancillary products, for example credit protection, were often packaged into the
monthly payment.
Self-testing and self-assessment results during this time reflected changes in the credit
marketplace. While loan denial rates have declined, differences in treatment between protected
and non-protected classes of consumers have increased. These differences are reflected in
product discussion and explanation, suitability questioning, explanation and disclosures
concerning annual percentage rate and fees and confusion over whether or not credit insurance is
required with the loan. At the same time consumers have encountered more aggressive sales
tactics. Encouragement of frequent refinancing and consolidation of secured and non-secured
debt, diminished emphasis on exploring the consumers¡¯ needs and ability to pay, emphasizing
reduced monthly payments without regard to loan principal and interest payments over the life of
the loan and packaging credit insurance into the loan payment without informing the consumer
are just some examples of the issues pointed out by self-testing or self-assessment techniques.
There are many reasons lenders and the nation should engage in self critical analysis and
self-testing of lending practices.
Risk to the economy is one reason. Not treating consumers as long-term assets and not
selling appropriate loan products based on the consumers¡¯ ability to pay damages wealth at the
individual level. Such damage ripples thru the economy, limits long-term growth and can
damage the economy as evidenced by the 2007/2008 disruptions in the credit markets.
Ethics is another reason. Strictly regulated or not, the government, consumers,
community and business leaders, and lenders should abhor prejudicial and unfair treatment of
customers and potential customers.
Legal liability is another reason lenders should adopt monitoring programs. Penalties
associated with discrimination and unfair sales practices can be severe.
Reputation risk is still another reason. Allegations of discrimination and unfair sales
practices can severely affect the ability of a lender to operate and attract customers and may
therefore negatively impact the financial standing of the lender.
Business risk is also a reason. If a lender fails to offer an application and discourages an
African American to apply the lender may lose a good customer and revenues will suffer. In
addition if the lender fails to gather all the necessary information from an applicant the lender
may recommend the wrong product and the consumer may end up with less than optimal loan
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terms. Ultimately this may result in higher rates of delinquencies and foreclosures which will
affect profits.
Lenders owe it to themselves and their customers and the government owes it to
consumers to use these and other techniques to assess lending business practices and how they
affect the consumer. The costs are not great. The techniques are time-tested, and akin to the
customer surveys many lenders and government agencies already perform to measure customer
satisfaction and consumer opinions.
The costs of not using them, however, can be high for the lender, the economy and the
consumer.
What Is Self-testing?
Self-testing offers the credit provider a critical window into the experience encountered by
consumers applying for a loan. It is a voluntary undertaking designed to minimize business and
legal risk. The procedure helps ensure compliance with the law and adherence to business
protocols and standards.
By using self-testing a lender can help ensure the various phases of the loan process
provide consumers with the necessary information to make appropriate credit decisions. It helps
ensure compliance with a web of fair-lending rules and guidelines intended to insure that
customers receive equal and fair treatment. In light of these rules ¨C overseen by the Federal
Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance
Corporation, Office of Thrift Supervision and other Federal agencies ¨C lenders have developed
monitoring techniques to detect if they treat customers unfairly and whether this is due to race,
national origin, age or sex.
The most frequently used form of self testing calls for the use of testers or mystery
shoppers posing as potential or actual buyers. Unlike statistical procedures which require
outcomes (loan approval, loan denial, pricing) and rely on abstract arguments and statistical
principals, testing provides a record of the treatment or experience encountered by the mystery
shopper or tester. In tests for discrimination, a direct comparison of the experience encountered
by protected and non-protected classes of testers is made.
Another form of self-test is a post application survey which measures the assistance and
treatment encountered by loan applicants.
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