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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