Loan Pricing Risks Elevated
Compliance officers and chief credit officers need to be focused on internal controls surrounding the pricing of consumer loans
The most obvious need for this focus is the Fair and Accurate Credit Transactions Act (FACTA) change that came into effect on Jan. 1, 2011. However, an equal need for attention comes from the regulatory scrutiny on loan pricing discrimination. This article will address both issues and provide you with information to ask critical questions to stave off regulator action.
Implementation of final rules for risk-based pricing issued
FACTA was signed into law on Dec. 4, 2003. It amended the Fair Credit Reporting Act (FCRA) by making it easier for consumers to fight identity theft, improving the accuracy of credit reports and enhancing consumers’ control over credit solicitations. Section 311 of FACTA added a new section to the FCRA, section 615(h), to address risk-based pricing. Section 615(h) required the Federal Reserve Board of Governors and the Federal Trade Commission to jointly issue rules implementing the risk-based pricing provisions. The proposed rules were issued on May 19, 2008 with comment period ending Aug. 18, 2008. The final rules were published in the Federal Register on Jan. 15, 2010, and are codified as part of Regulation V, at 12 CFR 222. The rules were effective Jan. 1, 2011 and can be found on the Federal Reserve website.
Risk-based pricing refers to the practice of offering different pricing plans for credit offered to consumers based on the risk of nonpayment by that consumer. The consumer’s credit score, obtained from a credit report, is usually the driving factor in assessing this risk. In general, creditors using a risk-based pricing model offer more favorable terms, including lower interest rates and fees, to consumers with higher credit scores, and less favorable terms, often higher interest rates and fees, to consumers with lower credit scores. Under the new rules, these practices require the delivery of a notice.
Simply, the notice is required to be issued by a financial institution that:
- Uses a consumer report in connection with an application of credit to a consumer
- Based on that report, grants or extends credit on material terms that are materially less favorable than the most favorable terms available to a substantial number of consumers by that institution
For this article, we have stated the requirements too simply. After all, this is a compliance regulation, so there are plenty of exceptions, commentaries and clarifications. Your compliance officer should be on top of this and if not, an outside compliance specialist can help you, and your compliance officer navigate through the requirements.
Fair lending examinations focused on fair pricing
Coupled with the above requirements for disclosure, we are seeing a significant uptick in examination issues related to fair pricing. In short, the agencies are focused on the pricing of consumer loans when executing their fair lending examination procedures.
To be sure, no new requirements are causing the focus on fair pricing discrimination. The Federal Financial Institutions Examination Council’s (FFIEC) examination procedures have always had fair pricing as a potential focal point for an exam. In fact, the procedures have long held that examiners should be concerned with five primary risk factors for pricing discrimination. Specifically, those factors are:
- P1 - Relationship between loan pricing and compensation of loan officers or brokers
- P2 - Lenders having broad discretion in pricing or transaction fees
- P3 - Use of a risk-based pricing system that is not empirically based and statistically sound
- P4 - Substantial disparities among price quoted or charged to applicants differing by prohibited basis characteristics
- P5 - Consumer complaints alleging discrimination in loan pricing
From our perspective, P5 is the biggest risk for community based financial institutions. We are dealing with several examination issues currently where the lender lacked controls on how prices were set. Additionally, a few institutions are dealing with issues where their loan officers chose to override established controls due to circumstances or happenstance. The key to your institution’s fair pricing compliance will be the ability to demonstrate a consistent routine in the pricing decision. Whether that routine is through a risk-based pricing grid or a flat one-price-fits-all pricing structure is dependent on your strategies. However, regardless of the strategy you employ, it will be scrutinized.
How it is scrutinized is what is catching the community based financial institutions off-guard. The agencies are starting to rely more heavily on a mathematical approach to fair lending reviews. They often employ regression analysis to assess whether an institutions’ pricing on consumer loans is statistically different for minority vs. non-minority applications.
For consumer loans, we find this is tricky for several reasons. First, the examiners employ a controversial technique to identify the minority applications called “surname surrogates.” Using a list of common Asian or Hispanic surnames, they can approximate the minority applications for their testing. This technique is problematic at best, but the agencies seem to be comfortable with it. Second, the regression is often based on what your lenders say they use in pricing, and lacks the complex variables that consumer loans can present. This results in an over simplified model. And third, most community based financial institutions do not have the experience or personnel that can defend a model.
Clearly, this uptick in focus on pricing is rising out of the subprime mortgage lending crisis. And the analysis is much easier on mortgage products than other loan types because mortgage lending has more homogeneous characteristics in addition to the fact that Home Mortgage Disclosure Act data provides race and gender variables. Our advice to clients is to be prepared for a potential pricing review of consumer loans. In addition, be prepared to have it looked at mathematically.
For more information, please contact McGladrey Managing Director Ty Beasley at 972.764.7100.