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Compliance Corner: Second Quarter 2002

Easing the Burden: An Alternative Fair Lending Examination Approach for "Low-Risk" Banks

The Federal Reserve System recently adopted an alternative fair lending examination approach for banks that exhibit little discrimination risk. This new examination approach reflects the experience gained using the FFIEC fair lending examination procedures, which were distributed in January 1999.

Why Adopt an Alternative Approach?
Through experience, bank supervisors have learned that some banks have a common risk profile. Typically, these are stable community banks that are often located in suburban or rural areas where the area demographics show a very low percentage of minority residents. These banks offer standard products, and many of them are predominantly commercial or agricultural lenders. In these cases, a comparative file analysis would usually focus on gender as the prohibited basis. However, in many cases there are an insufficient number of prohibited basis denials to conduct an underwriting analysis, and a terms and conditions analysis might have been conducted in the previous examination with no concerns identified. In addition, lending policies and staff have not changed.

In such cases, there may be insufficient risk to warrant establishing any focal points for the onsite portion of the fair lending examination. The alternative procedures have been designed for situations such as this. 

The alternative procedures are intended to help validate the conclusions that were drawn by examiners in the scoping process and will result in a reduction of resources being devoted to banks where the level of risk clearly is not sufficient to support extensive comparative file analysis.

Which Institutions Will Qualify?
Examiners will determine whether an institution qualifies for the alternative approach during the pre-examination scoping process. Generally, examiners will use the alternative procedures at institutions meeting the following criteria: 

  • The bank is a stable community bank with a very low percentage of minority residents in its assessment area.
  • The bank offers standard products, with commercial or agricultural loans as the predominant product line.
  • An insufficient number of minority group denials exist to make a meaningful comparative file analysis.
  • No significant fair lending concerns were identified at the previous compliance examination.
  • No significant changes have occurred in lending policies or lending staff since the prior compliance examination.

How Will the Alternative Approach Work?
The alternative procedures allow an examiner to verify whether the bank's practices are consistent with the loan policy data that was reviewed during the scoping process. If no inconsistencies were noted, the examiner would conclude the discrimination analysis without expending the significant level of resources typically associated with an extensive file review. 

The success of this approach depends upon the integrity of the scoping process. Therefore, all appropriate areas of credit operations will be analyzed in the scoping process, including consumer, commercial, and agricultural lending. If no risk factors are identified during scoping, that is, the examiners believe that the institution might be a low-risk institution, the examiners will proceed with the following steps. 

First, examiners will select a judgmental sample of loans for review to test how the lending criteria are actually applied. The sample will be representative of the major product lines of the institution and will include both denials and approvals that were processed in the preceding 12 months. The examiners will review the sample transactions to determine if they were underwritten according to the bank's articulated lending criteria. The transactions will not be compared with each other as they are in the benchmark/overlap analysis. Examiners will investigate and document any deviations in underwriting. This review will verify the actual underwriting practices of the bank and may result in the identification of risk factors. 

Next, examiners will use the same sample to review the bank's pricing practices. Since denials are not priced, it may be necessary to add additional approvals to take the place of the denials in the original sample. Examiners will compare the sample's loan pricing to the bank's pricing methodology as described during the scoping process. The transactions will not be compared with each other as they are in the terms and conditions analysis. Examiners will investigate and document any pricing deviations. This review will verify the actual pricing practices and may result in the identification of risk factors.

If examiners identify no risk factors using these alternative procedures, then the low-risk conclusion drawn in the scoping process is validated. At this point, the discrimination analysis is complete. However, if risk factors are identified through either the underwriting or pricing reviews, the examiners will establish a focal point and expand the sample for that particular product line, performing a full analysis using either the benchmark/overlap or terms and conditions examination procedures. Sample sizes will correspond to those in the sample size tables, and will be focused on marginal applicants.

Even if examiners determine that an institution is low-risk during one fair lending examination, the scoping for the next examination will not include an automatic assumption that the bank remains low-risk. During the subsequent scoping process, examiners will make a new determination of the risk level of the bank.

Examiners in the Third Federal Reserve District have used the alternative fair lending examination approach on several compliance examinations conducted during the second half of 2001 and the first quarter of 2002. The approach has been well received by Third District institutions since it has achieved one of its intended purposes–reducing regulatory burden. Bank supervisors have also been pleased with the new approach since it has enabled examiner resources to be redirected to more critical high-risk areas of compliance reviews.

If you have any questions regarding the alternative fair lending approach, please contact  Connie Wallgren, Vice President and Chief Examinations Officer at (215) 574-6217.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.