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Banks must have adequate operating procedures and internal controls in place to ensure that the terms and conditions expressed in their contracts and disclosures are consistent with their operating system specifications and parameters. Examiners often uncover discrepancies between what is stated in a bank’s legal agreements or required disclosures and the institution’s actual operating practices. While all discrepancies are not necessarily strict violations of consumer protection regulations, they may expose the institution to potential civil liability and increased compliance, legal, and reputational risk.
Banks are contractually obligated to follow the terms and conditions of any legal agreement formed with their customers. So it is essential that the contractual language accurately describe what the bank intends and that it accurately reflect the bank’s operating practices. Discrepancies have been found in all facets of customer disclosures; however, they appear to occur more frequently in connection with consumer open-end credit.
Let’s look at Regulation Z, the implementing regulation for the Truth in Lending Act, to illustrate this point. One of the primary tenets of Regulation Z is “disclosures shall reflect the terms of the legal obligation between the parties.”1 Generally, this is not an issue because it is common for the legal obligation and disclosures to be contained within the same document. However, problems arise when the legal obligations and disclosures say one thing, and the bank’s actual operating practices are not reflective of these documents.
The following two examples illustrate some of the common Regulation Z violations related to the examination of home equity plans that examiners have uncovered.
Regulation Z requires institutions to accurately disclose information regarding the payment terms of a home equity plan. Specifically, the disclosures should accurately describe the length of any draw and repayment periods and the manner in which the minimum periodic payment will be determined.
Examiners have found numerous instances where the disclosed payment terms were inconsistent with the bank’s actual operating practices. It can be argued that, unless the bank’s loan accounting system precisely replicates what is stated in the legal documents or disclosures, not only has a violation of Regulation Z occurred, but customers also may have been harmed, because what they had contractually agreed to was not being adhered to by the bank. This is especially true with regard to the minimum payment, which
directly affects the amount the borrower is required to pay and the length of repayment if a customer only makes the minimum payment.
Consider the following: a contract states that the minimum payment will equal 2 percent of the outstanding principal balance at the end of the billing cycle. Assuming that $10,000 was outstanding at the end of the billing cycle, the minimum payment would be $200.00. Let’s further assume that the billing cycle was 30 days and the interest rate during the entire billing cycle was 10%. So according to the contract, $82.20 ($10,000 x 0.10/365 x 30) would be applied to interest, and the remaining $117.80 would be applied to principal.
However, this is not how the bank intended to calculate the minimum payment, nor is it how it is actually calculated on the bank’s loan accounting system. The bank intended to and actually calculates the minimum payment as 2 percent of the outstanding principal balance at the end of the billing cycle, plus all accrued finance charges. Therefore, the minimum payment is not $200.00, but rather $282.20, with $200.00 being applied to principal and $82.20 being applied to interest.
This is just one example of how unintentionally misstating the payment terms could directly affect the amount the borrower is required to pay and the length of repayment if a customer was to make only the minimum payment. Not only could this disclosure error result in numerous violations of Regulation Z, it also could lead to increased compliance, legal, and reputational risk.
Regulation Z requires institutions to disclose the method used to determine the balance on which the finance charge may be computed on both the initial disclosure and the periodic statement.
This is an area where examiners have found numerous inconsistencies. It should also be noted that the actual method must also be accurately described on the bank’s periodic statement.
Consider the following: a bank offers a variable rate home equity line of credit program, and the rate is subject to change on a daily basis. The account agreement and the initial disclosure states that finance charges are calculated using the "average daily balance" method. The bank’s periodic statement states that finance charges are calculated using the "daily balance” method. The bank's actual practice is to calculate finance charges using the "daily balance" method.
It should be noted that either balance computation method will yield the same finance charge if the interest rate does not vary during the cycle. However, if the rate varies during the statement cycle, a different finance charge could be obtained, depending on the balance computation method used. The amount of the difference is a function of the timing and magnitude of changes in both interest rates and the outstanding principal balance.
If the method used to calculate finance charges differs from the method described in the loan agreement or required disclosures, the bank may either be undercharging or overcharging its customers. Again, this disclosure error may result in violations of Regulation Z, and it could also lead to increased compliance, legal, and reputational risk.
The examples above illustrate the point that the terms and conditions of a legal agreement between a bank and its customers and all required disclosures must be consistent with the bank’s actual operating practices. Unfortunately, errors and discrepancies are occurring all too frequently. Management must be vigilant in establishing strong controls to ensure compliance with consumer laws and regulations and to avoid increased legal, compliance, and reputational risk.
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.