8 minute read
Fair Lending
by Timothy A. Schenk KBA Assistant General Counsel tschenk@kybanks.com
The Challenge of Meeting Regulatory Change
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On March 16, the Consumer Financial Protection Bureau (CFPB) “announced changes to its supervisory operations to better protect families and communities from illegal discrimination.” “The CFPB will scrutinize discriminatory conduct that violates the federal prohibition against unfair practices. The CFPB will closely examine financial institutions’ decision-making in advertising, pricing, and other areas to ensure that companies are appropriately testing for and eliminating illegal discrimination.”
While these announcements from the CFPB, and many other agencies, are not new, the question remains, what is “fair lending”? Practitioners can look to laws like the Equal Credit Opportunity Act (ECOA), Consumer Financial Protection Act (CFPA), Home Mortgage Disclosure Act (HMDA), Fair Housing Act (FHA), the Real Estate Settlement Practices Act (RESPA) and others for direction. In reality, however, these laws generally only provide a baseline standard that tells what is not fair lending; not “what is fair lending.”
When you talk to regulators and regulatory experts, most say, “You will know a fair lending violation when you see it” and it is not fair lending if your practices have a “disparate impact.” That doesn’t really provide clear guidance which we look for as practitioners. Furthermore, the regulatory enforcement action database generally only tells us the worst of the worst with acts of clear discrimination and redlining that leaves out real guidance for those institutions working to implement a robust compliance management system.
The reality is that banks must be proactive in utilizing every tool at their disposal to ensure fair lending. This includes understanding that review is not just at consummation at the loan; but rather throughout “the life” of the loan.
In reviewing loan practices at the time of consummation or “front end,” there are a number of areas to review for compliance. This includes reviewing the numbers of applications and approvals in low-to-moderate income areas. It includes ensuring that your marketing targets everyone in your service area, not just specific income levels and that your strategy is understandable to all people, including those individuals with English as their second language. This also includes reviewing loan policies to ensure your underwriting policies are non-discriminatory and that your employees fully understand the policy. A compliant fair lending program avoids minimum loan amounts and programs that may have unintended negative consequences.
For loans in default, the CFPB and other regulators expect banks to have resources to respond to requests and applications for loss mitigation assistance to reduce “avoidable” foreclosure. These action items include: being proactive; working with borrowers; addressing language access; evaluating income fairly; handling inquiries fairly; preventing avoidable foreclosures; and using all tools to communicate with borrowers within legal confines.
Regardless of whether you are viewing fair lending at the beginning, middle or end of a loan, the key to a successful fair lending management system is to analyze data and document your actions. In order to be successful at fair lending, an institution must implement a system of oversight and accountability. One expert that I talk to regularly working with banks in the regulatory process always says, “You tell your story. Do not let a newspaper tell it for you.”
“Telling your own story” is a process. This means instituting a robust compliance management system that can monitor loan processing and underwriting activities for compliance and issue reports related to compliance. Your compliance management system should test, monitor and audit your loan activities and be able to conduct a comparative analysis for peer groups within similar markets. Your compliance management system should be able to identity disparities between groups in key-lending metrics. If you see disparities, determine whether that disparity equates to discrimination and if so, determine what you will do to remedy it. By addressing all of these areas prior to examination, you can explain any differences and show how you are taking steps to ensure that your institution is fair lending compliant.
It is also important to understand the systems implemented to protect your institution. You have three lines of defense: (1) your front-line business unit and partners; (2) your compliance risk management system and compliance department; and (3) your internal and external audits.
Fair lending is making sure that problems areas do not make it through the first line of defense, but certainly not all three lines of defense. While these lines of defense can seem burdensome, they will protect your institution from fair lending risk and ensure a culture of fair lending compliance.
The reality is that all banks face ever-changing fair lending risk. Asset size does not matter when it comes to enforcement. All agencies are expected to issue new regulations and enforcement items related to fair lending. While we expect regulatory enforcement to increase, we do not expect new guidance directing banks how to lend and further defining “fair lending”. This can be challenging for banks. However, if you properly analyze your data and focus on your three lines of defense, you are likely to be deemed a fair lender regardless of what definition of “fair lending” is being utilized.
by Robert Biggs, Duncan Williams VP & Senior Market Analyst, Fixed-Income Strategies
Preceding the pandemic, the average Yield on Earning Assets for Kentucky Banks ranged from a high of 7.58% (2021) to a low 4.12% (2016) over the past two decades, while Cost of Funds varied from 3.71% to .43%. Despite the wide variances in YoEA and COFs, Net Interest Margin stayed within a 32-bps range (3.97%-3.69%). The past two years bucked the tight range trend as NIM fell to 3.58% in 2020 and then to 3.37% in 2021. What changed in the past two years, and why is the traditional approach to NIM Dead?
Historically, CEOs and CFOs had to implement an asset and a liability strategy to achieve an attractive NIM. While the components of NIM are unchanged, their characteristics and risk profiles are wildly different from previous years.
YoEA’s declined by over 100 bps in the past two years as asset sizes ballooned in a low-rate environment, but YoEA is not to blame for compressing NIM. From 2007 to 2009, YoEA fell by 145 bps, and NIM only compressed by three bps because COFs also dropped by 143 bps. During the pandemic, COFs fell by only 59 bps to 30 bps, which did not compensate enough for declining YoEA. With excess liquidity and prolonged low overnight rates, banks have lost the ability to sufficiently contract their funding rates to bolster NIM.
Consequently, liabilities have become more negatively convex, with significantly more opportunities for COFs to move higher and no room for them to fall. In managing net interest income moving forward, CEOs and CFOs must recognize that they can only materially affect one side of the balance sheet to prepare for a falling rate environment.
However, banks also feel little pressure to raise the COFs. From 2003 to 2007, Kentucky banks had a COFs Beta of 35% relative to the effective fed funds rate. The beta plummeted to 16% during the 20152019 rate hikes. The beta should fall further in the current tightening cycle as banks are less exposed to wholesale funding—11.7% of liabilities in 2015 Q3, 6% of liabilities in 2021 Q4—and excessive liquidity mitigates depositors’ pricing power. The stickiness of the current COFs range mutes the need for a traditional liability strategy.
While YoEA fell by over 100 bps in the past two years, the interest income only dropped by 5% because the 22% growth in assets supported revenue at the expense of margins. In the era of low rates, revenue is created in volume, not spread, but the volume approach is not without risks. The increased economic value of equity exposure is a natural byproduct of ballooning asset sizes, but also more challenging as financial institutions are undertaking more market value risk to earn less revenue. Examining the bond portfolio, many banks have the lowest investment yield coupled with the largest loss in their organization’s history. The dual side of the balance sheet approach to creating a compelling NIM appears to no longer be necessary. A/L Committees should focus almost solely on the asset side to generate interest income with manageable exposure to rising interest rates and call protection to defend NIM against falling interest rates.
Floating-rate assets protect EVE in a rising rate environment but often fail to generate sustainable revenue. Longer-duration assets offer attractive yields but expose the bank to rising interest rates. A barbell approach of pairing longer-duration assets with floating-rate loans and investments should create income while managing interest rate risk. Unfortunately, many institutions look at their reports and see tremendous unrealized losses. They only feel comfortable adding the floating rate component despite multi-year high yields.
In the new banking environment with bloated securities and cash positions, financial institutions should begin evaluating their excess liquidity with their investment portfolio to understand their risk tolerances better. Excess liquidity is not a placeholder for potential lending opportunities; it is a measurable opportunity cost that reduces the bank’s exposure to rising interest rates and lowers their loss percentage when paired with the investment portfolio.
Unless we see a meaningful decline in the monetary supply, banks will continue to generate net interest income by a volume approach. Ignoring multi-year high entry points out of fear of compounding unrealized losses eliminates the opportunity to finally add accretive revenue to the income statement. Excess liquidity, if not invested, should at least be considered in the bond portfolio’s analytics to measure risks tolerances, and most banks will find that they have room to take advantage of the current interest rate environment.
