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The establishment of the Consumer Financial Protection Bureau (CFPB) brought not only a new regulator to conduct these types of reviews, but an ever-evolving definition of what constitutes a redlining practice, creating a moving target for financial institutions to aim for while conducting internal reviews and analyses.
Redlining gets its name from “the old days” wherein a group of bank executives would draw a red line on a map to mark off an area considered “high risk” where no loans should be granted. Typically, these areas consisted of high portions of low income or minority populations. Applications in these areas would be flat out refused or swiftly denied simply based on a directive not to service “those” areas.
While the days of the infamous redlined map may be gone, in the modern context redlining is not only any practice that leads to the direct denial to provide financial services to low income or high minority neighborhoods, but also any activity that could be construed as discouragement towards these same neighborhoods from even applying at an institution.
In essence, if a regulator determines an institution did not try hard enough to attract business from these types of areas, this too can be cited as a redlining violation. While disparate treatment such as directly refusing to service or increasing pricing for customers from these areas will always cause issue, disparate impact is the name of today’s game and activities warranting this label can be harder to detect.
Activities that are considered disparate treatment which could be found as a redlining violation include failing to appropriately place branches or billboards, direct marketing campaigns disproportionately targeted to avoid certain areas, or even low application volume from protected classes, regardless of origination percentage. Not only is your origination activity a key metric to review, but an institution can be cited for the lack of applications walking in the door, even if a disproportionate number of those applications result in originated loans.
Charges of redlining can have severe consequences for financial institutions. Of course, there’s the financial penalties such as the $10.6 million for BancorpSouth or the $27 million for Hudson City Savings. Institutions penalized for redlining violations can be required to remediate in the form of direct loan subsidies, contributions towards community programs, advertising, outreach, and credit repair along with direct remediation to consumers who were unlawfully denied or overcharged for loans.
As impactful as the immediate financial costs of these penalties could be for an institution, the long-term impact on their reputation and CRA score could be worse, driving away potential investors, business partners and applicants.
Considering the long-term impacts of a redlining violation, it’s absolutely vital to avoid being accused of carrying out the practice. The problem is that it can be difficult to even know for certain that redlining is occurring at your own financial institution.
This is why conducting redlining reviews is a must. But how do you run redlining analyses so that you can take that data and use it to protect your financial institution from allegations of redlining?
While the methods for evaluating potential redlining activities seems to be ever-evolving, there are four fundamentals that have repeatedly surfaced that any prudent redlining review will take into account.
One of the most basic ways of measuring redlining or disparate impact risk is to analyze the penetration rate of an institution’s own lending in Low & Moderate Income (LMI) and/or majority-minority areas compared to the totality of that institution’s lending. This test examines the portions of tracts where lending activity took place in LMI census tracts or MMCTs vs non-LMI or non-MMCTs. Those rates are then compared and examined for areas in which the penetration rate of the minority areas was significantly less than the rate of the non-minority areas. Any area where this difference is statistically significant can be flagged as a high-risk geography.
The idea here is that if you are putting forth the same effort to attract loans across the entirety of an area, you should be attracting loans from the same portion of LMICTs and MMCTs as compared to non-LMI or low minority tracts.
While this is the simplest metric to calculate in a redlining review, it is often the metric most institutions find to be the least favorable. There can be a variety of market context factors leading to poor penetration, including heavy competition in these areas, which leads us to our next fundamental.
After you know how you are doing in LMI and MMCTs, the next question to ask is “how are my peers performing?” Another key indicator that regulators have relied on in redlining analyses is a “peer” comparison that checks the lending institution’s activities against those of similar institutions operating in that region. This test looks for areas of statistical significance when comparing your percentage of lending in LMI/MMCTs to that of your peers.
Naturally the next question becomes “who are my peers?” Ideally, this comparison is made against peers that are similarly situated to your institution, but oftentimes defining “similarly situated” can be challenging. Non-banks vs banks, national lenders vs community banks, and varying product availability can all be differentiating factors among institutions generating volume in the same regional markets.
Some would argue that the regulators’ methods for defining “similarly situated” has been flawed and tends to be over-inclusive. The important question becomes, who do YOU think your peers are? It is critical to find your own regional competitors and document your method and your argument as to who you consider to be your peers, and just as importantly, who you do not. A defendable group of peers can improve your likelihood of accurately estimating your institution’s redlining risk.
If your lending is not so great, and your peers’ activity isn’t great, are you in the clear? Not just yet… the next fundamental metric you need to evaluate is the market aggregate performance. In a way, a market aggregate comparison is similar to a peer comparison in that it compares one lending institution’s business to that of other lending institutions. However, where it differs is that it compares the lender’s activity to ALL lenders in that geography, regardless of business model and lending type.
As the name suggests, this is an aggregate value for all lending activity in the region or market. Because all lending is typically considered in this metric, it can be difficult to meet the standard of the area if your lending institution’s products and business strategies are significantly different than others in the same market. The metric is still important because it can provide the best overall insight into the demand for services of a particular region. If the market aggregate reveals the opportunity to lend is minimal, it can help to explain the lower volumes. Conversely if this metric shows a large demand is there, but you and your peers fail to capture that business, the regulators are going to ask why and continue to probe for reasons.
The final fundamental most regulators are utilizing are lending distribution maps. Having a list of loans in LMI and MMCT areas can be helpful for showing overall market penetration, but having a map showing your lending distribution can be much more useful for evaluating shortcomings in your lending practices.
A visual representation of lending activity shows where a lending institution’s loans are most tightly clustered, and where gaps may occur. Regulators use these distribution maps to isolate areas that appear to have been excluded from lending activities, but proactively monitoring this view of your data can help management restructure loan practices to resolve these gaps and limit redlining risks.
While there’s no telling what new perspective tomorrow’s redlining enforcement action may reveal, these four items constitute the fundamentals of redlining reviews in the US financial services industry today. No longer will the excuse of “we didn’t know” get any institution a free pass, and no matter your particular business model, being aware of your redlining risk is a must. By taking these pillars into account when assessing that risk, your lending institution can be better-prepared for fair lending assessments and to defend against any allegations that may come along.
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