Re-Imagining Compliance- A Three-Part series

Part One – Compliance is here to Stay

Every culture has its own languages and code words.  Benign words in one culture can be offensive in another.  There was a time when something that was “Phat” was really desirable and cool while there are very few people who would like being called fat!  Compliance is one of those words that, depending on the culture, may illicit varying degrees of response.  In the culture of financial institutions, the word compliance has some negative associations.   Compliance is often considered an unnecessary and crippling cost of doing business.  Many of the rules and regulations that are part of the compliance world are confusing and elusive.  For many institutions, has been the dark cloud over attempts to provide new and different services and products.  

Despite the many negative connotations that surround compliance in the financial services industry, there are many forces coming together to alter the financial services landscape.  These forces can greatly impact the overall view of compliance.  In fact, it is increasingly possible to view expenditures in compliance as an investment rather than a simple expense.   In this three-part blog, we ask that you reimagine your approach to compliance.  

Why do we have Compliance Regulations?

 Many a compliance professionals can tell you about how difficult it is to keep everybody up to date on the many regulations that apply to financial institutions.  However, if you ask why exactly do we even have an Equal Credit Opportunity Act or a Home Mortgage Disclosure Act (“HMDA”), it would difficult to get a consensus.   All of the compliance regulations share a very similar origin story.   There was bad or onerous behavior on the part of financial institutions, followed by a public outcry, legislative action to address the bad behavior and then eventually regulations.  The history of Regulation B provides a good example:

A Little History

The consumer credit market as we now know it grew up in the time period from World War II and the 1960’s.  It was during this time that the market for mortgages grew and developed and became the accepted means for acquiring property, financing businesses, developing wealth and upward mobility.  By the late 1960’s the consumer credit market was booming. 

The Equal Credit Opportunity Act (“ECOA”) and regulation B are not nearly as old as you might think. In fact, the first attempt at regulating credit access was the Consumer Credit Protection Act of 1968.  This legislation was passed to protect consumer credit rights that up to that point been largely ignored.  The 1968 regulation was passed as the result of continuing growth in consumer credit and its effects on the economy.  For example, in the year before the regulation was passed, consumers were paying fees and interest that equaled the government’s payments on the national debt!  One of the goals of the Consumer Credit Protection Act was to protect consumer rights and to preserve the consumer credit industry.  

The Civil Rights Movement was occurring at the same time as the passage of the CCPA and in 1968, the Fair Housing Act was passed by Congress.  The FHA was designed to assist communities that that had been excluded from credit markets obtain access to credit.  We will discuss the Fair Housing Act in more detail next month.  

One of the things that the CCPA did was to empanel a commission of Congress called the National Commission on Consumer Finance.  This commission was directed to hold hearings about the structure and operation of the consumer credit industry.  

Unintended Consequences

While performing the duties they were assigned, the members of the National Commission on Consumer Finance conducted several hearings about the credit approval process for consumer loans.  The stories and anecdotes from these hearings raised a tremendous public outcry about the behavior of banks and financial institutions that were in the business of granting credit.   One of the common themes of the testimonies given was that women and minorities were being left behind when it came to the growth of the consumer credit market.  Public pressure forced additional hearings on the consumer credit market, and the evidence showed that women in particular and minorities in general were being given unfair and unequal treatment by banks. 

What was Going On? 

So what were banks doing that was a cause of concern?  There were several practices that had become normal and regular for banks when the applicant for consumer credit was a woman or a member of a racial minority group.  

Women had more difficulty than men in obtaining or maintaining credit, more frequently were asked embarrassing questions when applying for credit, and more frequently were required to have cosigners or extra collateral.   When a divorced or single woman applied for credit she was immediately asked questions about her life choices, sexual habits, and various other personal information that was both irrelevant to the credit decision and not asked of men. 

Racial minorities had difficulty even obtaining credit applications let alone credit approvals.  In cases, where members of minority groups attempted to get a loan applicant, there were either told that the bank was not making consumer loans, or that the area that the person lived was outside of the lending area of the bank. 

For applicants that receive public assistance, child support of alimony, banks would not consider these as sources of income under the theory that they were temporary and might disappear.  

Despite being subjected to embarrassing or incorrect information, in the cases where women and minorities persisted and completed a credit applications, banks would drag out the process for interminable time periods and would engage in strong efforts to discourage the applicant from going forward.  

In many cases, when a person lived in a neighborhood that was predominately comprised of minorities, the borrower was told that the collateral did not have enough value without further explanation.  

The ECOA

Though these stories created a great deal of interest, the CCPA was not amended until 1974 when the first Equal Credit Opportunity Act was passed.  This Act prevented discrimination in credit based on sex and marital status. 

Why are there a Regulation B and the ECOA?

The development of the consumer credit market brought with it a series of bad behaviors that directly and negatively impacted the ability of women and minorities to obtain credit.   These behaviors included asking women to check with their husbands before getting a loan, denying a single woman credit, discouraging minorities from applying for credit and outright refusal to grant credit.  

The law and regulation are designed to open credit to all who are worthy by limiting practices that unfairly exclude groups of people and by making sure that applicants are fairly informed of the reasons for a denial.  

The regulations exist because there was bad behavior that was not being addressed by the industry alone.  Many of the compliance regulations share the same origin story. 

Compliance is not all Bad

Sometimes, we are caught up on focusing on the negative to the point that it is hard to see the overall impact of bank regulations.   One of the positive effects of compliance regulations is they go a long way toward “leveling the playing field” among banks.   RESPA (the Real Estate Settlement Procedures Act) provides a good example.  The focus of this regulation is to get financial institutions to disclose the costs of getting a mortgage in the same format throughout the country.   The real costs associated with a mortgage and any deals a bank has with third parties, the amount that is being charged for insurance taxes and professional reports that are being obtained all have to be listed in the same way for all potential lenders.  In this manner, the borrower is supposed to be able to line up the offers and compare costs.  This is ultimately good news for community banks.  The public gets a chance to see what exactly your lending program is and how it compares to your competitors.  The overall effect of this legislation is to make it harder for unscrupulous lending outfits to make outrageous claims about the costs of their mortgages.   This begins to level the playing field for all banks.  The public report requirements for the Community Reinvestment Act and the Home Mortgage Disclosure Act can result in positive information about your bank.    A strong record of lending within the assessment area and focusing on reinvigoration of neighborhoods is a certainly a positive for the bank’s reputation.  The overall effects of the regulations and should be viewed as a positive.  

Protections not just for Customers

In some cases, consumer regulations provide protection not just for consumers but also for banks.  The most recent qualifying mortgage and ability to repay rules present a good case.  These rules are designed to require additional disclosures for borrowers that have loans with high interest rates.   In addition to the disclosure requirements, the regulations establish a safe harbor for banks that make loans within the “qualifying mortgage” limits.  This part of the regulation provides strong protection for banks.  The ability to repay rules establish that when a bank makes a loan below the established loan to value and debt to income levels, then the bank will enjoy the presumption that the loan was made in good faith.  This presumption is very valuable in that It can greatly reduce the litigation costs associated with mortgage loans.  Moreover, if a bank makes only “qualifying mortgages’ the level of regulatory scrutiny will likely be lower than in the instance of banks that make high priced loans. 

Compliance regulations will no doubt be a part of doing business in the financial industry for the foreseeable future.   However, all is not Considering a strategy that embraces the regulatory structure as an overall positive will allow management to start to re-imagine compliance and consider greater investment.   In our next blog, we will discuss the forces that are converging to make the return on investment in compliance strong.