Section 1071 of the Dodd Frank Act- A New Look at Fair Lending -  A Two-Part Series

Part One- Towards a LAR for Commercial Loans

As the dust settled form the financial meltdown of 2008 there were a large number of new significant regulations to consider.  The qualified mortgage rules, mortgage servicing rules and appraisal valuations all garnered a great deal of attention and focus.  Of course, due to the impact of these rules, this attention was well deserved.   However, as the dust settled from getting compliance programs in place, it is time to give attention to future regulatory requirements.  

One of the most significant of the future regulations is section 1071 of the Dodd Frank Act.  This section amends the Equal Credit Opportunity Act (AKA as Reg. B) to require banks to gather information about applicants for commercial loans.   The information that will be gathered is very similar to information that is currently required by the Home Mortgage Disclosure Act (HMDA).  Many believe that the future of this regulation is in doubt due to the general hostility of the current presidential administration to the Dodd Frank Act.  Regardless of whether this regulation becomes fully implemented, the information that it requires is well worth considering.

Specifics

For the time being, this section of the Dodd Frank Act has been put on hold until the implementing regulations have been written.  There are many who believe the future of the CFPB is in doubt, but merely hoping things change is not a successful strategy.  Earlier in 2017, the CFPB started taking comments on the regulation with an eye toward developing a final rule early next year. It is likely the regulation will be implemented in some form early in 2018.  

What is the type of information that is required?  So far, the list of information required is as follows: 

‘‘(1) IN GENERAL. —Each financial institution shall compile and maintain, in accordance with regulations of the Bureau, a record of the information provided by any loan applicant pursuant to a request under subsection (b).

‘‘(2) ITEMIZATION.—Information compiled and maintained under paragraph (1) shall be itemized in order to clearly and conspicuously disclose—

‘‘(A) the number of the application and the date on which the application was received;

‘‘(B) the type and purpose of the loan or other credit being applied for;

‘‘(C) the amount of the credit or credit limit applied for, and the amount of the credit transaction or the credit limit approved for such applicant;

‘‘(D) the type of action taken with respect to such application, and the date of such action;

‘‘(E) the census tract in which is located the principal place of business of the women-owned, minority-owned, or small business loan applicant;

‘‘(F) the gross annual revenue of the business in the last fiscal year of the women-owned, minority-owned, or small business loan applicant preceding the date of the application;

‘‘(G) the race, sex, and ethnicity of the principal owners of the business; and

‘‘(H) any additional data that the Bureau determines would aid in fulfilling the purposes of this section.

‘‘(3) NO PERSONALLY IDENTIFIABLE INFORMATION.—In compiling and maintaining any record of information under this section, a financial institution may not include in such record the name, specific address (other than the census tract required under paragraph (1)(E)), telephone number, electronic mail address, or any other personally identifiable information concerning any individual who is, or is connected with, the women owned, minority-owned, or small business loan applicant.

When the regulation is enacted, what will be required?  Why are the regulators doing this to us?   In reverse order, the reason given for this change to the ECOA is as follows:

“The purpose of this section is to facilitate enforcement of fair lending laws and enable communities, governmental entities, and creditors to identify business and community development needs and opportunities of women-owned, minority owned, and small businesses” [1]

Put another way, the purpose of the collection of this information will be to allow banks, economists and regulators to more completely and accurately determine the types of loans that are being requested by minority and women owned business.  Presumably, the collected data will be used to provide regulators with tools to craft legislation to help expand fair lending laws and rules to the commercial lending area.  The merits of whether these regulations should be expanded to the commercial lending will be discussed in part two of this blog.

There are some unique features to the requirements of this law.  For example, the lending staff member who is doing the underwriting is NOT ALLOWED to ask the questions required by the law;

Where feasible, no loan underwriter or other officer or employee of a financial institution, or any affiliate of a financial institution, involved in making any determination concerning an application for credit shall have access to any information provided by the applicant pursuant to a request under subsection (b) in connection with such application.[2]

The idea here is this information must not be part of any credit decision, and the bank is under an obligation to present evidence that this information has been segregated from the credit decision.  Therefore, even in cases where there are too few staff members to totally segregate the collection of the information from the loan staff, a protective wall still must be created. 

If a financial institution determines that a loan underwriter or other officer or employee of a financial institution, or any affiliate of a financial institution, involved in making any determination concerning an application for credit should have access to any information provided by the applicant pursuant to a request under subsection (b), the financial institution shall provide notice to the applicant of the access of the underwriter to such information, along with notice that the financial institution may not discriminate on the basis of such information[3]

The time is coming when this information must be collected and the Bank must make sure that once it is collected, that the information has no impact on the credit decision. 

Implications for the Future

What does this regulation mean for the future?  It is of course, difficult to predict the future with any real accuracy.    However, it is clear that the trend for regulations is that the scope and influence of fair lending and equal credit opportunity laws will increase in influence over the next decade.   It will be increasingly important for banks to determine with detail the credit needs of the communities they serve.  Moreover, there will be increased emphasis on banks’ ability to show how the credit products being offered meet the credit  needs of that same community. 

Why not start now?

The obvious question to ask is with all of the regulations that are coming into effect at this point  and the resulting requirements, why start dealing with a regulation that has not come into existence?  Why not cross that bridge when we come to it? In fact, there is a chance that this law may never get an implementing regulation. 

Delay will result in higher costs and increase the risk of noncompliance.   Whether or not Section 1071 is implemented within the next year or the next few years, information about the borrowers you serve and the products that you offer to serve them should be part of your strategic plan, fair lending plan and CRA plan.  This information will be a critical component of showing your regulators that you are a vital part of the local economy and community.  Moreover, this information should be a critical part of your institutions’ drive to reach out to the new customers who are currently among the large number of unbanked and underbanked.  This pool of potential customers is one of the keys to successful banking in the future.  In fact, whether or not the regulation is ever implemented, developing information on women and minority owned businesses will be a ket strategic advantage for the financial institutions that realize the vast potential that these business owners present. 

In Part two of this blog, we will make the case for collection of information on loans to women and minority owned businesses regardless of regulation requirements. 

Why Should Small Financial Institutions Perform Compliance Risk Assessments?   

The concept of risk assessments is often associated with large banks and financial institutions – but it shouldn’t be.  Oftentimes, the ugly truth about risk assessments is that they are prepared specifically to meet a regulatory requirement and not much more.  The common practice is to perform an annual risk assessment for BSA, get it approved and for the most part, put it away and don’t think about it again until the next year.  The completion of this risk assessment is performed to meet regulatory requirements and not much else.    Risk assessments of the overall compliance program are rare, due to many factors including lack of time and resources.

Risk assessments can, and should be, used as a tool in the overall compliance toolkit.   When a compliance risk assessment is properly completed and deployed it have many uses including audit planning, cost reduction, training development and resource allocation to name a few.   Ultimately, the risk assessment should be used as the bedrock of a strong compliance program.  

The Component Parts of a strong Compliance Risk Assessment

Past examination and audit results- It goes without saying that the past can be a prelude to the future, especially in compliance.   Prior findings are an immediate indication of problems in the compliance program.   It is important that the root cause of the finding is determined and addressed.  The compliance risk assessment must include a description of the cause of the findings and the steps being taken to mitigate the risk of a repeat.  We recommend that the action should be more than additional training.   However, without testing to determine whether the training is effective, the risk of repeat findings remains high.  It should also be noted that a lack of past findings does not necessarily mean that that the coast is clear. Each compliance area should be reviewed and rated regardless of whether there were past findings.   In some cases, there are findings that are lying in wait and have not yet been discovered.    

 Changes in staff and management- change is inevitable and along with changes comes the possibility that additional training should be implemented or that the resources available to staff should also change.  For example, suppose the head of Note Operations is brand new.  This new manager will want to process loans using her/his own system.  Loan staff who may be used to doing compliance checks at certain times during the loan origination process might become confused.  This increases the possibility of findings or mistakes.   Your compliance risk assessment should consider the risks associated with changes and how best to address them.

Changes in products, customers or branches-It is important that your risk assessment consider all the different aspects of changes that have occurred or will occur in the Bank during the year.  This will include any new products or services, new vendors and marketing campaigns that are designed to entice new types of customers.  The risk assessment should consider what resources will be required and how they should best be deployed.  Before new products are introduced, the compliance team should consider the time necessary to make sure that all of the processes are in place.  New advertising means both technical and fair lending compliance considerations.  

Changes in Regulations- Over the past five years, there have been a huge number of changes to regulations, guidance and directives from Federal and State agencies.  Many of these changes do not impact small financial institutions directly, but many do.  Moreover, there are often regulations that are finalized in one year that don’t become effective until the following year.   Part of your risk assessment process must consider changes that affect your bank or will affect you bank.   As a best practice, it is advisable to review the annual report of your regulator to determine the areas of focused that are planned for the year.  Regulators are transparent with this information and their publications will indicate areas of examiner focus for the upcoming year.   

Monitoring systems in place – Finally, the systems that you use to monitor compliance should be considered.  For many small institutions, this system is comprised of word of mouth and the results of audits and examinations.   Part of your assessment should include a plan to do some basic testing of compliance on a regular basis.  After all an ounce of prevention……

The Analysis

Once you have gathered all the information necessary for completing the analysis, we suggest using analyses that doesn’t necessary assign numbers to risk, but prioritizes the potential for findings.  Remember the effectiveness of your compliance program is ultimately judged by the level and frequency of findings.   The effective risk assessment reviews those areas that are most likely to result in findings and develops a plan for reduction.   

Inherent Risk

For each regulation that applies to your institution, you must first determine the level of inherent risk. According to the Federal Reserve Bank, inherent risk can be defined this way: 

“Inherent consumer compliance risk is the risk associated with product and service offerings, practices, or other activities that could result in significant consumer harm or contribute to an institution’s noncompliance with consumer protection laws and regulations. It is the risk these activities pose absent controls or other mitigating factors.”[1]

Your compliance risk assessment should consider the inherent risk associated with each product that is offered.  For each regulation, consideration should be given to the penalties associated with a violation. As a best practice, the likelihood of review of the area by regulators should also be factored into the overall level of inherent risk.  For example, flood insurance is an area that is likely to be examined every time the examiners conduct a review and this should factor into the overall inherent risk rating of the area.  

Effectiveness of Controls  

Once the inherent risk has been established, the next step is to assess the overall effectiveness of internal controls.  Your internal controls are the policies, procedures, training and monitoring that are performed on a regular basis.   This includes audits and internal reviews that are performed by the compliance department.  

To complete the analysis, it is necessary to be self-reflective, honest and brutal!  If staff is weak in its understanding of the requirements of Regulation B, it is necessary to plan to address the weakness.   If more training is necessary, or if, heaven forbid, a consultant is needed in certain areas, it really is appropriate as part of the assessment to say so and attempt to make the case to management.  We have found that the cost of compliance goes up geometrically when faced with enforcement action.  It is much more efficient to seek the assistance when there are only potential problems as opposed to when actual problems have been found.   

Residual Risk  

Residual risk is defined as the possibility that compliance findings will occur after consideration of the effectiveness of controls.  The less effective the controls, the higher the residual risk.   Again, it is critical that the assessment in this area is one that must be brutally honest.  If overall controls, are not what they should be, the weaknesses that exist should be reflected in the risk assessment.  The goal of the assessment is to determine the areas that have the highest levels of risk and to allocate resources accordingly.  

Using the Document

The compliance risk assessment is like a Swiss army knife- it has several uses.   First, the compliance risk assessment should be used to help with the planning and scoping of audits for the year.  The highest areas of risk should receive the greatest scrutiny by the auditors.  Moreover, the highest risk areas should be scheduled for review as early in the year as possible so that remediation efforts can be commenced and tested.  

Rather than setting a basic training schedule, use the assessment to make sure that classes are focused on areas where the risk assessment has shown the potential for problems.    The risk assessment can also be used to set the priorities for which policies and procedures need to be updated and in what order.  The compliance risk assessment is a good tool for measuring the level and quality of compliance resources. As part of the risk assessment process, the level and quality of resources must be considered.   As the process is concluded, it is natural to use the results to develop specific requests for additional staff, software, training or other resources that are necessary to maintain a strong compliance program.  

Creating the Compliance Environment

Probably the greatest untapped asset for any compliance officer is the staff at your institution.  Without the support and input of the people who are contacting customers and performing day to day operations, the effectiveness of your compliance program will be greatly limited.    Of course, one of the greatest impediments to getting the “buy-in” of staff is the perception of compliance that many in the banking industry have.  There is generally dislike and disdain for anything compliance related.  Compliance rules have been developed over time in response to unfair and sometimes immoral behavior on the part of banks.  Most of the regulations have a history that is interesting and can help explain what it is that the regulation is attempting to address.  Taking the time to discuss the history of the regulations and what it is that they are trying to address can go a long way toward getting staff involvement. Making sure that senior management accepts the importance of compliance and the costs of non- compliance can help increase support. 

A comprehensive compliance risk assessment should be the key to a strong compliance program. Using the results of the compliance risk assessments to plan the compliance year and deploy resources can be a very effective tool towards reducing compliance risks.

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[1]COMMUNITY BANK RISK-FOCUSED CONSUMER COMPLIANCE SUPERVISION PROGRAM

Getting to the Root of the Problem- An Important Step for Strong Compliance

You have just received word that the compliance examiners are coming.  So now it is time to get everything together to prepare for the onslaught, right?   Time to review every consumer loan that has been made and every account that has been opened in the last 12 months, right? Not necessarily; the compliance examination is really an evaluation of the effectiveness of your compliance management program (“CMP”).  By approaching your examinations and audits as a test of the compliance program, the news of an upcoming review becomes (almost) welcome.  

Because the examiners are ultimately making an assessment of the CMP, it is critical to understand the overall effectiveness of your program from the outset.  In particular, it is necessary to be able to detect and analyze the root cause of compliance problems at your institution. 

The Elements of the CMP

There is really no “one size fits all” way to set up a strong compliance program.  There are, however, basic components that all compliance management systems need.  These components are often called the pillars of the CMP.  The pillars are:

·        Board Oversight

·        Policies and procedures

·        Management Information systems including risk monitoring

·        Internal Controls

The relative importance of each of these pillars depends on the risk levels at individual institutions.  The compliance examination is a test of how well the institution has identified these risks and deployed resources.   For example, in a financial institution that has highly experienced and trained staff coupled with low turnover, the need for fully detailed procedures may be minimal.  On the other hand, when new products are being offered regularly, the need for training can be critical.   The central question is whether the institution has identified the risks of a compliance finding and having done so, taken steps to mitigate risks.  

Making the CMP fit Your Institution   

Making sure that your CMP is right-sized starts with an evaluation of the products that are being offered and the inherent risk in that activity.  For example, consumer lending comes with a level of risk.  Missed deadlines, improper disclosures or misinterpretations of the requirements of the regulations are risks that are inherent in a consumer portfolio.   In addition to the risks inherent in the portfolio are the risks associated with the way the institution conducts it consumer business.   Are risk assessments conducted when a product is going to be added or terminated?  Both adding and ending a product can create risk.   For example, the decision to cease HELOCs may create a fair lending issue; while the decision to start making HELOCs should consider the knowledge and abilities of the staff that will be making the loans and the staff that will be reviewing for compliance.  

As a best practice, compliance has to be a part of the overall business and strategic plan of a financial institution.  The CMP has to be flexible enough to absorb changes at the bank while remaining effective and strong.  

The True Test of the CMP

Probably the most efficient way to determine the strengths and weakness of the CMP is by reviewing the findings of internal audits and examinations.  Most important is determining what caused the problem.  Moreover, not only the findings, but the recommendations for improvement that can be found in examination and audit reports can be used to help “tell the story” of the effectiveness of the CMP.  It is very important to determine the root cause the finding.  Generally, the answer will be extremely helpful in addressing the problem.  There are times when the finding is the result of a staff member having a bad day.  On those bad days, even the secondary review may not quite catch the problem.  For the most part, these are the types of findings that should not keep you up at night.  

 The findings that cause concerns are the ones that result from lack of knowledge or lack of information about the requirements of a regulation.  These findings are systemic and tend to raise the antenna of auditors and examiners.  Unfortunately, too often the tendency is to respond to this kind of finding by agreeing with it and promising to take immediate steps to address it.  Without knowing the root cause of the problem, the fix becomes the banking version of sticking one’s finger in the dyke to avoid a flood.  

Addressing Findings  

We suggest a five-step process to truly address findings and strengthen the CMP.

 1.       Make sure that the compliance staff truly understands the nature of the finding.  This may sound obvious, but far too many times there is a great deal lost in translation between the readout and the final report.  If staff feels like what was discussed at the exit doesn’t match the final report, here is a communication concern.  We recommend fighting the urge to dismiss the auditor/examiner as a zealot!  Call the agency making the report and get clarification to make sure that the concern that is being expressed is understood by staff.   

 2.       Develop an understanding of the root cause of the finding.  Does this finding represent a problem with our training?  Perhaps we have not deployed our personnel in the most effective manner.  It is critical that management and the compliance team develop an understanding for why this finding occurred to most effectively address it.  

 3.       Assign personal responsible,  along with an action plan,  and benchmark due dates.   Developing the plan of action and setting dates develops an accountability for ensuring that the matter is addressed. 

 4.       Assign an individual to monitor progress in addressing findings.  We also recommend that this person should report directly to the Audit Committee of the Board of Directors.  This builds further accountability into the system.   

5.       Validate the response.   Before an item can be removed from the tracking list, there should be an independent validation of the response.  For example, if training was the issue; the response should not be simply that all staff have now taken the training.  The process should include a review of the training materials to ensure that they are sufficient, feedback from staff members taking the training, and finally a quality control check of the area affected.   

Not only does determining the root cause of a problem make the response more effective, but in doing so, the CMP will be strengthened.  For example, It may be easy to see a problem with disclosing right of recession disclosures.  It may be harder to see that the problem is not the people at all, but that the training they received is confusing and ineffective.  Only by diving into the root cause of the problem can the CMP be fully effective.