Why bankers fear the effects test

To the dismay of bankers everywhere, HUD has officially adopted the effects test in its regulations issued under the Fair Housing Act. In doing so, HUD explains that this is not a change. Instead, it has stated, the action merely represents a codification of how HUD has always approached enforcement of the Fair Housing Act. But bankers are not happy with this development.

If you mention "effects test" among a group of bankers, you can see fear all over their faces. Nothing seems more threatening or daunting than having the effects test raised in a fair-lending examination or audit.

Why? What is actually so scary about the effects test? Let's examine it more closely.

Reviewing the facts about the test

The effects test is a three-part analysis:

1. The analysis starts with whether a policy or practice that appears neutral on its face has a discriminatory effect on a prohibited basis--disparate impact.

2. Next the test looks at whether the policy or practice that seems to discriminate on a prohibited basis actually has a business necessity supporting its use.

3. The final step is to determine whether there is a way to meet the same business necessity without such a discriminatory impact.

The first part is what really strikes terror into the heart of bankers.

Anyone in the business of making credit decisions knows that credit qualifications tend to rise as income rises. Creditors also know--all too well--that there is a strong correlation between income levels and racial or ethnic minority groups. In fact, there is also a difference in the income levels of men and women--and gender is a prohibited basis.

When these realities underlie credit decisions, it is highly likely that sound credit decisions will result in a disparate impact. In fact, given these realities, it is highly unlikely that there won't be a disparate impact. So already, at Step 1, bankers feel the threat of a lawsuit or enforcement action.

Life after Step 1

But the effects test is interesting--because it doesn't stop with step one. The first step simply raises an issue. The subsequent steps put the issue into context. So, an examiner or a consumer raises the concern that a credit policy has a disparate impact. Now what?

Next comes step two: Is there a sound business reason or business necessity for the policy or procedure?

In some fields, what constitutes a business purpose or necessity is not always clear. Fortunately in the world of credit there is one fundamental business purpose: distinguishing between good credit risks and bad credit risks.

Any criterion that helps a creditor make these distinctions accurately is important to the business purpose.

Step two is where the fear level should drop because credit underwriting standards are all about finding the good credit risks while rejecting the bad. The more accurately credit underwriting does this, the stronger the business.

Step two is where the real analysis should begin. The more accurate and effective the factors considered in evaluating credit are, the more accurately they will distinguish between good and bad credit risks. And, the accuracy of the factors becomes a powerful defense against any challenge of discrimination in effect.

Common sense should tell you that this works.

For example, creditors have long used the ratio of debt to income to evaluate credit applicants. This ratio effectively considers whether the applicant has enough income to manage credit payments, along with other debt. It also indicates whether the applicant manages debts responsibly.

There is clearly a business purpose to this ratio--so strong a business purpose that it has been reinstated after the mortgage crisis. 

The fact is that good underwriting automatically meets step two.

Underwriting that is based on assumptions--such as an assumption that people working construction are less creditworthy than people working in offices--could fail unless there is sound analysis underlying that factor. (And there probably isn't. Factors such as this are usually based on assumptions.)

Is there an alternative?

Enter step three. Every banker in the country should be familiar with step three. This type of analysis has been at the core of what is inaccurately referred to as "CRA lending."  The question in this phase is to figure out whether there is any other way to achieve the business purpose of distinguishing between good and bad credit risks than to use the factor that is challenged as discriminatory.

In looking for ways to make loans to low-income credit applicants, the industry has reevaluated almost all of the underwriting principles. Often, community groups asked banks to apply different debt ratios to low-income applicants or look instead to cash flow and proven ability to manage a high housing cost relative to income. In many situations, these loans could be supported by the alternative analysis. In these cases, there was an alternative way to make the loan that reduced any disparate impact of using ratios.

Of course, using alternatives can go too far. Many mortgages made in the first decade of this century went too far with alternative underwriting--or little if any underwriting.

Recovering from those mistakes continues to be painful, but there is a silver lining. Some of the alternatives to basic underwriting principles have been tested and proven dangerous. This experience helps with the third step of the effects test. It makes clear that flexible underwriting is something to be done only with great care. Underwriting should not be changed simply to change the demographic effect. Before changes there should be careful research and testing.

So, why are bankers so afraid of the effects test?  Protection is available: Good underwriting, with regular evaluations of the factors and any impact the factors may have on the people in the market area, should help a bank prevail on step three.