Auto Lending's Dangerous Trio of Fair Lending Risk Factors
Indirect lending - including auto, marine, and recreational vehicle lending - and the associated Fair Lending risk continues to garner attention from the regulators, politicians and industry associations. We'll share the trio of factors that increase Fair Lending risk for indirect and automotive lending.
Three factors have historically co-existed in indirect lending that collectively amplify Fair Lending risk. This dangerous trio of risk factors are:
- Dealer discretion regarding the pricing paid by borrowers;
- Dealer compensation systems that may allow for increased rewards for more expensive deal terms;
- Existence of consumer pricing disparities between groups.
Dealer Discretion + Dealer Compensation + Disparities in Rates Paid by Borrowers = Fair Lending Risk.
This is especially true for auto lending.
Through many communication mediums, from bulletins and fact sheets to speeches, the CFPB has made it clear to those involved in the lending process that they have a clear dislike and a low tolerance for any compensation programs that reward discretion where there are disparities in the results. This dislike of discretion and mark-ups is true for marine, recreation vehicle, and of course, auto lending.
Why the regulatory focus on automotive? According to the CFPB, automotive lending is the third largest source of outstanding household debt, after mortgages and student loans. Many consider auto lending an essential service afforded to consumers, recognizing the transportation it provides to and from work. “Cars and trucks can quite literally take consumers to new opportunities,” said Richard Cordray, the CFPB’s Director. Since the regulators understand how important and common it is, they want to make sure that consumers are protected in that process. Below, we’ll dive into the three things that the regulators believe can amplify Fair Lending risk, then we'll share some best practice advice for minimizing Fair Lending risk.
The 3 Fair Lending Risk Factors for Auto Lending
Dealer Discretion: The regulators do not like discretionary dealer markups. Discretionary dealer markups occur when dealers charge a higher interest rate than the minimum rate or buy rate established by lenders. It’s apparent that the regulators believe that discretionary dealer markups are viewed as a flawed approach because it results in higher mark-up rates paid by minority groups when compared to non-minority borrowers.
"When lenders have policies that provide incentives to charge higher interest rates, it can lead to unequal, discriminatory access to credit. We saw similar issues in the mortgage market with yield spread premiums. Discretionary markup policies create a significant risk of pricing disparities, and research indicates that such policies may result in African-American and Hispanic borrowers paying more for auto loans than other customers. We are also concerned that similar risks may exist for pricing disparities based on other prohibited bases under federal fair lending laws.”
- Richard Cordray, Director of the CFPB
Compensation Systems: For similar reasons, the regulators do not like compensation systems that allow for increased rewards for more expensive deal terms. They believe that it incentivizes discretionary dealer markups, which can contribute to a risk of pricing disparities. We will cover pricing disparities next.
Consumer Pricing Disparities: Regulators are concerned about consumer pricing disparities because they can lead to disparate impact. The doctrine of disparate impact holds that lending practices may be considered discriminatory and illegal if they have a disproportionate adverse impact on protected classes or prohibited basis groups (e.g. females and Hispanics). Evidence of discriminatory intent is not necessary to establish that your collective approach to pricing has a disparate impact and is in violation of the ECOA.
Now that we've explained the regulatory focal points, below is some best practice advice for minimizing risk.
Two-Step Approach to Mitigating Risk
Step 1: Reconsider Approach to Pricing
The CFPB has stopped short of consistently endorsing any form of dealer pricing and compensation. They have consistently endorsed non-discretionary pricing and compensation policies that include flat fees. In their indirect auto lending bulletin, the CFPB said that steps to comply with the Equal Credit Opportunity Act may include “eliminating dealer discretion to mark up buy rates and fairly compensating dealers using another mechanism, such as a flat fee per transaction, that does not result in discrimination.” First and foremost, the financial institution’s approach must make sense for the organization and fit inside the overall strategy. Options used to limit dealer discretion, and the associated fair lending risk, include:
Flat Fees: Flat fee is typically discussed as a common percentage (e.g. 3 percent) of the amount financed up to a maximum fee (e.g., 3% flat fee x $25,000 amount financed = $750). Auto dealers and industry associations have been hesitant to embrace the flat fee approach. One argument stems from the belief that dealers would be encouraged to seek out lenders that pay the best flat fee compensation, rather than offer the lowest interest rates to the consumer. For example, the CFPB publicly applauded BMO Harris Bank’s recent move in April 2014 to this flat compensation structure. They are the first large bank to make the move.
Capping Mark-Up (Maximum Spread Between Buy Rate and Contract Rate): A common approach that is currently employed is the “maximum” applied mark-up applied to the buy rate offered by the financial institutions. The common maximum spread is between 200-300 basis points. However, there is no suggested threshold from the agencies. While this capped approach limits the mark-ups, it still faces criticism from the regulators who believe this approach still affords discretion to dealers.
Standardized Pricing for Borrowers: NADA, and other associations, have endorsed an approach where the dealer reserve (money paid to the dealership for arranging the car loan) is based on a preset amount which is the same for every consumer. If the preset ceiling amount needs to be adjusted down, the dealer can document the reasons why (e.g., competitive offer, inability to make monthly payment, and promotional offer available to all borrowers). This approach is consistent with a DOJ settlement (Pacifico Ford Settlement) where dealers agreed to follow the same procedures for setting markups for all customers.
Step 2: Strengthen Fair Lending Compliance Management Program
Research on best practices shows that strong compliance management programs typically include the following elements:
Policies and Procedures Specific to Indirect Auto Fair Lending: Your approach should consider a consistent dealer compensation program; an up-to-date fair lending policy and statement; an annual due diligence process of auto dealers (including data review); assignment of clear responsibility for team members to manage the indirect lending program and associated fair lending; develop appropriate committees that help monitor the key activities; and develop a reporting program that provides management the appropriate optics. Without defined policies and procedures, you can leave the day-to-day operation practices in the hands of unique and individual interpretation.
Train Your Team Members (Fair Lending is a Team Sport): It is clear that standard or generic fair lending training is not sufficient. Role specific training for individuals involved in any indirect financing is critical (Dealer Account Executives, Underwriters, Personnel that Set Pricing/Rate Sheets, Management). These team members must understand how to apply fair lending to their day-to-day activities.
Monitor the Data: The Ally Financial case alleged that the financial institution “failed to implement an effective compliance program to monitor its loan portfolio for discrimination.” This helps highlight the fact that it is critically important to analyze both the aggregated data as well as the dealer-by-dealer results. With the assignment of proxies for gender, ethnicity and even race, you should look to determine if there are significant disparities between groups of borrowers (e.g, male vs. female). More sophisticated analysis, like regression, may be required at the aggregated level if significant disparities exist. A strong monitoring program will help the financial institution demonstrate both internally and externally that they are taking reasonable steps to comply with fair lending laws.
TRUPOINT Viewpoint: The regulators have prioritized indirect lending, and especially auto lending, as a top area of focus. From the eyes of the regulators, this simple rule applies: the more discretion permitted in pricing, the more fair lending risk that exists. Financial institutions can look to contain the fair lending risk through limiting risk in their approach to pricing and employing a compliance management system. Regardless of the chosen path with indirect lending, you need a strong data monitoring program to understand where risk may exist.
TRUPOINT Partners helps organizations proactively manage their regulatory compliance. This includes data analytics, risk assessments, and consultative guidance. If you’re concerned about your auto lending compliance, please click here to request information about our auto fair lending compliance solutions.
Additional Auto-Related Blogs From TRUPOINT Partners:
- 4.5 Fair Lending Trip Wires for Auto Lending
- Are Your Auto Loans Creating Fair Lending Risk?
- CFPB Provides Warning on Indirect Lending - You Have Been Deputized
- CFPB Bulletin: Indirect Auto Lending – Compliance with the Equal Credit Opportunity Act
- CFPB Factsheet: CFPB to Hold Auto Lenders Accountable
- Ally to Repay $80 Million
- CFPB Auto Finance Forum Remarks by Richard Cordray
- CFPB Auto Lending Blog – Use of Proxies (first name and last name databases)
NADA Fair Credit Compliance Policy and Program