Three Hurdles To Jump Pose No Obstacle To An Elephant

Banking compliance consultant Nancy Griffin thinks that bankers fear the "effects test" (i.e., "disparate impact"), which, I think, is correct. She also thinks that they should not be as afraid of disparate impact as they seem to be, because it's a three-part test and the "effect" is only one part.

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.

Obviously, step 1 has received all the press, and causes the most heartburn. The problem for bankers is that they rarely know what the "unintended" effects on a protected class of a facially bias-neutral practice might be. However, Nancy thinks that Step 2 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.

I have no problem with those statements.

As to step 3, Nancy claims that every banker should already be familiar with making this determination.

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.

While she mentions the fact that many of these "alternative ways to make loans" went too far and resulted in some serious pain (in other words, the subprime mortgage meltdown), she claims this result has 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.

I suppose that is true to some extent. However, I'm not as sanguine as Nancy that step 3 will be that easy to support in every case where the stricter underwriting standards that are used to achieve "QM" or "QRM" status are always employed. I can see the day, especially when the economy improves, when the fact that a bank is simply trying to meet the Dodd-Frank "safe harbor" underwriting standards is far from being a lock on satisfying steps 2 and 3. I especially think that an ideologically motivated Justice Department (and HUD) of the type we have in place currently, will remain unimpressed by any logical arguments that support a bank on steps 2 and 3 if they "find" that there's been a "disparate impact" on a protected class under step 1.

We need to remember that "disparate impact" itself is a questionable legal theory, so questionable that the US Justice Department fears its consideration by the US Supreme Court. Banks aren't scared of "disparate impact" claims only because they're so difficult to anticipate in the ordinary course of business, but because the federal government seems intent on using such claims to browbeat large settlements out of bankers on a cost-benefits basis (pay the government to end the pain), regardless of whether or not the highest court in the land would ultimately overturn the government. If the government is willing to use a questionable legal theory to serve ideological notions of "fairness" in credit redistribution (as it does in its quest for income redistribution), why would steps 2 and 3 deter it? If step 1 is bogus, why would objectively valid opinions that steps 2 and 3 favor the bank be impediments to simply alleging that they do not, and beating the bank over the head with litigation defense costs until it yields?

Yes, bankers fear the effects test. The fact that the test involves a three step process should provide only cold comfort to them.