Loan Pricing

Mismatched Regulation

A couple of weeks ago, the Independent Bankers Association of Texas (IBAT) asked members for stories on regulation problems that the Association’s leadership could use in lobbying efforts to support the passage of the TAILOR act and other efforts to roll back some of the provisions of Dodd-Frank. I decided to write an article on the subject rather than just a letter, to at least get some search engine optimization value for the time spent.

Strategic Planning Surrendered

My primary product, a loan rate sheet profit optimization tool, has not sold. People with quantitative backgrounds are very excited about what I am doing, but bankers are not. The primary reason for this is my poor sales ability, but when I speak to bankers, they clearly understand what I am doing and then state “but that isn’t how we do business.” At the 2014 IBAT Convention, the exhibit hall was poorly arranged and few bankers were hanging out with the vendors who were exhibiting, so I had a chance to have some extended conversations with several accountants and other vendors with no bankers present. I got some disheartening, but ultimately very helpful comments:

  • “This makes a lot of sense, but they (bankers) won’t do this unless the regulators tell them to.”
  • “They (bankers) have surrendered all strategic planning to the regulators.”

How did this happen? In today’s banking world, you can still see the vestiges of the pre-1980 era when interest rates were regulated and banks competed strictly on customer service and personal relationships; community bankers today overwhelming come up through the loan sales ranks rather than operational or financial career paths. The sales career path is how they do business. This vestige of the pre-1980 era manifests itself with bankers who do not have strong quantitative skills by the standards of current business practice, and are less prepared to recognize, adapt or adopt new technologies than are managers in other industries. Until someone with a strong quantitative background gets to C-level at a bank, the prospects are not good for quantitative approaches like mine. As one person said of my business prospects, “waiting for someone to die is not a good business strategy.”

After the passage of Dodd-Frank, Community Bankers have been overwhelmed with the volume of regulation and regulatory change. While I am not an expert on the specific changes, I have heard of numerous examples of regulations that clearly address abusive practices at high-volume too-big-to-fail banks, but which make no sense for low-volume small banks where loan officers have very visible and personal responsibility for the loans they sell. I have commented that bankers are so consumed with regulatory change that the building could be burning down and they would not notice.

Interest rate regulations from a generation ago did not require bankers with quantitative skills and have constrained the current pool of executives to those without strong quantitative backgrounds; current regulations, and regulatory churn require executives with legal and compliance skills but not the analytical and quantitative skills that are used by executives in virtually all other industries. Current regulations will constrain the executive pool for the next generation to executives with legal, but not quantitative skills. This will continue to make it difficult for banks to even think about the future even when forward-thinking leadership is in place. For vendors like me, this means that getting traction will be difficult until the succession of past regulated-rate era executives is complete and the analytics-era executives are not tied up with regulatory spaghetti.

Fair Lending and Disparate Impact

In recent years, Fair Lending regulation has focused on disparate impact where a bank can be penalized for policies or procedures that have disparate impact for different racial and ethnic groups even when there was no intent to discriminate. While I have not met any bankers that I believe were racist, I think that unintentional racially disparate pricing is probably far more common than anyone would like to admit; read the discussion in How a Bank Can Get in Trouble with Fair Lending Statistical Analysis for an understanding of why price discrimination is probably common for minority borrowers even without intentional discrimination on the part of bankers.

Some bank lobbyists hope to require that regulators show that the bank intended to discriminate against minorities in order to trigger a Fair Lending violation. I think this approach is wrong and short-sighted. The problem with the current regulatory approach stems not from being laborious; the problem is that current methods will not readily identify banks that do have price discrimination problems and sometimes falsely identify a bank as having a Fair Lending problem. Changing the regulatory standards to require “intent” for a violation will not improve the accuracy of identifying instances where discrimination is occurring, nor will it reduce the labor required for analysis. Requiring intent for a violation would probably increase the labor required for both regulators and bankers without improving the situation for borrowers who have experienced race-related price discrimination.

Banks will make much more progress in reducing the regulatory burden and the fights over regulation by admitting that minorities do face unintentional discriminatory pricing and then working to eliminate the causes of discriminatory pricing. About 20 years ago, the Wall Street Journal published an article about different approaches taken by medical professional societies to reducing malpractice insurance (if you do not have a WSJ subscription, How Anesthesiologists Reduced Medical Errors provides a summary). The association with the highest premiums, anesthesiologists, took the approach of studying anesthesia-related deaths and changing practice to reduce deaths. All other associations took the approach of pursuing legal limits on malpractice insurance. Anesthesiologists ultimately ended up with the lowest insurance rates. Bankers should take the same approach; admit the problem and fix it.

The current approach depends upon an error-prone estimate of a borrower’s race and ethnicity; the current surname and geographic race estimation method is especially error-prone for blacks descended from slaves. The errors effectively hide discriminatory pricing when it occurs.

One possible approach would be to offer a safe-harbor for loan products where no rate negotiation is allowed; compliance could then be measured by auditing applications for accurate pricing classification. When a pricing classification error is noted, two things would occur:

  • Determine the race and ethnicity of the borrower by contacting the borrower directly, and then look for patterns within the pricing classification errors.
  • Increase the size of the audit pool to improve the power of the statistical analysis.

Banks need to recognize that there are problems and address them, or plan for additional generations of fighting related regulatory oversight.

Fair Lending, and Indirect Lending

Indirect lending is perhaps the highest risk area for Fair Lending violations, but it is one where current regulatory practices will not identify a dealer that is intentionally discriminating against minorities; a discriminatory dealer’s loans are diluted with loans from non-discriminating dealers so that analysis at the bank level will not identify the problem dealer (unless the dealer decides to intentionally create problems for a bank). Analysis of loans at the dealer level must occur to fix this problem.

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