Second of two parts. Part one here.

The Consumer Financial Protection Bureau has detected alleged racial discrimination in the auto loan market. Finding the evidence was the easy part — the tougher questions involve what the agency intends to do about it, and how its eventual actions will affect competition among lenders.

The CFPB began collecting data through civil investigative demands early last year, notifying major bank auto lenders in February that it had grounds to sue them over fair-lending infractions. It released an industry bulletin warning banks to monitor the loans they buy from dealers, and its staff have repeatedly addressed the topic at industry forums.

"The discriminatory harm experienced by consumers is considerable. We estimate it's in the tens of millions of dollars," the CFPB wrote in response to questions. "This represents significant discriminatory harm to individual consumers of a particular race or ethnicity."

But the bureau has refrained from a politically and procedurally fraught effort to create rules banning dealer markups, the commonplace auto lending compensation practice that creates the potential for discrimination. That leaves bankers facing the question of how to legally protect themselves without jeopardizing their place in a competitive market with $700 billion in loans outstanding.

Underlying the dilemma that both CFPB officials and bankers face is the unique nature of the auto loan market. Banks and other lenders have long paid car dealers for originating loans, adding extra incentives for dealers when borrowers agree to pay above-market interest rates.

Consumer advocates allege the practice has encouraged dealers to steer customers into expensive loans and disproportionately hurt minorities. Those claims were bolstered by class action suits a decade ago that alleged discrimination and prompted lenders to cut around $100 million in settlements. Most auto lenders are avid in their desire to avoid a repeat.

"Banks choose not to litigate [auto financing discrimination allegations] with the regulatory agencies for reputational and other reasons" explains Leonard Chanin, a former head of the CFPB's rulemaking division who now represents banks at Morrison Foerster. "Enforcement is going to be used to establish policy in a significant area of the law."

The CFPB downplays the idea that it's using enforcement as a substitute for rulemaking. Anti-discrimination laws already apply, it noted in a March bulletin.

"Indirect auto lenders [those who originate loans through dealers] must comply with fair-lending laws and are responsible for ensuring that the dealer compensation system they are using does not result in unlawful discrimination," it added in response to questions about its approach to dealer markups.

The CFPB's approach to ferreting out discrimination in auto lending is controversial but hardly new. The banking industry has long taken issue with fair-lending laws, most notably the theory that lenders can be held liable for having a "disparate impact" even when they had no intention to discriminate.

In the housing market, determining whether racial bias exists is relatively straightforward. The Home Mortgage Disclosure Act has required lenders to collect data on the race of borrowers since 1975, which has made identifying disparate patterns straightforward. Doing so is often tougher in other markets where banks do not keep data. With auto loans it is the dealers who interact with customers; bankers typically have no access to the limited data that is collected.

In the absence of specifics, fair-lending advocates have sought to prove discrimination exists by conducting so-called proxy analysis. It involves determining the ethnicity of borrowers based on last names and ZIP codes.

Advocates for auto lenders dispute the propriety and validity of such methods.

"They want lenders to profile you," John Campbell, the chairman of the House Financial Services Committee, wrote in a Wall Street Journal op-ed last month.

Statisticians and industry consultants are well versed in proxy analysis and its weaknesses. Amy Matsuo leads KPMG's financial services regulatory compliance group, where she helps banks monitor exposure to fair-lending violations. Matsuo is white but has a Japanese surname through marriage. If she were to take out a car loan, she's likely be classified as Asian in a proxy analysis of the loan portfolio, she notes.

"That would be one of the pitfalls," Matsuo laughs.

Another problem with proxy analysis is that banking regulators have never established hard-and-fast rules for how it is applied. Some proxy software classifies people by gender, based on their first names. Notably, no clear standard exists over whether a borrower be classified as female if more than 50%, 80% or some other ratio of individuals with that first name are women.

But courts have generally accepted the validity of such proxy analysis methods, given that whatever statistical techniques tend to compensate for an individual errors. Moreover, even bank industry consultants give the consumer bureau high marks for its expertise.

"I think the CFPB is actually armed with a very good level of technical experts," says Raman Mandapaka, an economist at Navigant, which assists banks conduct their own analyses. "They have a good army of statisticians and econometricians."

According to industry sources, the letters that CFPB began sending to auto lenders early this year stated that proxy analysis had identified minority borrowers are paying an average of 20 to 30 basis points (0.2 to 0.3 percentage points) more for loans than are whites. On a $26,000 loan, the current average, a 0.2 percentage point difference represents $165 more in payments over the life of the loan.

"Banks are now going to be held accountable for disparate lending behaviors by auto dealers all through the country," U.S. Bancorp Chief Executive Richard Davis warned during an April 16 earnings call. "That's … going to be well worth watching in the next 90 days, to see what the banks are going to do."

In U.S. Bank's case, the answer appears to be new limits on the pricing latitude that it allows the dealers who originate its car loans, according to Davis. Such preemptive action may be precisely what the CFPB had in mind.

In talks with at least one financial institution, CFPB officials suggested that the company might face less risk of enforcement action if it narrowed the dealer markups it allows to between 0.4 and 0.5 percentage points, Kenneth Rojc, an industry lawyer with Nisen & Elliott, said during a March banking conference.

That's about 80% less than was allowed under the civil settlements reached a decade ago. If those numbers are accurate, they suggest that the consumer bureau is trying to squeeze markups out of the market without imposing an outright ban. The bureau says that it has not established formally a tolerance for any specific rate increase.

The bureau disputes that it's approved markups under a certain size. "We have not published any safe harbor for markup programs," the bureau stated in response to questions.

Industry groups and consumer advocates agree that CFPB officials would be happy to see lenders end dealer markups voluntarily. Less clear is whether enforcement actions against individual lenders would serve as a catalyst for the same result.

The auto loan market is highly fragmented, unlike that for credit cards. That means if big banks begin making terms less advantageous to car dealers, smaller lenders and the auto manufacturers' financing arms, known as captive finance companies, may simply take over the business.

The CFPB has always maintained a desire to maintain a level playing field among auto lenders. In recent weeks, the bureau's top leaders held a meeting with consumer groups in which they emphasized the need to ensure their actions influence the entire auto loan market equally, according to three sources who learned of the meeting after the fact.

Even so, the CFPB's investigation of big-bank lenders is far ahead of its work with captive finance companies. It only finalized a rule giving it the authority to regulate them last July, and banking sources are unclear as to whether the bureau has even begun to request loan data from the captives.

Still, major non-bank lenders will quickly comply with the Bureau's demands if the CFPB begins taking enforcement actions, predicts Morrison Foerster's Chanin.

"I'd be stunned if they didn't ramp up" compliance programs following enforcement actions against their competitors, he says.

Either way, the top 20 auto lenders control just 55% of the market. The smaller banks and credit unions that are also active in auto lending fall outside the CFPB's jurisdiction and are under the purview of prudential regulators like the Federal Trade Commission.

How banks can stay on the CFPB's good side while awaiting its next move is an open question. CFPB fair-lending director Patrice Ficklin recommended during a March 12 presentation to the Consumer Bankers Association's annual conference that banks develop fair-lending policy statements, conduct training and monitor own lending data for potentially discriminatory loans.

Lenders should also consider "other policies and procedures that are intended to reduce fair-lending risk," such as controls on dealer discretion, Ficklin's presentation stated.

The CFPB is publicly agnostic about how banks prevent discrimination, but its preference would be for them to drop dealer incentives, says Chanin. Monitoring results, he notes, is retrospective, and detecting discrimination dealer by dealer is difficult.

"To satisfy the CFPB, banks will likely need to fix a dollar amount for compensation, or maybe a percentage of loan amount," he says.

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