As has been widely reported, federal regulators are increasing their study of bank lending practices for possible racial discrimination.

Utilizing data released under the Home Disclosure Act, the regulators are targeting institutions for in-depth reviews of their compliance with the fair-lending and the Community Reinvestment Act.

A significant amount of attention was focused on bank lending practices last fall when the Federal Reserve released a length report on the 1990 filings under the disclosure act.

The report provided the first detailed information on relative rejection rates for mortgage applicants categorized by race and income.

Disclosure-act data show rejection rates substantially higher for black and Hispanic applicants than for white.

Prelude to Investigations

Regulators have acknowledged that this statistical information is not sufficient to demonstrate discriminatory lending practices. But they have indicated that they will use the information as a guide in conducting targeted investigations of lending practices.

Using computer-based systems, the regulators can target specific institutions or branches where lending patterns may suggest a discriminatory practice.

Examiners can then conduct an in-depth review of the individual application files underlying disclosure-act data.

The regulators have reportedly referred a small number of cases to the Justice Department for further investigation, and more referrals are possible.

A number of private lawsuits have also been filed against lending institutions charging racial discrimination and redlining. All such investigations and suits should be treated seriously, specially in the current political environment.

The Statutory Framework

Financial institution are required to comply with a wide range of antidiscrimination laws, including the Equal Credit Opportunity Act, the Fair Housing Act, and the Home Mortgage Disclosure Act. This statutory scheme supplements civil rights statutes of general application.

The statutes are supported by extensive regulations, administrative powers, and civil and criminal penalties. The Equal Credit Opportunity Act and the Fair Housing Act also can be cited to support private legal actions.

The fair-lending laws have the potential to reach conduct ranging from intentional overt acts of discrimination by particular employees to policies, procedures, or underwriting standards that may have a disparate impact on minorities.

Structuring a Defense

To defend practices that disparately effect minorities, an institution must establish that the lending practices are nondiscriminatory in intent and a matter of business necessity, and that no less discriminatory means are available that are consistent with prudent lending practices.

The obligations imposed under these fair-lending laws differ substantially from the general duties imposed under the Community Reinvestment Act.

The act was adopted in 1977 to address the general concern that banks were not doing enough to meet the credit needs of all members of their communities.

Under the reinvestment act, every bank must -- consistent with safe and sound banking practices -- help meet the credit needs of its entire community, including low-and moderate-income neighborhoods.

These obligations are enforced by federal bank regulators through on-site examinations and public evaluations and in connection with merger and other applications.

Significant Merger Implications

As witnessed in several recent mergers, including NCNBC&S/Sovran and BankAmerica-Security Pacific, the Federal Reserve gives substantial attention to Community Reinvestment Act issues during the merger approval process. In the past year, the Federal Reserve for the first time denied a merger application on the basis of the act.

The stringency of on-site reinvestment examinations has also been increasing.

Despite claims by community groups that the regulators have been to lenient, or perhaps because of such claims, many banks have received significant criticism of their reinvestment act efforts in their most recent examinations.

Community groups have been effective in gaining enhanced access to banks through lobbying efforts related to the reinvestment act. To date, they have been less successful in their efforts to bring major discrimination cases against banks under the fair-lending laws.

In light of the new Home Mortgage Disclosure Act data, however, community activists could shift their focus from the regulatory arena to the courtroom.

Understanding HMDA Data

The Home Mortgage Disclosure Act of 1975 was enacted by Congress to provide information to assist in determining whether financial institutions are serving the housing needs of their communities.

Prior to 1990, disclosure-act data were compiled in geographically aggregated form. The number and dollar volume of conventional and government-insured home mortgage and improvement loans by banks, savings and loan associations, and credit unions were reported by census tract.

With data from the U.S. Census on the racial composition and median income of census tracts, disclosure-act data made it possible to analyze the total number of mortgage loans made in each census tract and compare loan volume with the composition of the tract.

A number of research studies using pre-1990 disclosure-act data attempted to examine the relationship between the racial composition of neighborhoods and residential mortgage lending.

The Federal Reserve noted in a 1989 report to Congress that while various studies "appeared to indicate that disparities existed ... between minority and nonminority areas, they did not draw definitive conclusions about the existence or extent of racial discrimination in mortgage lending and did not account for certain factors other than discrimination in lending that might account for the disparities."

Responding in part to concerns raised in these earlier studies, Congress enacted certain amendments to the Home Mortgage Disclosure Act as part of the bailout law. The 1989 amendments expanded the scope of the disclosure act to include essentially all types of mortgage lenders.

Commencing with 1990 data, it requires disclosure of data on rejections and approvals of home loan applications. In addition, for the first time, the 1989 amendment required that disclosure-act data be coded directly by race, gender, and income level.

Even after the 1989 amendments, there are still substantial limits on how disclosure-act data can be interpreted.

The limited information included in these data does not provide meaningful information about the creditworthiness of individual applicants.

These data provide no information about an applicant's asset level, existing debt burden, credit history, employment history, or other important credit criteria. Such difference are often linked to systematic socioeconomic conditions.

Fair-Treatment Factors

Other important factors, such as frequency of housing turnover, availability of brokers and appraisers, mortgage insurance, and government assistance programs are also not captured by these data.

"Without taking into account such information, one cannot determine whether individual applicants grouped by common characteristics (such as race or gender) have been treated fairly," as G. Canner and D. Smith noted in the Federal Reserve Bulletin.

The limitations of statistical analyses are greatest when they attempt to reach sweeping conclusions about an institution's overall lending performance. Data show that lending patterns vary greatly -- among institutions and across geographic regions.

Such patterns result from a variety of factors, including demographics, geographic location, types of applicants, types of loan products, and applicable credit standards.

A Case in Point

An April 27 American Banker Comment ["Bias Data Can Make the Good Look Bad," page 4] by James P. Scanlan, an assistant general counsel at the Equal Employment Opportunity Commission, made an equally compelling point:

Most analyses have focused on the disparities in rejection rates between white and black applicants and ignore disparities in pass rates. By focusing on rejection rates, the banks appearing to have the most discriminatory practices may actually be the banks more likely to make loans to minority (and white) applicants.

For example, if Bank A approves 80 out of 100 white loan applicants and 60 out of 100 minority loan applicants, it will have a 2-to-1 rejection rate disparity. If Bank B approves 50 out of 100 white loan applicants and only 10 out of 100 minority loan applicants, it will have an apparently better 1.8-to-1 rejection rate disparity.

Thus, the more aggressive an institution's community investment activities are, the greater the potential may be for generating discrepancies in data rejection statistics. This can be especially true when the general pool of applicants upon which such comparisons are drawn tend to changes as the result of aggressive advertising, counseling, and other community development efforts.

Despite such limitations in analyses, it must be acknowledged that Home Mortgage Disclosure Act data do validate concerns about the need for more credit to be extended to minority customers and in low- and moderate-income areas.

The data make it possible for banks to further analyze their experience and to continue to improve their performance.

What Steps Can Be Taken?

All depository institutions are required to develop comprehensive community lending programs to meet their reinvestment-act obligations. As a matter of prudence, they should develop comprehensive antidiscrimination training programs for employees.

The federal bank regulatory agencies have issued a variety of guidelines on how institutions can meet their responsibilities under the reinvestment act and the fair-lending laws.

An example can be found in the May 1990 "Uniform Interagency CRA Final Guidelines for Disclosure of Written Evaluations and Revised Assessment Rating System."

These guidelines set forth 12 assessment factors to which the regulators look in evaluating performance.

Following Lead of High-Scorers

The reinvestment examination process should allow for an open dialogue with bank examiners. Deficiencies or criticisms identified in past examinations should be discussed with the regulators and rectified.

The reinvestment act does not establish specific lending requirements or programs that must be implemented Nevertheless, careful attention should be paid to the community development programs and products being offered by other institutions.

Much can be learned by following the lead of banks receiving high reinvestment ratings.

In addition, each institution needs to carefully analyze the geographic and ethnic distributions of its lending patterns as part of its Community Reinvestment Act planning process.

Process and procedures are important -- starting at the top with strong involvement by an institution's board of directors.

Finally, if policies or procedures come under attack, either by the regulators or in a private lawsuit, such situations should be treated with attention and sensitivity. No inquiry, investigation, or suit involving questions of potential racial discrimination should be taken lightly. Mr. Stern, Mr. Coates, and Mr. Lang are lawyers with the New York law firm of Wachtell, Lipton, Rosen & Katz.

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