In his book David and Goliath, Malcolm Gladwell explores the U-shaped curve for different efforts. Specifically, he discusses the effect that reducing class size has on education performance, increasing incarceration has on crime and social welfare, and increasing parental income has on child rearing.  Gladwell posits that, at some point, not only do efforts to weed out certain societal ills stop working, they actually can become counterproductive. Thus, further efforts may cause diseconomies that reduce overall societal welfare. 

We may have now reached the point on fair lending where current enforcement efforts may actually be producing more societal harm than benefit. This despite what may be the noble motivations of those behind such efforts.

The poster child for how the regulatory approach to fair lending is failing is Nixon State Bank in Texas. On June 17, 2011, the $80 million-asset bank entered into a settlement agreement with the Department of Justice in which it was required to pay almost $100,000 in restitution and penalties. The DOJ alleged that the bank charged higher prices on unsecured consumer loans made to Hispanic borrowers in violation of the Equal Credit Opportunity Act.

At the time of the settlement, the bank had approximately $8 million of unsecured loans of $500 or less per borrower. The top interest rate charged was less than 10%--a reasonable rate that is well below what consumers would get from most other lenders. The FDIC, which has long been encouraging banks to develop small-dollar loan programs, considers any rate below 35% acceptable. Nonetheless, the FDIC alleged that Hispanics paid more than Anglos based on a regression analysis. Assume that the FDIC and DOJ were correct in their analysis, despite the issues with whether such models replicate reality, and the utility of such an approach to small pools of loans in the first place, the bank was in no position to fight it.It agreed to a settlement because the cost of defense in the form of economists, document production firms and lawyers, was more than it could afford. The settlement required the bank to adopt DOJ-approved policies and procedures, including those for underwriting and pricing loans.

In the DOJ’s June 17, 2011 press release, Mark Pearce, director of the FDIC’s Division of Depositor and Consumer Protection, stated that, “[t]his particular matter highlights the dangers of discretionary pricing in loan products.” Accordingly, impact of the settlement presumably should have been beneficial for Hispanics.

What has happened since then, though, is that the bank has increased the interest rates charged on such loans to 18%, with very little pricing reduction for such issues as funds on deposit, length of relationship and credit history. The bank eliminated discretion and charges everyone the same price. The bank, however, is also trying to price enforcement risk, as well as costs of defaults, into such loans. It is no longer willing to take chances on marginal credits and consequently, the bank’s small-dollar unsecured loan pool shrank to $4 million. After defaults, the bank was not making much money on such loan pool, let alone a fair return on capital.

The FDIC in its analysis of small-dollar lending, has found that small loans may not be profitable at even 35% fees and interest. Yet prior to the settlement, the bank’s top rate had been less than 10% for such loans because the bank believed it was providing a service.

The DOJ trumpeted the Nixon State Bank settlement – the first community-bank agreed order using the disparate-impact theory – as if the DOJ were saving customers from a predatory lender. “Fair and equal access to credit is critical and lenders have a responsibility to have protocols in place that ensure all of their lending programs comply with the law and don’t discriminate,” said Thomas E. Perez, then Assistant Attorney General in charge of the DOJ’s Civil Rights Division and now Secretary of Labor.

Did the DOJ action help? Some people received DOJ-ordered restitution (including people who had defaulted on their loans in the first place), but this was a small group of people, some of whom obviously received a windfall. On the flipside, clearly access to credit in Nixon, Texas, was diminished. Moreover, an attractive, if not remarkably cheap, credit alternative to credit cards, finance companies and payday lenders is now dramatically more expensive.  So, for the community, for the customers and for the bank, the DOJ action has been a classic lose, lose, lose. It may be no coincidence that Nixon State Bank just sold itself to another Texas bank.  

Settlements like that involving Nixon State Bank have imposed much higher compliance costs on the banking industry. It is not unusual for bankers to suggest that overall compliance costs now account for 20% to 30% of their budgets. Other banks have changed their pricing models to address fair-lending risk or have elected to get out of certain lines of business entirely. Thus, the experience of Nixon State bank is unfortunately not unique. The current approach to fair-lending enforcement, at least at the community bank level, should be re-examined.  Intentional discrimination should not be tolerated, but we should question the benefits of disparate impact theory for fair-lending enforcement. By forcing everyone to aim to the highest common denominator created by expensive testing related to a mathematical model, the impact is hurting everyone. We have approached the point where such efforts may be putting society on the wrong part of a U-shaped curve.  Further enforcement just may make everything worse.

Peter G. Weinstock is the Practice Group Leader of the Financial Institutions Corporate and Regulatory practice group at Hunton & Williams LLP.