As the Consumer Financial Protection Bureau (CFPB) continues to expand the reach of its regulatory oversight, indirect auto lenders are increasingly becoming a target. In this industry segment, where financing between customer and lender is arranged and facilitated by a third-party dealer, regulators are focusing on dealer compensation models. Consumer credit discrimination under the Equal Credit Opportunity Act (ECOA), which in the view of the CFPB includes disparate impact on the basis of race, religion, gender and other characteristics, is especially in the regulators’ crosshairs. To minimize the potential for running afoul of consumer discrimination laws and to ensure compliance with new regulations, lenders should implement automated technology programs that provide greater access to data analytics and improved consistency in dealer compensation models.
Dealer Reserve and its Risks to Lenders
Dealer reserve is an instrumental function of the auto loan financing process. In a routine that is familiar to most lenders, the dealer collects information, except for elements referencing protected classes, about buyers during closing and documentation activities. The lender determines a “buy rate,” the minimum interest rate at which the lender is willing to purchase the contract, and the dealer, seeking to capitalize on his or her competitive advantage, can add points to the interest rate. This addition is the dealer reserve, or markup, and the profit from this interest is frequently shared by both the lender and the dealer.
This process is similar to a retailer adding a markup to clothing, or a grocer marking up the price of produce. However, due to the subjective nature of the process, the CFPB conducted data analysis and concluded that unintentional discrimination had resulted in the auto lending market. In December 2013, the CFPB filed a Complaint against a lender for allegedly engaging in discriminatory lending, and the lender agreed to a consent judgment and a multi-million dollar fine that put the entire industry on notice.
In a 2013 bulletin issued before the above-mentioned fine, the CFPB warned indirect auto lenders of the risks inherent in dealer reserve. “Because of the incentives these policies create, and the discretion they permit, there is a significant risk that they will result in pricing disparities on the basis of race, national origin, and potentially other prohibited bases,” the agency wrote. Indirect auto lenders, continued the CFPB, are considered creditors if in the ordinary course of business they are regularly participating in credit decisions. Of course, credit decisions are a critical component of auto financing decisions and are made every day by active auto lenders. Perhaps the greatest potential consequence for lenders is the CFPB statement that “lenders may be liable under the legal doctrines of both disparate treatment and disparate impact” if pricing disparities exist in an auto lender’s portfolio. The warnings are particularly striking because the CFPB does not believe that it needs to prove that any actual intent to discriminate exists or existed in order to pursue enforcement.
Compliance with Equal Credit Opportunity Act
It’s important for lenders to fully understand the reach and influence of current regulatory scrutiny of auto lending practices. The ECOA prohibits discrimination related to credit based on gender, race, color, marital status, religion, national origin, age, receipt of public assistance or exercising rights under the federal Consumer Credit Protection Act. Furthermore, the ECOA requires creditors to provide consumers with the information on which the denial of financing was based.
Since dealers cannot legally collect the racial demographics of its customers and pass them to the lender, the CFPB uses proxy metrics to detect price discrimination. The last-name proxy uses Census data, by race and national origin, of the proportion of citizens with a given last name. The geographic proxy uses the demographics of the borrower’s residence to calculate probabilities of the borrower’s race.
By understanding the regulatory considerations, lack of an intent requirement and the CFPB’s views of dealer reserve, it’s easy to see how some auto lenders believe the deck is stacked against them. So how should indirect auto lenders navigate this compliance minefield?
Technology Provides Compliance Capabilities
Dealers who support the dealer reserve practice should evaluate their technology solutions and improve their audit controls as part of their comprehensive compliance planning. Lenders and dealers would be wise to agree on a standard markup and to program their audit controls to alert all parties involved if there is any deviation from the model. The automated technology should incorporate the following capabilities and features:
- A sensitive pricing model that provides deal-based pricing updates back to the dealer at the point of credit decision
- A module with the sole purpose of calculating dealer profit relative to reserve
- Controls so the lender can establish how much markup a dealer is allowed to add
- A comprehensive rules engine automatically plugged into the module to flag any inconsistencies
- The ability to both identify and flag exceptions to norm, and as importantly, provide the business reason for all exceptions
- Use of data-driven analysis within their audit functions to track how the group’s interest rates compare to the overall rate
Indirect auto lenders today face increasing vulnerabilities and risks. As the CFPB broadens and deepens its regulatory oversight of the lending industry, and homes in on dealer reserve practices, these risks will only grow in size and scope. By implementing automated technology solutions and audit controls, lenders can not only work to mitigate these vulnerabilities, but also ensure continued compliance.
–By Scott Hendriks, Senior Product Manager, Lending Solutions, FiservLike This Post