Understanding and managing loan policy exceptions is critical to a financial institution’s fair lending compliance. In this article we explain policy exceptions and describe the different types of exceptions. How an institution defines policy exceptions is also critical and will be the subject of another post.
Overrides and Policy Exceptions
An override occurs when a decision made concerning a loan transaction falls outside of loan policy. Overrides can be policy exceptions for:
- Underwriting (approval or denial) or
- Terms and conditions (such as pricing).
Both categories of overrides are further divided into two categories: (1) high-side and (2) low-side overrides. A high-side override occurs when loan policy dictates an approval or less stringent terms and conditions and a decision is made to either deny the loan or to apply more stringent terms. Conversely, a low-side override occurs when loan policy suggests a denial or stringent terms and conditions and a decision is made either to approve the loan or waive the more stringent terms and conditions.
Approach To Overrides
Exceptions to loan policy that take place are either (1) discretionary or (2) based on some type of compensating factor or extenuating circumstance. Discretionary overrides are decisions made that fall within a loan officer’s lending authority in which there may not be any quantifiable attributes documented that influenced the decision. These types of overrides tend to be subjective, resulting in inconsistencies which can adversely impact fair lending over time.
Overrides based on compensating factors tend to be less subjective, more consistent, and are generally quantifiable. Financial institutions should strive for all overrides to fall into this category and, as much as possible, avoid discretionary overrides.
Another issue to be avoided is that of “selective overrides”; that is, “going the distance” for one customer in trying to work out a loan or better terms and not doing so for another. Although not intended this increases the risk of the appearance of discriminatory preferences.
Compensating Factors
By definition, compensating factors are attributes that offset some component of a credit transaction.
A compensating factor can offset either a positive or a negative.
For example, a loan that would be approved according to policy may be denied because it is discovered that the applicant’s otherwise stable employment history is not going to continue. This is an example of a compensating factor being used for a high-side override.
Equally, an applicant that would be denied because of a low credit score may be approved if the only derogatory on their credit report was a medical collection and the debt had been satisfied. This is an example of a low-side override.
Guidelines For Compensating Factors
Compensating factors should be well defined and quantifiable. In general they should relate to (i) risk, (ii) profitability, or (iii) competitive considerations. If a potential compensating factor does not affect one of these criteria, it is not an appropriate attribute.
The fair lending regulations specifically prohibit “unduly subjective standards.” Financial institutions should strive to minimize subjectivity in determining compensating factors. Factors can be considered subjective when they are either not quantifiable or not well defined.[1]
For example, to override a decision because an applicant is “a good customer” is not easily quantifiable and thus subjective. Similarly, to approve a customer for “excessive collateral” is quantifiable but not well defined. If an acceptable loan-to-value was determined and then established as a compensating factor, however, it would no longer be subjective.
Summary
A managed approach is the best way to avoid issues with fair lending. Our recommendation is to keep discretionary overrides to a minimum, apply policy exceptions consistently, and utilize compensating factors that are as objective as possible. This, coupled with definitive policy that is closely followed will provide a firm foundation to successfully navigate the world of fair lending.
[1] This definition is our own and not in the regulations.
