Background On Credit Scoring Issues Examined
To gain an understanding of industry, advocacy group and regulator concerns, the Federal Reserve Banks of Boston, Chicago and San Francisco conducted focus groups in their home cities during the winter of 1998. Committee members developed nine issue statements that encapsulated the findings of the focus groups.
The nine issue statements follow:
- In developing credit scoring policies, a lender may neglect to:
- Establish clear risk-tolerance policies and consistent guidelines for how scoring cutoffs are determined and loans are priced;
- Ensure that the model accurately reflects the characteristics/demographics of its applicant pool.
- New models are unlikely to include prohibited basis factors in their programs. However, if models are not well-constructed and updated over time, they could:
- Produce unjustifiable disparate impact, or b. Become based on a pool of borrowers that is incompatible with a lender's market demographics.
- Some third-party brokers who fail to comply with fair lending laws may be censured or have their lending licenses placed in jeopardy. It is important that lenders monitor the practices of their third-party brokers, especially for compliance with fair lending laws, pricing policies and the use of credit scoring models. Lenders who knowingly work with noncompliant brokers (and take no action) may be liable as co-creditors.
- Inadequate staff training and oversight regarding bank credit policy and fair lending guidelines may lead to inconsistent and unlawful treatment of loan applicants.
- Lack of information regarding the credit (application) process and available loan options could dissuade an applicant from completing the application process. Loan officers who fail to notify the applicant of the nature of a credit rating, and the important role it plays in the approval and pricing of a loan, could unfairly deny or overcharge an otherwise worthy applicant.
- Credit/mortgage scoring systems are only as effective as the data fed into them. Inaccurate or incomplete data regarding an applicant's income or credit history may adversely affect the applicant's mortgage score. In the process of ensuring accurate data, lenders must treat all applicants consistently. For example, assistance with credit (report) corrections or accounting for protected or nontaxable income must be offered and applied uniformly to all applicants.
- Credit scoring and counteroffers can serve as important functions to maximize access to credit. However, their nature and usage could result in unlawful discrimination. The need for frequent score overrides could indicate a larger problem with the scoring system. Furthermore, inconsistency in utilizing either "high-side" or "low-side" overrides to alter a credit decision may result in disparate treatment. Finally, inconsistent counteroffers made to applicants who received essentially identical scores also may result in disparate treatment on a prohibited basis as defined in fair lending regulations.
- If a lender engages in a subjective second-review process, inconsistent practices could result in disparate treatment of applicants. Discriminatory disparities may result from the absence of established and carefully observed second-review guidelines that specify:
- The bottom-level mortgage score of applications subject to second review; and, b. Explicit procedures and explanations of judgmental factors, covering most or all contingencies.
- Lenders who do not track loan performance based on their established credit scoring model characteristics may rely on risk limits that are unnecessarily restrictive and also may produce an unjustifiable disparate impact on prohibited basis group applicants.
The two-page flow chart, located on pages five and six, illustrates the process a credit-scored mortgage typically goes through; it also includes the development of a risk management policy. The issues identified in the 1998 focus groups, and the flow chart, were used as exhibits in a survey of industry leaders conducted in 1999. Among the survey responses were the following.
In developing policy:
- Changes over a business cycle in the environment of a lender can affect the predictive ability of a credit scoring model; a bank should have a clear methodology for changing its cutoff scores.
- Banks should have a clear plan for handling applicants who do not have established credit and would, therefore, score poorly with most credit scoring models.
In dealing with loan applicants:
- Some lenders may provide advice to an applicant—such as closing or paying down credit lines, with the intent of improving the applicant's credit score —but may actually affect the credit score negatively.
- Accuracy of credit reports may vary among population segments; lenders need to recognize the potential need to verify credit report information when the information will be used to score the applicant.
Two additional focus groups, using the findings of the survey as a basis for further discussion, were conducted in Washington, D.C., during the spring of 1999. Based on the findings of this research, the Credit Scoring Committee elected to develop a five-installment series to highlight some of the key issues identified with respect to credit scoring and fair lending.
An important goal of this series is to provide the industry, and concerned groups and individuals, the opportunity to comment on their own related concerns. Each installment incorporates statements we requested from organizations; they were selected because of their interest in, and differing perspectives on, credit scoring and fair lending.
Once the comments were received, committee members edited them to capture the key points made and to bring some level of uniformity to the length of each response. The original respondents then approved the edited versions of their comments. These edited comments are presented in the following five installments.
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