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Fair Lending Implicationsof Credit Scoring Systemsuring the past decade, lenders’use of credit scoring systemshas increased significantly, andexaminers routinely consider the roleof credit scores in lending decisions.The comparative analysis portion ofa fair lending examination includesan interview to determine the criteriathe lender considered in the decisionpoint (underwriting, pricing, etc.)selected for review.1 This interview frequently reveals that a credit score wasone of the criteria. At this point, examiners can determine how to proceed byconsulting the Interagency Fair LendingExamination Procedures.2 However,examiners must synthesize informationfrom several sections of the Proceduresand the appendixes.DThis article gives examiners the toolsthey will need to navigate this situation.It provides an overview of credit scoringsystems, analyzes why the use of creditscores has proliferated, and explainshow their use is considered as part of afair lending examination. It then recommends a concise conceptual frameworkfor proceeding with a fair lending examination when a credit score is one of thecriteria considered by the lender.An Overview of CreditScoring SystemsA credit scoring system mechanicallyevaluates creditworthiness on the basisof key attributes of the applicant andaspects of the transaction.3 A systemcan be as simple as a form the loanofficer completes by hand that assignspoints to particular attributes, or ascomplex as an artificial intelligencebased neural network with a continuousfeedback loop that adjusts the weightingcoefficients and the cutoff score. Acredit scoring system can be the onlyfactor considered in making the creditdecision, or the lender may combinea credit score with other criteria.4Two types of credit scores exist—bureau scores and custom scores. Abureau score considers only the information on an individual’s credit reportand is generated by a consumer reporting agency. The largest three consumerreporting agencies are Experian,Equifax, and TransUnion. A lenderpays the consumer reporting agency anadditional fee to obtain the score at thetime it obtains a copy of the creditreport. An “acceptable” score varieswith the lender’s appetite for risk;however, an acceptable score usuallyfalls around 600.A custom score (sometimes referredto as an application score) is generatedby the lender from a scoring systemeither developed by the lender orpurchased from a vendor. A customscore usually considers the information on the applicant’s credit report,selected information about the applicant, and characteristics of the credittransaction. Examples of commonlyconsidered applicant information aretype of residence, length of time at1FDIC-regulated institutions are subject to two Federal statutes that prohibit discrimination in lending. The EqualCredit Opportunity Act (ECOA) covers all credit transactions. It prohibits discrimination on nine bases—race, color,religion, sex, national origin, age, marital status, receipt of public assistance, and the exercise of a right under theConsumer Credit Protection Act. The regulation that implements ECOA is 12 C.F.R., Part 202 (Regulation B). The FairHousing Act covers residential real estate-related credit transactions. It prohibits discrimination on seven bases—race, color, religion, sex, national origin, handicap, and familial status. The regulation that implements the FairHousing Act is 24 C.F.R., Part 100.2Interagency Fair Lending Examination Procedures, www.fdic.gov/consumers/community/fairlend.pdf312 C.F.R. 202.2(p)(1).4Official Staff Interpretations at Paragraph 202.6(b)(2), Comment 5.23Supervisory InsightsSummer 2005

Fair Lendingcontinued from pg. 23current residence, type of employment,length of time in current employment,and income. Typically, eight to tenvariables are considered in a customscorecard. Many custom scoring systemsare scaled so that an acceptable scorewill be around 200, again dependingon the lender’s risk appetite. The scaling of custom credit scoring systemsvaries considerably among vendorsand lenders. Some lenders blend anapplicant’s bureau score and a customscore in making a credit decision.The Use of Credit ScoringSystems Has IncreasedConsiderablyThe accuracy and cost of credit scoringsystems have benefited substantially fromtechnological advances in automateddata processing and improvements instatistical methodologies. Many lendershave found that credit scoring systemsare cutting the time and administrativecosts of making credit decisions, aswell as improving the consistency ofthe decisions within their organizations.As a result: More lenders are using credit scoringsystems. Lenders are applying credit scoringsystems to more credit products. Lenders are using credit scoringsystems in additional aspects ofcredit transactions, such as pricingand account administration. Lenders are using multiple systemsin a single credit product.5The increased use of credit scoringsystems has implications for examiners asthey conduct fair lending examinations.The Role of Credit ScoringSystems in a Fair LendingExaminationA fair lending examination attemptsto detect either overt discriminationor disparate treatment on a prohibitedbasis. Examiners select a focal pointbased on the risk that discriminationmay be occurring, determine the criteria the lender considers in making thecredit decision, evaluate the criteria andprocedures for overt discrimination, andcompare how the criteria are applied toa selected prohibited basis group withhow they are applied to an appropriatecontrol group. For example, the treatment of Hispanic applicants may becompared with the treatment of nonHispanic whites.6The use of a fairly developed andapplied credit scoring system can reducethe possibility of unlawful discriminationby helping to ensure consistency anduniformity and minimizing individualjudgment and discretion. However, acredit scoring system is not a panacea,and in certain circumstances, it caneven be the source of fair lendingviolations.Disparate treatment can occur atthree stages in the use of a customcredit scoring system: Data development and input: Forexample, a lender credits whiteapplicants with the length of timethey have worked in the same fieldbut credits Hispanic applicants onlywith the length of time they haveworked for their present employer.Or, a lender credits white applicantswith secondary income (such asbonuses, overtime, or commissions)5Many lenders segment the applicant population by applicant characteristics, channels through which the application was received, or both. For example, a lender may have one system for applicants with nothing worse thana 30-day late on their credit report and a different system for applicants with more serious derogatory information.Or, a lender may have one system for automobile loan applications received directly from the borrower and adifferent system for automobile loan applications received indirectly through an auto dealer.6See footnote 2.24Supervisory InsightsSummer 2005

but credits Hispanic applicants onlywith base salary. In either example,because discriminatory data areinput into the system, the systemwill produce a discriminatory result. Within the credit scoring system:The system could include a prohibited basis as one of the variables,or, if not a prohibited basis itself,a factor that is so highly correlatedwith a prohibited basis that itserves as a proxy for the basis.(As discussed later in this article,in certain circumstances age canbe considered in a credit scoringsystem.) A variable that considersthe geographic area in which anapplicant lives should be carefullyscrutinized to determine if thegeographic distinctions are sohighly correlated with a prohibitedbasis that they serve as a proxy forthat basis. In 2001, the Departmentof Justice (DOJ) settled a caseagainst Associates National Bankin which the bank required a highercutoff score for applicants whoapplied on Spanish-language applications than it required of applicantswho applied on English-languageapplications.7 DOJ treated theSpanish-language application as aproxy for ethnicity.8 Discretionary overrides: The morediscretion bank staff is permitted inoverriding a credit scoring system,and the greater the number of staffwith override authority, the greaterthe risk that the discretion will beexercised discriminatorily. Discretionary overrides fall into two categories. Low-side overrides aredecisions to approve an applicantwhose credit score falls below thecutoff score, and high-side overridesare decisions to deny an applicantwhose credit score exceeds the cutoff score. The two types of overridesshould be independently analyzedto detect an overall pattern ofdisparate treatment. This type ofviolation is illustrated by a settlement agreement between DOJ andDeposit Guaranty National Bankin 1999. The bank used a customscorecard to underwrite applications for home improvement loans,but gave broad discretion to loanofficers to override the creditscoring system. The pattern ofoverrides showed that white applicants were significantly more likelythan black applicants to be approvedwith a credit score below the cutoff,and black applicants were significantly more likely than white applicants to be denied with a creditscore above the cutoff.9How should a fair lending examination be conducted once an examinerlearns that a credit score is one ofthe criteria used in making a creditdecision? Initially, the examiner shoulddetermine if the credit score is a bureauscore or a custom score. If it is a bureauscore, the examiner does not need toobtain more information about the scoring system. The comparative analysisshould focus on the pattern of overridesand the lender’s consideration of othercriteria unrelated to the system. It israre for a bureau score to be the onlycriterion considered in making a creditdecision.However, if the credit score is a customscore, the examiner should obtain a list7United States v. Associates National Bank (D. Del.), e opportunity for overt discrimination or disparate treatment to occur does not exist in the first two stagesif the lender uses a bureau score, because (1) the lender does not develop or input the data and (2) we canconfirm from publicly available information that bureau scores do not consider any prohibited basis, includingage, or any variable that could be considered a proxy for a prohibited basis.9United States v. Deposit Guaranty National Bank (N.D. Miss.). upervisory InsightsSummer 2005