Table Of ContentDISCRIMINATION IN
FINANCIAL SERVICES
A Special Issue of the Journal of
Financial Services Research
edited by
George J. Benston
Emory University
w.
Curt Hunter
Federal Reserve Bank o/Chicago
George G. Kaufman
Loyola University Chicago
Reprinted from the
Journal of Financial Services Research
Volume 11: 112 (1997)
KLUWER ACADEMIC PUBLISHERS
BostonIDordrechtILondon
Journal of Financial
Services Research
Volume 11, Numbers 1 and 2, February/April 1997
Special Double Issue: Discrimination in Financial Services
Guest Editors: George J. Benston, W. Curt Hunter, and George G. Kaufman
Editors' Note. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Detecting Discrimination in Mortgage Lending
Using HMDA Data as a Regulatory Screen for Fair Lending Compliance ...... .. ... . .
· . ... ... ........ .......... Robert B. Avery, Patricia E. Beeson, and Paul S. Calem 9
Mortgage Lending, Race, and Model Specification .. .. .... .... ... .. David K. Horne 43
Strategic Responses to Bank Regulation: Evidence from HMDA Data ... ....... .. .. .
· ......... ............... ...... .. .... Douglas D. Evanoff and Lewis M. Segal 69
Issues in Redlining, Underwriting, and Pricing
Mortgage Loans to Nonoccupants as an Indicator of Racial Redlining ......... .. ... .
· .. ....... ... ..... ..... .... .. Andrew Holmes, Paul M. Horvitz, and Joe F. James 95
A Reconsideration of Discrimination in Mortgage Underwriting with Data from a National
Mortgage Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . E. r. ic . R.o .s e. n.b .l a. t.t . . 109 .
Discrimination Resulting from Overage Practices ....... .. .. ................ .. .
· . ..... ..... .................. ....... Marsha Courchane and David Nickerson 133
Models of Discrimination in Credit Markets
Cultural Affinity and Lending Discrimination: The Impact of Underwriting Errors and
Credit Risk Distribution on Applicant Denial Rates ..... ........ ......... .... .
· ... .. ... .... .... .............. .. .. Michael F. Ferguson and Stephen R. Peters 153
The Economics of Low-Income Mortgage Lending ....... .. .. .. .......... ..... .
· . ...... ...... ....... .. David Malmquist, Fred Phillips-Patrick, and Clifford Rossi 169
Do Black-Owned Banks Discriminate against Black Borrowers? ...... ....... ..... .
· ... ..... ...... .. ....... .... Harold A. Black, M. Cary Collins, and Ken B. Cyree 189
Discrimination in Financial Services: Panel
What Do We Know? . . . . . . . . . . . . . . . . . . . . . . . . . . . . Su.s a. n. .W . a. c.h .t e.r 20.5 . .
What Do We Not Know? ............ ............... .. ... ... George 1. Benston 209
How Should We Proceed? ..... .. .. ......... ..... ...... .. ... .R obert Townsend 215
Shadow Financial Regulatory Committee Statements. . . . . . . . . . . . . . . . . . . .2 1.9 . . . .
Financial Economists Roundtable Statement on Risk Disclosure by Mutual Funds. . . 227
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Editors' Note
This issue ushers in the second decade of the Journal of Financial Services Research. By
all accounts the first ten years have been extremely successful in meeting our mission of
providing a comprehensive forum for rigorous theoretical and applied microeconomic
analysis of financial services institutions, instruments and markets. The Journal is an
influential journal in the field of financial institutions, and the Editors look forward to
continuation and further enhancement of this position. Success and a healthy backlog of
articles have let to an expansion of the Journal from four to six issues per year, which
will be published in two volumes yearly. Part of the rationale for this expansion was the
success of several special issues devoted to publishing quality papers from conferences,
our desire to encourage and continue this practice, and the belief that this initiative should
not adversely impact on the ability to publish regular refereed papers in a timely fashion.
The Editors have introduced what we believe are several innovative changes in the
Journal over its first ten years. This includes creating a special forum for policy papers,
which are refereed directly by the Editors to expedite the publishing of timely analyses
before the issues have faded away. The Journal also prints the policy statements of the
Shadow Financial Regulatory Committee and the Financial Economists Roundtable. We
have introduced the practice of providing nominal compensation to incent reviewers to
respond promptly and have also committed to return the submission fee if a decision is not
provided within ten weeks. In the near future, the Journal will introduce means to submit
papers and reviews electronically and also plans to use e-mail to correspond with both
authors and reviewers.
Additionally, in keeping with the desire to attract the best papers in the areas of financial
institutions and markets, the Editors are pleased to announce the establishment of an
annual prize for the best refereed paper to appear in a regular issue of the Journal. This
prize will commence with Vol. 13 and will carry with it financial recognition.
Announcement of the award-winning author or authors will appear in the first issue of
the succeeding year.
The Editors wish to thank current and past members of the editorial board, and all those
who have given their time to provide peer reviews. Without them, the Journal would not
be what it is today. We look forward in the coming decade to providing a forum for the
highest quality scholarship in the area of financial institutions and markets.
George J. Benston, Emory University
Franklin R. Edwards, Columbia University
Robert A. Eisenbeis, Federal Reserve Bank of Atlanta
Paul M. Horvitz, University of Houston
Edward J. Kane, Boston College
George G. Kaufman, Loyola University Chicago
Journal of Financial Services Research II: 3 (1997)
© 1997 Kluwer Academic Publishers
Introduction
Equal treatment in access to credit has long been a fundamental social goal in the United
States. However, despite the passage of several laws prohibiting discrimination in the
provision of financial services on the basis of race, gender, and marital status, among other
factors, questions concerning the existence of racial discrimination in such areas as home
mortgage loans and small business credit continue and confound public policy makers.
To be sure, the search for statistical evidence of racial discrimination in economic life is
exceedingly difficult. However, as a result of data recently made available by the Federal
Reserve System (under the Home Mortgage Disclosure Act) and other public and private
institutions and organizations, much new research has been initiated exploring the issue of
discrimination in the provision of financial services (especially home mortgage loans). To
provide a forum for involved researchers and policy-makers from the universities' and
regulatory agencies, government, private financial institutions, trade associations, and the
interested public (including community groups) to review recent research and further the
current state of knowledge in this important area, the Federal Reserve Bank of Chicago, the
Center for Financial and Policy Studies at Loyola University, Chicago, and the Journal of
Financial Services Research jointly cosponsored a conference on Discrimination on
Financial Services, on March 22, 1996, at the Federal Reserve Bank of Chicago. This issue
of the JFSR contains selected papers from this conference. In addition to being presented
and discussed at the conference, the nine papers published in this issue were also refereed.
The conference concluded with a policy roundtable discussion examining the questions of
"What do we know?" "What don't we know?" and "How should we proceed?" about
discrimination in financial services. The abridged transcript of the comments of the three
moderators of this roundtable discussion is also included in this issue.
The guest editors would like to thank the following individuals who served as discussants
at the conference and referees for the papers: Anthony Yezer (George Washington
University), Eli Brewer (Federal Reserve Bank of Chicago), John Yinger (Syracuse
University), Wayne Passmore (Federal Reserve Board), James Berkovec (Federal Home
Loan Mortgage Corporation), Daniel Sullivan (Federal Reserve Bank of Chicago), Glenn
Canner (Federal Reserve Board), Raphael Bostic (Federal Reserve Board), Leonard
Nakamura (Federal Reserve Bank of Philadelphia), Stanley Longhofer (Federal Reserve
Bank of Cleveland), and Paula Worthington (Federal Reserve Bank of Chicago). In addition,
Stanley Liebowitz (University of Texas at Dallas) and Dwight Steward (Welch Consulting)
served with the guest editors as session moderators. Finally, special thanks are due to Shirley
Harris, Sandy Schneider, and Kathleen Solitroff of the Federal Reserve Bank of Chicago for
their efficient and smooth handling of the conference arrangements.
George 1. Benston, Emory University
W. Curt Hunter, Federal Reserve Bank of Chicago
George G. Kaufman, Loyola University Chicago
Journal of Financial Services Research 11: 9-42 (1997)
© 1997 Kluwer Academic Publishers
Using HMDA Data as a Regulatory Screen for Fair
Lending Compliance
ROBERT B. AVERY
Board of Governors of the Federal Reserve System
PATRICIA E. BEESON
University of Pittsburgh and the Federal Reserve Bank of Cleveland
PAUL S. CALEM
Board of Governors of the Federal Reserve System
Abstract
This paper describes and evaluates the Federal Reserve System's recently developed program designed to use
HMDA data as a screening device for fair lending enforcement. The program is designed to identify institutions
showing potentially discriminatory patterns in their treatment of minority mortgage applicants vis-a-vis
nonminority applicants. The program also selects specific loan files to pull for additional information in cases
where a more comprehensive evaluation might be appropriate. This paper discusses the motivation behind the
adoption of the program and its innovative "matched-pair" method and assesses its value and potential
shortcomings.
1. Introduction
Federal fair lending laws require that creditors must not discriminate against loan
applicants on the basis of race, ethnic origin, gender, receipt of public assistance, religion,
and in some instances, age. The government agencies charged with regulating depository
institutions are responsible for monitoring each individual lender's compliance with these
statutes. In 1989, as part of the Financial Institutions Reform, Recovery, and Enforcement
Act, Congress amended the 1975 Home Mortgage Disclosure Act (HMDA) to require
covered institutions to collect and disclose data on lending decisions that could be used to
assist regulators and the public in identifying possible discriminatory patterns and
enforcing fair lending laws.
This paper presents an overview and evaluation of the Federal Reserve Board's recently
developed program designed to use HMDA data as a screening device for fair lending
enforcement in the home mortgage market. The program is designed to identify
institutions showing potentially discriminatory patterns in evaluating mortgage loan
applications. It is also designed to identify specific geographic markets and product areas
where these institutions may have particular "problems," warranting more detailed
examination. Finally, the program will select specific loan files to pull for additional
information in cases where a more comprehensive evaluation is indicated. The program
10 ROBERT B. AVERY, PATRICIA E. BEESON, AND PAUL S. CALEM
employs a "matched-pair" method that is comparatively new to the economics
profession. This paper discusses the motivation behind the adoption of the program and
assesses its value and potential shortcomings.
It should be pointed out that these procedures are only part of the Federal Reserve's
consumer compliance examination system. Institutions also are subject to examination for
compliance with the Community Reinvestment Act (CRA). CRA exams focus on an
institution's record of meeting legitimate credit needs within its community and can
identify discriminatory policies not identified during the fair lending portion of the
compliance examination. If, for example, institutions prescreen minority applicants
differently than nonminority applicants, they may show no apparent treatment disparities
among actual applicants yet would still be "treating" the minority and nonminority
populations differently, and this may be evident from their geographic lending patterns.
Accurate assessment of an institution's full record requires combining information from
both the fair lending and CRA exams.
Preliminary evidence suggests that HMDA data can provide an efficient and
inexpensive way of screening for fair lending enforcement. A substantial number of
institutions can be eliminated as likely candidates for detailed statistical examination of
discriminatory violations in their mortgage underwriting decisions, either because they
have too few applications for a meaningful statistical analysis or because any differences
that exist can be attributed to income, loan amount, or possibly, property location. Fair
lending exams for these institutions can be focused on procedural issues or qualitative
assessments of treatment rather than on the costly process of gathering data and
undertaking comprehensive statistical evaluations. A substantial number of other
institutions, however, show statistically significant differences in the disposition of
applications from minorities and nonminorities that cannot be explained by income,
product, or general locational factors. The new HMDA screening procedures pinpoint
markets and loan products in the institutions where such differences are most pronounced.
Thus, follow-up efforts can be focused where they may be most effective.
The paper is organized as follows. The next section presents a review of the fair lending
laws and the Home Mortgage Disclosure Act. Section 3 describes the fair lending exam
procedures used by the Federal Reserve System. The traditional procedures are compared
with the new screening program. A description of the new program is provided as well as a
discussion of its econometric justification and its potential shortcomings. Section 4
presents descriptive statistics reflecting the application of the new procedures to
institutions regulated by the Federal Reserve in 1994 and discusses issues of data quality.
In section 5 data collected by the Federal Reserve Bank of Boston are used to examine how
sample selection under the new procedures affects the second-stage, comprehensive
statistical analysis. Concluding remarks are given in section 6.
2. Background
In response to community concerns with the flow of housing credit to minority and low
income communities, Congress passed a series of laws during the 1960s and 1970s. The
Fair Housing Act of 1968 (as amended in 1988) and the 1974 Equal Credit Opportunity
USING HMDA DATA AS A REGULATORY SCREEN 11
Act (ECOA) require that lenders do not discriminate against individual applicants on the
basis of race or ethnic origin, gender, or religion, among other factors. Enforcement of
these fair lending laws for depository institutions was made the responsibility of federal
banking agencies. Depository institutions are also subject to the 1977 Community
Reinvestment Act. This act mandates that depository institutions must help meet the credit
needs of their communities, including low- and moderate-income neighborhoods, in a
manner consistent with safe and sound banking practices. One of the items that regulators
examine in determining compliance with the CRA is fair lending law violations.
To complement the legislation prohibiting lending discrimination, Congress also
provided some of the means of monitoring lending activity in enacting the Home
Mortgage Disclosure Act in 1975. Initially, HMDA was designed to provide a national
system for collecting and publicly disseminating data on the number and dollar value of
home mortgage and home improvement loans by depository institutions on a census tract
basis within metropolitan statistical areas (MSAs).
Congress enacted major changes to HMDA in 1989, in part to enhance the regulators'
ability to detect instances of disparate treatment or discrimination in mortgage lending.
One important change was to expand the class of institutions required to report HMDA
data beyond the depositories and their holding company affiliates to include independent
mortgage companies. More dramatically, however, the reporting framework shifted to
record keeping on an individual basis of every application for housing credit.
HMDA now requires commercial banks, savings and loan associations, credit unions,
and nearly all other mortgage lending institutions that have assets of more than $10 million
and an office in an MSA to report on each mortgage loan application for a loan processed
and purchased for a property in an MSA during the calendar year. I Lenders are required to
file by March 1 of the succeeding year with their appropriate regulator. Lenders must
report the loan amount, the census tract of the property, whether the property is owner
occupied, the purpose of the loan (home purchase, home improvement, or refinancing),
loan type (conventional, FHA, or VA), loan disposition (loan approved and originated,
application approved but withdrawn, no lender action taken such as loan withdrawn or
incomplete data, or application denied), the dates of application and action taken, the race
and gender of the loan applicant (and coapplicant, if any), and income relied on by the
lending institution in making the loan decision. Finally, institutions are asked, but not
required, to report the reasons why individual applications were denied.2 Data are
processed by the regulatory agencies and run through various automated edit checks.
Lenders are asked to correct errors for the preparation of a data tape containing the loan
by-loan information, which is released to the public in July.
3. Fair lending enforcement
3.1. Traditional fair lending enforcement
Traditionally, fair lending examinations have begun with a review of a lender's loan
policies and procedures? There are two reasons for undertaking this review: to confirm
12 ROBERT B. AVERY, PATRICIA E. BEESON, AND PAUL S. CALEM
that the policies and procedures are not inherently discriminatory and to provide a basis for
assessing whether loan policies are applied consistently across loan applicants.
To help assess the consistency of underwriting decisions, examiners traditionally have
applied a technique known as comparative loan file review. Essentially, this procedure can
be described as follows. The examiners begin by selecting a sample of applications of
nonminorities and minorities from a particular loan category and time period. This sample
mayor may not be drawn in a systematic fashion. They note the disposition of each
application and the key factors considered in the underwriting decision, looking for
potential instances where similarly qualified applicants (so-called close matches) were
treated differently, including disparities in loan disposition, credit terms, or the process by
which decisions were reached. The examiners then go back to specific loan files where
preliminary analysis suggests a problem. They more closely examine these particular files
and seek explanations from bank management before making any final determination as to
discriminatory practices.
There are several limitations to this approach. First, even if close matches among an
institution's loan applications exist, it may be difficult for an examiner to find them
through manual effort alone. Second, even if some differences in treatment are detected, it
is hard to determine whether these are isolated events that do not result from
discrimination or are the result of a pattern or practice of discrimination. Differences in
treatment observed for a particular pair of applications could be a purely random outcome
of the underwriting process. For instance, purely by chance, the minority applicant in
question may have been assigned to a loan underwriter who applied the institution's
underwriting standards more rigidly to all applications. Furthermore, some of the
institution's nonminority applicants may have been treated similarly but they may not
have been included among the files examined. These concerns are exacerbated in cases
where the files chosen for comparative review are not selected randomly.
These two important limitations led the Federal Reserve to search for some additional
tools to enhance fair lending enforcement efforts. HMDA was a logical place to look for
assistance.
3.2. New screening procedures
The new system has two goals. One is to determine which institutions and which loan
products or markets served by the institution show statistically significant evidence of
disparities in the disposition of loan applications by race (or some other protected
characteristic) that cannot be explained with the limited set of explanatory variables
available in HMDA. The second is to provide examiners with a specific list of matched
files to pull in those cases where detailed follow-up review is to be conducted. A special
computer-based program has been created for the new system to accomplish both tasks.
The new procedures are designed to replace only the file-sampling components of fair
lending exams; examiners will continue to examine institutions' procedures and policies
as before. In most cases, examiners focus on the latest year for which HMDA data have
been processed.
USING HMDA DATA AS A REGULATORY SCREEN 13
The new examination procedures follow five steps. First, the HMDA filings for each
reporting institution are reviewed for errors and statistical validity. This involves drawing
a sample of loan applications and checking that the information in the applications has
been correctly reported. Institutions with dubious reportings or an excessive amount of
missing information are deemed ineligible for application of the program. In many of these
cases, institutions will be asked to refile a corrected HMDA report. Institutions with
insufficient numbers of minority (Native Americans, Hispanics, blacks, Asians and" other
races") or nonminority (whites) applicants to make any meaningful statistical
comparisons also are deemed ineligible. Applications where either the applicant or
coapplicant is a minority person are treated as minority applications.4
The second step is to perform a statistical evaluation of all institutions passing the initial
error and size screen. Applications reported by each institution are sorted by product type
(conventional home purchase; government [FHA- or VA-insured], home purchase;
conventional refinance; government refinance; and home improvement); number of
applicants (single or more than one); market (MSA); action date (for large institutions);
and applicant's race.
Each minority application is matched to all nonminority applications filed with the same
lender for the same product, same market, same quarter of action date (for large
institutions), with the same number of applicants (single or joint), and similar income and
loan amount. Ideally, similar would mean identical income and loan amount. In practice, if
the average of the absolute amounts of the income and loan amount differences is less than
8%, the applications are deemed to be "matched.,,5 The disposition of the minority
application is then compared with the average disposition of all nonminority applications
matched to it.6 This comparison is averaged over all minority applications in the institution
(or the institution's market/product subcategories). Minority applications that cannot be
matched to any nonminority applications are not included in the analysis.
The third step is to screen institutions based on the outcome of the statistical evaluation,
to determine which institutions warrant detailed further review. In short, detailed further
investigation is warranted if the difference in matched-pair denial rates for the institution
as a whole, or for any of its major product areas or markets, is sufficiently large (the
criteria are discussed more fully in section 4). Institutions are sorted into three categories:
(1) those where no detailed further review is indicated, (2) those with product or market
areas where there is a statistically significant denial rate disparity and where there are
enough applications from minorities and nonminorities (including a reasonable mix of
approvals and denials) to warrant further statistical review, and (3) those where the
institution as a whole (or a particular product or product/market area) shows evidence of a
substantial disparity but where no individual product or market area has enough
applications from minorities or nonminorities or both to qualify for further statistical
analysis. For the third set of institutions, detailed qualitative, but not statistical, analyses of
loan files are conducted.
The fourth step is to select the specific loan files for additional data collection when
warranted. For institutions with multiple product or market areas qualifying for further
statistical review, judgment is used to determine which specific subsamples should be
targeted. Once product and/or market areas are selected, a slightly modified version of the
matched-pair process used for the initial screening is employed to select which loan files
