Compliance Considerations of Indirect Auto Lending Programs

by Sherry Jones, Senior Consultant, CRCM, Regulatory Advisory Services

During the past decade, multiple supervisory reviews have identified indirect auto lenders with discretionary pricing policies that resulted in discrimination against borrowers in violation of ECOA. In these cases, the institutions maintained discretionary pricing policies with auto dealers that were not adequately monitored or controlled for fair lending risks. Whenever there is “reason” to believe that a lender’s discretionary pricing policies have resulted in a pattern or practice of discrimination in violation of ECOA, the Consumer Financial Protection Bureau (CFPB), is required to refer the matter to the U.S. Department of Justice (DOJ).

Indirect auto lending is a highly competitive market with significant competitive pressures exerted by the captive finance companies of automobile manufacturers. Anecdotal evidence suggests that increased competition is influencing many indirect auto lending programs at financial institutions to offer lower interest rates, lengthen amortization periods, and scale down payment requirements, which in turn can have an impact on the institution's delinquency rates, collateral adequacy, charge offs, and allowance for loan and lease losses (ALLL). In addition, the number of institutions granting lending authority in order to expedite the approval process for loans that fall within the institution’s approved guidelines has grown significantly over the past decade.  

Compliance Risks Associated with Indirect Auto Lending

Compliance risks associated with indirect auto lending appear in the form of fair lending and UDAAP risks. There can be multiple creditors in a single credit transaction. A “creditor” is defined in Regulation B (12 CFR 1002.4(1)) as “a person who, in the ordinary course of business, regularly participates in a credit decision, including setting the terms of the credit.” In the case of indirect lending, there are two creditors: (1) the institution and (2) the dealer.  

The Institution sets the “buy rate” or the minimum interest rate at which the lender is willing to purchase the retail installment sales contract from the dealer. This “buy rate” can vary from dealer to dealer within the same financial institution. In most instances, lenders have the policy to allow the dealer to “markup” the interest rate above the institution’s “buy rate.” When a dealer charges the consumer an interest rate that is higher than the lender’s buy rate, the lender may pay the dealer what is typically referred to as “reserve” or “participation” which is compensation based upon the difference in interest revenues between the buy rate and the actual note rate charged to the consumer in the retail installment contract. 

Fair Lending implications can arise when a dealer is allowed to set retail interest rates and those rates result in statistically significant differences in pricing or underwriting that disadvantages Hispanic, Asian or Pacific Islander, African American, or female consumers.

A financial institution is directly responsible for any discriminatory pricing, or any other discriminatory decisions made by the dealer acting as an agent of the institution. As with any other regulatory requirement, an institution may outsource a function, but it cannot outsource the regulatory risk(s) associated with that function.

Warning Signs and Red Flags 

Examiners are looking for warning signs or "red flags" such as: 

• A high concentration of indirect loans to total loans or net worth without adequate controls in place
• Incentive programs tying loan officer bonuses to indirect loan volume
• Inadequate analysis of overall indirect loan portfolio performance
• High instances of first payment default, payment deferment, and account re-aging
• Frequent refinancing of past due interest, repairs, and add-on expenses (GAP Insurance)
• Insufficient loan documentation; or 
• Poor dealer management including reliance on the dealer to obtain credit reports; accepting loan payments from dealers; dealer-created down payments through dealer incentives, inflated or fraudulent trade-in or purchase price; or continuous overdrafts in dealer reserve accounts.

Risk Mitigation Best Practices 

• Ensure your indirect auto lending is included in your Fair Lending Risk Assessment
• Regularly review your indirect auto lending portfolio for potential signs of disparate treatment or disparate impact, including statistical analysis
• Limiting discretionary markups by dealers
• Require dealers to stay within the institution's written credit underwriting standards
• Regulation B generally prohibits a creditor from inquiring about “race, color, religion, national origin or sex of an applicant,” not subject to HMDA reporting. When direct evidence of a particular prohibited basis characteristic is not otherwise available, the CFPB examination teams and other federal supervisory and enforcement agencies as well as many lenders, use a proxy methodology to differentiate among consumers based on race, national origin, and sex such as name and geographic information to match data that is publicly available from the Social Security Administration and the United States Census Bureau.

How Capco Can Help You with Your Fair Lending/Indirect Auto Lending Program

Discrimination is at the top of the examiners' radar today. Our team of compliance experts is here to assist you in your quest to remain compliant and avoid potential fair lending and UDAAP risks. Browse our compliance course catalog for courses designed to help you identify potential risks in your program and help you mitigate or eliminate identified risks