Last Thursday, the Consumer Financial Protection Bureau (CFPB) released a final rule for Section 1071. This decision comes over a decade after Section 1071 entered into law with the Dodd-Frank Act. The section addresses discrimination in the small business loan industry by better enforcing the Equal Credit Opportunity Act (ECOA). While this objective is commendable, its implementation will require creating a database for all small business loans issued to minority and female business owners. Such a system will raise costs for filing credit applications while leaving lenders worried about lawsuits for perceived infractions. The result will inevitably be reduced consumer (in this case, small businesses) access to credit.
The initially proposed rule for Section 1071 was far more intrusive, requiring lenders to record the race and ethnicity of the borrower based on visible cues. Though that provision has been removed, borrowers can still voluntarily give their race, ethnicity, gender and multiple other data points upon request. To prevent this information from biasing the lender’s final decision, two separate systems of filing will be used: one without demographic information for the lender to use to decide whether to approve the application or not and one with demographic information to be made available to the public and the CFPB.
The dual filing system effectively doubles the paperwork required for all loan applications. While making demographic data collection voluntary may reduce the paperwork compared with the first rule proposal, the CFPB will ensure lenders are not dissuading applicants from giving their information.
The increases in overhead costs associated with managing this new system are significant. According to a study by the American Bankers Association, implementation costs could be between $312 million and $323 million, with annual costs between $372 million and $392 million. The added overhead will naturally need to be passed on to the consumer seeking access to credit, resulting in higher fees and interest. These price hikes create barriers to credit that disproportionately affect minority borrowers — the opposite of the intended effect.
Increased overhead costs could make interest rates prohibitively high, eliminating small-dollar short-term lending to small businesses. For these loans to remain profitable, higher-than-average interest rates are required to offset the fixed expenses on administration. With many states implementing 36 percent interest caps, lenders will set higher minimum loan amounts to remain profitable. A measure like this will limit options for borrowers to only large loans.
Additionally, some critics are concerned the CFPB could be planning to use this demographic database to manage private lenders, undermining their ability to evaluate applicants. A similar issue was seen with the Federal Communications Commission’s (FCC) announcement to move to a disparate impact model for anti-discrimination action instead of a disparate treatment model. The difference between the two is that the impact model evaluates discrimination based on the results of a program while the treatment model does so by finding observable cases of discrimination.
If the CFPB implemented a similar disparate impact model to the FCC, the result could be a further decline in consumer access to credit. Lenders use a multitude of factors when evaluating to whom to lend. When lenders make decisions to avoid litigation and not maximize investment, inefficiency ensues.
To illustrate an example of this, look at credit scores. Credit scores provide lenders with a fair sense of whether a loan will be repaid. Credit scores also vary across racial and ethnic groups, with minority borrowers having disproportionately lower credit scores on average. Though credit scores are useful measurements, they can have a disparate impact on members of protected classes. The risk of creating disparate impact through normal lending could result in less available credit.
It remains to be seen how the CFPB will choose to enforce this rule. Under Regulation B comment 6(a)-2, useful standards could be deemed discriminatory under the disparate impact model or necessary, depending on the CFPB.
An increased bureaucratic overhead and the introduction of inefficiencies in evaluations will likely result in less credit and higher fees. Ultimately, consumers pay the cost for programs like this. If the CFPB wanted to increase access to credit for protected classes, it would lower barriers, not build them up.
Isaac Schick is a policy analyst at the American Consumer Institute, a nonprofit education and research organization. For more information about the Institute, visit www.TheAmericanConsumer.Org or follow us on Twitter @ConsumerPal.