Lynn Woosley is a Senior Director with Treliant. She is a seasoned executive with extensive risk management experience in regulatory compliance, consumer and commercial credit risk, credit and compliance risk modeling, model governance, regulatory change management, acquisition due diligence, and operational risk in both financial services and regulatory environments.
Two major trends in the U.S. banking sector are headed on a potential collision course. Bank mergers and acquisitions (M&As) are surging just as the Biden Administration is raising the bar on fair lending regulation. The point of impact is clear. To gain regulatory approval, any bank pursuing an M&A deal needs to scrutinize the fair lending practices of its acquisition target and submit a plan to correct any issues. Otherwise, the deal could be soured by closing delays, higher integration costs, reputational damage, and other risks.
Your M&A due diligence needs to prioritize fair lending compliance to a degree that hasn’t been required in years, if ever. The stakes are high. After all, you’re buying this bank—or fintech or other lender—for a reason, whether it’s to achieve economies of scale, gain access to technology, or expand into a new line of business. And time is of the essence.
To preserve the value of your acquisition and smooth out its regulatory approval process, consider the approach to due diligence outlined below. As you do, remember these two “big picture” items:
- The standards are changing. Just because an acquired bank is well managed in other areas and has a Satisfactory CRA rating does not mean its fair lending compliance management system will meet current expectations, especially if the target is smaller than the acquiring institution.
- Fair lending problems can be solved, so don’t give up just because you find some potential issues. Identifying risks early in the process and creating an appropriate action plan can increase effectiveness and reduce remediation costs.
The New Imperative of Due Diligence
Acquiring banks typically use robust M&A due diligence processes that include reviews of financial performance, asset quality, legal and compliance risks, and operational processes. Acquirers develop checklists and playbooks to assess corporate records, loan and investment portfolios, deposits, fixed assets, human resources, material contracts, information technology, taxes, insurance, interest rate risk, liquidity risk, and litigation. In short, acquirers make a determined effort to assess the transaction’s risk and prepare for integration.
In many instances, though, due diligence processes have not been sufficiently assessing fair lending practices and compliance risk. If it wasn’t clear before, it is now: Every due diligence review of a lender should include an in-depth evaluation of the target’s fair lending performance. If acquirers pay insufficient attention to this aspect of due diligence, they may find they have purchased a substantial, and expensive, problem.
Regulators are looking more closely than ever at fair lending practices before approving acquisitions, and they’re giving more weight to input from consumer advocates and community groups. At the same time, fair lending regulation has become a moving target, perhaps leaving your target bank lagging as agencies have issued new and stronger requirements.
In past periods of heightened regulatory expectations—after the global financial crisis, for example—compliance issues have been known to delay closing dates by as long as two years.1 Delays are inimical to dealmaking. With competitors, customers, investors, and employees all aware that a bank’s sale is pending, a lengthy approval process can cause the loss of key employees, customers, business, and momentum—or the deal could fall through.
Addressing these heightened regulatory risks requires acquiring banks to focus their due diligence on the fair lending priorities enunciated by the Consumer Financial Protection Bureau (CFPB) as well as the Justice Department, Federal Reserve, and other financial regulators that play a role in vetting M&A deals. And in fact, federal legislation was reintroduced in September to require formal CFPB approval of any bank merger.2
Steps to Analyze Fair Lending
So how can acquirers manage this risk? Specific focus areas should include:
- Fair access to banking services and the equitable pricing of those services, including avoidance of disparate treatment and disparate impact under the Fair Housing Act and Equal Credit Opportunity Act;
- Consumer protection against Unfair, Deceptive, or Abusive Acts or Practices (UDAAP); and
- Community development benefitting low- and moderate-income people and neighborhoods under the Community Reinvestment Act (CRA).
Acquiring banks have powerful tools within reach to analyze compliance risk in these and other areas. Publicly available Home Mortgage Disclosure Act (HMDA) and branching data includes coverage footprints, loan types, and other statistical data for low-income and minority consumers. Disparate impact analyses can be conducted relatively easily using these and other data sources, whether in-house or by a consultant. Banks confident in their compliance with the CFPB’s UDAAP standards and others can compare their acquisition target’s compliance management system with their own. Specific areas to analyze include:
Public Performance Evaluations: The acquisition target’s CRA public performance evaluations should be analyzed at several levels. In the first instance, ask whether the target has at least a “Satisfactory” rating. Don’t stop there, though. Dig deeper: Were there any ratings downgrades for violations of consumer protection laws? If the target has any CRA complaints, what was the nature of the complaints?
Assessment Areas: Ask similarly detailed questions in evaluating the target’s CRA assessment areas (AAs). Do the target’s AAs appear to be drawn to avoid serving minority and low- or moderate-income (LMI) neighborhoods as well as non-minority and middle- and upper-income neighborhoods? If so, you may be acquiring redlining risk along with the target.
Branch Distribution: Look at the target’s branch and loan production office (LPO) distribution. A target without offices in LMI neighborhoods is another indicator of redlining risk. Make sure you also consider the target’s office network combined with your office network. When considering the combined network and any branch closure plans, remember to evaluate:
- Any gaps in coverage of minority and LMI neighborhoods in the combined network after planned branch closures or consolidations; and
- Differences in location types and service offerings in offices serving minority or LMI neighborhoods, such as:
- Full-service branches in non-minority areas, but limited-service branches or LPOs in minority neighborhoods;
- Branches in upper-income neighborhoods being staffed with loan officers, while branches in LMI neighborhoods are not;
- Differences in hours of operation that are correlated with neighborhood characteristics; or
- Interactive video teller machines (ITMs) or deposit-taking ATMs in non-minority neighborhoods, but only cash-dispensing ATMs in minority neighborhoods.
Lending Activity: Public data sources for loans reported under the HMDA or CRA can assist in evaluating the target’s lending activity. Is most of the target’s lending activity within its AAs? Does the target show lending activity distributed throughout its AAs? Gaps in lending affecting minority or LMI areas could indicate redlining risk. Steering risk could be indicated by differences in HMDA-reportable loan types offered by neighborhood characteristics, such as conventional loans offered in higher-income or non-minority areas while FHA loans are offered in LMI or minority neighborhoods. Offering high-cost mortgages under the Home Ownership and Equity Protection Act (HOEPA), or mortgages with less preferential, non-amortizing features predominantly in LMI or minority areas, indicates reverse redlining risk.
Once your institution has access to complete lending data from the target, consider a fair lending regression analysis to detect disparities in underwriting and pricing outcomes on a prohibited basis.
Complaints Data: The CFPB complaints database and other complaints data should also be leveraged during due diligence. How does the target’s complaint data compare to the industry overall? Are there complaint trends that might indicate fair lending or UDAAP risks? Once your institution has access to the target’s complaint program information, assess the scope of the program and complaint responses to detect additional risks.
Steps to Correct Fair Lending Issues
After you’ve completed your analysis of fair lending risks, consider the results holistically. If your analysis identifies risks, or if consumer advocates, community groups, or regulators express concerns, develop a plan to mitigate the risks. The plan’s details will depend on the nature of the risks identified. Here are six typical scenarios and the steps they would require:
- If the combined AAs appear to omit minority neighborhoods, expand the AAs to include adjacent minority areas.
- If there are differences in branch service levels or access to loan officers, increase service offerings or staffing at branches in minority or LMI neighborhoods.
- If the combined branch network lacks locations in minority or LMI areas, develop a branch and LPO opening plan to close the gaps.
- If there are gaps in lending patterns, plan for additional outreach in those areas, including hiring additional loan officers if needed.
- If your analysis of the target’s lending patterns indicates fair lending risk, or if the target’s CRA evaluations include downgrades for consumer protection violations, evaluate whether the target’s response was appropriate and sufficient or whether borrower-level remediation is required.
- If the target’s CRA public file includes complaints from consumer advocates or community groups, or if they protest the merger, conduct proactive outreach to listen to the groups’ concerns and seek common ground to resolve those concerns.
Regulators, consumer advocates, and community groups are pushing fair lending up the checklist of criteria for bank merger approvals. Acquiring banks need to get ahead of any issues in their target’s compliance that might otherwise derail and devalue planned M&A deals. Identifying fair lending shortfalls and submitting plans to correct them is best done sooner rather than later, because changes will be required either way. A proactive approach puts the bank in the driver’s seat, while a reactive strategy puts consumer advocates and regulators in the driver’s seat. Choose wisely.
1 “M&T-Hudson City Merger Still Stalled After Two Years,” Wall Street Journal: https://www.wsj.com/articles/m-t-hudson-city-merger-still-stalled-after-two-years-1409157228
2 “Senator Warren and Rep. Chuy García Introduce the Bank Merger Review Modernization Act,” Office of Sen. Elizabeth Warren: https://www.warren.senate.gov/newsroom/press-releases/senator-warren-and-rep-chuy-garca-introduce-the-bank-merger-review-modernization-act-to-end-rubber-stamping-of-bank-merger-applications