Home > finance > How can we regulate around discrimination?

How can we regulate around discrimination?

February 24, 2014

I am looking into the history of anti-discrimination laws like the Equal Credit Opportunity Act, (ECOA) and how it got passed, and hopefully find data to measure how well it’s worked since it got passed in 1974.

Putting aside the history of this legislation for now – although it is fascinating – I’d like to talk this morning about this paper from 1989 written by Gregory Elliehausen and Thomas Durkin from the Board of Governors of the Federal Reserve System, which discusses the abstract question of approaches to defining and regulation around discrimination.

This came up because when Congress passed ECOA, they left it to the regulators – in this case the Federal Reserve – to decide exactly how to write the rules, which pertain to credit decisions (think credit card offerings). From the article:

The term “discriminate against an applicant” was defined in Section 202. 2(n) as meaning “to treat an applicant less favorably than other applicants.” By itself, this rule does not offer an unquestionably unambiguous operational definition of socially unacceptable discrimination in a screening context where limited selections are constantly being made from a longer list of applicants.

The paper then goes on to list 3 separate regulatory approaches to anti-discrimination regulation. I have found these three definition really interesting and thought-provoking. I won’t even go into the rest of the paper on this post because I think just this list of three approaches is so interesting. Tell me if you agree.

1) The “effects-based” approach to regulation. This is the idea that, we don’t need to know how you actually make credit decisions, but if the effect is that no women or minorities ever get credit from you, then you’re doing something wrong. If you want to be really extreme in this category you get to things like quotas. if you want to be less extreme you think about studying applications that are similar except for one thing like race or gender, kind of like the the male vs. female science lab application test studied here. Needless to say, effects-based regulation is not in use, it’s considered too extreme.

2) The “intent-based” approach to regulation. This is where you have to prove intent to discriminate. It’s super rare that you can do that, because it’s super rare that people aiming to discriminate are dumb enough to make it obvious. Far easier to embed discrimination in a model where you can maintain plausible deniability. Although intent-based regulation is considered too extreme in the other direction, it seems to be what surfaces when there’s a legal case (although I’m not a legal expert).

3) The “practices-based” approach to regulation. This is where you make a list of acceptable or unacceptable practices in extending credit and hope you cover everything. So for example you aren’t allowed to explicitly use race or marital status or governmental assistance status in your credit models. This is what the Fed finally decided to use, and it makes sense in that it’s easy to implement, but of course the lists change over time, and that’s the key issue (for me anyway): we need to update those lists in the age of big data.

Tell me if you think there’s yet another approach not mentioned. And note these regulatory approaches correspond to different ways of thinking about or even defining discrimination, which is itself a great reason to list them comprehensively. I think my future discussions about what constitutes discrimination will be informed by which above approach will pick up on a given instance.

Categories: finance
  1. Josh
    February 24, 2014 at 12:24 pm

    I think there is an iterative version mixing (3) and (1) where you define acceptable and unacceptable practice, see what the effect is, then change your definitions if you don’t like the effect.

    One other reason the Fed chose option (3) is because of the bias toward rules instead of principles in US law and regulation.

    Another complication: is it discrimination to give someone credit or not give them credit and does the answer depend on context? Is it discrimination to give someone a different product or the same product at a different price?

  2. February 24, 2014 at 12:27 pm

    Wouldn’t affirmative action qualify as an “effects-based” regulatory approach to discrimination? I’m not sure if it’s used in credit decisions but it wouldn’t be too difficult to implement and monitor. Are lenders making more money from discriminated classes than others?

    Seems like “practices-based” approaches are easily gamed by using acceptable proxies that achieve the same results as unacceptable practices. I don’t see an easy way around this.

    Fair and equal access to low-risk credit is important. Weak underwriting standards are another story. Turning down a marginal borrower for an inessential loan is probably in his or her long-term best interests. Having one in eight people chased by debt collectors can’t be a mark of a healthy society. That’s probably the best argument for not using affirmative action for access to credit. Still, AA could be used in qualifying for best credit terms.

  3. bob
    February 24, 2014 at 12:58 pm

    #1 is probably discriminatory in some way. It may requires taking gender into account in order to ensure an equal distribution of loans.

    Any ‘use of gender’ or ‘use of race’ is inherently discriminatory – even where the stated goal is to ensure equality

  4. Thomas
    February 24, 2014 at 10:20 pm

    Discriminatory practices are one thing, the criteria for exclusion another. As long as credit granting companies do not deny credit “on the basis of race, color, religion, national origin, sex or marital status, and age” then they are within the letter of the 1989 law. The exclusion criteria are things about which few would disagree. If anything they leave gaping loopholes and considerable latitude for abuse and discrimination. Today’s discrimination doesn’t begin with exclusion criteria, It starts way before they even come into play.

    The risks assumed by the credit card issuers presume credit-worthiness as a minimum threshold. And the various tranches among that credit-worthy subset of the adult population define the risk their underwriters are willing to assume: the riskier tranches impose higher interest rates to subsidize the greater likelihood of late payment or default.

    Discrimination begins with access to credit. Obtaining credit is predicated on a credit history of some kind and having no access to credit means there is no credit history and vice-versa…it’s a vicious circle. Education, income and geography are a few of the factors that are not excluded by the law but they are strong proxies for the things that are. So, poverty and being poor isn’t one of the exclusion criteria but poverty is highly correlated with credit access.

    Focusing on the factors that distinguish between credit-worthiness (i.e., having access) vs not credit-worthy (no access) would uncover the real dimensions of the discriminatory practices that are currently in use.

  5. Nathanael
    March 19, 2014 at 11:04 pm

    “Effects” is actually the right way to do it, but only for the very large operators where there’s enough data to do a statistical analysis of whether they’re creating discriminatory results or not. For them, hard population-based quotas. They’re large enough operators that they can fix any problems: if you can’t find people who are credit-worthy, MAKE THEM credit-worthy. It cuts into the banks’ profit to force this social obligation on them — I don’t care.

    For everyone else, the small operators, you have to go with practices.

  1. February 28, 2014 at 12:47 pm
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