Effects Test

What Is an Effects Test?

The effects test is a method used to assess the discriminatory impact of credit policies. The statutory basis is the Equal Credit Opportunity Act (ECOA), which prohibits credit denials on the basis of race, color, religion, national origin, sex marital status, or age.

Understanding the Effects Test

The effects test is based on a legal theory called “disparate impact,” which proposes that discrimination can occur without a company or individual overtly exhibiting bias against a protected class. Rather, discrimination can be attributed to a wide range of socioeconomic and cultural factors that have the effect of creating hurdles for some borrowers. Disparate impact was first outlined in the Fair Housing Act, which is Title VII of the Civil Rights Act of 1968.

During the Civil Rights era, the disparate impact was noted in the widespread practice of redlining, in which banks denied mortgages within certain neighborhoods around which they had drawn “red lines” on a map. While the banks could claim their decisions were based on business concerns about the viability of loans in those neighborhoods, in practice, the policies were largely implemented in African-American neighborhoods and thus were discriminatory.

Controversy Around the Effects Test

To counteract these less overt forms of discrimination, effects tests assume that demographic and statistical information can be used to demonstrate discriminatory practices. Effects tests are controversial, however, because demographic information is not entirely empirical and can itself be manipulated to produce desired outcomes. Moreover, some credit and hiring practices found to be statistically discriminatory could be justified in some circumstances.

For example, the Supreme Court has ruled that companies have the right to screen potential employees for criminal records even though a larger percentage of African-American men have criminal records. The Equal Employment Opportunity Commission gives detailed guidance on the permissible use of criminal background screenings. It is not an absolute right. Background screenings must be "job-related and consistent with business necessity."

The Supreme Court has also narrowed disparate impact claims, giving banks the right to base the effect test on borrowers who are similarly situated. That is, they must be in similar markets, have applied for similar credit products, and be of similar creditworthiness. Banks can also defend themselves by citing a legitimate business justification.

Finally, any solution to the discrimination must be equally effective as the statistically discriminatory method with a legitimate business justification. And to be found in violation of discrimination laws, the bank must have known about the other business method previously, yet still chosen not to use it.

The Supreme Court decision led to what is known as Regulation B of Title VII. It is now the basis of the effects test used by the Consumer Financial Protection Bureau.

Effective from Oct. 2020, the Department of Housing and Urban Development (HUD) released a new Disparate Impact Rule that shifts the burden of proof to the plaintiff in proving discrimination. However, implementation of the rule was enjoined prior to it going into effect. In June of 2021 HUD issued a Notice of Proposed Rule Making (NPRM) that would rescind the new rule, seeking to return to the prior burden of proof, thereby making it less onerous for plaintiffs seeking relief.