By Jong Eun Jung
Awareness of racism has increased more than ever due to the recent resurgence of the Black Lives Matter movement. Over the past few weeks, professors at Vanderbilt Business School have used their expertise to explore various issues related to race and diversity via socially distanced video talks. In his talk, Mark Cohen, Justin Potter Professor of American Competitive Enterprise and Professor of Law, shared insights from his 20 years of research on racial disparities in lending markets. Here is a brief summary of his talk:
Behind the Scenes of a Deal
Cohen started off by explaining the process for securing an auto loan. When people want to buy a car, they usually contact a finance and insurance person at a dealership to help them find a good deal on a loan to finance their payment. The dealer then acts as an agent for a lender and connects the customer with the lender. During this process, the dealer can mark up the price of the loan by a certain percentage to earn a profit. In these cases, the customer lacks knowledge of the markup, while the dealer has perfect information about the customer’s credit rating, leading to asymmetric information. In addition, a markup is subjective, because the dealer can choose how high to mark up every deal. “So (dealers) possibly look for ways to discriminate the price depending on who’s walking in,” Cohen said.
The Problem in Lending Markets
Currently, it’s not illegal to charge different customers different prices during deals. However, the Equal Credit Opportunity Act does make it illegal to discriminate in credit transactions on terms of race or color. Despite this law, Cohen’s study on racial disparity in discretionary markups found that African Americans paid almost twice the markup whites did. This shows that there are racial disparities in the auto loan market. Unfortunately, those racial disparities aren’t limited to deals for automobile loans; they occur in other industries as well, such as mortgage lending. “There are similar issues that arise anytime a company uses agents,” Cohen said.
So the question is, how could the industry have avoided this problem? One way is to regulate the dealer’s commission. “This policy that lenders have allows their agents to markup loans,” Cohen said. “(Lenders) don’t necessarily have to do that. They could have changed the compensation policy to fixed commission.” However, dealers ignored one lender that tried this tactic in the past, because dealers can profit off of higher markups. Another solution is for dealers or mortgage brokers to change internal compensation and incentives. Currently, finance and insurance people at dealers earn a profit with markups, so the incentive is aligned with a higher markup. In addition, restructuring the industry with vertical integration can reduce conflicts of interest and contribute to mitigating racial disparities.
“Racial disparity is oftentimes very subtle, hard to detect. It can occur without any racial animus, and may require changes in business policies, innovative business models, or government regulation if all else fails to solve,” Cohen said. To watch his entire talk, visit this link.