It might sound illegal, but it’s not.

Let’s say you’re a bank, and you recognize that the world is biased against certain individuals, specifically women or people of color. You can find evidence that credit scoring systems, which only date to the late 1980s, perpetuate past discrimination against people of color.

And let’s say a Black or Latina small business owner walks into your bank looking for a loan, and you know as a group this demographic is likely to have lower credit scores on average than white business owners because of that structural bias and not because of actual likelihood to repay a small business loan.

You can set your lending policy to account for that. It has to be done very carefully, and with full transparency to bank regulators, but, as long as conditions of historic discrimination show up in credit scores, banks have the option to set lower credit score minimums for women or people of color versus white male clients.

California-based MUFG Union Bank has been providing small business loans this way since 1993, under what’s known externally today as its “Business Diversity Lending Program.” It’s one of the rare and longest-running known examples of a “special purpose credit program,” and it’s completely legal under the Equal Credit Opportunity Act, as amended in 1976.

One beneficiary of the program was Pam Isom, founder and CEO of what is now a multi-million-dollar workplace safety company. Through this special lending program, “Union Bank was able to look at my potential when no other bank would lend to me,” she said in a promotional video.

To access MUFG Union Bank’s special purpose credit program, prospective borrowers simply have to check a box on the bank’s standard small business loan application, self-identifying that they are a business whose ownership and management are at least 51% women, people of color or veterans. The bank verifies eligibility later.

“We’re able to approve more loans when a person of color, woman or veteran checks that box,” says Frank Robinson, who ran the program for nearly 20 years and currently leads diverse markets and community-based programs at Union Bank. “Sometimes that check is the difference between them having a loan and not.”

Actual Risk Versus Perception of Risk

Robinson says about a third of Union Bank’s small business loan portfolio falls under its special purpose credit program. (He says federal banking regulators do not permit the bank to disclose an exact number of special purpose credit program loans or dollar amount.) According to the bank’s latest quarterly report to banking regulators, its overall small business loan portfolio includes around 51,000 active loans totaling $1.5 billion.

After nearly 30 years, Union Bank now has proof that making loans to women or people of color using more flexible criteria actually doesn’t lead to a higher rate of loan default for the bank. According to Robinson, Union Bank’s special purpose credit program loans fail at the same rate as its conventionally made loans. He also says many clients over the years who first qualified under special purpose credit program criteria have since reached the point where they qualify for additional loans later under conventional criteria.

Special purpose credit programs sound like discrimination, and in a way they are, but it’s discrimination made explicitly to counter pre-existing discrimination that’s been baked-in to the economy through things like credit scores or the real estate appraisal system. Beyond just lower credit score minimums, banks can set all kinds of different criteria or lending terms to account for racial, gender or other kinds of historical discrimination.

When a small business wants to buy the property in which it’s located, under conventional terms, the bank can make a loan of up to 70% of the value of the property. Under Union Bank’s special purpose credit program, the bank can make a loan of up to 80% of the property value. That can help make up for the racial wealth inequality that means business owners of color typically have less personal or family wealth they can use to help purchase property.

Special purpose credit programs can have a surprising amount of flexibility in loan criteria and terms, as long as banks can first provide proof to regulators that the historical bias is real and that it results in the denial of otherwise safe and sound loans.

But a new special purpose credit program also creates an important extra upfront cost to a bank. All banks have to set aside a small amount of cash as a cushion against the potential for failed loans — it’s known as loan loss reserves. A new special purpose credit program typically means a bank has to set aside extra dollars for loan loss reserves, to compensate for what regulators perceive as higher-risk borrowers. Those are dollars that might otherwise get paid out as bonuses to employees or dividends to shareholders. The bank’s board and management have to be willing to set aside extra dollars for a bank to start making special purpose credit program loans.

Now that Union Bank has evidence that its special purpose credit program is no riskier than its conventional lending, Robinson says Union Bank no longer has to set aside extra loan loss reserve dollars for its diverse lending program — it only needs to set aside the amount associated with its overall loan portfolio risk.

“I’m telling you, you can do almost damn near anything, if you have the risk tolerance to go ahead and get that done,” Robinson says. “That’s where your board of directors has to come in to say they’re willing to do that. And I think that comes back to a couple of things, number one, how diverse is the board?”

Expanding Special Purpose Credit Programs

All banks have the option to set up special purpose credit programs under the Equal Credit Opportunity Act. The law outlawed discrimination in lending, but it also included a provision that allows banks to create special purpose credit programs to make loans on different terms or different criteria to “economically disadvantaged” classes of people. The loans could be for small businesses, homeownership, personal loans or any other lawful purpose.

More banks of every size have recently started looking into setting up special purpose credit programs, especially in the wake of the racial reckoning over the past two years after the deaths of George Floyd, Breonna Taylor and other Black individuals at the hands of police.

Meanwhile, Union Bank’s special purpose credit program may soon see major changes. Union Bank, whose footprint is mostly limited to California, is awaiting federal approval for its acquisition by the much larger U.S. Bank. As part of a Community Benefits Plan tied to the merger, U.S. Bank has committed in writing to expand Union Bank’s special purpose credit program for small businesses to the combined bank’s 26-state footprint.

Robinson is excited about the merger.

“It would be absolutely foolhardy to try and change it and make it more stringent after you acquire somebody who’s had it going for over 20 years,” Robinson says. “Technically, Union Bank has been a very conservative bank overall, and if U.S. Bank is going to change it, they could make it even more flexible, so I’m down with that.”

(U.S. Bank declined to speak with Next City about Union Bank’s special purpose credit program, citing the ongoing merger approval process as a constraint against commenting.)

But special purpose credit programs overall remain rare, in part due to legal confusion over creating programs that target certain borrowers based on demographics and lack of awareness of the program provision among banking professionals as well as among bank regulator staff.

In general, banks don’t like to collect racial or gender demographic data from clients. They don’t want to get caught violating fair lending laws. It’s simply easier not to collect that information and therefore not gather potential evidence that you are biased against any particular demographic.

The Equal Credit Opportunity Act specifically gives banks permission to request voluntary demographic identification from prospective loan applicants as part of implementing special purpose credit programs. But banks can’t require borrowers to submit anything they aren’t legally required to submit to comply with other regulations, like the Home Mortgage Disclosure Act of 1975, which requires banks to collect and submit to federal regulators anonymized data on race and ethnicity, gender and income as part of all residential mortgage applications

In response to the legal haziness around asking prospective borrowers for more demographic information than is required — as well as using that data to create targeted programs for certain demographic groups — over the years federal officials have issued inter-agency guidance clarifying legal questions and encouraging more banks to create special purpose credit programs — such as in 2003, 2009, and most recently in February 2022.

Setting Up a Special Purpose Credit Program

There is no formal regulatory process for creating a special purpose credit program. It’s mostly an informal exchange between a bank and its primary federal regulator, either the Federal Deposit Insurance Corporation or the Office of the Comptroller of the Currency. The documentation doesn’t need to be extensive — Union Bank’s special purpose credit program plan is only 7-10 pages long — but there are three main requirements.

First, the special purpose credit program plan must identify at least one category of borrowers facing discrimination because of race, gender, disability status or other federally recognized categories. Some banks have created special purpose credit programs to offer home mortgage loans to individuals using only Individual Taxpayer Identification Numbers instead of social security numbers or permanent residency documents. Banks can use public data sources, for example the Federal Reserve Small Business Credit Survey, to show that certain borrowers still don’t have the same access to credit as other borrowers.

“When you look at the numbers for women, people of color, veterans, it is still dismal when it comes to their access to small business credit,” Robinson says. “So based on that we have kept the program going and doing our part to ensure people get access to capital.”

Second, the special purpose credit program plan must clearly outline the program design, from the proposed loan criteria or terms, a marketing plan, and loan loss reserve commitment.

Despite statements from bank regulatory agencies to promote and encourage more special purpose credit programs, some banks have recently encountered initial resistance from bank regulator staff who aren’t aware of the special purpose credit program provision of the Equal Credit Opportunity Act. Robinson says his bank has been doing this for so long, he hasn’t faced that particular barrier.

Third, the special purpose credit program must provide a timeline for reevaluating the program and whether there is still a need for it. Robinson says Union Bank has typically set a two-year reevaluation period, and in fact it may adjust criteria on an annual basis to make the program more or less flexible depending on overall economic conditions.

“Special purpose credit programs are supposed to be temporary, they’re not supposed to be forever at the end of the day,” Robinson says.

Building Culture Matters

Once you get through the process to run your special purpose credit program by your regulator, there can be a lot of work afterward to get the program up and running across the bank. Since 1993, Union Bank has gone through several iterations of structuring its special purpose credit program across its network of hundreds of branches, almost all of them in California.

When Robinson first took over Union Bank’s special purpose credit program, in 2003, the bank had an entirely separate application process, dedicated loan officers known as “urban bankers,” and the program was known externally as the “urban enterprise banking” program.

Under Robinson’s leadership, the bank changed the name to the “Business Diversity Lending” Program, streamlined the application process to become a checkbox within the bank’s standard small business loan application, and gave Robinson a new mandate to spend most of his time flying around California educating everyone he could about the program — starting with the bank’s own branch employees, small business loan specialists, and the underwriting staff who are a crucial part of every bank’s loan approval process.

“I asked my former boss, ‘Where do you want me live? You’re in San Francisco, I live in San Diego, you want me in LA?’” Robinson says. “She said ‘No, I just want you near an airport because you’re going to be meeting with everybody and going to every branch to tell them about this product.’”

After a while, Robinson says it became so ingrained in the culture that now the bank’s underwriters sometimes call him to say they are evaluating a small business loan application where the borrower doesn’t qualify conventionally but might qualify under the special purpose credit program criteria.

“You have some folks who are too scared to check the box, so we have those situations where we knew and we had to go back to certain people to say it would be approved if you would check the box,” Robinson says. “We can’t assume. But goddamn it, let’s make sure. When you start talking about people in these situations, you get the folks who have sunk everything they own into that business, it’s their livelihood, so you better do your due diligence.”

With the U.S. Bank merger imminent, there’s a risk that the culture Robinson has helped build around Union Bank’s special purpose credit program could be lost. Robinson is advocating for the creation of an underwriting team specifically devoted to special purpose credit programs across U.S. Bank. He’s also hopeful that branch employees at the combined bank’s 2,500 branches across 26 states will help root the culture in the organization from the bottom up.

“Branch staff will be highly receptive to having this program available for them to market to communities,” Robinson says. “A lot of people who work in the branches are people of color. Those are their communities and they want to go around helping the people who look like them.”