Today's Trends in Credit Regulation

Variations on the Pareto Principle
By Elizabeth C. Yen

The Pareto principle (also known as the 80-20 rule) is named after an Italian economist and sociologist, Vilfredo Pareto (1848-1923), who determined that 80% of the land in Italy was owned by 20% of the population, and who theorized that 80% of a society's income is generally distributed among 20% of the society's population. Some businesses have subsequently determined that 80% of their profits come from 20% of their customers. Others have postulated that 20% of a person's work-related effort generates 80% of the person's work-related income.

If one accepts the general proposition that a small number of accounts or a small number of customers often may be disproportionately responsible for the profits realized by a business, the question arises whether a similarly small number of customers, accounts, or business decisions could also often be disproportionately responsible for significant losses realized by that business. Consider, for example, the "Challenger" space shuttle: The first nine missions, beginning in 1983, were successful. The tenth mission ended disastrously in 1986, approximately 73 seconds after lift-off, due to "O" ring booster seals that did not function properly in cold weather. Or consider as another example residential mortgage loan charge-offs and delinquencies responsible for recent extensive revisions to Regulation Z, Regulation X and state foreclosure, pre-foreclosure and loan servicing requirements: During the height of residential mortgage loan charge-offs and delinquencies, in the first quarter of 2010, U.S. commercial banks were reporting slightly over 11% of their residential mortgage loans as 30 or more days past due.

Engineers sometimes discuss "points of failure" and focus on whether there might be mission-critical "single points of failure" that lack appropriate back-up redundancy. If an acknowledged mission-critical component or part has an automatic or nearly automatic back-up in case of malfunction, a system's design might be able to limit certain catastrophic failure scenarios to those situations where both the mission-critical part and its back-up fail at about the same time. The Challenger's "O" rings come to mind as examples of mission-critical failure points (at least in hindsight). The "O" rings' vulnerability to cold temperatures may have been masked during the first nine "Challenger" missions (as well as during countless other successful space shuttle missions using the same "O" ring booster seals) through the happenstance of warmer weather. In the mortgage loan default servicing world, several examples of (in hindsight) critically important failure points come to mind, including so-called "robo-signing" and "dual tracking" practices. Default servicing practices did not attract significant attention while real property values and the job market allowed homeowners to sell their homes, downsize, and relocate if necessary to reduce their debt burden, but a sudden unanticipated and prolonged economic downturn effectively put default servicing under a microscope and created an unfortunate "live" or real-time worst-case stress-testing environment for the loan servicing industry.

To continue the analogy between a highly technical, rigorously designed and tested feat of modern-day engineering (such as our space shuttles) and a similarly carefully designed, tested, and implemented internal compliance management system: Both require ongoing attention to (and appropriate reduction of) malfunction risk and possible failure modes. An effective compliance risk management program should carefully consider how certain known, recognized imperfections in everyday account servicing and other routine business practices that might be relatively inconsequential for 80% or more of the customer base (or for at least 80% of all affected transactions) could potentially morph into significant "points of failure" that may cause significant business disruptions. Using another NASA space shuttle accident as an example, it became known to engineers that space shuttle heat shield tiles and other related critical components are subject to damage by debris during and after lift-off, creating the potential for significant safety issues upon re-entry into the earth's atmosphere. Various design redundancies and other safety precautions were executed, but it is not feasible to design a shuttle in a manner that effectively protects against every single vagary of space travel. Space shuttle "Columbia" had 26 successful missions, beginning in 1981, before it was destroyed with all of its crew approximately 16 minutes before landing in 2003, because of damage to heat shield tiles. (One mission in 1997 was successfully cut short after launch because of a fuel cell problem.) Current space shuttle design incorporates a back-up in-flight repair option, allowing crew members to perform certain shuttle repairs while in orbit.

The analogy between space shuttles and financial services products is of course imperfect at best. Financial services customers, unlike astronauts, do not usually enter into transactions that include signed acknowledgments confirming that they are embarking on an inherently life-threatening mission. However, the consequences of a poorly performing financial services portfolio or poor account servicing could include significant economic harm to customers as well as the financial services provider and its partners and investors. As is the case with space shuttle performance, successful financial services products and accounts vastly outnumber failures, and a certain baseline level of default may be reasonably anticipated and incorporated into product design and operation. In addition, a very high success rate creates risk of over-confidence and a prevailing belief among industry insiders that few, if any, problems that may arise will create mission-critical "single point of failure" scenarios.

Appropriate anticipation of, and defensive measures against, potential or threatened write-offs, fines, or possible involuntary externally-mandated expensive changes to internal business practices may require an "outside the box" holistic analysis of a provider's products and services. In addition to analyzing customer complaints and mildly delinquent accounts for possibly worrisome trends (a rear-view mirror type of approach to compliance risk management), more forward-looking prognostication is also appropriate. For example, is the overall customer mix trending towards or away from older or younger persons? This might become the source of future age, disability, or other discrimination issues, and potential collection issues involving protected income sources such as child support or disability benefits. This might also eventually require increased interaction with probate courts, conservators, legal guardians, or other third parties charged with overseeing customers' financial affairs. Does the current heightened focus on a customer's "ability to pay" create incentives to discount an individual's anticipated future income for reasons prohibited by equal credit opportunity laws? Are new products and services increasingly being targeted at customers who use hand-held electronic devices to conduct transactions? In addition to the obvious privacy, data security, fraud, and related issues associated with the use of such devices, does this create an impliedly less preferred class of customer (customers who do not want to use mobile electronic devices for financial transactions) or a "second class" set of products and services that may also raise potential discrimination issues? Are new products or services being offered that are (for now) relatively unregulated and therefore largely governed by the terms of the actual customer contract? (These types of products and services may be particularly vulnerable to claims of unfairness and may also present a higher risk of triggering new laws, regulations, or similar edicts.)

The list of potential issues to explore for compliance risk management purposes should reflect a financial services provider's actual and projected mix of products, services, customers, and account transactions, with special attention paid to potential sources of future significant "points of failure," bearing in mind that major failure points often stem from a very small percentage of total customers and account transaction types, and may occur in unexpected circumstances.

Elizabeth C. Yen is a partner in the Connecticut office of Hudson Cook, LLP. Elizabeth can be reached at 203-776-1911 or by email at

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