The Greatest Law — in theory — that No One’s Ever Heard Of: The Community Reinvestment Act
“It may be one of the most impactful laws people have never heard of” – Kevin Stein, deputy director of the California Reinvestment Coalition
I wish I could agree with Kevin Stein’s statement in totality, but how impactful is the Community Reinvestment Act (“CRA”) if no one has ever heard of it? I’ve conducted an informal survey of friends, classmates, entrepreneurs, and fintech venture capitalists near the Stanford Graduate School of Business to determine people’s awareness of CRA and found that most people had not heard of it; even though, CRA was enacted forty-one years ago in 1977!
This sort of reminds me of something my high school basketball coach would say: “Chris, what’s the most dangerous word in the English dictionary?”
So what is the CRA?
I’m very happy you asked. The Community Reinvestment Act is a federal law, enacted in 1977, to address concerns that banks were not effectively meeting the credit needs of the communities they were chartered to serve. As a result of a practice called redlining, where banks figuratively and systemically drew red lines around certain low- and moderate-income communities — often as a function of racial discrimination — and refused to lend in those communities, many inner-cities became destitute of economic opportunity; resulting in urban blight, income disparity, and insufficient credit opportunities.
Look below at this official map from 1937 of my hometown of Baltimore showing redlined neighborhoods.
Redlining was outlawed forty years ago through the CRA. Through the CRA, a bank is federally mandated to provide services to clients in every community in which the bank has physical branch locations. And in an effort to drive compliance, bank regulators may perform an examination on a bank to ensure three things — that (1) the bank devotes a portion of its loan portfolio, (2) provides a level of investment, and (3) delivers some community development services to low- and moderate-income communities for which the bank has physical branch locations.
The CRA Sounds Great Right?!
If I could be so fortunate to have a few more minutes of your time, I want to drill home the point that the Community Reinvestment Act is a four-decade-old well-intentioned law meant to address really serious income and wealth inequality issues in America. However, problems evolve over time and entire communities of people are living with the consequences.
As a result, I want you to know that I believe that the Community Reinvestment Act is ineffective in its current form and that we may need a mix of social, political, and regulatory solutions to get things on the right track.
Why is the CRA ineffective — in its current form?
There are a number of current studies on “modern-day redlining” and how banks, for example, continue to block people of color from homeownership. The Chicago Tribune reported in February that modern-day redlining persists in 61 metro areas even when controlling for applicants’ income, loan amount and neighborhood.
But how is this possible? Maybe, the CRA is victim to weak enforcement, regulatory capture, lobbying, and limited press coverage. Let’s break these down a little bit.
In the case of the Community Reinvestment Act, there is no single federal government agency responsible for monitoring and evaluating CRA’s overall effectiveness; instead there’s three — the Federal Reserve (“FRB”), the Federal Depository Insurance Corporation (“FDIC”) and the Office of the Comptroller of Currency (“OCC”). And to better streamline everything, leaders from these agencies participate in the Federal Financial Institutions Examination Council (“FFIEC”), which prescribes requirements, produces interagency Q&As, and even publishes CRA information, such as, exam schedules and exam results on the internet.
Quick aside: When’s the last time the FFIEC has been written about in the news? Google found an article from April of this year, not bad.
Nevertheless, a wise philosopher once said, “When everyone’s in charge, no one’s in charge.” By failing to assign responsibility of the CRA to one federal agency, the legislators created a lack of accountability from an enforcement perspective for any one federal agency and reduced the strength of enforcement. There should be someone waving the CRA flag and making CRA a priority. While all agencies should care about community development, one agency should step up and ensure that regulations associated with community development are being appropriately addressed.
But what constitutes “appropriately” addressed? The CRA examination in its current form is subjective. In a Congressional Research Service report for Congress by Darryl E. Getter, Specialist in Financial Economics, Darryl discusses how that “CRA does not impose lending quotas or benchmarks”. As a result, regulators’ use a lot of judgement in examining compliance. Banks work with regulators to set the “assessment area” by which they are evaluated, negotiate their peer sets, and seem to measure their success based on improvements from their prior CRA evaluation report.
To further highlight weak enforcement, let’s consider the average rating of all banks and the average examination cycle across all banks. From 2006 to 2014, approximately 97% of banks examined received ratings of Satisfactory or Outstanding as seen below in Figure I.
Is this level of compliance due to great initiatives by the banks or is it this a function of something else? Have the regulators visited some of the low-and moderate-income neighborhoods that the CRA was created to support? Have the regulators talked with some of the people in those underserved communities and heard first-hand stories of positive impact as a direct result of CRA efforts?
The high passing rate of exams on an annual basis seems to signal grade inflation. Similar to school, grade inflation makes it more difficult to separate superior performance from average performance. It complicates benchmarking efforts, reduces motivation to become outstanding, and puts pressure on regulators to go easy on the underachievers. Say for example that a regulator “grades tough” and provides critical feedback through a “Needs to Improve” CRA rating. That regulator may be labeled “difficult” and feel pressured into revising the bank’s CRA rating.
In a comment letter to the Treasury Department, the National Community Reinvestment Coalition pointed out that the CRA exam cycle is supposed to be a two-to-three-year cycle; yet, the largest banks have a great likelihood of being examined in an untimely manner. “The top five banks in asset size had exams that ranged from five to seven years old.” Inconsistent examination schedules reduce incentives for consistent compliance.
Regulatory capture — picking regulators of choice
This leads to a point on regulatory capture and the failure of the federal government to ensure that bank regulatory agencies enforced the CRA in the public’s best interest. In 1995, for example, the Office of Comptroller of the Currency (OCC) reformed the Community Reinvestment Act. In that year, “10 percent of banks failed their CRA exam, which was unheard of… But the banks responded. 120 banks changed their charters to be regulated by the OCC to be regulated by the Federal Reserve, because banks can choose how they are structured and who regulates them,” said John Taylor, President and CEO of the National Community Reinvestment Coalition in an interview.
The broader the mandate of a regulatory agency, the more power it assumes. The more banks under supervision, the greater power that particular regulatory agency wields. With 120 banks leaving the OCC and changing their charters to the Federal Reserve, the OCC clearly loss some of its power. The fact that 120 banks decided to do this highlights a concern and incentive issue between banks and regulatory agencies. Bank regulatory agencies were created to act in the public’s interest, but the ability of banks to change their charters in hopes of weaker enforcement highlights political concerns.
Lobbying — powerful financial institutions, undermine effectiveness
Some have stated that the “CRA creates incentives for banks to make loans to unqualified borrowers likely to have repayment problems, which can translate into losses for lenders.” A study by the National Bureau of Economic Research in 2012 highlighted this point by determining that banks showed riskier lending behavior on average by about 5 percent during the six months surrounding and undergoing CRA examinations. These loans defaulted by about 15 percent more often. Nevertheless, other economists, such as Paul Krugman argued that “the Community Reinvestment Act of 1977 was irrelevant to the subprime boom, which was overwhelmingly driven by loan originators not subject to the Act.”
A later research report by the Federal Reserve cleared up confusion around the CRA, noting that CRA-covered bank lending has lower delinquencies and default rates than non-CRA covered lending.
A study published by the Journal of Real Estate Research confirmed that reinvestment loans had a lower default risk than subprime loans. It showed that loans originated from 2003 to 2006 through a major CRA-related lending program performed almost as well as prime loans and far better than the average subprime mortgage during the housing bust. CRA products usually have prime-term characteristics.
But why is there a debate about CRA’s role in the Financial Crisis of 2007 in the first place? The answer is lobbying. Financial institutions are powerful and strive to participate in transactions that have a net positive impact on their bottom line. As Senator Dick Durbin famously once said, banks are the most powerful lobby on Capitol Hill.
Regulatory procedures — continuing to miss the mark
While the CRA was enacted in response to redlining, the examination procedures do not explicitly mention race or ethnic characteristics, therefore the procedures do not truly assess whether banks are making loans to ethnic and racial minorities.
How can we fix the CRA?
The CRA needs an update. It needs modernized regulatory examination procedures that make exams more objective, predictable, consistent, and simplistic. It needs better connection with other functions of a bank to better incentive bank executives to strive for outstanding CRA performance ratings rather than just satisfactory compliance. And the CRA needs to become a law that people are aware of.
Increased media coverage and improved public awareness
In today’s regulatory regime, banks with “needs to improve” CRA ratings are able to reap second order benefits through compliance efforts. Santander Bank, for example, received a “needs to improve” CRA in February 2017 despite the fact that in the three years leading up to this CRA downgrade, Santander failed its capital stress test three years in a row and agreed to three settlements for alleged illegal credit practices. Rather than acknowledging CRA non-compliance explicitly, Santander spun its regulatory settlement for CRA non-compliance with a positive story, announcing an “Inclusive Communities” Plan to increase “CRA activity by 50 percent” over the next five years. Santander Bank’s public relations strategy goes to show how banks continue to own the story line and minimize the Community Reinvestment Act. Santander Bank effectively spun an $11 billion-dollar regulatory settlement plan into an $11 billion-dollar “true commitment” to the needs of all communities that the bank serves, when in actuality the plan was a remediation effort for past compliance failures.
Local community organizations, small business owners, and community constituents need to better understand their bank’s obligations to their communities and hold their bankers accountable for meeting those obligations. There are weak incentives for banks to provide the “best” products to low- and moderate-income borrowers. And with nearly 60% of Americans feeling financially illiterate, it can be assumed that many bank customers that may qualify for CRA-eligible loans, investments, and community development services are missing out on resources that are federally mandated for them.
Modernized regulatory examination procedures
As previously discussed, regulatory procedures suggest that banks should be examined on an average, every three-year cycle, but some top 50 banks have not had examinations in up to seven years. There should be a set of annual lending, investment, and service obligations that banks must meet that are clear, measurable, and transparent for the public and regulatory examiners to quickly assess. Better predictability of CRA examinations can make an impact.
Assessment area procedures also need reform. Banks have the ability to determine the scope or assessment area evaluated during an examination. The examination process for assessment area determination is handled on an examiner-by-examiner basis. Better consistency can make a more meaningful impact.
Enhanced Incentives for Outstanding CRA performance
Two years ago, in an American Banker Op-Ed, Kenneth H. Thomas, lecturer at the University of Pennsylvania’s Wharton School, said “such as tax rebates, reduced FDIC insurance premiums and a longer period until the next exams for banks that receive the highest rating. Each of these would have a quantifiable bottom-line impact to a bank as compared to a press release or local news article announcing the Outstanding rating.” Currently, a bank’s CRA status is considered by regulators when approving mergers and acquisition requests. Merger applications can be delayed or denied due to poor CRA evaluations. A fine and a potential merger delay is the stick for a poor CRA rating, but what is the carrot for outstanding performance?
The regulators should find ways to better connect CRA performance with other functions of financial institutions to incentive banks to strive for outstanding CRA performance ratings.
And while we have “potential” technological, social, and political solutions…
The CRA may remain toothless
Despite the need for better access to credit for all people in America, “too little finance” will persists in low- and moderate-income communities. CRA was meant to provide better access to credit, but underserved borrowers continue to find it difficult to obtain quality, low cost capital to fund small businesses and obtain investments for their communities.
In June 2017, the Treasury issued a report titled, “A Financial System that Creates Opportunities — Banks and Credit Unions” stating that the government is reviewing several aspects of the CRA. As a result, we may see proposed changes and modifications to CRA regulations any day now.
Without a strong voice highlighting CRA’s importance, despite its limited impact in its current form, we may see even greater problems in low-and moderate-incomes across the United States.
With a toothless CRA, local communities lose. When local communities lose, society loses; and when society loses, the economy loses. Without a revamp of CRA examination procedures and a more concerted effort by regulators to exam banks consistently and credibly, banks will likely continue with the status quo. A financial sector with inequitable incentives truly harms society. Appropriate CRA regulation is essential to inclusive economic growth.
So what is the Community Reinvestment Act?