By Karen Shaw Petrou
On January 10, the Wall Street Journal confirmed that Trump Administration regulators plan to advance the reforms to the Community Reinvestment Act (CRA) first outlined in a 2017 Treasury Department report. The CRA dates backs to an era when progressive Democrats controlled federal financial regulation and is now a hallowed artifact of policy that progressives believe advances economic equality. Community advocates and many Democrats will thus cry foul as this Trump Administration initiative begins. Are they right? Does the CRA really advance economic equality?
Forty years after its enactment is time enough to tell, but CRA’s community-development impact is at best uncertain. In this post, we look at what CRA has done so far and how best to reform it for maximum equality impact.
What is the CRA?
As its name suggests, the Community Reinvestment Act requires banks and their parent holding companies to support community development. The rationale for this 1977 statute is that insured depositories take funds from communities with the taxpayer benefit of FDIC insurance. Given this competitive and cost advantage, CRA sets standards for “reinvestment” (generally lending) in the communities from which deposits are extracted and where services are offered. Absent the CRA, the thinking went, banks would draw funds from lower-income depositors and lend them out in higher-income communities – in essence using money from one customer base to fund prosperity for another.
Under the CRA, federal banking agencies examine banks to see if they are offering enough of the loans and other services defined in a complex body of rule. When bank ratings are deficient or advocates persuade a regulator that a bank should do better despite a good rating, mergers or branch expansions can be delayed or even defeated.
The law does not “allocate credit” by stipulating that banks must make certain types of loans or investments. However, CRA still has this effect to some degree by virtue of the activities prescribed in rule by which banks are judged. Importantly, some favored activities (e.g., origination of mortgages for the GSEs and FHA) often have little CRA benefit. Including them in CRA enhances ratings but does little for economic equality.
CRA is also posited on well-documented incidents of “red-lining” – i.e., banks refusing to make loans in the communities from which they drew deposits because borrowers in those areas were low-income, African-American, or otherwise not to the bank’s liking. Although there is considerable evidence that redlining is a significant cause of racial segregation, it is also against many other laws. As a result, CRA’s value here is principally via added transparency due to public CRA rating and accountability, not to act as the sole guardian against credit discrimination.
Despite a lot of political rhetoric, CRA did not cause the subprime-mortgage crisis – the worst offenders here were investment banks, finance companies, and mortgage brokers outside banks and thus immune from CRA. However, CRA did legitimize subprime lending in ways that created the false impression that high-risk loans to under-served communities somehow “democratized” credit. Relevant research finds that “democratization,” backed by near-term pressure at banks facing CRA examination, added mortgage credit risk prior to the financial crisis. Since the crisis, critics – many of them Republicans – have blamed CRA in concert with other affordable-housing goals as the main cause of the 2008 conflagration. However, a comprehensive CRA-literature survey looks hard at this claim and finds that, “mortgage loans induced by CRA performed no worse, and often better, than their non-CRA counterparts such as subprime loans.” CRA may thus have helped a bit in terms of sound credit availability, but the extent to which this occurred given the subprime-mortgage race to the bottom before the crisis is hard to discern.
In sum, CRA had high aspirations, but uncertain success ensuring mortgage-credit access for low-and-moderate income (LMI) communities. This same comprehensive literature survey of CRA’s impact on mortgage finance found that, “CRA has expanded access to credit in LMI communities, but the magnitude of the increase and the mechanisms of the impact of CRA are far from conclusive.”
CRA is also supposed to support small-business lending in LMI communities, but there is virtually no literature on this point due in part to the difficulties capturing data on it. In the absence of post-crisis empirical studies, it is hard to say now how CRA affects mortgage finance or other critical financial-inclusion products even though extensive research affirms that financial inclusion expands economic equality and promotes growth.
How to Make Lending More Equal
As demonstrated by the equivocal research and fact record described above, it is clear that CRA has failed. This may well be true due to the diminishing role of banks as key sources of equality-generating credit, and some have thus suggested that CRA be expanded to cover all providers of retail financial services (see for example this letter sent by Congressional Democrats to the federal banking agencies). Any legislation along these lines not only has slim to no chance of enactment under current circumstances, but would also do little more than perhaps boost a bit of additional credit to LMI communities and significant contributions to non-profit groups advocating on their behalf.
At a time when the Department of Housing and Urban Development says that access to affordable housing is at an all-time low and the new tax law is likely to make this still worse, a CRA salve would be a small bit of superficial first aid over a gaping wound. Small-business lending is in a similarly parlous state, especially in LMI communities, as the Fed study cited above also demonstrates. But tougher CRA requirements would only add a more ferocious mask to a toothless law.
CRA would of course make a meaningful difference if it were something other than the compliance headache it has long proved. Mandatory credit allocation forcing banks and even non-banks to favor certain sectors would redirect credit and meet under-served needs, but only at grave cost to market efficiencies and risk mitigation.
To offset the fundamental economic problems of high-risk lending, much higher interest rates might be possible in a mandatory credit-allocation scheme, but then what good would it do? Higher-cost loans are far more likely to go unpaid, exposing both the lender and borrower to long-term costs and subjecting communities to the type of blight evident in cities such as Detroit when too many high-cost mortgages were made to borrowers with scant ability to repay.
The only solution I see to making CRA a meaningful boost to community-based lending is to understand the financial realities of community-based lending and offset these to the greatest extent possible by direct and indirect government programs. Much is already done in the name of affordable housing for residential mortgages, but more could be done to target it far better and enhance the social-welfare benefit of federally-backed lending. The Small Business Administration (SBA) is also aimed at enhancing small-business credit availability, but its track record in LMI communities is mixed at best. Banking agencies now also provide certain regulatory exemptions for “public-welfare” investments designed to spur community development. These rules should be expanded and made still more generous as long as banks adhere to appropriate risk controls. As I have noted before, aspects of post-crisis rules – stress tests, for example – also harshly penalize equality-generating lending with no evident safety-and-soundness rationale.
Would the Trump Plan Make CRA Work?
The Treasury’s plans for CRA says it will consider:
- CRA review criteria;
- harmonization of multi-agency jurisdiction;
- changes to CRA-assessment geographic areas; and
- the supervisory and rating process (e.g., frequency, remediation opportunities, transparency).
Will this make much of a difference? For banks, yes – the compliance migraine caused by CRA will go down to a dull ache.
What about for meaningful community-development finance? Nothing suggested so far gives one hope. Community-development that builds long-term economic equality is only nicked a bit by compliance burden if underlying economics make sustainable, affordable credit products a viable, profitable business proposition. The best way to ensure economic equality through the financial system is not by adding more CRA standards or redrafting them a bit at the margin. The solution lies in a hard look at how financial institutions can make good money by doing well by under-served borrowers for whom a long-term, low-cost loan is an equality lifeline.