Have Banks, After 25 Years, Made Peace with the Community Reinvestment Act?

When Congress enacted the Community Reinvestment Act of 1977 (CRA), many financial institutions bristled at the thought of additional regulatory oversight, particularly when it would require the industry to consider lending to those in low-and moderate-income neighborhoods. These communities, traditionally underserved by banks and thrifts, were neglected in favor of larger and more profitable loans in more affluent areas.

Bank and thrift compliance with CRA is under the supervision of the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision. These regulators monitor the extent to which financial institutions are providing acceptable levels of lending in low- and moderate-income areas, in exchange for approvals of bank merger and expansion plans. “CRA was once the most hated law in banking, with the Federal Reserve itself originally against it,” says Kenneth Thomas, a finance lecturer at Wharton. “While no banks like regulation, they now have learned to live with CRA.” He describes CRA as the nearly perfect balance between corporate and consumer interests. Access to credit is provided to low- and moderate-income neighborhoods, but banks are still able to apply creditworthiness standards to underwrite home mortgage, small business and other loans.

In his new research paper titled, “CRA’s 25th Anniversary: The Past, Present and Future,” Thomas looks back at the history of the CRA and offers his suggestions for reforms needed to improve the law’s effectiveness. Regulators will soon release details of proposed reform measures to the CRA, based on public commentary received last year.

The brainchild of former Wisconsin Senator William Proxmire, CRA was meant to provide a solution to the redlining practices of some financial institutions. (Redlining refers to the practice of geographic discrimination in the granting of credit to qualified, though low- or moderate-income applicants, in certain neighborhoods.) Proxmire saw the measure as a “quid pro quo” for the federal subsidies the banks and thrifts received for such things as federal deposit insurance and below-market rate lending from the Federal Reserve System.

Under the 1977 law, regulators would evaluate each bank’s community performance record and issue a confidential exam and rating to the bank. According to Thomas, the confidentiality of CRA exams and ratings of financial institutions – plus a failure of regulators to follow through on enforcement of banks with substandard CRA performance – undermined CRA until 1989. Then there was a major change in the “congressional climate in the midst of the S&L scandal.” His paper notes the reform efforts of Massachusetts Congressman Joe Kennedy in 1990 as a major turning point for the CRA, as he pushed through the then-radical reform, as part of the S&L bailout, to make public the CRA ratings and a portion of the examinations of banks and thrifts. “This was a defining moment” because it put the banks under the scrutiny of the media, Thomas says. “It was the first time that any bank exam or rating was made public in the U.S.”

At the time the CRA examinations became public, Thomas went to Washington, D.C. and made copies of several thousand exams. He took the closest look at 250 exams with the highest and lowest ratings in the early 1990s, and repeated this process for more than 1,500 exams in the late 1990s. The process involved collecting additional bank and community data, and putting himself in the regulators’ shoes by completely redoing the examinations from scratch based on the performance standards used in the CRA exam process. He concluded there was a grade inflation problem with as many as half the ratings, possibly indicative of a less than arms-length relationship between the regulators and the financial institutions.

Says Thomas, “Sometimes government gets too cozy with industry, and it doesn’t necessarily represent the people it is supposed to represent. Disclosure is the greatest disinfectant. Transparency is the easiest way to get through the problems along the way.”

His research found that “even before CRA ratings were to be made public, just the prospect that they would be disclosed had an apparent impact on regulators, [resulting in] an increase in the proportion of below-average ratings and a decrease in the percentage of above-average ones. The proportion of banks with below average ratings for the first 18 months that ratings were made public reached its highest level ever (11%) and was over three times the comparable pre-disclosure average level.”

But despite the more stringent ratings, CRA denials of branch and merger applications remained minimal, with only “31 denials out of nearly 105,000 applications” by 1996. Thomas argues that the relationship between government and industry often undermines the process, as some regulators and other members of the government envision a comfortable banking career after leaving public service.

Thomas says that, surprisingly, a few of the community groups that set out to encourage lending in low- and moderate-income areas may themselves be conflicted in certain cases. For example, many nonprofit community organizations receive considerable donations from the banking industry, with the leaders of some of the largest organizations having salaries greater than many bankers, and even more than the Fed’s Alan Greenspan in one case. (In 1995, one California community organization provided 89% of the witnesses supporting one bank’s successful hostile bid for another. The organization stood almost alone among major community groups in supporting the bid. In addition, the organization and the bank making the hostile bid were not forthcoming about the bank’s contributions – later revealed to be sizeable – to the organization.)

Before 1995, CRA ratings were based on assessments of community credit needs, types of credit offered, geographic distribution of offices and record of opening and closing branches, in addition to community development and discriminatory banking practices. Since amendments to CRA in 1995, the ratings for large banks are based on a variety of measures, including a 25% investment test, specifically weighing the efforts of banks and thrifts to invest in local economic developments and to buy securities backed by CRA loans and projects.

Wall Street, unfortunately, has gamed the CRA process by, for example, enabling several banks to get repeated credit for buying and selling one investment secured by the same CRA loan, says Thomas. Community groups, he adds, are working hard to keep the investment test as part of the rating process, partly because their donations from banks count as qualified CRA investments. In one case, the head of a national community group is also the chairman of a for-profit CRA mutual fund that gives a percentage of assets under management to that group.

Another measure in the large bank rating process is the 25% weighted service test, also added in 1995. Thomas suggests that community groups are “potentially conflicted” in defending this test. The paper states, “In the case of the service test, some groups benefit by acting either directly as a beneficiary of some community development services or indirectly by sometimes being compensated for performing such services by banks” (e.g., home ownership counseling to low- and moderate-income home buyers).

Thomas concludes that the investment and service tests should be eliminated so that CRA ratings are based purely on low- and moderate-income lending, as was originally intended by the 1977 law, and not watered down by non-lending activities.