Critical Look at the Community Reinvestment Act

Financial Services & E-Commerce Newsletter - Volume 2, Issue 2, Summer 1998

August 1, 1998

Gerald A. Reynolds

Some federal statutes fail to accomplish the goals established by Congress due to false assumption, faulty premises or perverse incentives contained within the statutes. The Community Reinvestment Act (the "Act" or "CRA") is an excellent example.

Last year marked the twentieth anniversary of the CRA's passage. The Act requires federal banking regulators to "encourage ... [financial] institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions." The statute provides that regulators should evaluate a fmancial institution's CRA performance "when examining financial institutions" and that regulators may take CRA performance into account "in an application for a deposit facility."

By 1977, it was clear to most activists that the most effective means of achieving "social justice" was to recast an economic or social issue as a civil rights issue. When the CRA legislation was introduced, proponents of the Act argued that it was needed to eliminate lending policies that discriminate against applicants on the basis of race and to increase lending in inner-city communities. One could argue that the Act was redundant in some respects. There were already two federal anti-discrimination statutes on the books that prohibited lenders from discriminating against applicants on the basis. of race. The Equal Credit Opportunity Act made it "unlawful for any creditor to discriminate against any applicant, with respect to any aspect of a credit transaction on the basis of race, color, religion, national origin, sex or marital status or age .... " The Fair Housing Act of 1968 also prohibited racial discrimination in the loan process. The main thrust of the CRA was not to curtail racial discrimination in the banking industry, rather, it was to "encourage" lenders to extend credit facilities in low-income communities.

Once analyzed, it becomes clear that the Act is more an efficient mechanism for redistributing wealth than an anti-discrimination statute. The CRA as it is currently enforced is not an appropriate tool for dealing with discrimination in the lending market. Many proponents and opponents of the Act agree that the level of discrimination in the lending process has declined. Some argue that the Act is responsible for the reduction in discrimination. At best, the Act's effect on the level of racial discrimination is marginal. It is more likely that impersonal market forces, changes in racial attitudes and the increased use of credit scoring have had a greater effect on racially discriminatory lending practices than the Act. Nevertheless, many activists use the Act to extract economic concessions from the banking industry.

Under the current enforcement framework, banks and thrifts are examined by one of the relevant federal regulatory bodies-Federal Reserve System, Office of the Comptroller of the Currency, Office of Thrift Supervision, and the Federal Deposit Insurance Corporation- for compliance with the CRA and graded according to the level of compliance. Compliance grades become an issue when the bank applies for approval for a merger, the acquisition of a new branch, or some other expansion. If the bank has received poor compliance grades, the regulatory body may refuse to approve the bank's merger application. However, the approval process is not limited to a mere consideration of the bank's compliance grades. Third parties are permitted to intervene and submit letters protesting the merger because of the bank's failure to comply with the CRA. The statute pennits virtually anyone to intervene in this fashion. The present enforcement mechanism provides housing activists with the power to disrupt a proposed merger.

To keep affordable housing activists and federal regulators content, those banks with expansion plans either subsidize community development corporations that build affordable housing or lower racially neutral underwriting standards to increase the number of loans made to minority applicants. Rather than help inner-city residents meet conventional underwriting standards by teaching them how to repair credit blemishes and establish sound savings plans, those banks that intend to merge with other banks are forced into a perverted form of subprime lending. Unlike their competitors in the subprime lending sector, a bank that makes a CRA loan to improve its standing with federal regulators cannot price the loan so that it reflects the increased risk. In addition to below-market interest rates, many CRA beneficiaries are not required to make down payments that are sufficient to protect the lenders from a fmancial loss in the event of a default. Most, if not all, of the empirical studies demonstrate that CRA loans have a higher default rate than conventional loans. Consequently, those banks covered by the Act are forced to pay what amounts to a housing tax to obtain additional federal charters or merge with other banks. Some commentators correctly point out that one of the Act's goals is to stem the decline of inner-city neighborhoods. While the goal is laudable, the means used to achieve the goal are questionable.

To no avail, the federal goverrunent has spent, and continues to spend, billions of tax dollars in an attempt to revitalize America's deteriorating inner cities. With the passage of the Act, the government commandeered a portion of the banking industry's profits to use in its efforts to revitalize inner-city neighborhoods. A massive infusion of capital into our inner cities, whether it be through government subsidies or coerced contributions from the banking industry, has not had a significant effect on the social ills that are devastating these areas. The federal goverrunent has demonstrated that it has the will and ability to confront invidious discrimination. However, the government has also demonstrated that it is capable of selecting ineffective means toward those ends, and is ill-equipped to deal with problems that result less from discrimination by lenders than from what might be called the spiritUal infirmities of loan applicants.

For example, 66% of black children are born to unwed mothers. Many of these mothers are teenagers. The government cannot instill a set of values in black teenagers that results in a decrease in the number of out-of-wedlock children. However, churches and other community-based organizations can. They are better suited to inculcate values that encourage abstinence in teenagers. Federal and state governments have an important role to play in dealing with the crises unfolding across our cities. However, many of the problems confronting black communities only can be solved if the government plays a subordinate role. Community leaders must lead the charge against drug addiction, crime, teenage pregnancy and other social pathologies. For many blacks residing in these communities these problems, not racial animus, constitute an insurmountable barrier to advancement. Lending policies do not address these grave social ills. Consequently, the modification of lending policies cannot, cannot stem the decline of the inner city.

Racial discrimination is one of the rationales offered in support of the Act. This rationale is not persuasive. There are few, if any, methodologically-sound studies that have produced evidence of wide-spread intentional racial discrimination in the banking industry. Direct examination of the behavior of presumptive non-discriminators reveals little evidence that these financial institutions behave differently from the typical lender. Who are presumptive non-discriminators? In many large cities, such as Chicago, these are black-owned banks. Whatever may be said of them, it is highly unlikely that these banks discriminate against black loan applicants on the basis of race. However, among municipal depositories in Chicago, within-city loan to deposit ratios are lower for minority-owned than for white-owned banks. In general, minority-owned banks tend to perform less well on CRA evaluations than white-owned banks. Thus, black-owned banks seem to be as reluctant to lend as their white-owned counterparts. One plausible explanation for this is that small, black-own banks cannot afford to make too many mistakes in their risk assessment process. Accordingly, black-owned banks are more likely to base their lending decisions solely on sound underwriting standards and actuarial data. However, those midsize and large banks that wish to expand by obtaining additional federal charters or merging with other banks must insure that their CRA activities satisfy federal regulators.

To date, the one legislative proposal that addresses some of the social as well as economic problems plaguing minority communities is the American Community Renewal Act, sponsored by Republican Representatives J.e. Watts of Oklahoma and Jim Talent of Missouri. The bill would create 100 Renewal Communities across the country and would also focus on supporting families and rebuilding neighborhood institutions in the areas selected. As stated earlier, the government should work with churches and other community-based organizations to stem the decline of our inner cities. Under the proposed legislation, religious institutions would benefit due to the changes in the tax laws. If enacted, the Renewal Act also will enable municipalities to use federal money to provide vouchers to low-income families. These communities would be chosen based on the existence of pervasive poverty and economic distress.

The Renewal Act also contains incentives such as tax credits and regulatory relief, and low-interest loans would be offered to businesses and individuals who invested in these neighborhoods. By making certain approved types of investments in Renewal Communities, banks would be able to satisfy their obligations under the CRA. Although the comprehensive-community approach of the Watts-Talent proposal makes the mistake of keeping much of the current CRA enforcement framework intact, it lessens the regulatory burdens on banks, while providing much needed assistance to religious institutions via the tax code. It's a small step forward that should be taken.

*Gerald A. Reynolds is the president of the Center for New Black Leadership, a Washington-based public policy organization. He also is Vice-chairman of the Federalist Society's Civil Rights Practice Group. Sections of this articles first appeared in a report entitled The Community Reinvestment Act: Questionable Premises & Perverse Incentives, a copy of which may be reviewed on