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12/18/02: The American Banker

Community Reinvestment Act at 25: Reforming an Almost Perfect Law

How do you celebrate the 25th anniversary of one of the most hated laws in America's most heavily regulated industry? Instead of calling for the repeal of the Community Reinvestment Act of 1977, the banking industry is asking regulators that this year's mandated reform of the law result in a more efficient and streamlined regulation.

The CRA may be the best example of smart regulation. It strikes the correct balance between government and market forces in a capitalist economy. It encourages but does not require federally insured banks and thrifts to help meet the credit needs of their communities -- including low- and moderate-income (LMI) neighborhoods -- in a manner consistent with safe and sound banking practices.

The law has proved that capitalism can have a corporate conscience without degrading itself into socialism or gambling on completely unregulated markets. Though there is a reasonable compliance cost to banks, there is little or no cost to taxpayers, who get something in return for federal subsidies to the banking industry. Since the law has more bark than bite, it is not overly intrusive to business. It relies more on the power of disclosure than on regulatory brute force -- and it is reformed periodically, so it remains responsive to both consumer and industry interests.

Under the CRA everyone is supposed to have an equal opportunity to apply for credit. The law's beneficiaries are the 40% of Americans with an income of 80% or less of the median, which works out to $40,000 or less per family nationwide, according to the 2000 Census.

The road to the CRA's success began with heavy opposition not only from banks but also from the Federal Reserve, which publicly supported the measure but privately encouraged member banks to lobby Congress to weaken it.

Under the CRA, the four federal bank and thrift agencies periodically assess an institution's CRA record and consider that record when acting on branch or merger applications. This affords community groups the possibility of holding up expansion plans while they persuade regulators to require changes in a bank's credit practices.

These efforts also sometimes result in grants to the protesting groups. A longtime foe of the law, Sen. Phil Gramm of Texas, complained that this amounts to "legalized extortion." He got a sunshine requirement that requires community groups to disclose how much they receive from banks.

The CRA was effectively dormant until 1989, when Chicago's Continental Illinois was the first big bank to have a merger application denied on CRA grounds. That year's S&L bailout was used as leverage to require that a bank's CRA rating and a portion of its exam be made public, a first for American banking.

Grade inflation is rampant in CRA exams; during the law's first 19 years only 31 of 105,000 applications were denied on CRA grounds. This was the proverbial law without teeth, with one very important exception: the public disclosure that began in 1990 of the names and exams of banks with failing CRA ratings.

Bankers then appeared to reconsider making LMI home and small-business loans in their communities.

The proportion of conventional home purchase loans to LMI borrowers (regardless of area) jumped to 24.7% last year, from 14.4% in 1990.

The proportion made in LMI areas (regardless of income) grew to 11.7%, from 10.7%.

Ultimately a few trillion dollars of CRA loans or commitments were made. These results were much better than banks, their doubting regulators, or anyone else expected -- to the chagrin of free-market academics and writers. Though it is more efficient to make a single $1 million loan than 10 LMI home loans of $100,000, the latter result in a more diversified and often stronger portfolio. That is because an LMI family will do just about anything, including taking on an additional job, to keep current on mortgage payments.

(Wall Street later discovered an even better secret about LMI loans: The borrowers are much less likely than others to prepay or refinance when rates drop. Banks such as J.P. Morgan Chase ~Co. that have been hurt by loans to Enron and Argentina probably wish they would had made more LMI loans.)

The CRA has never caused a bank to fail or lose significant market capitalization. In fact, separate studies by the Treasury Department and the Fed have dispelled the urban myth that such loans are unprofitable -- a myth usually cited as a justification for a law to encourage LMI lending.

Another CRA urban myth is that the law's main benefactors are minorities, particularly African-Americans. Because the CRA is an income-based law, there is no race card. In fact, 60% of LMI individuals are non-Hispanic white. That explains why it has Congressional supporters on both sides of the aisle.

One last myth is that compliance with the law is extremely costly to banks. Though this may have been somewhat true in the early 1990s, the situation greatly improved for most banks following the law's 1995 reform. That reform created a streamlined test for special-purpose and small banks -- about 80% of the total -- and a three-part test (lending, investment, and service) for large ones, with lending counting just 50% of the overall rating.

Besides watering down the original LMI lending objective of the CRA, this three-part test for big banks proved both costly and problematic, as there was and is still a shortage of suitable CRA investments. Wall Street immediately capitalized on this shortage by creating an entire "CRA investment" industry of mutual funds and other investment vehicles, some with attractive tax credits.

Many of these CRA investments, however, do little to help LMI people or neighborhoods -- because one LMI securitized loan, for example, might be repeatedly flipped so several banks get investment test credit. The "CRA premium" paid by banks has made this one of the few bright spots on Wall Street in recent years.

The CRA is again being reformed this year.

Big banks are asking that it be restored to its LMI lending roots by abolishing the investment and service tests or at least making them optional, as they are for small banks.

Small banks want to increase, by as much as four times, the current $250 million cutoff size for a streamlined exam. A doubling to $500 million would be more than sufficient.

Community groups are correct in asking for reform to rampant grade inflation and an expansion of the CRA to credit unions and bank-owned mortgage companies as the proportion of home purchase loans made by CRA-covered institutions continues to fall.

However, community-group attempts to hold on to the nonlending tests are not only unrealistic but self-serving. Some groups have financial incentives to maintain the investment test (for example, bank contributions to them count as qualified CRA investments).

Community groups are also wrong to ask that the CRA be based on race. That could jeopardize the future of this needs-based law.

Mr. Thomas is a lecturer in finance at the University of Pennsylvania's Wharton School. His proposed CRA reform package is available as Public Policy Brief No. 68 at