Investing in Communal Failure: The Current Economic Crisis as a Result of Regulation

Unfettered greed is the suspect many point at to explain the current economic crisis. To some extent, they are right, but it isn’t irrational greed on the part of bank managers or fat cat CEOs. It is the unwieldy bank regulations that forced the entire industry to walk the proverbial plank and then blame it for drowning.

Critics have alternately claimed that over-regulation and under-regulation are the causes for the current crisis. I believe one specific regulation, the Community Reinvestment Act (CRA), should shoulder a lot of the blame for creating an environment where a lending institution’s short-term survival hinged on it making the decisions that in the long-term would likely cause its demise.

As I noted in my paper The Community Reinvestment Act’s Harmful Legacy, one of the effects of the CRA was the creation of a weapon that has been effectively utilized to extort money from lenders. When lending institutions wish to open a new branch, expand, or merge, they must apply for permission from one of the four governing bodies (Federal Reserve, Office of Comptroller of the Currency, Federal Deposit Insurance Corporation, and Office of Thrift Supervision). Their request can be postponed or outright denied if any community group files a CRA protest. Lending institutions can of course fight these protests, but CRA investigations can take months and cost large sums of money.

The institution under investigation stands to lose money due to the actual costs of the process of investigation as well as the potential loss of money (millions or even billions of dollars) for each day a merger is postponed. Such loses could be the ruin of a lending institution. In an attempt to bypass CRA protests, banks make sure they comply with CRA regulations (making risky lending choices), make sure the public knows they are in compliance (wasting money on PR campaigns), and often bribe these “community groups” to guarantee that they won’t file a protest.

The correlation between a bank’s compliance with CRA and its relative financial health has been well documented. As I noted in my paper The Community Reinvestment Act’s Harmful Legacy, there is a discernible correlation between a lending institutions’ compliance with CRA regulations and a decrease in their financial health. In his paper, Jeffrey W. Gunther noted that banks engaging in the risky and aggressive lending that would get it a good CRA rating would result in a lower rating for the institution’s financial soundness.

Despite this correlation financial institutions continued to tailor their lending habits in order to maintain satisfactory CRA ratings decreasing their ability to respond to market shifts. The reason is, until now, the threat of CRA costs was more present than the potential loss in a banks ability to react to a down-turning market. But building sand on top of sand only works for so long.

So yeah, maybe irrational greed is a factor in the current crisis, but it is the irrationality of regulators and the greedy demands of community groups that we should be pointing fingers at. If banks had been allowed to act in their own long-term best interest, sure some ill-managed institutions would still crumble, but we would not be witnessing such a wide-spread failure that indicates a system wide error in judgment.