The Community Reinvestment Act’s Absurd Unintended Consequences

What qualifies as a poor neighborhood?

The answer is largely subjective, depending on which criteria one chooses to focus on. So when government regulators set out to impose a strict definition, things can easily go awry.

That is exactly what’s happened with the Community Reinvestment Act (CRA), a 1977 law intended to improve access to financial services to low-income communities.

It hasn’t gone quite as planned. Many neighborhoods designated as poor for CRA purposes are among the wealthiest in the nation. As The Wall Street Journal reported this week:

Six of the 10 most popular poor areas for banks to have branches, including the Manhattan tract, are slated to lose that classification when more recent census data go into effect this year, according to regulators and data from fair-lending software company ComplianceTech. But bank regulators have been using the older data because they stick to a preset schedule of switching every five years.

In one of these census tracts, a “low income” area in downtown San Francisco, one of the most expensive cities in the country, 53 branches pack into an area that census data indicate has only 1,783 residents. That’s 52 more branches than the average poor district in the U.S. has, despite the fact the San Francisco tract has far fewer residents than average.

About 30 miles away in Menlo Park, Calif., a First Republic Bank branch on Facebook Inc.’s corporate campus is classified as lower income because the surrounding areas have lower incomes than the median of the broader area. But the only people with access to the branch are employees and guests of Facebook, which paid an average of $189,000 in stock-based compensation last year for each employee globally. Facebook and First Republic declined to comment.

Bank regulators rely on Census data for CRA enforcement. But outdated data isn’t the real problem. Simply updating the data more often cannot enable regulators to react to demographic shifts the way market actors can.

Worse, as CEI’s Michelle Minton notes in a 2008 paper, the Community Reinvestment Act has actually decreased access to credit for residents of low-income communities:

The Community Reinvestment Act does not appear to have had any positive effect on lending to residents of LMI [low-and-moderate-income] neighborhoods. In fact, it appears to have had a negative effect on CRA lenders and LMI residents alike.

Increased Risk. While both CRA- and non-CRA lenders have increased the number of loans to low-income borrowers, the financial soundness of CRA-covered institutions decreases the better they conform to the CRA. [Federal Reserve economist Jeffrey W.] Gunther compares certain institutions’ CRA ratings to their CAMELS score—a formula used by bank regulators to assign safety and soundness ratings that takes into account capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risks. He found that the better a lender was rated by CRA standards, the worse was its CAMELS rating.

Increased Costs for Small Lenders. Apart from the cumulative cost of writing riskier loans, CRA-covered institutions must cope with the direct costs of complying with the Act. The burden is especially heavy on small lenders that might compete directly with credit unions, which are exempt from the Act. A 1992 survey of 445 small banks found that compliance with CRA cost 4.5 percent of their pretax income and, on average, 0.25 percent of their total assets.

The negative effect of CRA on small banks compounds in light of the observation by George Benston of Emory University that larger banks often operate in LMI as a strategic loss, in order to get a satisfactory CRA rating for regulatory approval for mergers and acquisitions. Thus, expecting a loss, large banks charge extremely low rates against which smaller banks cannot compete. This drives out smaller lending institutions. Once 5 large banks fulfill the required compliance with CRA, they often discontinue lending in the area.

The CRA discourages lenders from moving in to replace those lenders that have moved out, because its LMI lending requirements makes closing, or moving branches difficult and more costly for lenders in those neighborhoods, thus adding another layer of risk. Federal regulators take CRA compliance ratings into not only when banks apply for new charters or branches, but also when they apply to move or close a branch. The CRA, then, denies creditworthy borrowers in LMI neighborhoods access to of depository institutions that would have otherwise taken the risk of opening branches in those neighborhoods.

For more on the Community Reinvestment Act, see here.