The Reinvented Community Reinvestment Act By Hal S. Scott The Community Reinvestment Act (CRA), enacted in 1977 during the Carter Admini- stration, requires federal banking agencies to encourage banks and thrifts (banks, for short) to meet the credit need s of their local communities (including low and moderate income neighborhoods) consistent with safety and soundness considerations. Communities are the areas contiguous to bank offices. At the outset, there are major flaws in the concept. First, absent rac i al discrimination- which is subject to attack under a variety of other federal laws including the Equal Credit Opportunity and Fair Housing Acts (see the Justice Department's action in the Chevy Chase case)-why wouldn't the market dictate that banks loan t o their communities when it was consistent with safety and soundness? The Act can only be understood as pressuring banks to make non-market loans. Second, why is this obligation put only on banks, as compared with other lenders- for ex- ample, finance com p anies or credit unions? If the idea is that banks should invest a portion of local savings in the communities from which they are taken, this flies in the face of the basic idea behind banking-to direct savings to their highest economic use. Only in this w ay can savers in poor communities get high rates of interest. Less profit for banks will translate into lower returns for savers who will eventually move their funds into other insti- tutions (mutual funds, for example) without such reinvestment obligatio n s. Moreover, poor communities are capital poor, not capital rich. Real development cannot be meaningfully fi- nanced from local savings. If the idea is that banks should repay society for the benefit they receive from the federal safety net-deposit insura n ce, bailouts, lender-of-last resort facilities-those benefits have been vastly curtailed since the thrift crisis. Ken McLean, the key staffer for Senator Proxmire, the Chairman of the Senate Banking Committee in 1977 who pushed for CRA, has recently made t his point. We now have risk-based deposit insurance, least-cost resolu- tion requirements for bank failures, and restrictions on central bank support. Indeed, banks over the last few decades have become less profitable; many large U.S. banks' shares have t raded at discounts from book value. The imposition of social lending requirements on banks will mean that capital will go elsewhere. Third, it discourages banks from locating in poorer communities where they will be saddled with legal obligations to loan money.

CRA Today Under current regulations, four different CRA ratings are assigned to institutions based on examinations with regard to 12 very general assessment factors, many of which are proce- dural- for example, the extent of participation by the ban k's board of directors in formulating and reviewing the bank's CRA policies. Some, however, are substantive- for example, the bank's participation in government-subsidized loans for housing, small busi-

Hal S. Scott is Nomura Professor of International Fin ancial Systems, Harvard Law School. 11is is an updated version of his March 30, 1994, remarks to The Heritage Foundation's Regulatory Reform Advisory Council. ISSN 0272-1155 0 1995 by The Heritage Foundation.

ness, or small farms. There is no specific m ention of racial minorities, women, or poor peo- ple; the emphasi's is on meeting the general credit needs of the community. CRA performance is taken into account by banking regulators whenever a banking organi- zation applies for permission to open a new branch or make an acquisition. Interest groups have used this requirement to file extensive protests against applications based on banks' al- leged shortcomings in fulfilling their CRA obligations under the general assessment factors. These protests can l e ad to hearings and significant costly delays in approving applications. In many cases, groups have threatened to file oppositions unless the bank agreed to loan an agreed amount of money to certain groups or projects, a form of regulatory blackmail. While regulators have generally given banks high CRA ratings based on examinations-94 percent were rated in the top two categories in 1994-they have not relied exclusively on these ex- aminations; instead they have been susceptible to the protests of interest g roups.

The Clinton Administration Proposals In December 1993, the Clinton Administration proposed a new set of regulations to rein- vent the Community Reinvestment Act. It described its proposals as "performance" -based rather than "process" -based. Compli ance was to be measured not by whether a bank had a process designed to achieve more community-based lending, but by whether such lending actually occurred. The proposals were also justified as providing more objective measures of CRA compliance in lieu o f examiner discretion. The proposals were actually put forward on a coordinated basis by the banking regulators. The Administration has political control over three of them: the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and t h e Office of the Comptroller of the Cur- rency. The Fed, which is independent, has reluctantly gone along, some governors secretly hoping, I believe, that adverse reaction would derail the proposals. When the December 1993 proposals were widely criticized b y the industry as being too rigid and burdensome, and by community groups as being too lax, a new set of proposals were put forward in September 1994. Under the revised proposals, CRA compliance for large retail banks ($250 million or more in assets) is t o be primarily measured by ratings under three performance tests-Lending, Investment, and Service Tests. Unlike the original proposal, performance is to be judged in "the context" in which the institution being evaluated operates. Thus, the agencies would t ake into account the demographics and credit needs of an institution's service area and the banks' product offerings, business strategy, and condition. The introduction of "context" represents a retreat from objectivity and a return to regulatory discreti on.

The Lending Test The objective of the LendingTest is to increase certain types of lending-small business and small farm (annual revenues of $1 million or less), home mortgage, community develop- ment, and, at a bank's election, consumer loans (target l oans)-to low- and moderate-income areas (target areas). "Community development loans" are explicitly de- fined as nonmarket loans for affordable housing or other community economic development needs. Performance under the LendingTest is measured by a numb er of factors, including the proportion of an institution's lending within its service area and the extent to which such loans are made to preferred borrowers within that area. Five rating categories are formulated

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to measure performance (Outstanding , High Satisfactory, Low Satisfactory, Needs to Im- prove, Substantial Noncompliance). Under the original proposal, ratings were to be assigned primarily on the basis of a market share test: how a bank's market share of target loans in its target area com p ared with its mar- ket share of target loans in the rest of its service area. This test was heavily criticized. The measurement device did not insure more preferred lending. Suppose a bank had a market share of 20 percent in the target area and 40 percent outside. It could respond by decreasing its market share in target loans outside the target area, for example, by making more loans to large corporations, or increasing its loans within the target area by buying loans from banks with surplus target area l o ans. Deadweight compliance costs would be incurred with no benefit for low- or moderate-income areas. On the other hand, any real increase in target area lending could well lead banks to make riskier loans, given the limited pool of sound credits in these areas. Having rejected an objective but flawed market share performance measure, the proposal now ostensibly uses a catalog of factors to arrive at a rating, all of which call for substantial discretion on the part of examiners. For example, among the fac t ors leading to an "outstand- ing" rating would be "excellent responsiveness" to the credit needs of its service area, being a "leader" in making community development loans, or "extensive use" of innova- tive or flexible lending practices. However, one su spects market share calculations may still be used in the background.

The Investment Test The Investment Test seeks to increase certain target investments that would benefit low- and moderate-income areas or persons within a bank's service area or a broade r statewide or regional area that includes the service area. Target investments include investments (or grants) in support of affordable housing or other community economic development needs that are not being met by the private market. They also include i nvestments that primarily benefit low- or moderate-income individuals and small businesses or small farms, as well as rent-free donations of branches in minority neighborhoods to any minority depository insti- tution or women's depository institution. Und e r the original proposal, Investment Test ratings would have been based on the ratio of target investments to capital. This would have penalized banks with high capital. For safety and soundness reasons we want to keep capital high; this would have given b anks the opposite incentive. Under the revised proposal, the ratio test was dropped in favor of more discretionary criteria like those used for the Lending Test.

The Service Test The Service Test would evaluate a bank's systems for delivering retail bankin g services. For example, it would look at the distribution of a bank's branches and ATMs among differ- ent income areas, and its record of opening and closing branches and ATMS, or the availability of alternative systems for delivering retail services (e. g ., home banking) as be- tween such areas. The Service Test would also evaluate the extent to which banks offer community development services-services provided to preferred groups (e.g., low- or mod- erate-income individuals) or small businesses or small farms. Again, a variety of discretionary criteria are used to arrive at a rating.

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Composite Ratings A complex two-step system is used to arrive at an overa 11 CRA rating for retail banks. First, a bank's rating for e ach of the component tests would be assigned on the following ba- sis: Component Test Ratings Lending Investment Service Outstanding 12 6 6 High Satisfactory 9 4 4 Low Satisfactory 6 3 3 Needs to Improve 3 1 1 Substantial Noncompliance 0 0 0

Second, a ban k's total points would be combined to reach an overall rating: Outstanding, 18 or more; Satisfactory, 9-17; Needs to Improve, 5-8; and Substantial Noncompliance, 0-4. At the urging of community groups who wished to put primary weight on lending, points as - signed to investment and service cannot, in combination, exceed those for lending. For example, if lending was 5 and combined investment and service were 8, the total score would-be 10 (5+5). High ratings do not ensure regulatory approvals-they are not c onclusive evidence of per- formance. Community group protests can still be taken into account.

Special Rules: Strategic Plans, Wholesale and Small Banks The proposal would afford all banks an alternative to using the various Tests discussed above. A bank c ould have its CRA performance evaluated under a "strategic plan" submit- ted for public comment and approved by regulators. The plan has to specify measurable goals for lending, investment, and services. The rating would he based on whether a bank subs-ta n tially achieved those goals. Special rules are used to assess the performance of "wholesale" or "limited-purpose" banks, basically banks not engaged in the business of making retail loans. CRA performance for these banks is evaluated under a "Community De v elopment Test" which focuses on community development loans and services in addition to application of the Investment Test. Banks will receive credit for loans, service, and investment both within and outside their service areas, but credit for outside th e service area cannot normally exceed credit for inside. Small banks (less than $250 million in assets) are subject, at their election, to a stream- lined CRA review. Their performance would be evaluated on the basis of a watered-down version of the Lendin gTest.

Data Reporting Large banks would have new data reporting requirements with respect to target loans. Loan data would have to include the number of applications and denials and the number and amount of approvals for loans secured by properties outside a bank's mortgage service

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area, data not presently required under the Home Mortgage Disclosure ACL While some of the additional reporting is less than originally proposed, the revised proposal requires, for the first time, that race and gender data be reported for small business and small farm loans.

Enforcement The revised proposal, like the original, calls for new enforcement techniques. Enforce- ment of the regulations would no longer be done exclusively through the application review process. T he proposal would allow the regulatory agencies to impose cease-and-desist or- ders and civil money penalties in cases of the lowest rating-Substantial Noncompliance. The Department of Justice, however, determined in December 1994 that there was no author ity under CRA for these new enforcement measures.

Commentaq These proposals will impose serious new compliance costs. The Independent Bankers As- sociation has estimated that current CRA compliance costs are $1 billion annually, and the American Bankers As sociation's recent survey estimated that the original proposals would cost an additional $100 million. Also, there is the potential for significantly higher loan losses. It is thus likely that, in the short term, the marginal cost of credit for all borrow e rs will increase (or the returns to savers will decrease) as banks pass on some of these new costs. And the amount of government tax revenue will decrease as banks become less profit- able. In the longer term, bank safety and soundness may be significantl y eroded. Credit allocation schemes have indeed bankrupted banking systems in other countries. The Clinton Administration began reinventing CRA by trumpeting the virtue of perform- ance- rather than "process" -based assessments. At first, many banks were s y mpathetic to the approach; given CRA, they wanted to make a reasonable amount of targeted lending and be done with it. The original proposals, however, imposed costly new requirements with no safe harbors. After being widely criticized, the agencies retre a ted into the more shadowy world of regulatory discretion. The proposal is full of vague concepts like "con- text" and "innovative" lending. The scoring system is arbitrary. For example, why does lending count less than investment and service for an Outsta n ding score (12 compared with 6+6) than it does for a High Satisfactory score (9 compared with 4+4)? The Clinton propos- als demonstrate proverbial weaknesses of state planning-it is either too rigid or too discretionary. There is no way out of this dilemm a short of discarding CRA entirely and per- mitting the market to determine who receives bank loans, investments, and services. The original purpose of CRA- to encourage lending within the bank's local community - has been significantly distorted by the Cl i nton proposals. Now, only loans to preferred borrowers (low- and moderate-income, small businesses, and small farms) within the local community count. Rather than recognizing that wholesale banks have no "local commu- nity" but rather serve national and i n ternational markets, wholesale banks are directed to steer investments or grants to preferred recipients. And by asking for new data on the sex and gender of borrowers, a clear message is being sent as to which preferred borrowers or re- cipients may coun t the most. These initiatives are completely misguided. The entire class of targeted borrowers would be better served by loans made to the most productive enter- prises because those firms can provide more jobs to everyone, including the targeted borrowers . It is wrong to require consumers to subsidize non-market (e.g., overly risky) loans by paying higher bank charges. The original and revised proposals were importantly shaped by the input of community groups. These groups have been successful in securing their own piece of the pie in these

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proposals. Under the Investment Test, qualified investments include grants to minority- and women-owned. financial institutions and to organizations engaged in affordable housing rehabilitation and construction, as well as not-for-profit 'Organizations serving community economic development needs or supporting activities essential to the capacity of low- or moderate-income individuals to utilize credit or sustain economic development. Naturally, the regulations do n o t require any assessment of the performance of the grantees. Similar goodies for community groups are available under the Community Development Test for wholesale banks. Small banks get an exemption from these requirements; instead, they must comply with a watered-down version of the regulation. Why is there an exemption for small banks at all? Is this another manifestation of small is beautiful? The reason, of course, is clear-the Admini- stration feared their opposition. Small banks were not exempt from p revious CRA requirements. There is no reason to give small banks a competitive edge over large banks, and at the margin such exemptions may discourage productive consolidations or mergers. These new proposals will be quite costly and counterproductive. Re a l costs will be im- posed on the general public. Borrowing costs will go up, and tax revenues (which will have to be made up somewhere) will go down. Productive activity will decrease. In the longer term we risk endangering the banking system, and ultimat e ly the American economy, by adopting those kinds of command-and-control credit policies. The only virtue of the Clinton proposals is to show how costly the CRA is when taken se- riously. The right thing to do now is to repeal CRA; even in its watered-down form it was undesirable, basically offering leverage to community groups to grind their particular axes or enrich their own coffers.

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