The Community Reinvestment Act and the economics of regulatory policy.

• Author: Richardson, Christopher A.

INTRODUCTION

The Community Reinvestment Act of 1977 (1) ("CRA") represents an attempt to shape the economic and social condition of communities by altering the economic policies of depository institutions. The CRA was passed to discourage disinvestment in urban, typically minority areas and to ensure that all communities, regardless of their economic or demographic characteristics, have fair access to credit. Its stated intent is vague, yet simple: to encourage each bank (2) "to meet the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with [the] safe and sound operation of the bank." (3) The CRA has stimulated debate across the ideological spectrum. (4) The CRA's supporters believe that it has provided increased access to credit in low- and moderate-income ("LMI") neighborhoods, and that it could be even more effective with greater enforcement. (5) Critics of the CRA, on the other hand, argue that the law saddles banks with substantial compliance costs and that unfettered credit markets can properly allocate credit without ponderous government regulation. (6) Even with the dismantling of the walls of separation between banking, insurance, and securities underwriting achieved by the Gramm-Leach-Bliley Financial Modernization Act of 1999, (7) the CRA remains relevant. Its relevance emanates not only from its economic impact on LMI neighborhoods and financial institutions subject to CRA regulations, but also, as this Article discusses, from its fusion of economic and social policy.

The CRA illustrates how regulatory policies can have both economic consequences and social implications. The CRA's passage in 1977 was based in part on the belief that it would benefit LMI communities by providing access to more credit than would be available otherwise. (8) The Act's enforcement mechanism requires that a bank comply with the CRA when it wishes to merge, acquire existing branches, or open or close branches. (9) Thus, the CRA has direct economic effects on banks as well as on neighborhoods.

LMI areas, however, also may accrue social benefits from improved access to credit. Greater credit access increases economic prospects for residents and businesses in LMI areas. Improved economic prospects can in turn improve the social condition of residents by decreasing crime, homelessness, inadequate heath care, and neighborhood instability caused by low homeownership rates. (10) These external benefits--otherwise known as positive externalities--are not limited to LMI areas themselves. High-income suburban residents enjoy activities in central cities such as cultural attractions and sporting events, and central cities continue to be major hubs of economic activity in most large metropolitan areas. A decrease in social problems in LMI communities is likely to confer positive benefits to residents in other communities as well. Because these benefits do not accrue to banks lending in LMI neighborhoods, however, banks do not take them into account when making their lending and investment decisions. This leads to a below-optimal level of lending and investment in LMI areas. By requiring banks to meet the credit needs of LMI areas in their markets, CRA lending, investment, and service requirements (11) can lead to a higher level of social benefits than would be produced absent credit market intervention.

The CRA stands out as a model for regulation based on economic principles--the correction of redlining (12) and inadequate lending in LMI areas--and its attempt to encourage banks to operate in the best interest of consumers and society. Part I of this Article examines the economic issues associated with providing access to credit in LMI areas. Particular attention is paid to market failure, information asymmetries, and social welfare maximization. Market failure results, in part, from the positive externalities associated with lending in LMI areas that are not internalized by lenders. Even without these externalities, however, the amount of lending to LMI areas suffers from the informational asymmetries inherent in bank lending: Borrowers know more about their probability of loan repayment and of the expected profitability of their investment projects than do lenders. Such informational asymmetries can cause lenders to ration the amount of credit they provide to potentially high risk customers. (13) Informational asymmetries are larger in LMI areas than in more affluent areas due to the larger proportion of LMI borrowers who lack bank checking or savings accounts--the so-called "unbanked." (14) Such borrowers increase the riskiness and lower the volume of LMI-area lending. Indeed, the inherent risk involved in lending in LMI areas means that absent regulation, lending volume and financial services will be more volatile in LMI areas than elsewhere. Government regulations such as the CRA can act as a buffer to the detrimental effects of the withdrawal of credit.

To the extent that adequate flows of credit to LMI communities provide external social benefits to society, the goal of improving access to credit can be examined within the framework of the government's attempt to maximize social welfare. Within this paradigm, government regulations (and their method of enforcement) affect both efficiency (obtaining the highest possible aggregate social welfare, given resource constraints) and equity (distributing aggregate social welfare in the most socially beneficial manner). (15) The operative choices with regard to formulating governmental policies and choosing the "best" policy from an array of alternatives thus become the choice of incentives, created by the policies, on which economic actors--consumers, firms, and the government--will base their decisions. (16)

Part II of this Article examines the interplay between incentives and economic decision-making within the context of a conceptual framework for investigating regulatory policy. The framework involves separating the economic actions firms take in their normal course of business--producing goods and services for profit--from the regulatory actions the firm must undertake as required by the relevant governing institution. Creating the dichotomy between economic actions and regulatory actions allows a policymaker to focus more sharply on two tasks fundamental to fostering the goal of efficiency without undermining legitimate concerns of equity: (1) deciding what goals are valued among economic actors and consequently by society as a whole, and (2) implementing an incentive structure that will support those societal goals in the most efficient manner, while allowing actors to freely choose their actions. (17) Ironically, a positive aspect of the CRA is its inherent ambiguity, which stems from its vague wording (18) and its reliance on bank regulators to craft regulations that delineate its enforcement procedures. That ambiguity facilitates laying a foundation for a regulatory structure that gives the CRA the flexibility it needs to be a viable mechanism achieving efficiency and equity.

Despite the great potential of the CRA as a vehicle for progressive economic and social policy, the current enforcement regime of the CRA (initiated in 1995 as a revision of the pre-1995 "efforts-based" regime) can still be improved upon. (19) Part III of this Article offers a market-based enhancement to the CRA that can improve its efficiency by creating property rights for a new financial asset that gives banks more flexibility in meeting their CRA lending requirements. This increased flexibility will allow banks to meet their CRA requirements at lower cost, while ensuring the same amount of or more CRA lending in the aggregate. The market-based enhancement that this Article proposes can be implemented by a simple revision of the regulations (20) without the need for new legislation.

1. THE ECONOMIC RATIONALE FOR THE CRA

   To a large extent, the writing and passage of the CRA in 1977 was motivated by evidence of redlining and disinvestment of bank deposits in LMI areas. (21) Some scholars believe that an underlying motivation for the CRA was not just to correct geographic credit imbalances, but also to prevent racial discrimination in credit markets. (22) Although this may have been seen as a desirable byproduct of the CRA, race is not explicitly mentioned in the CRA statute. To the extent that minorities are more likely to live in LMI neighborhoods, ensuring fair access to credit for LMI neighborhoods implies ensuring fair access to credit for minorities as well. Certainly, by requiring banks to make credit available in areas where they might not otherwise, the CRA can be expected to have indirect positive effects on the incidence of discrimination in credit markets. A strict interpretation of the CRA's purpose, however, suggests that it is an anti-redlining statute and not an anti-discrimination statute. (23)

   The CRA's goal of encouraging banks to meet the credit needs of the communities where they accept deposits is more nebulous than the intent of related anti-discrimination laws such as the Equal Credit Opportunity Act (24) and the Fair Housing Act. (25) It is therefore particularly important that the CRA have a strong economic basis. The CRA is justified on economic grounds by three principles: (1) the presence of externalities in the market for mortgage and business loans in LMI areas that lead to the failure of unregulated markets to produce adequate levels of credit to LMI areas; (2) information asymmetries, whereby potential lenders in LMI areas may find it too costly to obtain the requisite information for determining profitability of prospective lending opportunities and to properly assess credit risk in LMI areas; and (3) the government's (implicit) desire to maximize some measure of social welfare in the aggregate while increasing the social welfare of LMI areas through the socially optimal allocation of credit.

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