Equality of opportunity and investment in creditworthiness.

• Author: Swire, Peter P.
• Position: Symposium - Shaping American Communities: Segregation, Housing & the Urban Poor

The Community Reinvestment Act (CRA) was enacted in 1977.(1) Its vague provisions initially resulted in only modest enforcement efforts by regulators, and the law received scant attention from academics.(2) The CRA was reinvigorated in the late 1980s. The change occurred in part when the statute was amended in 1989, notably by requiring banks' CRA ratings to be disclosed publicly.(3) Perhaps just as importantly, the change occurred as regulators made enforcement of the Act a higher priority, both before and especially after the election of President Clinton in 1992.(4) This second incarnation of the CRA has created a furor in the banking community(5) and has attracted a rapidly growing body of academic literature.(6)

The time is thus opportune for a critical examination of the CRA, as Professor A. Brooke Overby performs in The Community Reinvestment Act Reconsidered.(7) In this short Paper, I cannot comment on many of the interesting and provocative points made in Overby's article. Instead, I will consider some implications of two of her points. First, Overby makes the linguistically surprising argument that the CRA "has little, if anything, to do with 'community.'"(8) Overby's examination of the legislative history shows that the CRA as introduced was targeted especially at disinvestment, which occurs when the deposits taken from a community are not invested back into that community.(9) Overby shows how these disinvestment provisions were largely stripped from the law as enacted.(10) The CRA can thus plausibly be understood as primarily directed toward the problem of redlining, which occurs when banks or other lenders refuse to loan based on the neighborhood, rather than on the characteristics of a particular borrower.

This emphasis on redlining, in turn, leads directly to Overby's second point, that the CRA should be understood as seeking the goal of equality, and especially equality of opportunity for those seeking credit.(11) I agree that equality of opportunity provides a vital reason for supporting the CRA and fair lending initiatives more generally. This Paper will explore some aspects of equality of opportunity in lending.

In particular, I will consider the implications of borrowers' investment in creditworthiness. Part I of this discussion develops a model showing how borrowers in a group that is discriminated against will not receive the same return on their efforts to prove their creditworthiness as other borrowers. The model predicts that borrowers in the discriminated-against group will, on average, not educate themselves as much about the financial system and will not make costly efforts to conform to behavior that lenders prefer.

To get an intuitive feel for the investment in creditworthiness model, consider a borrower's attitude in two settings--an efficient lending market that she expects to visit repeatedly versus a discriminatory market that she believes is likely to deny her credit in the future. In the efficient market, the long-run advantages of learning about the financial system and making timely payments are obvious. By contrast, a person may reasonably decide not to bother participating in a lending market that seems discriminatory. And, if a person is in fact approved for a loan in such a market, greater incentives exist to take the money and run, or at least not to strive so valiantly to pay on time.

Such responses from borrowers can reinforce discriminatory practices of lenders. This problem of the "self-fulfilling prophecy" is familiar in redlining discussions.(12) Michael Klausner's contribution to this Symposium, for instance, discusses two self-reinforcing effects.(13) The first effect is based on information externalities. Where there are few comparable transactions in a neighborhood, lenders lack needed information about the neighborhood.(14) Lenders thus consider the neighborhood increasingly risky as transactions diminish, and they further reduce their loans there. The second effect Klausner calls a neighborhood externality--lenders are reluctant to do business in a neighborhood unless other lenders also do business there.(15) Any one lender does not wish either to make all the loans to a neighborhood or to suffer a loss in the value of collateral when liquidity dries up. Thus, a lender perceives higher risk when other lenders pull out. As some lenders no longer do business in a neighborhood, other lenders have a reason to leave, too.

The investment in creditworthiness model lets us understand an additional self-reinforcing pattern in credit markets. The model shows that borrowers in a discriminated-against group have less incentive to make themselves attractive to lenders. Over time, these actions by borrowers can reinforce the initial discrimination by lenders. The result can be a downward spiral in which the discriminated-against group becomes far less involved in credit markets than other groups. The investment in creditworthiness model also reinforces the geographic explanations for self-fulfilling prophecies. To the extent those geographic explanations depend on borrower behavior,(16) the model here gives a more general account of why borrowers in a discriminated-against group would rationally invest less in creditworthiness over time.

The model of lower investment in creditworthiness would apply generally to any group that is the target of discrimination by lenders. The model may be of particular interest, however, when applied to the experience of blacks in the United States. There is an unquestioned history of public and private discrimination against blacks in lending markets.(17) There is considerable evidence, although subject to more debate, that lending discrimination against blacks persists today.(18) In the face of this discrimination, it is possible that blacks have, on average, reasonably decided not to enter credit markets as often as whites and have made fewer efforts to conform their behavior to lenders' preferences.

Part II of this Paper explores some implications of the creditworthiness argument as applied to black households in the United States. Part III presents empirical evidence that supports the predictions of the investment in creditworthiness model. In 1989, 44.6% of black households had checking accounts, compared to 79.9% of all other households.(19) This Paper presents a series of regressions showing that race is a highly significant factor in explaining which households have checking accounts, even after accounting for relevant economic and demographic variables. The essential point is that failing to have a checking account would seem to be evidence of a low level of investment in creditworthiness. The much higher rate of black households without checking accounts thus fits the model's prediction of lower investment in creditworthiness. Other explanations exist for the data, but it is interesting to note that many of them presuppose other forms of significant continuing discrimination in lending markets.

The conclusion returns to the question of equality of opportunity in lending markets. The investment in creditworthiness model helps illuminate the difficulty of even approaching that goal. Rational borrower behavior can magnify the effects of discrimination by lenders, potentially leading to the self-reinforcing pattern already discussed. The checking account data, which has not previously been the subject of careful analysis, offers additional reasons for believing that equal opportunity is not available to blacks in credit markets today.

1. A MODEL OF UNDERINVESTMENT IN CREDITWORTHINESS

   The underinvestment in creditworthiness model draws on the underinvestment in human capital model developed by Shelly Lundberg and Richard Startz in employment markets.(20) Lundberg and Startz's model assumes that workers have both innate and acquired characteristics that determine their productive abilities. Each worker acquires human capital to the point where the marginal cost of more training equals the marginal benefit in the form of higher wages.(21) "Human capital" here includes not only formal schooling, but also, in the words of Kenneth Arrow, the "more subtle types of personal deprivation and deferment of gratification which lead to the habits of action and thought that favor good performance" in a job.(22)

   Lundberg and Startz explore the effects on employees of "statistical discrimination," which involves use of a general category, such as race or neighborhood, to reduce the costs of particularized inquiry into an individual's qualifications for a job or a loan.(23) They assume that employers are provided with test scores that provide information about each worker's marginal product, and that employers can identify each employee as either white or black.(24) Lundberg and Startz show mathematically that the wage offered to a worker will depend on the individual's test score as well as some adjustment for membership in the group.(25) The source of the adjustment can be quite subtle--Lundberg and Startz assume that both groups have the same innate ability and that the test score gives the same average result.(26) Their model nonetheless shows the effects of discrimination simply when the random error in the test score is greater for one group (blacks) than for the other (whites).(27) Because the test score, on average, is not as precise, blacks appear riskier to employers; therefore profit-maximizing employers will offer blacks lower wages.(28)

   Under the Lundberg and Startz model, white workers will receive larger raises for increased test scores, as well as higher average raises.(29) Because they are more highly rewarded for improved test scores, white workers will rationally invest more in human capital--they receive a greater marginal return from each unit of education than do black workers. Generalizing from the Lundberg and Startz model, Professor Cass Sunstein explains how underinvestment in human capital can result...