Market failure and community investment: a market-oriented alternative to the Community Reinvestment Act.

• Author: Klausner, Michael
• Position: Symposium - Shaping American Communities: Segregation, Housing & the Urban Poor

The Community Reinvestment Act (CRA) is a model of ambiguity. In a roundabout way, it directs banks to meet "the credit needs of [their] entire communit[ies], including low- and moderate-income neighborhoods, consistent with ... safe and sound operation."(1) In enacting the CRA and making specific reference to low- and moderate-income communities, Congress presumably sought to have banks do something that market forces would not lead them to do, but exactly what is unclear. Did Congress intend to implement an ill defined "localist" or "communitarian" ideology by limiting the geographic scope of their lending? Did it intend to redress discrimination against ethnic and racial groups that reside disproportionately in low- and moderate-income neighborhoods? Did it intend to redistribute wealth from bank shareholders to residents of targeted communities? Or, did it intend, on efficiency grounds, to remedy market imperfections? Congress's intent is wholly unclear.(2)

In debating the wisdom of the CRA, most commentators have paid little, if any, attention to the justification for regulatory intervention in low-income community credit markets. Community advocates call for more intervention and more loans.(3) Critics, emphasizing the cost of the CRA to banks as well as incidental social costs, argue against government intervention.(4) To the extent that commentators identify justifications more refined than more money for low-income neighborhoods or lower costs to banks, they refer to different justifications and largely fail to join issue.(5)

In this symposium issue of the University of Pennsylvania Law Review, Professor Overby attempts to place some structure on this unwieldy debate by focusing on the ends and means of the CRA. She argues that the CRA was intended to be, and can be justified as an antidiscrimination law--an adjunct to the Equal Credit Opportunity Act, which prohibits discrimination in lending on the basis of "race, color, religion, national origin, sex or marital status, or age."(6) In support of this reading of congressional intent, she relies on statements in the legislative history regarding "redlining," and in support of her normative view, she invokes an equality argument.(7)

Overby concludes that an antidiscrimination objective requires an efforts-based enforcement regime rather than a results-based regime. She argues that banks should be required to search for lending opportunities in their local communities but that they should not be required to lend there if, after searching, they choose not to. Imposing an outreach and search obligation on banks, she contends, would create equality of access to credit at the least cost to banks. Requiring a bank to make loans, on the other hand, she argues, would compromise the bank's financial safety and soundness.(8)

The CRA, however, is poorly suited to the task of combatting discrimination. It applies to residents of low- and moderate-income neighborhoods without regard to race or ethnicity, and even without regard to their individual incomes.(9) Moreover, the Equal Credit Opportunity Act specifically addresses lending discrimination. Finally, as discussed in Part I, there are at least theoretical reasons to believe that CRA-targeted neighborhoods may be systematically denied access to credit for reasons unrelated to racial or ethnic discrimination.

As for efforts-oriented versus results-oriented enforcement of the CRA, both modes of enforcement impose costs on banks. Whether one imposes higher costs than the other depends on how much effort is required, what amount of lending is required, and how much record keeping is necessary for a bank to prove compliance. A major criticism of current CRA regulations is that their efforts-based orientation leads to too much paperwork. This has engendered in many banks a willingness, in principle, to accept a results-based regime.(10)

In the discussion below, I analyze whether there may be an efficiency-based justification for intervening in low-income community credit markets, and whether, as some have suggested, the CRA can be justified on efficiency grounds.(11) I begin by describing market imperfections that may leave low-income neighborhoods with suboptimally low levels of credit. I then analyze whether the CRA promotes efficiency by responding effectively to those imperfections, and I conclude that it does not. Finally, I propose a system of "tradable obligations" as a potentially more effective alternative to the current CRA regime.(12)

1. MARKET IMPERFECTIONS AFFECTING LOW-INCOME NEIGHBORHOOD CREDIT MARKETS

   Several economists have examined the possibility that market imperfections may result in a suboptimally low volume of credit reaching low-income neighborhoods. Some have referred to lending patterns created by such market imperfections as "rational redlining."(13) This Part examines these market imperfections.

   1. Information Costs

      For a bank to make a loan to a borrower, the bank needs information regarding the likelihood that the borrower will default. Acquisition of that information, however, entails costs. Whether a bank will incur those costs and evaluate the creditworthiness of a particular borrower depends on the magnitude of the costs compared to the expected return from the loan. If the costs are higher than the expected return, the bank will forego consideration of the loan altogether.

      The information costs of lending are compounded by an asymmetry of information between banks and borrowers. In general, a borrower knows more about his own risk of default than does the bank to which he applies for a loan. As I will discuss in subsection 1, this asymmetry compounds the problem of information costs and can lead lenders to decline to serve entire low-income neighborhoods.

      Information costs of lending are mitigated to some degree by positive information externalities that flow from one loan transaction to another. In the process of granting a loan, a bank produces information that can be used to facilitate future lending. For instance, in the case of a home loan, a bank's willingness to make a loan following an appraisal of the mortgaged property constitutes valuable information regarding the value of comparable houses. This information can reduce the cost of financing the sale of those comparable homes by increasing the accuracy with which lenders can appraise those properties. If sales slow down in a neighborhood, however, this information becomes less available, and the information cost of lending can rise. As I will discuss in subsection 2, this possibility is of particular concern in low-income neighborhoods.

      1. Asymmetric Information and Credit Rationing

         Asymmetric information is inherent in credit relationships. Not only do borrowers often know more about their own risk of default than do lenders, they can increase their riskiness after a loan has been made. This asymmetry can lead to "credit rationing," a situation in which a lender declines to lend to a group of borrowers that, on average, pose a high risk of default, even if some members of the group are not as risky as others.(14)

         In this scenario, lenders decline to lend to some groups of borrowers at any interest rate. The underlying dynamic is that, as a bank raises the rate it charges a particular group of borrowers, the composition of the pool of potential borrowers within the group can be expected to shift toward riskier members.(15) At some point, the increased expected return attributable to a higher rate is offset by the increase in expected defaults attributable to the riskier composition of the borrower pool. At that point, if the bank were to increase the interest rate it charges the group, it would actually reduce its expected return.(16) To the extent that borrowers in low-income neighborhoods are on average relatively risky, this dynamic may result in these neighborhoods being rationed out of the credit market.(17)

         The credit-rationing scenario described above assumes, perhaps unrealistically, that a lender cannot distinguish between low- and high-risk borrowers in a low-income neighborhood. It assumes away the possibility that a lender can acquire information that allows it to identify the relatively low-risk borrowers, to restrain them from increasing their riskiness once a loan is made, and to offer them interest rates commensurate with their individual risks of default.

         In a related model, this assumption is relaxed, and banks are assumed to be capable of acquiring information regarding the default risk of individual borrowers. Acquisition of this information, however, is assumed, realistically, to entail costs. In this model, not surprisingly, the extent to which a lender lends to groups that, on average, pose a high risk of default depends on the cost and value of information regarding such a group. The lower the cost and the greater the benefit of acquiring information about borrowers in the high-risk group, the more lending there will be to members of the group.(18)

         This model also suggests that banks may rationally decline to lend in low-income neighborhoods, where the cost to a bank of acquiring credit-related information may well be high and the benefit low. Credit analysis involves substantial fixed costs in initially assessing and then monitoring the economic conditions of a neighborhood and its surrounding area and in becoming familiar and maintaining familiarity with the neighborhood's businesses and residents. Moreover, there are significant fixed costs involved in evaluating an individual loan application and monitoring the riskiness of an individual borrower.(19) This is true for all lending. In a low-income neighborhood, however, the cost of lending is higher than that of lending in other neighborhoods. Potential borrowers are less likely to have had prior borrowing experience and are more likely to need special help both in applying for a loan and in repaying it. Outreach efforts are needed...