Academic journal article Journal of Commercial Banking and Finance

The Community Reinvestment Act and Efficient Markets Debate: A Review of Theory

Academic journal article Journal of Commercial Banking and Finance

The Community Reinvestment Act and Efficient Markets Debate: A Review of Theory

Article excerpt

ABSTRACT

This paper crosses two existing lines of research. On the one hand, there is the literature on the community reinvestment act (CRA) and on the other there is the literature on the efficient markets hypothesis (EMH). The paper, therefore, first reintroduces each line of research and then focuses on the discussion of how they might be related. More specifically, this paper discusses three major different perspectives: (1) The lending market is efficient, (2) The lending market is inefficient due to illegal "discrimination," and (3) The lending market is socially inefficient as caused by "externalities." The efficient markets view regards the CRA as a "tax" on the banking system, whereas the latter two views mostly support the idea that the CRA benefits lenders as well as low- and moderate-income borrowers and their neighborhoods.

INTRODUCTION

This paper crosses two existing lines of research. On the one hand, there is the literature on the community reinvestment act (CRA) and on the other there is the literature on the efficient markets hypothesis (EMH). The paper, therefore, first reintroduces each line of research and then focuses on the discussion of how they might be related.

The Community Reinvestment Act (CRA) was enacted in 1977 based on the argument that depository institutions were taking deposits from households and businesses in low- and moderateincome areas while lending mostly elsewhere and neglecting qualified loan applicants in their neighborhoods. It was believed that the failure of depository institutions to take advantage of such sound lending opportunities accelerated the process of urban economic decay and prevented private revitalization efforts. The mortgage lending was viewed as particularly important for neighborhood stability and revitalization.

The CRA was enacted to curb what was believed to be a lack of adequate lending in low- and moderate-income neighborhoods. It was meant to ensure that bankers did not ignore good lending opportunities to creditworthy borrowers in their communities. The CRA was not intended to force highrisk lending, instead the safety and soundness was to remain the overriding factor in loan decisions. Author (2005a) provides an overview of the development and the effects of the CRA. Author (2005b) provides a review of empirical evidence on the CRA.

The debate preceding the enactment of CRA has continued to this date. There are three major different perspectives: (1) The lending market is efficient, (2) The lending market is inefficient due to illegal "discrimination," and (3) The lending market is socially inefficient as caused by "externalities." The efficient markets view regards the CRA as a "tax" on the banking system, whereas the latter two views mostly support the idea that the CRA benefits lenders as well as low- and moderate-income borrowers and their neighborhoods. This is because any market failure causes banks to reduce lending in low- and moderate-income neighborhoods. That is, bankers refrain from taking advantage of profitable lending opportunities because of racial or ethnic prejudice. Moreover, although joint lending by many banks in such neighborhoods would be profitable no single bank volunteers to initiate this process due to the costs involved.

Arrow (1973), Barth, Cordes, and Yezer (1979), Bradbury, Case, and Dunham (1989), Cain (1986), Calomaris et al. (1994), Canner (1981), Canner and Passmore (1995), Clapp (1980), Evanoff and Segal (1996), Friedman (1962), Hylton and Rougeau (1996), Ladd (1998), Muth (1986), Papadimitriou, Phillips, and Wray (1993), Phelps (1972), Quercia and Stegman (1992), Schafer and Ladd (1981), Shear et al. (1995), Shear and Yezer (1985), Stiglitz and Weiss (1981), and Yinger (1986, 1995), discuss different aspects of the debate. The present study has greatly benefited from Belsky et al. (2001), Canner, Passmore, Cook, and Kirch (1995), Ford Founation (2002), Galster (1992), General Accounting Office (1995), Lacker (1995), and Yinger (1996). …

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