Academic journal article Quarterly Journal of Finance and Accounting

The Effects of Bank Lending Practices on CRA Compliance Examination Scheduling and Non-Compliant Banks' Recovery 1990-1998

Academic journal article Quarterly Journal of Finance and Accounting

The Effects of Bank Lending Practices on CRA Compliance Examination Scheduling and Non-Compliant Banks' Recovery 1990-1998

Article excerpt

Introduction

Few regulations have generated more controversy among financial institutions than the Community Reinvestment Act (CRA). Its fundamental premise, that depositories who take deposits from local markets should reinvest in local markets, has led to criticism by both proponents and opponents of the act. While opponents view it as a severe burden on credit allocation decision making, proponents argue that examiners have been overly lenient in their assessment of institutional performance. The latter issue leads directly to the question of whether CRA compliance examination procedures are related to objective, measurable criteria.

The degree of objective versus subjective assessment by compliance officers, given the wide array of institutions operating under different financial conditions and serving vastly different types of communities, has been a big question mark since the passage of the CRA. Studies by Gunther (1999) and Harrison (1999) that find that cross-sectional variation in CRA ratings are linked to bank-specific characteristics support the argument that compliance examination procedures are related to objective, measurable criteria. On the other hand, studies such as Bierman, Fraser, and Zardkoohi (1994) and Thomas (1998) suggest that CRA standards are so vague that supervisors basically can assign any rating they want. Other studies by Garwood and Smith (1993) and Thomas (1993) find that C RA examinations are inconsistent, giving credence to the argument that compliance examination procedures are overly subjective. This concern for excessive subjectivity led to the 1995 revisions of the CRA calling for more explicit performance standards.

More recent studies of safety and soundness examinations by Flannery and Houston (1999), Hirtle and Lopez (1999), and O'Keefe and Dahl (1999) provide mixed evidence of supervisory variation in examination frequency. Other studies examining determinants of CRA ratings by Gunther (1999), Harrison (1999), and Bierman et al. (1994) rely on cross-sectional comparisons at a particular point in time and also provide mixed findings. A study by Dahl et al. (2003) examines how supervisors evaluated bank compliance with the CRA prior to the passage of the new standards in 1995. They find that a bank's loan levels, size, and affiliation status influence both the scheduling and persistence of CRA ratings over the time period 1990 to 1996.

In this paper, we build on past studies of CRA examination practices by examining a sample of 25,146 CRA examinations of banks over the years 1990 through 1998. We first examine if CRA compliance examiners consider a bank's lending practices in scheduling its next examination. We then focus on the 1,265 observations in our sample receiving a substandard CRA rating and examine if the bank's lending practices influence its ability to recover from the substandard rating by the next examination. We also test for structural changes in the examination and recovery process following the 1995 passage of the amendments to the CRA examination criteria. (1)

We observe that a bank's loan levels and loan quality exert significant influence on the examination scheduling. We find some evidence that the probability of non-compliant banks' recovery is significantly influenced by its current loan levels and loan quality. We also observe the time interval between examinations is significantly longer after 1995, especially for smaller banks. In addition, we observe that the time interval until the next examination is influenced by a bank's capitalization, current CRA rating, principal regulator, size, and if it is in a SMSA (Standard Metropolitan Statistical Area). We also observe evidence that the probability of non-compliant banks' recovery is significantly influenced by the degree of its non-compliance (3 versus a 4 rating), return on assets, principal regulator, if it is part of a holding company, and if it is in a SMSA. …

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