Academic journal article Economic Inquiry

Safety and Soundness and the CRA: Is There a Conflict?

Academic journal article Economic Inquiry

Safety and Soundness and the CRA: Is There a Conflict?

Article excerpt

I. INTRODUCTION

Financial problems often pose a dilemma regarding the appropriate nature and timing of any regulatory response. Banks and the financial intermediation services they perform generally are viewed as crucial to economic growth, and the intermediary role of banks entails potential negative economic consequences of reducing permissible lending activities in response to an adverse financial shock, as in Bernanke and Gertler (1987). Equally well known, however, are the perverse incentives associated with allowing thinly capitalized banks to operate with federally guaranteed deposits, as in Kaufman (1987). To the extent both views are correct, they point to a potential trade-off between enhancing the supply of bank credit and promoting safe and sound banking practices in periods of financial difficulty. Although this type of trade-off has been debated and clarified in the context of banking crises, its implications for banking regulation more generally are underappreciated. In particular, limited attention has been given to the potential trade-off between the general credit enhancement objective of the Community Reinvestment Act (CRA) and the risk-constraining objectives of safety and soundness standards.

In October 1977, the U.S. Congress passed the CRA as Title VIII of the Housing and Community Development Act. The legislation is designed to encourage commercial banks and savings associations to help meet the credit needs of their communities, in a manner consistent with safe and sound banking practices. The CRA is often associated with the specific objective of enhancing the availability of credit for low-income neighborhoods in a bank's service area. However, the implementing regulations, in accordance with the general nature of the statute, also prominently feature general guidelines related to the total volume of lending activity conducted in an institution's market area, irrespective of neighborhood income levels. At its most fundamental level, the CRA is concerned with the credit needs of the communities in which banks are chartered; that is, federal regulators are to use their supervisory authority to encourage institutions to help meet local credit needs, as in Garwood and Smith (1993). Since July 1 990, CRA ratings have had four levels: 1--outstanding; 2--satisfactory; 3--needs to improve; and 4--substantial noncompliance (55 FR 18163). The CRA's specific and general credit enhancement objectives are qualified by reference to safe and sound banking practices, but the possibility nevertheless arises that favorable CRA ratings might reflect aggressive financial strategies designed to support an expansion of lending activity.

In contrast, bank regulators use very different criteria in assigning safety and soundness ratings. In 1979, federal agencies adopted the Uniform Financial Institutions Rating System. The resulting overall, or composite, safety and soundness ratings originally were derived from the onsite evaluation and rating of five separate factors--capital adequacy (C), asset quality (A), management (M), earnings (E), and liquidity (L). This CAMEL rating system was amended on 1 January 1997, to include a sixth component (61 FR 67021). The new S component focuses on sensitivity to market risk, such as the risk arising from changes in interest rates. Like the earlier CAMEL rating, the CAMELS overall rating has five levels: 1--basically sound in every respect; 2--fundamentally sound but with modest weaknesses; 3--financial, operational, or compliance weaknesses that cause supervisory concern; 4--serious financial weaknesses that could impair future viability; and 5--critical financial weaknesses that render the probability of near-term failure extremely high. For simplicity, this study applies the term CAMEL to both CAMEL and CAMELS ratings. In contrast to CRA ratings, the CAMEL rating system clearly is directed at containing risk.

Given the opposing perspectives on bank credit underlying CRA and safety and soundness ratings, in addition to the bank-level costs associated with CRA compliance efforts, current regulatory policies entail a potential conflict. …

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