Community Reinvestment Act: Review of Empirical Evidence

By Ardalan, Kavous | Journal of Commercial Banking and Finance, Annual 2006 | Go to article overview

Community Reinvestment Act: Review of Empirical Evidence


Ardalan, Kavous, Journal of Commercial Banking and Finance


ABSTRACT

This paper reviews the empirical evidence on the community reinvestment act (CRA) in light of 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 empirical evidence is reviewed for the evaluation of the relative merit of these perspectives.

INTRODUCTION

This paper reviews the empirical evidence on the community reinvestment act (CRA) in light of 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 empirical evidence is reviewed for the evaluation of the relative merit of these perspectives.

CRA AND EFFICIENT MARKETS DEBATE

The Community Reinvestment Act (CRA) was enacted in 1977 based on the concern that commercial banks and savings associations were engaging in "redlining" practices that were accelerating the decline of many inner-city urban areas. Redlining referred to the practice whereby depository institutions literally or figuratively drew a red line around certain neighborhoods on the basis of the racial composition, age of housing stock, or other factors regardless of the creditworthiness of individual loan applicants, and declined to make loans in those neighborhoods. The perception was that these practices were resulting in the disinvestment and decline of many older, central city, and typically low-income and minority neighborhoods and a shift of jobs to suburban areas. The CRA addressed this problem by requiring the banking regulators to encourage the institutions to help meet the credit needs of the communities in which they are chartered to do business. The hope was that by encouraging depository institutions to look for profitable lending opportunities in their local communities, the CRA would be helpful in revitalizing inner-cities at a time when investment was moving to distant money centers or to more affluent and outlying communities.

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 high-risk lending, instead the safety and soundness was to remain the overriding factor in loan decisions.

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.

According to the efficient markets view, as long as mortgage credit is extended in a competitive manner the market is best suited to determine which lenders and how many are needed to serve the borrowers. A good source of information on the EMH is Shiller (2002) and the references therein.

In the efficient markets view, depository institutions have private incentive to seek all profitable lending opportunities; therefore CRA should have little effect on lending because depository institutions already perform the tasks that the CRA intends to encourage them to do. However, if the CRA forces lenders to make unprofitable loans, then the efficient markets view would regard the CRA as a burden on the banking system. For instance, the CRA may impose substantial compliance costs, such as the costs of training staff to become familiar with the requirements of the CRA and the costs of maintaining records of actions taken to comply with the regulation to be shown to regulators. …

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