Does CRA Undermine Bank Safety?

Posted by Mark A. Calabria

A recent policy forum here at Cato discussed the role of the Community Reinvestment Act (CRA) in the financial crisis.  While the forum focused on the federal push for ever expanding homeownership to marginal borrowers, the analysis did not touch directly upon the question of whether CRA lending undermines bank safety.

Fortunately this is a question that one economist at the Federal Reserve Bank of Dallas bothered to ask.  While his research findings were available before the crisis, they were clearly ignored.

In a peer-reviewed published article, appearing in the journal Economic Inquiry, economist Jeff Gunther concludes that there is “evidence to suggest that a greater focus on lending in low-income neighborhoods helps CRA ratings but comes at the expense of safety and soundness.”  Specifically he finds an inverse relationship between CRA ratings and safety/soundness, as measured by CAMEL ratings.

In another study Gunther finds that increases in bank capital are associated with an increase substandard CRA ratings.  Apparently bank CRA examiners prefer that capital to be lend out, rather than serve as a cushion in times of financial distress.

Given the current attempts in Washington to expand CRA, it seems some people never learn.  One can always argue over how CRA should work, but the evidence is quite clear how it has worked, once again proving: there’s no free lunch.