CRA Background and Objectives
Congress passed the Community Reinvestment Act of 1977 (CRA; P.L. 95-128, 12 U.S.C. §§2901-2908) in response to concerns that federally insured banking institutions were not making sufficient credit available in the local areas in which they were chartered and acquiring deposits. According to some in Congress, the granting of a public bank charter should translate into a continuing obligation for that bank to serve the credit needs of the public where it was chartered.1 Consequently, the CRA was enacted to "re-affirm the obligation of federally chartered or insured financial institutions to serve the convenience and needs of their service areas" and "to help meet the credit needs of the localities in which they are chartered, consistent with the prudent operation of the institution." The CRA requires federal banking regulators to conduct examinations to regularly assess the records of banks in terms of meeting local credit needs and requires those records to be taken into account when institutions apply for charters, branches, mergers, acquisitions, and other applications that require regulatory approval.
Congress became concerned with the geographical mismatch of deposit-taking and lending activities for a variety of reasons.2 Deposits serve as a primary source of borrowed funds that banks may use to facilitate their lending. Hence, there was concern that deposits collected from local neighborhoods were being used to fund out-of-state as well as various international lending activities at the expense of addressing the local area's housing, agricultural, and small business credit needs.3 Another motivation for congressional action was to discourage redlining practices. One type of redlining can be defined as the refusal of a bank to make credit available to all of the neighborhoods in its immediate locality, including certain low- and moderate-income (LMI) neighborhoods where deposits may have been collected. A second type of redlining is the practice of denying a creditworthy applicant a loan for housing located in a certain neighborhood even though the applicant may qualify for a similar loan in another neighborhood. This type of redlining pertains to circumstances in which a bank refuses to serve all of the residents in an area, perhaps for reasons that may involve discrimination.4
The CRA applies to banking institutions with deposits insured by the Federal Deposit Insurance Corporation (FDIC), such as national banks, savings associations, and state-chartered commercial and savings banks.5 The CRA does not apply to credit unions, insurance companies, securities companies, and other nonbank institutions given the differences in their financial business models.6 The Office of the Comptroller of the Currency (OCC), the Federal Reserve System, and the FDIC administer the CRA, which is implemented via Regulation BB.7 The CRA requires federal banking regulatory agencies to evaluate the extent to which regulated institutions are effectively meeting the credit needs within their designated assessment areas (where institutions have local deposit-taking operations), including LMI neighborhoods, in a manner consistent with the federal prudential regulations for safety and soundness.8
The CRA's impact on lending activity has been publicly debated. Some observers are concerned that the CRA may induce banks to forgo more profitable lending opportunities in nontargeted neighborhoods by encouraging a disproportionate amount of lending in LMI communities.9 Furthermore, some argue that CRA compels banks to make loans to higher-risk borrowers that are more likely to have repayment problems, which may subsequently compromise the financial stability of the banking system.10 For example, some researchers have attributed the increase in risky lending prior to the 2007-2009 recession to banks attempting to comply with CRA objectives.11 Others are concerned that enforcement of CRA objectives has not been stringent enough to compel banks to increase financial services in LMI areas.12 Almost all banks receive Satisfactory or better performance ratings (discussed in more detail below) on their CRA examinations, which some may consider indicative of weak enforcement.
This report informs the congressional debate concerning the CRA's effectiveness in incentivizing bank lending and investment activity to LMI customers. It describes the three tests (i.e., lending, investment, and service) that collectively make up the CRA examination, as well as how bank CRA ratings are calculated. Next, it presents the difficulty of attributing bank lending decisions to CRA incentives. For example, it identifies subjectivity issues associated with CRA compliance costs and examination standards that vary by banking institution. Banks are unlikely to get credit for all the loans they make to LMI customers. Specifically, most higher-risk subprime and payday loans are not eligible for CRA consideration and, therefore, cannot be attributed to CRA incentives. In addition, greater mobility of lending and deposit-taking activity across regional boundaries due to the growth of nationwide banking and nonbank competitors in the financial markets has complicated the ability to geographically link various financial activities.13 Hence, it is possible that many bank investment activities occurring in a designated assessment area that are eligible for CRA consideration may simply be profitable, meaning they may have occurred without the CRA. In short, attributing the composition of bank loan portfolios to either too strong or too weak enforcement of the CRA is difficult.
CRA Examinations and Qualifying Activities
The CRA does not impose lending quotas or benchmarks. Instead, banks have a wide variety of options to serve the needs of assessment areas. These include mortgage, consumer, and business lending; community investments; and low-cost services that would benefit LMI areas and entities.14 For example, banks may receive CRA credits for such activities as
- investing in special purpose community development entities (CDEs), which facilitate capital investments in LMI communities (discussed below);
- providing support (e.g., consulting, detailing an employee, processing transactions for free or at a discounted rate, and providing office facilities) to minority- and women-owned financial institutions and low-income credit unions (MWLIs), thereby enhancing their ability to serve LMI customers;
- serving as a joint lender for a loan originated by MWLIs;15
- facilitating financial literacy education to LMI communities, including any support of efforts of MWLIs and CDEs to provide financial literacy education;
- opening or maintaining bank branches and other transactions facilities in LMI communities and designated disaster areas;
- providing low-cost education loans to low-income borrowers;16 and
- offering international remittance services in LMI communities.17
The examples listed above are not comprehensive, but they illustrate several ways banks may obtain consideration for CRA credits.18 CRA credits or points, which are awarded if the eligible activities occur within an assigned assessment area, are then used to compute a bank's overall composite CRA rating, discussed in more detail below.
The CRA Examination
Regulators apply up to three tests, which are known as the lending, investment, and service tests, respectively. The lending test evaluates the number, amount, and distribution across income and geographic classifications of mortgage, small business, small farm, and consumer loans. The investment test grades community development investments in the assessment area. The service test examines retail service delivery, such as the availability of branches and low-cost checking in the assessment area. The point system for bank performance under the lending, investment, and service tests is illustrated in Table 1.19 The lending test is generally regarded as the most important of the three tests, awarding banks the most points (CRA credits) in all rating categories.
Table 1. Points Assigned for CRA Performance Under the Individual Lending, Investment, and Service Tests
|
Rating |
Lending |
Investment |
Service |
|
Outstanding |
12 |
6 |
6 |
|
High Satisfactory |
9 |
4 |
4 |
|
Low Satisfactory |
6 |
3 |
3 |
|
Needs to Improve |
3 |
1 |
1 |
|
Substantial Noncompliance |
0 |
0 |
0 |
Source: Federal Financial Institutions Examination Council.
Federal banking regulators evaluate financial institutions based upon their capacity, constraints, and business strategies; demographic and economic data; lending, investment, and service opportunities; and benchmark against competitors and peers. Given that all of these factors vary across banks, the CRA examination was customized in 1995 to account for differences in bank sizes and business models.20 In 2005, the bank size definitions were revised to include "small," "intermediate small," and "large" banks. The asset size thresholds were also indexed to inflation using the Consumer Price Index. Effective January 1, 2016, a "small bank" is defined as having less than $1.216 billion in assets as of December 31 of either of the prior two calendar years; an "intermediate small bank" has at least $304 million as of December 31 of both of the prior two calendar years but less than $1.216 billion as of December 31 of either of the prior two calendar years.21 Consequently, a "large bank" would have $1.216 billion or more in assets.
Small banks are evaluated only under the lending test. Regulators review (1) loan-to-deposit ratios; (2) percentage of loans in an assessment area; (3) lending to borrowers of different incomes and in different amounts; (4) geographical distribution of loans; and (5) actions on complaints about performance. Intermediate small banks are subject to both the lending and investment tests. Large banks are subject to all three tests.
As shown in Table 1, banks receive fewer credits for making CRA-qualified investments than for providing direct loans to individuals under the lending test. CRA-eligible investments may not be simultaneously considered for both the lending and service tests.22 For example, a bank may receive CRA consideration under the lending test for making a loan to LMI individuals that is guaranteed by a federal agency, such as the Federal Home Administration (FHA).23 If, however, a bank purchases securities backed by pools of FHA-guaranteed mortgage originations, this activity receives credit under the investment test. Thus, the bank receives less CRA credit than it would for making a direct loan even though it would still be facilitating lending to LMI borrowers.
The CRA was revised in 1989 to require descriptive CRA composite performance ratings that must be disclosed to the public.24 The composite ratings illustrated in Table 2 are tabulated using the points assigned from the individual tests (shown in Table 1 above). The CRA ratings also appearing in Table 2 are assigned based upon the composite ratings. Grades of Outstanding and Satisfactory are acceptable; Satisfactory ratings in both community development and retail lending are necessary for a composite Satisfactory.25 Large banks must receive a sufficient amount of points from the investment and service tests to receive a composite Outstanding rating.
|
CRA Composite Rating |
Total Point Requirements (for Large Banks) |
|
Outstanding |
20 or more |
|
Satisfactory |
11-19 |
|
Needs to Improve |
5-10 |
|
Substantial Noncompliance |
0-4 |
Source: Federal Financial Institutions Examinations Council.
Regulators include CRA ratings as a factor when lenders request permission to engage in certain activities, such as moving offices or buying another institution. Denying requests, particularly applications for mergers and acquisitions, is a mechanism that may be applied against banking organizations with ratings below Satisfactory. Applicants with poor ratings may resubmit their applications after making the necessary improvements. In 2005, the banking regulators ruled that any evidence of discrimination or credit practices that violate an applicable law, rule, or regulation by any affiliate would adversely affect an agency's evaluation of a bank's CRA performance.26 Covered institutions must post a CRA notice in their main offices and make publicly available a record of their composite CRA performance.27
Community Investments Eligible for CRA Consideration
As mentioned previously, direct lending to borrowers, taking place in what is referred to as primary lending markets, is eligible for CRA credit under the lending test. Alternatively, investments taking place in secondary lending markets, in which investors purchase loans that have already been originated (such that little or no direct interaction occurs between investors and borrowers), are eligible for CRA credit under the investment test. Secondary market investors may assume the default risks of borrowers after purchasing their loans. Alternatively, they can form pools consisting of numerous loans and then issue financial securities to a multitude of investors, thereby sharing the risks. Originating loans directly to borrowers or purchasing debt securities, therefore, are simply alternative methods to facilitate lending.28
The activities that are eligible for CRA credit have been expanded to encourage banks to make public welfare investments. More specifically, eligible activities include
- a public welfare investment (PWI) that promotes the public welfare by providing housing, services, or jobs that primarily benefit LMI individuals;29 and
- a community development investment (CDI), economic development investment, or project that meets the PWI requirements.30 Examples of CDI activities include promoting affordable housing, financing small businesses and farms, and conducting activities that revitalize LMI areas.
The PWI authority allows banks to engage in activities that typically would not be permitted as long as these activities promote the public welfare and do not expose institutions to unlimited liability.31 For example, banks are not allowed to make direct purchases of the preferred or common equity shares of other banking firms. They may, however, purchase equity shares of institutions with a primary mission of community development (discussed in more detail in the Appendix) up to the allowable CDI limit. The Financial Services Regulatory Relief Act of 2006 (P.L. 109-351) increased the CDI limits of national banking associations and state banks (that are members of the Federal Reserve System) from 10% to 15% of a bank's unimpaired capital and unimpaired surplus for investments made to a single institution.32
CDIs that benefit a bank's designated assessment area are eligible to receive consideration for CRA credit. Thus, the revised PWI and CDI definitions made more banking activities eligible for CRA credits. For CRA purposes, the definition of CDI was expanded in 2005 to include "underserved and distressed" rural areas33 and "designated disaster areas" 34 to aid the regional rebuilding from severe hurricanes, flooding, earthquakes, tornados, and other disasters.35 The disaster area provision allows banks anywhere in America to receive consideration for CRA credit if they facilitate making credit available to a distressed location or geographic area outside of their own assessment areas.
CDI loans that banks made directly in their assessment areas would receive full CRA consideration under the lending test, but credits awarded under the investment test may be prorated when institutions provide indirect funding. For example, a bank would not receive CRA credits for investing in an entity that decides not to provide credit in LMI communities within the bank's assessment area. Regulators, therefore, prorate CRA credits for indirect investments to ensure they were applied to low-income community developments.36 The Appendix provides examples of CDI activities that would qualify for CRA consideration under the investment test. Any awarded CRA credits could be prorated given that investing banks typically would have less control over when and where the funds are loaned.
Difficulties Determining CRA Effectiveness
Given that the CRA is not a federal assistance program and that several regulators implement it separately, no single federal agency is responsible for evaluating its overall effectiveness. In 2000, Congress directed the Federal Reserve to study the CRA's effectiveness.37 The Federal Reserve's study reported that lending to LMI families had increased since the CRA's enactment but found that it was not possible to directly attribute all of that increase to the CRA. For example, advancements in underwriting over the last several decades have enabled lenders to better predict and price borrower default risk, thus making credit available to borrowers that might have been rejected prior to such technological advances.38 Some academic studies report similar findings.39 Although lending to LMI borrowers by CRA-covered institutions has increased during the act's existence, other financial developments make it difficult to attribute this outcome solely to the CRA.40 This section examines the difficulty of linking lending outcomes directly to the CRA.
Subjectivity Issues
CRA examinations have an element of subjectivity in terms of both the quality and quantity of CRA compliance. Regulators determine the "innovativeness or complexity of qualified investments" as well as whether the bank has undertaken a sufficient amount of CRA activities to be in compliance. Generally speaking, the number of points some CRA-eligible investments receive relative to others is up to the regulator's judgment given that no formal definition of "innovativeness" or "complexity" has been established (although regulators provide a variety of examples as guidelines for banks to follow).41 In addition, there is no official quota indicating when banks have done enough CRA-qualified activities to receive a particular rating. Without specific definitions of the criteria or quotas, CRA examination performance may be considered subjective.
Almost all banks pass their CRA examinations. Figure 1 shows the average annual composite scores of banks that received CRA examinations as well as the annual number of bank examinations by size. In 2015, for example, there were 981 CRA examinations—584 for small banks, 269 for intermediate small banks, and 109 for large banks.42 Generally, most banks receive a composite Satisfactory or better rating regardless of the number of banks examined in a year. For all years, approximately 97% or more of banks examined received ratings of Satisfactory or Outstanding. It is difficult to know whether the consistently high ratings reflect the CRA's influence on bank behavior or if the CRA examination procedures need improvement.
|
Figure 1. Summary of Annual CRA Examinations: Number of Banks Examined and Average Composite Ratings 2006-2015 |
|
Source: Data provided by the Federal Financial Institutions Examination Council CRA Rating Search, at http://www.ffiec.gov/craratings/default.aspx. |
Determining the costs associated with CRA compliance is also arguably subjective. For example, the CRA has been described by some bankers as burdensome, particularly in terms of the amount of documentation and paperwork required to demonstrate CRA eligibility. The law, P.L. 95-128, requires documentation and generates costs associated with reporting CRA-qualifying activities.43 The collecting and processing of statistics constitutes most of the burden, which arguably weighs disproportionately on community banks with smaller staffs.44 These costs, however, would still be incurred given that these institutions must comply with other regulatory mandates, such as the Home Mortgage Disclosure, Equal Credit Opportunity, and Fair Housing Acts. The 2005 rules simplified the CRA compliance requirements for smaller banks. The Financial Services Regulatory Relief Act of 2006 also reduced the frequency of on-site CRA examinations for smaller banking institutions.45
Do Higher-Risk Loans Receive CRA Consideration?
As previously stated, innovations, such as the adoption of automatic underwriting, which allows lenders to better identify riskier borrowers, have contributed to making more credit available to more people since passage of the CRA. Borrowers with weaker credit histories can be charged higher interest rates and fees than those with better credit histories to compensate lenders for taking on greater amounts of credit or default risk.46 Nontraditional (e.g., interest-only, initially low interest rates) loan products allow borrowers to obtain lower regular payments during the early stages of the loan, perhaps under the expectation that their financial circumstances may improve in the later stages as payments adjust to reflect the true costs. The ability to charge higher prices or offer such nontraditional loan products may result in greater higher-risk lending.
Meanwhile, federal banking regulators appear less willing to award banks CRA credit for originating most higher-risk loans, most likely because of the difficulty in determining whether the higher-risk loan was made for CRA purposes or resulted from discriminatory or predatory lending practices.47 For example, the actual costs of a loan may have been hidden or simply not transparent to borrowers when they entered into the lending transaction.48 It is difficult for regulators to monitor how well borrowers understood the disclosures regarding loan costs and features or whether any discriminatory or predatory behavior occurred at the time of loan origination.49 Regulators would not want to award CRA credits and later discover evidence of improper consumer disclosure or discrimination practices. In addition, regulators that focus primarily on the safety and soundness of the banking system are unlikely to support lending practices that could result in large concentrations of high-risk loans on bank balance sheets.50 Consequently, banks are unlikely to receive CRA consideration for higher-risk lending, particularly if regulators explicitly discourage certain practices (discussed below), arguably weakening the linkage between higher-risk lending and the CRA.
Subprime Mortgages and the Qualified Mortgage Rule
Although no consensus definition has emerged for subprime lending, this practice may generally be described as lending to borrowers with weak credit at higher costs relative to borrowers of higher credit quality.51 In September 2006, the banking regulatory agencies issued guidance on subprime lending that was restrictive in tone.52 The guidance warned banks of the risk posed by nontraditional mortgage loans, including interest-only and payment-option adjustable-rate mortgages. The agencies expressed concern about these loans because of the lack of principal amortization and the potential for negative amortization. Consequently, a study of 2006 Home Mortgage Disclosure Act data reported that banks subject to the CRA and their affiliates originated or purchased only 6% of the reported high-cost loans made to lower-income borrowers within their CRA assessment areas.53 Banks, therefore, received little or no CRA credit for subprime mortgage lending. Instead, federal regulators offered CRA consideration to banks that helped mitigate the effects of distressed subprime mortgages.54 On April 17, 2007, federal regulators provided examples of various arrangements that financial firms could provide to LMI borrowers to help them transition into affordable mortgages and avoid foreclosure. The various workout arrangements were eligible for favorable CRA consideration.55
Banks are unlikely to receive CRA consideration for originating subprime mortgages going forward. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act; P.L. 111-203) requires lenders to consider consumers' ability to repay before extending them mortgage credit, and one way for lenders to comply is to originate qualified mortgages (QMs) that satisfy various underwriting and product-feature requirements.56 For example, QMs may not have any negative amortization features, interest-only payments, or points and fees that exceed specified caps of the total loan amount; in most cases, borrowers' debt-to-income ratios shall not exceed 43%. QM originations will give lenders legal protections if the required income verification and other proper underwriting procedures were followed. Given the legal protections afforded to QMs, some banks might show greater reluctance toward making non-QM loans. With this in mind, the federal banking regulators announced that banks choosing to make only or predominately QM loans should not expect to see an adverse effect on their CRA evaluations; however, the regulators did not indicate that CRA consideration would be given for non-QMs.57 Arguably, the federal banking regulators appear less inclined to use the CRA to encourage lending that could be subject to greater legal risks.
Payday Lending
The willingness of banks to provide financial services in LMI communities suggests the existence of profit opportunities. For example, banks have demonstrated interest in providing financial services, such as payday loans (small dollar cash advances) in the form of products, such as subprime credit cards, overdraft protection services, and direct deposit advances. Legislation, such as the Credit Card Accountability Responsibility and Disclosure Act of 2009 (P.L. 111-24, which restricts subprime credit card lending), federal banking regulators, and the Consumer Financial Protection Bureau (CFPB), however, discourage banks from engaging in payday lending.58 Payday and similar loans have been criticized for their often triple-digit annual percentage rates and the frequency with which cash-constrained borrowers roll over or take out successive loans rather than repay the original principal amount in full when due.59 When regulations require "cooling off" periods between successive loans, banks arguably must offer financial products that payday borrowers are unlikely to find useful.60
In response, the FDIC conducted a small-dollar loan pilot program from February 2008 to December 2009 in which 28 banking firms voluntarily participated.61 The FDIC provided a template for small-dollar banking products designed to compete with more traditional payday loan products. Under these guidelines, all fees and interest associated with these loans must total less than 36% per year. In addition, the template required mandatory savings and financial education. Banks were also instructed to monitor excessive consumer usage of overdrafts (which are equivalent to rollovers). The FDIC reported that small-dollar loans were a useful business strategy for banks because they facilitated banks' ability to build or retain profitable, long-term relationships with their customers and obtain favorable CRA consideration.62 The profitability of this lending was contingent upon the ability of banks to generate higher transaction volumes, cover the underwriting and servicing costs, and cross-sell additional financial products to the borrowers.63 Nevertheless, higher-priced loan products with features similar to the template loan introduced in this pilot program could possibly receive CRA credit.
Competitive Advantages for Nonbank Lenders
Generally speaking, regulatory guidance that discourages banks from making higher-risk loans may result in customers migrating to nonbank financial service providers (including payday lenders), thus weakening the effectiveness of the CRA. During the 1980s and 1990s, LMI communities experienced an increase in the supply of (subprime) mortgage products by nonbanking institutions not covered by the CRA as well as an increase in the use of alternative financial service providers, such as check cashers and payday lenders.64 Furthermore, some banks saw declines in deposits during the 1997-2007 period.65 Shrinking customer deposit bases make it more difficult to meet CRA objectives (i.e., geographically match deposit-taking with lending activity), particularly for small and intermediate small community banks that are only evaluated under the direct lending component of the CRA test. Larger banks, which are subject to the CRA service test and thus get consideration for providing transaction services in LMI communities, also face challenges when they lose the short-term cash advance market segment to nonbanks and payday lenders.66 Hence, limitations on bank product offerings for consumer protection purposes may encourage migration to financial service providers not covered by the CRA, possibly one of many factors contributing to the growth of the shadow-banking sector.67
Concurrent Investment Incentives
As discussed earlier, activities that receive consideration under the investment test are awarded fewer CRA credits relative to the lending test. Despite the lower CRA incentive, banks make sizeable CRA-qualified investments because these activities are expected to be profitable. Consequently, it is difficult to determine whether banks are motivated to make these investments because of CRA incentives, profit incentives, or both.
During recessions, banks tend to reduce direct (or primary market) lending and increase their holdings of securities because both the demand and the supply of direct loan originations often decline during economic slowdowns and early recovery periods.68 Following the 2007-2009 recession, U.S. interest rates dropped to historically low levels for an abnormally long period of time. The household and business sectors reduced their demand for credit, and borrowing activity declined substantially.69 Low-yielding interest rate environments squeeze banking profits and encourage banks to search for higher-yielding lending opportunities, which might be found in the secondary markets and possibly even be eligible for CRA consideration. For example, banks receive CRA consideration under the investment test when purchasing state and local municipal bonds that fund public and community development projects in their designated assessment areas. Even if they do not receive CRA consideration, banks may still have an incentive to purchase municipal bonds given the current interest rate environment as well as the lower risk-weighting treatment relative to other asset holdings.70
Figure 2 presents the yields and rates of growth of portfolio holdings for mortgage loans and municipal bonds between 2000 and 2014. Mortgage yields have been steadily declining from more than 8% in 2000 to less than 4% in 2011, and yields have been slightly above 4% over the previous year. Mortgage yields are currently similar to those for municipal bonds. Although the growth rate of the residential mortgage loan share in bank portfolios was generally positive until about 2006, it has since been negative. Meanwhile, the growth rate of the share of bank municipal bond holdings has generally been rising since 2006.71 Given that capital requirements for holding municipal bonds are lower and fewer borrowers may qualify for mortgages, a positive growth rate of bank investments in municipal securities appears to occur simultaneously with a negative growth rate in mortgage investments holdings. The rising share of municipal bond holdings, however, may be more related to normal profit incentives than to CRA-related incentives, and benefits to designated assessment areas may be coincidental.
Bank investments in Small Business Investment Corporations (SBICs, defined in the Appendix) may also serve as an example of concurrent incentives. Banks typically provide senior debt rather than subordinate debt to businesses in need of financing. Senior lenders have first claims to the assets of the business in case of failure. Subordinate financiers tend to provide funds in the form of mezzanine capital or equity; they require a higher return given that they agree to take on more risk in the event of a failure.72 In a low-interest-rate environment, banks may have a greater incentive to provide higher-yielding, higher-risk mezzanine investment financing to a SBIC than to rely almost exclusively on lower-yielding senior financing.73 An increase in SBIC financing activities, as with any bank investment portfolio shifts, may reflect responses to normal profit incentives rather than to CRA-related incentives.
Finally, because lenders' CRA status is a factor in merger approvals, banks interested in mergers may be encouraged to engage in CRA-eligible activities.74 In recent years, the pace of bank mergers has slowed for several reasons. For example, the banking system is still accumulating sufficient capital reserves to cover current loan delinquencies.75 These higher capital requirements stem from implementation of the Basel III Capital Accords and the passage of the Dodd-Frank Act, and additional regulatory requirements increase with bank size.76 However, there may be incentives to merge if cost advantages associated with larger scales of operation exist. Rising merger activity among small and medium sized banks reflects an industry consolidation trend over the past several decades in which banking assets have increased even as the number of banking institutions has declined. Small banks lack benefits associated with economies of scale (volume of transactions) and economies of scope (array of financial services). Given fewer sources of revenue, smaller banks may be more vulnerable to revenue interruptions stemming from economic downturns or increasing compliance costs. Some banking firms hoping to capitalize on strategic merger opportunities that could potentially lower their operating costs and increase market share may consider CRA credits valuable. Consequently, the CRA's influence varies by bank size and current business strategies.
CRA Investment Options
Community development investments (CDIs) that meet public welfare investment (PWI) requirements are those that promote the public welfare, primarily resulting in economic benefits for low- and moderate-income (LMI) individuals. This appendix provides examples of CDI activities that would qualify for consideration under the CRA investment test. In many cases, covered banks are more likely to take advantage of these optional vehicles to obtain CRA credits if they perceive the underlying investment opportunities to have profit potential.
Loan Participations
Banks and credit unions often use participation (syndicated) loans to jointly provide credit. When a financial firm (e.g., bank, credit union) originates a loan for a customer, it may decide to structure loan participation arrangements with other institutions.77 The loan originator often retains a larger portion of the loan and sells smaller portions to other financial institutions willing to participate. Suppose a financial firm originates a business or mortgage loan in a LMI neighborhood. A bank may receive CRA investment credit consideration by purchasing a participation, thus becoming a joint lender to the LMI borrower. An advantage of loan participations is that the default risk is divided and shared among the participating banks (as opposed to one financial firm retaining all of the risk). CRA consideration is possible if the activity occurs within the designated assessment area. For all participating banks to receive credit, some overlap in their designated assessment areas must exist. An exception is made for participations made to benefit designated disaster areas, in which all participating banks would receive CRA consideration regardless of location.
State and Local Government Bonds
State and local governments issue municipal bonds, and the proceeds are used to fund public projects, community development activities, and other qualifying activities.78 The interest that nonbank municipal bondholders receive is exempt from federal income taxes to encourage investment in hospitals, schools, infrastructure, and community development projects that require state and local funding. Legislative actions during the 1980s eliminated the tax-exempt status of interest earned from holdings of municipal bonds for banks.79 Although banks no longer have a tax incentive to purchase municipal bonds, they still consider the profitability of holding these loans, as they do with all lending opportunities. Furthermore, banks receive CRA investment consideration when purchasing state and local municipal bonds that fund public and community development projects in their designated assessment areas.
CRA-Targeted Secondary Market Instruments
Secondary market financial products have been developed to facilitate the ability of banks to participate in lending activities eligible for CRA consideration, such as purchasing mortgage-backed securities (MBSs) or shares of real estate investment trusts (REITs). A MBS is a pool of mortgage loans secured by residential properties; a multifamily MBS is a pool of mortgage loans secured by multifamily properties, consisting of structures designed for five or more residential units, such as apartment buildings, hospitals, nursing homes, and manufactured homes. CRA-MBSs are MBSs consisting of loans that originated in specific geographic assessment areas, thereby allowing bank purchases into these pools to be eligible for CRA consideration under the investment test.80 Similarly, REITs may also pool mortgages, mortgage MBSs, and real estate investments (e.g., real property, apartments, office buildings, shopping malls, hotels). Investors purchase shares in REIT pools and defer the taxes.81 Banks may only invest in mortgage REITs and MBS REITs. Similar to the CRA-MBSs, the REITs must consist of mortgages and MBSs that would be eligible for CRA consideration. The Community Development Trust REIT is an example of a REIT that serves as a CRA-qualified investment for banks.82
Community Development Financial Institutions and Equity Equivalent Investments
The Community Development Financial Institutions (CDFI) Fund was created by the Riegle Community Development Regulatory Improvement Act of 1994 (the Riegle Act; P.L. 103-325).83 The CDFI Fund was established to promote economic development for distressed urban and rural communities. The CDFI Fund, currently located within the U.S. Department of the Treasury, is authorized to certify banks, credit unions, nonprofit loan funds, and (for-profit and nonprofit) venture capital funds as designated CDFIs.84 In other words, a bank may satisfy the requirements to become a CDFI, but not all CDFIs are banks. The primary focus of institutions with CDFI certification is to serve the financial needs of economically distressed people and places. The designation also makes these institutions eligible to receive financial awards and other assistance from the CDFI Fund.85
In contrast to non-CDFI banks, some CDFI banks have greater difficulty borrowing funds and then transforming them into loans for riskier, economically distressed consumers.86 The lack of loan level data for most CDFI banks causes creditors to hesitate in making low-cost, short-term loans to these institutions. Specifically, the lack of information on loan defaults and prepayment rates on CDFI banking assets is likely to result in limited ability to sell these loan originations to secondary loan markets. Consequently, the retention of higher-risk loans, combined with limited access to low-cost, short-term funding, makes CDFI banks more vulnerable to liquidity shortages.87 Hence, CDFIs rely primarily on funding their loans (assets) with net assets, which are proceeds analogous to the equity of a traditional bank or net worth of a credit union. CDFI net assets are often acquired in the form of awards or grants from the CDFI Fund or for-profit banks. Funding assets with net assets is less expensive for CDFIs than funding with longer-term borrowings.
Banks may obtain CRA investment credit consideration by making investments to CDFIs, which provides CDFIs with net assets (equity). Under PWI authority, banks are allowed to make equity investments in specialized financial institutions, such as CDFIs, as long as they are considered by their safety and soundness regulator to be at least adequately capitalized.88 Furthermore, the final Basel III notification of proposed regulation (NPR)89 allows for preferential capital treatment for equity investments made under PWI authority, meaning equity investments to designated CDFIs may receive more favorable capital treatment.90 Consequently, banks often provide funds to CDFIs through equity equivalent investments (EQ2s), which are debt instruments issued by CDFIs with a continuous rolling (indeterminate) maturity. EQ2s, from a bank's perspective, are analogous to holding convertible preferred stock with a regularly scheduled repayment.91 Hence, banks may view EQ2s as a potentially profitable opportunity to invest in other specialized financial institutions and receive CRA consideration, particularly when the funds are subsequently used by CDFIs to originate loans in the banks' assessment areas.92
Small Business Investment Companies
The Small Business Administration (SBA) was established in 1953 by the Small Business Act of 1953 (P.L. 83-163) to support small businesses' access to capital in a variety of ways.93 Although issuing loan guarantees for small businesses is a significant component of its operations, the SBA also has the authority to facilitate the equity financing of small business ventures through its Small Business Investment Company (SBIC) program, which was established by the Small Business Investment Act of 1958 (P.L. 85-699).94 SBICs that are licensed and regulated by the SBA may provide debt and equity financing and, although not a program requirement, educational (management consulting) resources for businesses that meet certain SBA size requirements.95
Banks may act as limited partners if they choose to provide funds to SBICs, which act as general partners.96 Banks may establish their own SBICs, jointly establish SBICs (with other banks), or provide funds to existing SBICs. SBICs subsequently use bank funding to invest in the long-term debt and equity securities of small, independent (SBA-eligible) businesses, and banks may receive CRA investment consideration if the activities benefit their assessment areas.97 Community banks invest in SBICs because of the profit potential as well as the opportunity to establish long-term relationships with business clients during their infancy stages. Banks that are considered by their regulators to be adequately capitalized are allowed to invest in these specialized financial institutions under PWI authority, but the investments still receive risk-based capital treatment.98 SBIC assets, similar to CDFIs, are illiquid given the difficulty to obtain credit ratings for SBIC investments; thus, they cannot be sold in secondary markets.99 Because banks risk losing the principal of their equity investments, they are required to perform the proper due diligence associated with prudent underwriting.100
Tax Credits
The low-income housing tax credit (LIHTC) program was created by the Tax Reform Act of 1986 (P.L. 99-514) to encourage the development and rehabilitation of affordable rental housing.101 Generally speaking, government (federal or state) issued tax credits may be bought and, in many cases, sold like any other financial asset (e.g., stocks and bonds). Owners of tax credits may reduce their tax liabilities either by the amount of the credits or by using the formulas specified on those credits, assuming the owners have participated in the specified activities that the government wants to encourage. For LIHTCs, banks may use a formula to reduce their federal tax liabilities when they provide either credit or equity contributions (grants) for the construction and rehabilitation of affordable housing. If a bank also owns a LIHTC, then a percentage of the equity grant may be tax deductible if the CDFI uses the funds from the grant to finance affordable rental housing. Furthermore, banks may receive consideration for CRA-qualified investment credits.
After a domestic corporation or partnership receives designation as a Community Development Entity (CDE) from the CFDI Fund, it may apply for New Markets Tax Credits (NMTCs). Encouraging capital investments in LMI communities is the primary mission of CDEs, and CDFIs and SBICs automatically qualify as CDEs.102 Only CDEs are eligible to compete for NMTCs, which are allocated by the CDFI Fund via a competitive process. Once awarded an allocation of NMTCs, the CDE must obtain equity investments in exchange for the credits. Then, the equity proceeds raised must either be used to provide loans or technical assistance or deployed in eligible community investment activities. Only for-profit CDEs, however, may provide NMTCs to their investors in exchange for equity investments.103 Investors making for-profit CDE equity investments can use the NMTCs to reduce their tax liabilities by a certain amount over a period of years. As previously discussed, a bank may receive CRA credit for making equity investments in nonprofit CDEs and for-profit subsidiaries, particularly if the investment occurs within the bank's assessment area. Furthermore, banks may be able to reduce their tax liabilities if they can obtain NMTCs from the CDEs in which their investments were made.