Headquartered in Chicago, First Colonial Bankshares Corp., with $1.6 billion of assets, was about to acquire two small suburban Chicago banks - Hi-Bancorp, with $87 million of assets, and GNP Bancorp, with $75 million of assets.

The deal was signed and the blessings were counted. But on May 19 the Federal Reserve Board, in a 7-to-0 vote, rejected First Colonial's application.

It was only the fourth merger to be denied under the Bank Holding Company Act because of failure to comply with the Community Reinvestment Act.

The board's denial was based upon the CRA performance rating of Avenue Bank of Oak Park, one of 16 banks owned by First Colonial.

Though the other 15 banks have CRA ratings of "satisfactory" or better, Avenue Bank, with 10% of the holding company's assets, holds a "needs to improve" rating, the third-lowest of four ratings, and has received it in the last two exams.

"Needs to improve" does not sound so bad to you and to me, but in Fedspeak it means a bank is in the penalty box.

The implication is that the offender will not get released from the penalty box until it can demonstrate improved performance. Usually, that can only be demonstrated by a new examination, and CRA examiners stop by only once a year.

Odd Pattern

We find it extremely curious that since the enactment of the CRA in 1977, only four merger applications have been denied on CRA grounds. Curiously, three out of the four have place in the Chicago Federal Reserve district. We can think of five possible reasons:.

CRA problems are more common in this district.

* Its bankers are so egomaniacal that they will not withdraw their applications.

* The district is more passionate about the CRA.

* There has been a change in the implementation of government policy with the Clinton administration. (This applies only to the latest rejection.)

* It is merely a coincidence.

Uneven Treatment

But not all mergers with CRA infractions are treated equally.

Banc One Corp. of Columbus, Ohio applied to acquire Valley National Corp., Phoenix.

The Fed received approximately 30 comments opposing the bank's merger proposal and criticizing Banc One's efforts to meet the credit needs of its community. Despite these numerous objections, on March 1, Banc One received approval of its merger application.

The Fed noted that Banc One's most recent CRA ratings indicated 19 "outstanding" and 41 "satisfactory" ratings [at its subsidiaries]. However, the Office of the Comptroller of the Currency had recently concluded a CRA exam of Banc One Cleveland with an indication of "needs to improve."

On this point, the Fed answered that Banc One Cleveland constituted only a small part of the overall Banc One organization! Banc One Cleveland, with $2.2 billion of assets, is substantially bigger than all of First Colonial's $1.6 billion of assets.

Sending a Message

In our opinion, the government used the rejection to send a message that there is a change in policy. Taking no chances on the banks' misreading the tea leaves, on May 27, the regulators sent letters to every bank and thrift in the country warning that enforcement of minority lending laws will be stepped up. The letter is signed by the leaders of Federal Reserve Board, the FDIC, the Office of Thrift Supervision, and the OCC.

The regulators, in our opinion, blindsided First Colonial with the May 19th denial in order to dramatically set the stage for their own letter.

Common sense favors this theory, since the odds of four government agencies agreeing on anything in just eight days are astronomical.

Down the Road

What is the likely impact on financial institutions? We foresee a burden on both CRA abusers and nonoffenders as well. Clearly, from a mergers-and-acquisition perspective, the focus has shifted to CRA ratings.

It is unclear whether certain districts will treat the CRA the same. What is clear is that an increasing number of CRA examiners will be sent out into the field to see if banks and thrifts are complying.

Ms. Stromberg and Mr. Coughlin are bank equity analysts at Chicago-based Howe Barnes.

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