One of the most controversial issues in the current CRA reform process is the fate of the investment and service tests tacked on between 1993 and 1995. Since they are weighted 25% each in the evaluation of large retail banks, they effectively reduce by one half the weighting of community lending, the law's primary purpose.
Banks generally supported these tests, which became optional in 1996 and mandatory in 1997, since it meant they could get Community Reinvestment Act credit - as much as 50% of their rating - for nonlending services. Community activists feared a weakening of the CRA's basic lending function but were more focused on other reforms that promised to improve that law.
Now the tables have turned - banks generally oppose the tests (especially the investment one) and community groups and investment-test profiteers strongly defend them. My independent review of the roughly 400 comments submitted to regulators as part of the current reform process found that much of the support for these tests is being driven by goals inconsistent with good public policy.
With the exception of former FDIC Chairman Donna Tanoue's proposal to replace the investment test with a new community-development test, federal bank regulators have been silent. Banks and trade associations are rightfully asking that CRA be returned to its roots in low- and moderate-income lending by abolishing the two tests or at least making them optional, as they are for small banks. For example, the $400 million-asset Southern Commercial Bank of St. Louis, in its Oct. 10, 2001, CRA reform comment, asked: "If CRA is about banks meeting the credit needs of their communities, why are there investment and service tests?"
Community groups generally want to keep everything in CRA and add new requirements. They are loath to admit that any part of the law cannot be cost-benefit-justified. Their apparent goal is to widen, not narrow, its coverage and scope. But this can be counterproductive since the investment and service tests reduce by 50% the weight given to low- and moderate-income lending.
The investment test sounded good on paper until everyone realized that few investments qualified. Thus a "CRA investment" industry was created by Wall Street to take advantage of the shortage of qualified investments, which, when coupled with the increased demand for them, resulted in a "CRA premium."
The general counsel for BancorpSouth Inc. of Tupelo, Miss., writes in his Oct. 17, 2001, reform comment about the dilemma of meeting CRA goals with limited qualified investment opportunities. "Securities dealers have 'learned' of this dilemma for financial institutions and are directly taking advantage of the dilemma. Securities dealers structure complex, risk-laden investments in a regulatory environment that is hyper-sensitive to risk management on the part of the bank. CRA requirements have therefore actually created a cottage industry within the investment community as dealers have discovered that banks are willing to pay above-market prices just to obtain CRA eligible investments."
California Federal Bank's Oct. 17, 2001, reform comment complained that the shortage of qualified investments has resulted in "newly formed investments that are highly risky and/or simply create profit opportunities for intermediaries with no or little benefit passed on to the community." The letter cited one such example: "Funds have been created that provide no or minimal added value to lower-income communities, but rather create profit opportunities to fund managers. … While the inclusion of a stand-alone investment test in the 1995 amendments was innovative and well intended, it has not worked well, and its unintended consequences have been severe."
The investment test has led to many "qualified investments" that merely recycle existing ones with no new underlying low- to moderate-income loans being created. One loan may be bought and sold many times and then securitized and repeatedly traded as a low- to moderate-income mortgage-backed security. Since it is defined as a qualified CRA investment, many banks get CRA credit for but one underlying low- to moderate-income loan.
Investment-test vendors and even their banking clients will argue that such activities enhance access to low- and moderate-income credit, but this is not unlike their Wall Street brethren's churning a portfolio for commissions. Some mortgage-backed securities have been churned so much by the investment test that the underlying low- to moderate-income purpose of the original loan and the CRA has been long forgotten.
J.P. Morgan Chase & Co.'s Oct. 17, 2001, reform comment about the investment-test "numbers game" emphasized its relatively limited community-development value.
"The current stand-alone investment test for large retail banks is of concern because there are not enough eligible investment funds or other investment vehicles to grow a large, profitable, responsive, and diverse CRA portfolio that has a meaningful impact on local community development needs," Morgan Chase stated. "There may be enough investment opportunities, however, to grow a very large, modestly profitable portfolio of CRA-eligible investments that has little community development value in terms of responsiveness to community development needs. In a numbers game, the latter is the portfolio of choice."
Community groups' attempts to defend the nonlending tests are not only unrealistic but also somewhat self-serving. In the case of the service test, some groups benefit by acting either directly as a beneficiary of some community-development service or indirectly by sometimes being compensated for performing such services by banks (for instance, homeownership counseling to low- to moderate-income homebuyers). This is a relatively minor concern next to the investment test.
The actual and potential conflict is most apparent with the investment test, because some groups have considerable financial incentives to maintain it. Bank contributions to community groups count as qualified CRA investments, and the groups may feel this source of funding will be cut or perhaps even eliminated without a stand-alone investment test.
This defense of the investment test was exemplified in the Oct. 15, 2001, reform comment of the Chicago Association of Neighborhood Development Organizations: "Over 22% of CANDO's revenues, for next fiscal year, are projected to come from grants by our bank partners. Grants from banks have provided critical operating support."
The Oct. 17, 2001, comment letter from the Association of Community Organizations for Reform Now made an unabashed proposal, writing, "Most notably, grants or commitments that support effective community efforts … should be given more weight than other investments."
The main defense of the investment test by community groups in their filed regulatory comments echoes an oft-repeated 1999 quote from Federal Reserve Chairman Alan Greenspan stressing the need for more "equity" investment in small businesses in lower-income communities. This is somewhat misleading, given that most qualified investments under the investment test are not of this type but are rather purchased and repurchased low- to moderate-income mortgage-backed securities or even certain municipal bonds and minority bank certificates of deposit. This is a very important distinction, because true equity investments as referenced in the Greenspan quote are very much the exception.
Bank of America Corp.'s comment of Oct. 16, 2001, for example, pointed out that "equity funding is less in demand and more expensive to maintain as part of balance-sheet management. Moreover, equity is a form of permanent and often nontransferable funding." Cal Fed's Oct. 17, 2001, comment was even blunter, stating that the current investment test results in "equity investments that are effectively grants with virtually no hope of a yield or return of principal."
Some community group leaders have attempted to defend the contentious investment test by arguing (through questionable assumptions and analysis) that its elimination would drain billions from communities. It appears, however, that the only possible drain would be from investment-test profiteers and some community groups that have funding arrangements with such firms.
These two tests should be reduced to individual performance-evaluation factors under a new 100%-weighted, streamlined, large-retail-bank lending test - as long as they can be documented to be related to low- to moderate-income credit. At some point they can even become optional to improve a "satisfactory" rating, as is currently the case under the streamlined small-bank exam that rightly stresses low- to moderate-income lending.
