Rising Above CRA Noncompliance

Community Reinvestment Act ratings and evaluations have been made public for over a year.

With nearly 4,400 banks and thrifts - or almost one out of three - having been evaluated, only 49 - or just over 1% - have received the lowest rating, "substantial noncompliance."

At this rate, about 150 banks and thrifts in the country are likely to receive this grade. These institutions, as well as the other 99%, may ask: How subjective are the ratings?

Substantially noncompliant institutions should ask a more pressing question: How can we get out of this category?

How One Bank Did It

To answer this question we will use the experience of the only bank or thrift of which we are aware that has been in and out of substantial noncompliance - and within a relatively short eight-month period.

Farmers and Merchants Bank of Long Beach, Calif., was one of the first banks in the nation to receive a rating of "substantial noncompliance."

The rating was given Aug. 6, 1990, by the Federal Reserve Bank of San Francisco. F&M Bank, with $1.4 billion in assets, is also the largest bank or thrift ever to receive that publicly released rating.

The bank, in its public written response to the rating, strongly protested the exam's contents and conclusions. This family-owned bank with 16 branches is strong and well-capitalized.

Positive Changes

F&M Bank did more than just protest. It made enough improvements in its performance to get an upgraded rating of "needs improvement" from the Fed on April 22 of this year.

The Federal Reserve System, the federal regulator with the smallest number of banks in its jurisdiction, has the shortest compliance-exam cycle, generally 10 to 14 months. An even shorter cycle, six to eight months, is appropriate for "substantial noncompliance" banks.

The fact that F&M had a de novo branch application pending before the board of governors since last November was obviously an item of concern.

The act does not require a bank to keep previous evaluations and the accompanying ratings in the public file that must be maintained. CRA statements for the past two years, however, are maintained there.

Shielded from the Public

As far as this bank or any other bank in this situation is concerned, a previous lower rating and evaluation is no longer part of the public record.

In fact, a representative of another bank that was upgraded - from "needs improvement" to "satisfactory" - last year refused to admit to us the existence of the previous lower rating and evaluation, even when specifically questioned about it.

We can learn a lot from what F&M Bank apparently did and did not do to get the higher rating. The records show that a different chief examiner was involved in each exam, although we understand the same examination team was utilized.

The second public evaluation, at nine pages, is roughly twice as long as the first and is much more detailed and analytical.

It is possible that the same analysis may have been completed the first time around but just not summarized in the public evaluation. But, that is all we have to go on from the Fed.

Making Lending Count

The bank's biggest improvement was its extension of nearly $38 million in loans to "development projects and to nonprofit organizations" since the first examination.

The first evaluation noted that the bank provided "extensive development and revitalization credits, primarily to local private developers," but the document gave no specifics.

The bank's public response, however, noted that approximately 10% of its total loan portfolio then was loans to nonprofit and charitable organizations.

The $38 million of Community Reinvestment Act loan extensions for community development and nonprofit projects identified in the second exam is quite large on both an absolute and relative basis.

Beyond Loan Commitments

Those loans over an eight-month period are equivalent to $57 million on an annual basis, which in turn would represent roughly 42 basis points of that bank's assets.

These are actual loans, not commitments for loans which might never be made.

Such commitments, among the large California banks that have made them, generally range from 25 to 50 basis points (0.25% to 0.50%) of assets per year. Many community groups consider a 50 basis-point commitment as socially responsive.

The largest such commitment to date, by NationsBank, represents 84 basis points of assets annually over 10 years, would become effective after approval of the merger of NCNB Corp. and C&S/Sovran Corp.

F&M's large CRA loan extensions apparently got the attention of the Fed examiners and may have been the most important determinant of the upgraded rating.

|Soft' Improvements

Some other cited improvements were "soft" in nature compared with the hard cash.

For example, the most recent evaluation states that the bank has "taken the first steps" in determining the geographic distribution of its credit extensions and denials.

A previous effort by the bank was discounted as providing no useful information; "faulty methodology" was cited.

Some past criticisms of the bank were not addressed in the new evaluation, or were addressed only briefly.

It Pays to Advertise

For example, the bank was criticized before because it did not advertise or market its credit products. Now the bank advertises its home equity loans on ATM machines at its branches and recently ran one ad for loans in a local magazine.

The format used by the Fed in the second evaluation was in itself an improvement. The new evaluation provides individual ratings for each of the 12 assessment factors under the act. Only the one overall rating was provided in the first evaluation.

The most recent evaluation for the F&M Bank revealed four "satisfactory," five "needs improvement," and three "substantial noncompliance" ratings for individual assessment factors.

The latter ratings were for assessment factors pertaining to credit marketing, government loan programs, and prohibited credit practices.

A Few Negatives

In a few areas the bank's Community Reinvestment Act performance actually deteriorated since the last examination.

For example, there was no indication of questionable geographic lending patterns in the first evaluation. The new evaluation, which compared 1990 and 1989 Home Mortgage Disclosure Act data, concluded that the bank's volume of home purchase and home improvement loans located in low- to moderate-income areas declines in 1990 compared to 1989.

Death Wish

Although the number of mortgage loans made during the two years is comparable, those located in low-and moderate-income areas declined 50% in 1990.

We were very surprised to learn that the new evaluation again found the F&M Bank in substantial noncompliance with the provisions of antidiscrimination laws and regulations, including Fed Regulation B under the Equal Credit Opportunity Act.

Violations of compliance laws and regulations are usually nothing short of a CRA death wish. This is especially true for substantive as compared with technical violations.

F&M Bank's original evaluation only noted that "a policy administered by the bank is in substantial noncompliance with the provisions of Regulation B."

The bank in its public response "expressly, explicitly, and absolutely" denied any such discrimination and contended that it was in full compliance with Regulation B.

The Fed apparently did not agree.

Card Problem

The new evaluation was specific in pointing out that the bank's credit card department engaged in a discriminatory practice in which "applicants were treated differently on a prohibited basis," that of age.

Surprisingly - for a bank that was attempting to improve its record - the Fed found in the most recent evaluation that "bank management has not been sufficiently responsive to previously cited violations of this nature, which permitted the practice to continue."

Furthermore, the new evaluation pointed out that the bank failed to file its 1990 mortgage disclosure report in a "timely manner," and that the report finally filed contained "significant factual inaccuracies."

We learned from this example that one very good deed can outweigh a bad one, even if the bad one has been around for a while and may have gotten worse.

In the F&M case, it appears that substantial CRA loan extensions (that is, the good deed) may have outweighed the Fed's finding of a violation of antidiscrimination laws and regulations.

Another lesson is that any bank with one of the lower Community Reinvestment Act grades - "needs improvement" or, especially, "substantial noncompliance" - is well advised to prepare a detailed public response to the evaluation.

Regulators Did Their Job

How subjective was the decision to elevate F&M Bank's overall rating out of the lowest category? Would a group of examiners from another Fed region have reached the same conclusion? What about another bank or thrift regulator?

The regulators clearly did their job in the F&M case. They were more analytical and comprehensive in the second exam than the first.

F&M Bank is likewise to be commended on its improved record, which puts it among the biggest CRA-related lenders on a relative basis.

Flexibility Essential

Despite attempts at setting objective criteria, the rating system requires examiners to be flexible.

However, the system emphasizes that of all assessment factors and performance categories, "compliance with antidiscrimination laws and regulations, including fair lending and fair housing laws, has great significance in reaching the overall conclusion."

How great is that significance? Does it mean a double, triple, or quadruple weighting? Assuming an equal weighting for each of 12 assessment factors, F&M Bank would receive an overall "needs improvement" rating, as it did.

The one assessment factor on prohibited discriminatory or other illegal credit practices would have had to carry not two or three but four times its normal weight to result in an overall "substantial noncompliance" rating for the bank, with everything else remaining the same.

Letting the Light In

The F&M case also teaches us something about the positive power of public disclosure of Community Reinvestment Act ratings and evaluations.

We do not know if this bank had previously received a poor 4 or 5 grade under the old system. It may have done so, considering the first public grade of "substantial noncompliance."

We do know that once public attention was drawn to the "substantial noncompliance" rating, positive changes apparently took place very quickly.

There is no way to prove that this bank's corrective action would have occurred anyway, without the subsequent disclosure. There is, however, a strong supposition that such public disclosure is a powerful catalyst for CRA improvements.

Depositors Undeterred

Publicity about the poor initial evaluation had one seemingly perverse effect. Eight million dollars in new deposits poured in - because, the bank said, its low mark signaled that it was very strong and conservative.

Significantly, there was no public confusion between that bank's good safety-and-soundness condition and its bad Community Reinvestment Act rating.

This experience supports the view that the regulatory Camel ratings - based on an assessment of capital, asset quality, management, earnings, and liquidity - should to some extent be made public.

Public disclosure can work more quickly and strongly to accomplish certain public policy objectives than the regulators' existing arsenal of enforcement and other tools.

If the social benefit of such disclosure outweighs the social costs, we ought to give thought to shining more light on the financial condition of our banks and thrifts.

Mr. Thomas is president of K.H. Thomas Associates, a Miami-based consulting firm, and a lecturer in finance at the Wharton School of the University of Pennsylvania. This article is an excerpt from his book, "The Highest and Lowest CRA Ratings in America," forthcoming from Business One Irwin, Homewood, Ill.

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