CRA rule gives smallish banks a kick in the pants — and that's good

Bloomberg News

Way back in 2015 when I covered the Federal Reserve, I got a chance to ask then-Fed Chair Janet Yellen a question about the Community Reinvestment Act and what, if anything, the Fed was considering doing to improve the implementing regulations of the statute. 

I got the distinct impression that my question was somewhat unanticipated — the agency's regulatory agenda at the time was centered around finalizing a capital buffer for Global Systemically Important Banks, known as the G-SIB surcharge, rather than on the CRA. But Yellen nonetheless affirmed the CRA's importance and acknowledged that the rules could stand to improve.  

Fast forward to today, when the Fed passed, by a 6-1 vote, a major overhaul of the implementing regulations of the CRA, the first such overhaul since the mid-1990s and one of only a few recalibrations of the rule since it was first passed in 1977. That progress was by no means linear — the Trump administration, particularly former Comptroller of the Currency Joseph Otting, had made a run at CRA reform before, though he was unable to get the Fed on board with his vision of what an overhauled CRA would look like. Then came the Biden administration, which vowed to do its own overhaul — but this time regulators would do it together as a team.

Both banks and community groups have had their own distinct gripes with how the CRA is implemented, and have had those gripes for quite some time. Banks have long argued that it is difficult to know ahead of time whether a particular loan or service would qualify for CRA credit — meaning a bank could incur the costs and risks of making a suboptimal loan only to learn later that it obtained no CRA benefit from doing so. Community groups, meanwhile, have long argued that tethering CRA obligations to places where a bank has physical branches disincentivizes banks from having a presence in marginalized communities and does not take into account online or mobile deposits when determining CRA service areas.

Enter today's final rule. The biggest changes from the current regime are the inclusion of a list of prequalified lending activities that banks can rely on to grant CRA credit on the one hand (a win for banks) and tethers CRA requirements to digital deposits and allows banks to get CRA credit for community development projects regardless of CRA service area (a win for community groups). 

One aspect of the final rule that caught my attention, however, is regulators' choice to tailor a bank's CRA obligations to its size. Regulators do this with almost all their rules, and typically banks with less than $10 billion of assets — the shorthand definition of a community bank — are exempt from the most binding and onerous requirements. 

But with the proposed CRA rule — and as affirmed in the final version — large banks are defined as those with $2 billion of assets or more. It is one thing to make rules more onerous, and quite another to make them more onerous for a wide swath of what are generally considered "small" banks, and I for one think that's a smart choice if regulators want the rules to affect meaningful changes for the banking industry.

Federal Reserve Gov. Michelle Bowman — the Fed's designated community bank representative and lone "no" vote on the final CRA rule — didn't agree, and took exception to the $2 billion threshold as the centerpiece of her opposition to the rule.

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"In no other provision of the regulatory framework is a bank with $2 billion in assets considered a 'large' bank," Bowman said. "For well over a decade, community banks have been defined to include banks with up to $10 billion in total assets. Characterizing these banks as 'large banks' simply ignores established definitions and is inconsistent with existing regulatory practice."

The U.S. has about 4,500 or so banks, and while the vast majority of those banks are small, the vast majority of all deposits are held by a relatively small number of big banks. So prudential regulations — those meant to ensure a bank does not fail, or if it does, does so without endangering the broader financial system — are logically focused on those few banks that pose the greatest macroprudential risk. But community banks also are often the only — or one of only a few — banks in the kinds of low- to moderate-income communities that the CRA is designed to help. So applying the $10 billion threshold here would be a detrimental narrowing of the rule's scope.

Unlike many regulations we spend our time thinking about, the CRA is not about protecting the financial system; it's about extending credit to communities and customers who don't already have it. A fundamental truth about credit is that the more money you have, the easier it is to get a loan — in other words, credit is inherently attracted to customers who don't need it. Any banker can tell you that there are creditworthy and sound investments to be found in underserved communities — there are needles in those haystacks — but they're harder, and therefore more costly and time consuming, to find. The CRA, then, is meant to push banks to look for those needles instead of looking for reasons not to look for them.

Bowman expressed misgivings about that outcome as well, arguing that "many banks will not be able to receive a 'Satisfactory' rating without significant changes that are largely dictated by regulators," with the result being that "regulators are effectively mandating that banks offer preferred products and services to counteract the downward pressure on ratings."

That is, and should be, the point of any earnest effort to reform the CRA's implementing regulations — getting banks to do things they might not do on their own, either for the sake of simplicity or to minimize risk. Bowman touched on that latter point in her remarks, saying that she is concerned that "the changes imposed by this rule will result in banks being criticized for extending credit to less creditworthy borrowers to account for the increased barriers to achieve a satisfactory rating."

Here, she has a very good point: If regulators all but require banks to take on riskier loans by extending credit to less well-heeled borrowers, they shouldn't penalize banks when some portion of those loans don't pan out. I suspect regulators will give assurances that such will not be the case, but given the considerable and deserved scrutiny swirling around the Fed's supervisory program of late, I'd say that skepticism of those assurances are reasonably well-founded. 

As Fed Gov. Chris Waller put it, no regulation is perfect, and there's reason to believe that this one isn't, either. But the status quo ex ante is even farther from perfect, and the most distressed communities stand to benefit considerably if banks have new reason to look at them as investment opportunities rather than obligatory afterthoughts.