CRA’s black box could prove difficult to open

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On April 3, the Treasury Department released a memorandum to the federal banking agencies with its findings and recommendations for reform of how those agencies administer the Community Reinvestment Act.

Whether it was the odd format (a memorandum), or just the press of other business, the Treasury’s effort did not receive the attention it deserved. Below are three observations.

First, the quality of the work is exceptional, and its assessment non-partisan. While the memorandum makes recommendations, it focuses mainly on information gleaned from interviews with almost 100 diverse stakeholders in the area. In many cases, Treasury reports that banks, consumer advocates and community advocates all see the same problems. It is heartening to see a policy document that bases its recommendations on facts, rather than doing the reverse.

Second, it paints a bleak picture of a system lacking objective standards, with compliance determined subjectively and unpredictably. “[B]anks remain unclear about whether more complex, innovative, or infrequent types of products and services will receive credit…. This is the case even if it is clear that potential activities would be responsive to, or geared toward meeting the needs of, the communities they serve,” the report said. The report added: “Treasury’s review of examiner guidance provided little clarity for the issues raised by stakeholders. When seeking to understand the level of activity a Large Bank needs to undertake to satisfy the Lending Test, guidance was absent on both the quality and quantity of activity required.”

Third, one question left open by the memorandum is how to engage the rationale put forward by the banking regulators in defense of subjectivity and opacity of the existing CRA examination process. As the report notes: “The CRA regulators recognize these challenges, yet stated that they are hesitant to provide specificity on scoring and rating determinations due to varying performance contexts and concerns that quantitative guidance could be perceived as the creation of federally mandated credit allocation requirements.”

It is easy to dismiss these concerns as convenient for regulators who wish to exercise unbridled discretion, and inconsistent with law to boot, but there are valid concerns about how objective standards for what types of lending earns CRA credit could easily be politicized. For example, should small business lending get extra credit? Green energy? Lending in certain geographic areas? Of course, Congress could have taken the regulators off the hook by prescribing clear statutory standards, but instead provided only a general mandate.

Note, here, the close parallel to CCAR (and, by the way, “you can’t spell CCAR without CRA”). There, too, regulators operating under a broad statutory mandate have argued that disclosing the Federal Reserve’s “black box” model for forecasting losses would unduly influence how banks allocate credit. This concern is quite valid; TCH research has previously shown that even absent publication of the black box, the stress scenarios and the observed results of the stress test are already driving credit allocation. That said, concerns about credit allocation appear readily solved in CCAR. Using multiple scenarios — with notice and comment sought on Federal Reserve-generated ones — and using banks’ own forecasting models (subject to back testing and Fed review) rather than a Fed black box would relieve any concern that the Fed was allocating credit. (So, too, could reducing the stringency of the exit requirements so that regulatory requirements do not drive bank decision making.)

With CRA, however, the problem is more difficult: Objective, transparent standards will necessarily involve regulators choosing what counts and what does not, even if done through a proper notice and comment process. So, they will have to play the role of Goldilocks in a way that the Fed need not in CCAR. One alternative — akin to to using bank models in CCAR — is expanding the use of CRA strategic plans, whereby banks develop their own CRA plans and submit them to the relevant regulator for approval. The Treasury reports that the regulatory burdens and delays associated with this option have deferred them from using a strategic plan since it first became an option in 1996. A streamlined process could be developed to make this a live option.

In any event, the Treasury Department has done regulators, and others who care about community reinvestment, a favor by recognizing the need for reform and establishing a sound analytical basis on which to begin that difficult task.

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