Community Reinvestment Act Distorted?

For John, BLUF:  Sometimes in doing good, we act foolishly.  Trying to increase home ownership by moderate and low income families is a good, but the way we did it since 1977 has created problems.  Nothing to see here; just move along.

The National Bureau of Economic Research, down County, in Cambridge, has a paper titled "Did the Community Reinvestment Act (CRA) Lead to Risky Lending?".  The answer from the four authors is:  "Yes, it did".

The Community Reinvestment Act was created to stop "Redlining", which was unfairly burdening ethnic minorities, particularly in inner cities.

Here is the abstract:

We use exogenous variation in banks’ incentives to conform to the standards of the Community Reinvestment Act (CRA) around regulatory exam dates to trace out the effect of the CRA on lending activity. Our empirical strategy compares lending behavior of banks undergoing CRA exams within a given census tract in a given month to the behavior of banks operating in the same census tract-month that do not face these exams. We find that adherence to the act led to riskier lending by banks: in the six quarters surrounding the CRA exams lending is elevated on average by about 5 percent every quarter and loans in these quarters default by about 15 percent more often. These patterns are accentuated in CRA-eligible census tracts and are concentrated among large banks. The effects are strongest during the time period when the market for private securitization was booming.

They use "exogenous variation"?  I am thinking that is outside the bank, external factors.

It is an aphorism in the military that you get what you inspect.  And not just in the military.  So, a combination of "the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS)" inspects individual banks and by their inspection encourage banks to engage in certain behaviors, including making loans that are more risky than they might otherwise do.

It is a social good that we encourage moderate and low income families to purchase and own homes.  However, people with less money may be at higher risk of defaulting on their mortgage.  The question is how to spread the risk.  It appears the Federal Government spread the risk by forcing banks to accept that risk.  The question is, did that risk acceptance contribute to the economic collapse we have experienced?  It would appear so.

My take-away is that one needs to be careful as to how the Federal Government, or a State Government, incentivizes subordinate government levels or private organizations.  It is the job of the US Congress to conduct investigations to ensure than we do not incentivize bad or dangerous behavior.  "Too big to fail" is one of those things that creates bad incentives—or "moral hazard", as some say.

Do the right thing, but do it the right way.

Regards  —  Cliff