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For release on delivery
September 24, 1993
Real Progress Without Unintended Consequences
Lawrence B. Lindsey
The Federal Reserve Bank of Cleveland's
Annual Community Reinvestment Forum
September 24, 1993
When President Clinton announced last summer that he wanted
the financial regulatory agencies to work together to reduce the
burden of and improve the results from the Community Reinvestment
Act (CRA), he indicated to the nation's banks and consumers that
CRA could undergo a sea change.
The President wanted to focus on
three types of community reinvestment activities - - lending to
low and moderate income individuals, small businesses and farms;
investment in low and moderate income neighborhoods; and the
provision of banking services to low and moderate income
His stated desire was to create "...more
objective, performance-based CRA assessment standards that
minimize the compliance burden on financial institutions while
stimulating improved CRA performance."
I applaud the President's timely and important initiative
and am working with my fellow Board members and colleagues at the
other agencies to fulfill the vision that President Clinton has
However, I must insert one note of caution.
plan, however well created and executed, can take the place of
prudent and consistent reason and judgement in the lending
Fair lending is not initiated by governmental agencies
but by individual lenders across the nation.
From its inception, the Community Reinvestment Act was
Congress wisely chose to avoid even the
appearance of prescribing the allocation of credit.
legislatively defined, required financial institutions to
demonstrate that their deposit facilities served the convenience
and needs of their communities including the "continuing and
affirmative obligation to help meet the credit needs of the local
communities in which they are chartered".
required to "encourage such institutions to help meet the credit
needs of the local communities in which they are chartered
consistent with the safe and sound operation of such
In recent years, CRA has come under attack for its apparent
failure to fully meet its stated objectives.
not without basis.
This criticism is
Inner cities still suffer from disinvestment.
Large sections of the population do not have ready access to a
Statistical studies indicate that racially based
differences in mortgage approval rates do exist, even after
taking economic variables into consideration.
When all is said and done however, the question still
remains -- will more specific guidance by Congress and/or the
regulators in fact generate the desired result -- equal access to
credit for all creditworthy Americans?
Before looking forward to
see if we can answer that question, let us first look back to the
early days of our nation for some possible guidance.
Although we may like to think otherwise, the CRA concept is
not a new one.
The proper role of banks in their communities has
been a controversial subject since the start of our country.
Philadelphia, the Bank of North America was chartered in 1782 by
some of our nation's leading citizens including Alexander
Hamilton and Benjamin Franklin.
The story of their experience is
an illustrative one.
The Bank of North America focussed primarily on financing
commerce through the thriving port of Philadelphia.
Pennsylvania's farmers, who dominated the state legislature, felt
that the bank was not lending enough to them.
They succeeded in
their drive to repeal the bank's existing charter and replace it
with a much more restrictive one.
This was truly a Phyrric
The bank's fortunes declined, as did banking services.
The result was a prolonged slump in economic activity in
Pennsylvania, a slump which also adversely impacted the farming
I think that there are some important lessons to be drawn
from this early experience.
First, political supervision of bank
lending practices is nothing new, and may be an inevitable part
of a democratic society.
That may not comport well with the
theoretical model of a completely free financial services
industry, but then neither do other aspects of banking including
federal deposit insurance and lending at the discount window.
The supervision and regulation function certainly provides a
public good, from which banks benefit, by providing a reassurance
For better or worse, political oversight of bank
lending practices is an inevitable extension of these other
aspects of government regulation of banking.
The second lesson of history is that moving in a purely
political direction of banking, or heavy handed credit
allocation, is not only bad for banking, it is harmful to society
as a whole.
This was of course the historical result in
In more recent times, the effects of misguided
credit allocation were evident in the economies of Eastern
Europe, a region whose patterns of development we all agree would
be foolish to emulate.
Thus, CRA is part of a longstanding balance between the need
for some political oversight of the lending process, and the
problems which result if such oversight becomes excessive.
However, we must bear in mind that because political oversight is
at best a blunt instrument, striking an appropriate balance
between constructive oversight and overburdening regulation has
always been a difficult task.
In recent years, that oversight
has escalated as it increasingly appeared that discrimination has
continued to permeate the lending process.
The issue of mortgage
discrimination burst to the forefront when CRA ratings and HMDA
data were made public in the late 1980's.
The heat was turned up
again as recent events in our urban areas as well as a new
activist Administration have further highlighted the dramatic
need for investment in communities across the nation.
Discrimination tears at the fabric of our democratic
It also tears at the fabric of our faith in capitalism
and the market.
One of the great advantages of the market is
that it is supposed to be color blind.
If that turns out not to
be the case, then the foundations of our economic system as well
as our political system are at risk.
So discrimination is a
fight that we as a society must win.
It is for this reason that
I see fair lending issues as having the greatest potential for
further legislative and regulatory activity - - activity which may
have at its root the increasing use of statistics.
Statistics have played a major role in our consideration of
the mortgage discrimination problem of late.
Their role as an
enforcement tool is just now beginning, and is likely to increase
dramatically in the years ahead.
But as a long time micro empiricist, I am well aware that
statistics can play only a supporting role in our quest.
understanding the limitations of statistical analysis may be key
to solving the underlying problem and establishing truly equal
credit opportunities for all Americans.
analysis can highlight inequity, it cannot eliminate it.
must be done on an individual basis, on the front lines, at the
level of the applicant and the loan officer.
However, the use of statistics can, and has, provided a
baseline from which to start.
Take for instance, the use of HMDA
While community activists, bankers, regulators and
legislators are all familiar with the limitations of the HMDA
data, the HMDA data do indicate that there is a racially based
problem in mortgage lending.
Having said that, two important qualifications are in order.
First, it is widely acknowledged that the HMDA data exaggerate
the extent to which approval rates differ for racial reasons.
When economic factors other than income are incorporated into the
analysis of HMDA data, the disparity between black and white
approval rates is sharply reduced.
Second, the evidence of race-based differences in loan
approvals is overwhelmingly of a statistical nature, based on
It is very hard to document by examining
specific loan applications, such as during the bank examination
Accepting this fact is difficult for those who seek
simple, straight-forward explanations for the racial disparities.
It's always easier when there's a smoking gun and an identifiable
Last fall, to clarify the HMDA data, the Federal Reserve
Bank of Boston ran what is certainly the most comprehensive
statistical analysis of lending patterns by race that has ever
That study found that what I would call "old
style" discrimination did not exist.
That is, clearly qualified
applicants of any race were approved for loans and clearly
unqualified applicants of any race were rejected.
The days when
members of minority groups who meet all of a bank's criteria for
lending are rejected anyway, seem to be gone.
I believe that is
why bankers believe so strongly that they do not discriminate.
However, what the study also found was that a careful
statistical comparison of applicants who were less than ideal
indicated that imperfect white applicants were more likely to be
approved than imperfect black applicants.
Three types of
explanations for this have been advanced.
First, some have
argued that the results are proof that racism still exists in our
society and in the banking industry.
From a statistical point of
view, there is no way that this hypothesis can really be tested.
It may be true.
My own judgment is that while some racism may
exist, it is probably not the dominant factor in bank decision
The institutions in question all have stated policies
against discriminatory practices, and the extent of
discrimination found, which affects roughly 7 out of every 100
minority applicants, does not comport with racism as dominating
I say that with the understanding that any amount
of discrimination is totally unacceptable.
The second hypothesis is that there is no racism in the
process, that in fact the banks have gotten their lending
practices about right.
What is missing from the Boston study is
a careful look at the long term default risks on these loans.
is true that the Boston study did not go into a detailed
examination of the actual loan files to see if some other
explanation for rejection existed.
Where this has been done,
some of the disparate rejection rate has been explained.
ultimately this hypothesis, like the racism hypothesis, cannot be
We cannot tell today what the ultimate
outcome of the loans we make today will be.
Nor will we ever be
able to tell what the hypothetical performance of rejected loans
would have been.
So, like the first hypothesis, I accept that
this one might well be the case, but that the evidence before me
today does not support it.
The third hypothesis is that some racially disparate loan
practices are occurring in spite of bank policies to the
This hypothesis not only comports with the Boston
findings, it also suggests that relatively minor adjustments in
institutional behavior will be appropriate remedies.
Reserve Bank of Boston has recently put out a pamphlet on these
remedies called Closing the Gap: A Guide to Equal Opportunity
Lending which I commend as important reading for all individuals
in the financial services industry.
Let me also stress that as long as behavior exists which
appears outrageous to reasonable individuals, the threat of
legislative and/or regulatory action, with all of its attendant
burdens remains likely.
Banks have a responsibility not only to
end the practice of discrimination, but end the appearance that
discrimination is occurring as well.
As long as large numbers of
minority customers remain dissatisfied with the treatment they
receive, greater regulation remains a likely prospect.
President Jordan of the Federal Reserve Bank of Cleveland has
argued, "This problem is not solved until everyone agrees it is
The prospective regulatory burden which might result from
not solving this problem is potentially enormous.
unchecked, a total reliance on statistics in credit enforcement
will ultimately lead to a complete replacement of bank judgment
and reason regarding loan approval with statistical rules.
fear that in some instances, the use of statistics to establish
discrimination may go too far.
At the Federal Reserve we are
using computer based statistical models as a part of our
However, these models are only used to
select particular loan applications to examine more closely.
statistical models in and of themselves will not, and should not,
be used to determine whether discrimination exists.
computer will select individual matched pairs of actual
applications to be examined.
We believe that this will improve
the efficiency of the examination process by reducing randomness
in selecting applications to be examined.
The potential overuse and abuse of statistics in this area
threatens the imposition of a burden in at least two ways.
First, the use of statistical models as the sole criteria
especially when the details of such models are unknown to the
banks being examined, means that no bank can know what rules it
actually has to comply with.
It would be like replacing the
speed limit on our nation's highways with some computer
determined "Conditions Adjusted Velocity" formula in order to
enforce traffic laws and not tell motorists what the Conditions
Adjusted Velocity formula was.
Laws can only work if people know
what they have to do to obey them.
Second, the likely result of statistics based examination of
loan approvals is statistics based approval of loans.
turn is likely to work against individuals who do not meet the
"normal criterion" of a one-size-fits-all statistical rule.
need only look at the historic performance of the secondary
market to see that minorities and other disadvantaged groups find
themselves only further disadvantaged by such inflexible
Statistics, however, are not only used by regulators.
also play a role in our nation's media.
when done well is an infinitely complicated and painstaking
But when statistics are run on the evening news or in
headlines across the country they are frequently reduced to the
lowest possible common denominator.
For example, in the Boston
study's sample, roughly 7 out of every 100 minority applicants
for a mortgage are rejected for reasons that cannot be explained
by factors other than the individual's race or the racial
composition of the neighborhood into which the applicant is
To the average editor or producer, 7 out of 100 may not
be a sufficiently dramatic statistic -- it won't give legs to the
So, the most widely reported number from the Boston Study
indicated that a black applicant was 60 percent more likely to be
turned down for a mortgage than a comparable white applicant.
Both statistics are absolutely correct with respect to the study.
However, the 60 percent statistic gives little indication to
applicants of what their actual chances of acceptance are.
more than 70 percent of minority applications are approved, a 60
percent higher rate of rejection would seem to needlessly
discourage potential applicants.
Another area where the media do not appropriately portray
reality involves the economic status of African-Americans, and
particularly the change in that status in the past decade.
is a very important subject to address because both banking in
general, and mortgage lending in particular, are profit driven
Lending will take place where there is money to be
made, or more precisely, where it is perceived that there is
money to be made.
Unfortunately, there is a widespread myth,
reinforced by the media, that the great majority of blacks live
in poverty, and that little progress has been made recently in
ending that situation.
The facts could not be more different.
During the 1980s
tremendous gains were made by the great majority of black
Between 1981 and 1990, median black family income rose
12.3 percent after controlling for inflation.
By contrast, the
income for the median white family rose 9.2 percent. Black income
growth particularly outpaced white income growth among those
families most likely to be' first time homebuyers.
controlling for family size, the top quintile of black families
saw their real income rise 28 percent during the 1980s.
second quintile of black families enjoyed a 19 percent gain.
proportion of black families living in suburban counties rose by
a third and the proportion of black families earning real incomes
over $50,000 rose by 42 percent.
Not only that, but the situation is likely to get better in
the next generation due to significant gains in black educational
During the 1980s, the SAT scores of black
children rose 23 points in math and 20 points on the verbal test,
compared with essentially stagnant scores for white students.
The black dropout rate from high school fell from 18 percent to
13 percent over the same period.
These facts augur well for
future black income gains.
So it cannot only be left to bankers to eliminate both the
practice and the perception of discrimination.
involved in this volatile and emotional issue must practice in
their professions what physicians, in taking the Hippocratic
oath, practice in theirs -- above all do no harm.
this means that any regulatory or legislative "fix" must be
carefully and thoroughly considered.
The potential for
pernicious, albeit unintended, consequences is great.
In proposing the CRA review, President Clinton has rightly
noted that it is performance not paperwork which indicates
whether a financial institution is meeting the needs of its
I agree with the Comptroller of the Currency,
Eugene Ludwig, when he testified last summer that "... between a
rigid system of numerical targets and the system we have today,
there is considerable room for improvement".
is always in the details.
However, the devil
We must be ever careful to not put
into motion the law of unintended consequences.
It is often well
intentioned legislation or regulatory improvements which can
exact a very high and unintended cost.
Consider for example, the legislation and organization which
created the secondary mortgage market in this country.
Mae has, by most accounts, been quite successful at its main
mission: to provide liquidity to the mortgage market by creating
easily traded mortgage backed financial instruments.
But a price
has been paid for such liquidity.
Increasingly, banks have moved
to standardized lending practices as they have seen their
mortgage business evolve into that of a broker, rather than a
It is no longer crucial that banks know
their customer, but rather that their customers fit a
Credit evaluation is based increasingly
on quantitative criteria, rather than qualitative judgments.
If you're a one-size-fits-all customer, you have probably
benefitted greatly from this approach.
If you are one of those
people who is different from the norm, as I mentioned earlier,
you may have been inadvertently left out.
Let me say that Fannie
Mae recognizes this problem and is striving to make sure its
guidelines take a broader array of applicants into account.
Yet another example of unintended consequences arose last
year when the Federal regulatory agencies, prompted by
Congressional action in the FDIC Improvement Act, considered
establishing maximum loan-to-value ratios for single family
I strongly opposed such a move because it would
have further exacerbated the difficulty of obtaining a loan for
individuals who do not meet the normal criteria.
particularly concerned about the impact of this on mortgage
lending to low and moderate income families who have limited
funds to cover closing costs, let alone provide a major
In fact, the fewer such rules we have, the easier
it will be for non-traditional borrowers, who are often members
of minority groups, to obtain credit.
As I've travelled around the country I've seen numerous
other examples of well intentioned government policies that are
making access to housing more difficult, particularly for
For example, consider the cap on the size of
loans eligible for FHA insurance.
As a result of these limits,
FHA loans are virtually unavailable in New York City, where the
overwhelming majority of housing costs more than the limits
Nearly every coordinator for the Neighborhood Housing
Services (a national housing and redevelopment organization) I
have spoken with felt limited by the Davis-Bacon legislation
which drives up the cost of housing construction and limits job
opportunities for inner city residents.
In city after city,
rules regarding the taxes owed on vacant land or on abandoned
buildings are inhibiting the development of low and moderate
income housing and the development of communities.
Inner cities and other hard-to-value areas are also
particularly starved for development funds in part because of
appraisal requirements imposed by law.
is, at best, an art not a science.
The whole appraisal area
This is particularly true in
areas where communities are changing.
Yet the Congress has
mandated costly appraisal requirements which are retarding
We at the Fed exercised the maximum
latitude the law allows us in setting a $100,000 threshold on
formal appraisal requirements and are seeking comment on raising
this threshold further to $250,000.
In addition to community redevelopment being constrained by
the unintended consequences of many different pieces of
legislation, we cannot overlook the dramatic changes that have
been made in the nature of bank regulation and their effect on
banks' available capital.
By international agreement, our banks
are now judged on the amount of capital they have relative to
their outstanding loans.
For a well capitalized institution this
means that they must have at least 6 cents in so-called Tier One
capital for every $1 in loans they make.
increase loans is to increase capital.
The only way to
There are two ways to
increase capital: after-tax profits, which increase capital
dollar for dollar, and new stock offerings.
These new stock
offerings, in turn, depend upon bank profitability.
in unnecessary costs imposed on banks means $16 less in loans
that the bank is able to make.
Of course, this does not mean that we must do everything
possible to maximize bank profits.
Far from it.
protect consumers and depositors and to enforce existing
regulation is essential.
But our regulation must be cost
Excessive regulation, by diminishing bank capital,
and therefore by a multiplier effect, the amount of funds that
banks can lend, could end up hurting the intended beneficiary of
We must be committed to making regulation as
cost effective as possible.
Let me revist my initial question.
Will more specific
guidance by Congress and/or the regulators in fact generate the
desired result -- equal access to credit for all creditworthy
But certainly not without a price.
National solutions to local problems generally cost more in time,
resources and money than local solutions to local problems.
the divisive problem of discrimination cannot be left to idle.
As a nation, we cannot move forward if the specter of racism is
not removed - - a t any price.