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New York's in a Move Your Money State of Mind, But CRA Reform Must Follow

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The Move Your Money campaign has some new allies: elected officials in the Empire State. Recent legislation passed by both houses of the state legislature directs that all state funds be deposited in financial institutions that meet the credit needs of low- and moderate-income communities. Similarly, New York City Comptroller John C. Liu has teamed with unions to press banks to improve their service to local communities by increasing the number of loan modifications they undertake so that these banks will reduce the number of foreclosures in New York City's neighborhoods. If the big banks fail to do so, there is the threat that these institutions will move their money to banks and credit unions with better track records of meeting community needs. These approaches combine two important concepts: the need for conscientious banking by consumers and making sure banks respond to community needs.

The most important federal legislation to address whether banks meet such community needs is the federal Community Reinvestment Act (CRA). While other states and localities are pursuing Move Your Money strategies, New York, like a handful of other states, has now passed legislation that gives those strategies the force of law. Not only should Governor Paterson sign the legislation into law, but other states should consider following suit. At the same time, if Move Your Money approaches are to tie themselves to CRA compliance and the extent to which bank conduct meets the needs of local communities, then Congress and federal regulators need to reform the CRA to expand its reach and fulfill its purpose.

The NY legislation that would tie state deposits to bank CRA ratings is championed by Democrats Kevin Parker and Liz Krueger in the state senate and Brian Kavanagh in the assembly. It authorizes the state comptroller to limit the institutions where state funds may be deposited by the state. Such state funds, which equal in the tens of billions, may only be invested with a financial institution that has received at least a "satisfactory" CRA grade from its federal bank regulators. Under the CRA, covered banking institutions--basically, any bank that has deposits insured by the FDIC--are graded by their federal regulators on their record of meeting the credit needs of low- and moderate-income communities. They currently receive one of four grades: "outstanding," "satisfactory," "needs to improve" and "substantial noncompliance."

This certainly seems like a worthwhile approach: heavy-hitting institutional investors like states should deposit their funds only with banks that are meeting the needs of local communities. The problem with linking the deposit of state funds to CRA grades is that, historically, there has been serious grade inflation by bank regulators under the CRA. As a result, in order to tie deposits to CRA grades, the manner in which those grades are issued must itself be reformed.

How bad is CRA grade inflation? In 2005, a year in which many financial institutions engaged in risky lending practices, to the detriment of countless local communities, 99% of all banks covered by the CRA received a passing grade of "satisfactory" or "outstanding" in terms of meeting their CRA obligations.

What's worse, the way these grades are supposed to work is that bank regulators are to take the grades into account when ruling on a bank's application to take such action like purchase another bank or open a new bank branch. Unfortunately, regulators have looked at this process as little more than a rubber stamp for far too long. When ruling on bank applications subject to CRA review, from 1985 to 1999, 8 such applications were denied by bank regulators on any grounds during that 15 year span. This figure might seem significant at first, until one understands that there were over 92,000 applications subject to CRA review filed during that period. Analysis of the Federal Reserve's record of passing on bank applications is similarly dismal: from 1988 through 2007, an era of great transformation in the banking industry, that regulator denied a total of 8 bank applications out of the more than 13,000 filed with it during that period.

Now, tying state banking to a financial institution's CRA record will likely make some conservatives' heads spin. Many try to blame the CRA for the subprime mortgage debacle, claiming the CRA forced banks to make risky loans to low-income borrowers. But such arguments cannot withstand any serious scrutiny. According to a Federal Reserve study, at least 94% of subprime lending at the height of the subprime mortgage frenzy occurred outside the CRA's reach. The reason for this gap in coverage is that the CRA is riddled with loopholes. The largest: the CRA does not cover stand-alone mortgage lenders, like Countrywide, that do not take deposits. In the end, it is hard to blame the CRA for subprime lending when the overwhelming majority of that lending was carried out by institutions not even covered by the law. If anything, the CRA was not too strong, but too weak: impotent to stop the wave of subprime lending that operated beyond its reach.

Even if the CRA is not to blame for the financial crisis, if states and other entities are going to tie their own banking to financial institutions' records of complying with the CRA, Congress must step in to strengthen and reform the law. Most importantly, the many loopholes that placed the riskiest lending beyond the scope of the CRA must be closed. Moreover, CRA grade inflation must come to an end, and bank practices must receive a hard look under the CRA.

If, like the children of Lake Wobegon, all banks are above average under the CRA, Move Your Money legislation or activities that operate in lock-stop with poor CRA oversight will not generate the desired effect. They will not bring about the reform of risky and dangerous bank practices because such efforts will not impact bank bottom lines from the bottom up. Instead, efforts at reform will serve--like the CRA grading process did in the last decade--as a fig leaf for risky practices that have devastating effects on local communities. During the height of the subprime lending frenzy, bank regulators looked the other way as subprime lenders ran rampant in the very communities the CRA was designed to protect. If it wasn't the fox guarding the hen house, perhaps it was the sheep.

Reform of the CRA on the federal level is necessary as a complement to organic, grassroots efforts on the local level, such as what New York State is trying to do by letting its billions in state funds do the talking on bank reform. In the end, such a market-oriented approach may be the only language banks really understand. In order for that talk to stand the best chance of success, consumer-driven reform tied to the CRA should make sure the law is updated to serve as an effective vehicle for gauging bank practices, and not just a rubber stamp for bank recklessness.