OBSTACLES TO DEVELOPMENT LENDING
Keith N. Hylton
Boston University School of Law Working Paper 99-15
Why are poor inner cities underserved by financial institutions, and why is it so difficult to find a solution to this problem? Explanations of the lending shortfall problem range between theories based on discrimination to the view that the lending market is working flawlessly. Drawing largely on the economic development literature, I elaborate an alternative explanation here. The asymmetric information theory I offer yields the prediction that urban minority communities will be underserved by financial institutions--indeed that minority loan applicants will experience discrimination, in the sense that they will be rejected more often and have to meet greater burdens in the creditworthiness assessment process--, even in the absence of discriminatory intent.
I claim that the existing framework of banking regulation is in part responsible for the difficulty of finding a solution to the lending shortfall problem. The existing regulatory framework makes it difficult for large scale development-oriented lending institutions to emerge. This is a result of the conflict between fair lending and safety regulation. Relatively small development-oriented banks are constrained by their own prudence or by safety regulators to diversify their loan portfolios, limiting the amount of lending geared toward community development. However, fair lending regulators, specifically Community Reinvestment Act examiners, give banks poor evaluations on the basis of a conservative lending policy. Banks that are forced to choose between satisfying the safety and the fair lending requirements will choose the former, since a failure to satisfy safety demands can lead to harsh disciplinary action by regulators.
An ideal regime would encourage development-oriented banks to expand, and adopt a safety regulation scheme that gives banks greater freedom to lend in poor communities. This implies that the CRA should be modified so that it no longer prevents small development-oriented banks that have followed a conservative lending policy from expanding, and at the same time deposit insurance should be privatized.
In spite of the potential benefits from these changes, they are unlikely to be observed in the near future. The reason is that the existing regime represents a political equilibrium supported by dominant interest group coalitions. Lending pressure groups, regulators, virtually all local politicians and some national politicians generally benefit from the existing enforcement regime for the CRA. More surprisingly, large banks enjoy some benefits and probably benefit overall from the existing CRA enforcement regime.
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Keith N. Hylton Contact Information
Boston University School of Law
765 Commonwealth Ave
Boston, MA 02215
Keith N. Hylton, "Banks and Inner Cities: Market and Regulatory Obstacles to Development Lending," 17 Yale J. on Regulation 197 (2000).