Banks and Inner Cities: Market and Regulatory Obstacles to Development Lending
Posted: 11 Feb 2000
Date Written: 1999
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 even in the absence of discriminatory intent.
I claim that the existing framework of banking regulation is in part responsible for the difficulty in 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 both that the CRA should be modified so that it no longer prevents the expansion of small development-oriented banks that have followed a conservative lending policy and that deposit insurance should be privatized.
In spite of the potential benefits from these changes, they are unlikely to be observed in the near future, because 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.
JEL Classification: G21, G28
Suggested Citation: Suggested Citation