Bank Supervision and Organizational Capital: The Case of Minority Lending

Abstract

Racial disparities in mortgage lending have important welfare implications. We investigate whether improvements in banks’ organizational capital and associated control systems facilitate increased loan origination to minority borrowers. We focus on bank supervisors’ enforcement decisions and orders (EDOs) against banks, which can enforce changes in banks’ internal processes, procedures, and management practices. We hypothesize that EDO-imposed improvements in loan policies, internal governance, and employee training mitigate deficiencies in credit assessments and lending decisions that previously disadvantaged minority borrowers. We find that relative to white borrowers, mortgage origination to minority borrowers significantly increases following the resolution of EDOs, where this positive effect increases with the strictness of bank supervisors and the severity of the EDO. Using a semi-supervised machine learning method to analyze and quantify the text of EDOs, we find that increases in minority loan origination are significantly higher for EDOs specifying revisions of loan policies, implementation of formal internal governance procedures, or more employee training, especially in areas with a high proportion of subprime borrowers. Overall, we find that EDO-driven improvements in organizational capital generate unintended, positive social externalities that enhance access to credit for minority borrowers.

Keywords: Banking, Bank supervision, Discrimination, Enforcement actions, Internal controls, Internal audit, Loan policy, Mortgage lending

JEL Classification: G21, G28, G38