The rising costs of complying with super- visory demands have brought the issue of regu- Between a Rock latory burden to the attention of both law- makers and bank regulators. But one relatively underappreciated aspect of regulatory burden is and a Hard Place: the potential for the supervisory process to impose conflicting demands on banks. In October 1977, Congress passed the The CRA—Safety and Community Reinvestment Act (CRA) as Title VIII of the Housing and Community Development Act. The legislation was designed to encourage Soundness Pinch commercial banks and thrifts to help meet the credit needs of their communities, including low- Jeffery W. Gunther and moderate-income neighborhoods, in a manner consistent with safe and sound banking prac- tices. In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act established four possible composite CRA ratings: 1—outstanding; 2—satisfactory; 3—needs to improve; and 4— substantial noncompliance. Federal agencies anking entails risk, historically considered twelve factors in decid- B ing how well financial institutions were meeting but can regulators the goals of the CRA (see Garwood and Smith 1993). Revised regulations announced in April decide how much 1995 replaced these factors with three tests—of lending, investment, and service—with the risk is appropriate? lending test receiving the most weight.1 Examiners have always focused on lend- ing activity in determining a bank’s CRA rating. The revised CRA rules reflect this focus, as it is difficult for a bank to receive an overall satis- factory rating unless its lending performance is satisfactory. In rating CRA compliance, regula- tors assess such factors as a bank’s overall lend- ing activity in its market area and the degree to which the bank provides credit throughout its market, with particular emphasis on low- and moderate-income neighborhoods and individu- als as well as small businesses and farms. But regulators use very different criteria in assigning safety and soundness ratings to banks. In 1979, federal agencies adopted the Uniform Financial Institutions Rating System. Under this system, ratings originally were derived from on-site evaluations of five factors—capital ade- quacy (C ), asset quality (A), management (M ), earnings (E ), and liquidity (L ). This CAMEL rat- ing system was revised on January 1, 1997, to include a sixth component.2 The new S compo- nent focuses on sensitivity to market risk, such as the risk arising from changes in interest rates. Like the earlier CAMEL ratings, the CAMELS ratings have five levels: 1—basically sound in every respect; 2—fundamentally sound but with Jeffery W. Gunther is a senior economist and policy advisor modest weaknesses; 3—financial, operational, in the Financial Industry Studies Department or compliance weaknesses that cause supervi- at the Federal Reserve Bank of Dallas. sory concern; 4—serious financial weaknesses 32 FEDERAL RESERVE BANK OF DALLAS that could impair future viability; and 5—critical by triggering asset quality problems. Similarly, if financial weaknesses that render the probability CRA examiners credit banks for pursuing gen- of near-term failure extremely high. (For sim- erally aggressive strategies that support high plicity, this article applies the term CAMEL to levels of lending but might detract from safety both CAMEL and CAMELS ratings.) and soundness, the implementation of such Even this brief description of CRA and strategies could push CAMEL and CRA ratings in safety and soundness ratings reveals the poten- opposite directions. tial for conflict. Although safety and soundness A good example involves the tendency for is a factor in CRA ratings, banks are encouraged growth- and lending-oriented banks to manage to boost the availability of credit throughout the their equity positions at lower levels than do communities they serve. In contrast, the primary more conservative banks. As a result, relatively focus of the safety and soundness exam process low capitalization may be a common feature of is the containment of risk in general and credit the strategies that closely conform to the credit- risk in particular. Lacker (1994) points out some enhancing objectives of the CRA. However, of the potential implications of requiring banks banks that manage their capital in this manner to lend in certain areas or to certain borrowers, leave themselves with a comparatively small including the possibility that regulators might be cushion between financial loss and insolvency culpable in the event of large-scale losses on and so may be viewed less favorably from a CRA-related loans. safety and soundness perspective. This type of This article formulates and tests hypothe- conflict and its various implications can be re- ses about the way the potential conflict between ferred to as the aggressive strategies hypothesis. CRA objectives and safety and soundness con- siderations may actually play out in the day-to- Necessary Retrenchment Hypothesis day operations of the supervisory process. The The second hypothesis involves the possi- next section discusses two types of events bility that financial losses might necessitate a involving potential conflict. A framework is then redirection of resources, away from CRA objec- developed for empirically identifying the deter- tives and to the process of financial recovery. minants of CAMEL and CRA ratings, with the When a bank encounters financial problems, goal of testing for conflict between the demands current legislation and regulations governing placed on banks by CRA exams, on one side, the safety and soundness exam process dictate and safety and soundness exams, on the other. financial retrenchment and corrective action to For smaller sized banks in particular, the find- avoid possible speculative or fraudulent end- ings of this exploratory study point to a super- games by bank owners and managers, while, at visory process in pursuit of conflicting goals and the same time, facilitating either the bank’s finan- suggest more thought may be needed regarding cial recovery or, if necessary, its prompt closure. the appropriateness of CRA regulations. The The possibility then arises that the CRA exam article concludes with ideas for further research process may not take into full account the slow- in this area. down in CRA-related activities that the situation requires. If this occurs, the CRA exam process may tend to assign inferior ratings to banks strug- TWO FACES OF BANK REGULATION gling with financial difficulties. In this case, the One type of potential conflict between CRA exam process would conflict with safety CRA objectives and safety and soundness con- and soundness considerations. This type of con- cerns revolves around risks associated with the flict and its various implications can be referred act’s attempt to boost the supply of credit. The to as the necessary retrenchment hypothesis. second potential conflict discussed in this article involves the resource constraints that arise A Clarification when a bank has financial problems and is It is important to note that both the struggling to cope with them. aggressive strategies and necessary retrench- ment hypotheses can operate on two levels. The Aggressive Strategies Hypothesis first concerns whether examiners rate banks in To the extent that the CRA exam process a manner consistent with the hypotheses. The rewards aggressive banking strategies, a poten- empirical work that follows addresses this issue. tial conflict arises with the primary goal of the A second question then arises regarding safety and soundness exam process, which is to the extent to which bank behavior can be attrib- contain risk. Increases in lending could tend to uted to the rating schemes examiners use. Even help CRA ratings but could hurt CAMEL ratings if the CRA exam process does reward aggressive ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 1999 33 growth and lending strategies, it cannot be in- and CAMEL ratings based on the hypotheses de- ferred from this alone that aggressively man- veloped above. Sample design is also considered. aged banks adopt such strategies in order to attain superior CRA ratings. Other motivations Variables may be at work. Similar reasoning applies to To estimate the model, it is necessary to safety and soundness exams. identify sets of variables upon which the results As a result, the scope of this article is of safety and soundness and CRA exams may limited to the goals of the supervisory process, depend. Numerous factors are undoubtedly leaving the task of assessing the success of considered in assigning both types of ratings. supervision in motivating bank behavior to However, data availability issues, coupled with other studies. the need for a parsimonious specification, sug- gest the best approach is to focus on key vari- ables capable of neatly summarizing a bank’s EMPIRICAL APPROACH strategy and condition.3 The statistical model used to test the Examiners looking at CRA compliance hypotheses under consideration accommodates have always maintained a strong focus on lend- a distinguishing feature of CRA and CAMEL rat- ing activity. If in valuing lending activity CRA ings. The ratings themselves are not continuous examiners knowingly or unknowingly reward variables. In addition, an unsatisfactory safety aggressive banking strategies, financial charac- and soundness rating corresponds to a CAMEL teristics typically associated with such strategies rating of 3, 4, or 5. The unsatisfactory CRA rat- might help predict how well a bank does on its ings are 3 and 4. Hence, if the purpose is to CRA exam. identify factors that contribute to unsatisfactory The model has three proxies for aggres- ratings, the variables to be explained are of the sive banking strategies to help explain CRA rat- either–or type; that is, banks are either satisfac- ings. The first is the ratio of equity capital to tory or unsatisfactory from safety and soundness total assets (CAR). As discussed earlier, it is nat- and CRA perspectives. ural for growth- and lending-oriented banks to Because the ratings are in this way limited manage their equity positions at lower levels to certain categories or levels, as opposed to than relatively conservative banks.