Wednesday, July 17, 2013

Do SIBs qualify for the Community Reinvestment Act? 
Oh, yeah.

[This post was originally published in SIB Trib No. 2.  I'm republishing it here to respond to the fine article by Diana Aviv and Antony Bugg-Levine, "Social-Service Groups Won’t Survive Without New Sources of Revenue," published in the Chronicle of Philanthropy.  Among other sound recommendations, the authors make the following proposal: 

"Expand the Community Reinvestment Act. For more than 35 years, the act has prompted banks to lend in underserved markets and spurred the creation of the community-finance industry. Expanding the law to facilitate easier investment in a wider range of organizations could make billions of dollars available to social-service organizations."

As sensible as this might be, modernizing any federal legislation, particularly one with fiscal implications, is exceptionally these days. I'm not a bona fide CRA lawyer, but I believe the act already covers SIBs.  If so, a simple interpretive letter from federal regulators might do the trick.  I'd welcome comments from CRA attorneys who actually know what they're talking about.]

Wouldn’t it be handy if there were some relatively painless way to attract commercial investment in SIBs that didn’t require all that messy business about outcomes and savings?  Something that didn’t involve financial modeling, risk management or counterfactuals?  Some incentive that was simple and pure, easy to fathom, but with a kick like moonshine whiskey?

Many have wondered if the federal Community Reinvestment Act might fit the bill.  Godeke and Resner think that “CRA capital may be a bridge between the first philanthropically-funded PFS financings and other investors.”  Social Finance US says that CRA qualification “would open up a new pool of institutional liquidity for SIBs within the banking community.”  Institutional Investor reports that Goldman Sachs intends to pursue CRA credit.  

So can SIBs take a page out of the Low Income Housing Tax Credit’s book?  “Many nonprofit executives spend a good chunk of their time trying to talk corporate executives into giving them money. And companies big and small often respond generously. But social entrepreneurs should also consider a less well-known technique for generating new revenues: lobbying for changes in government tax policy. Such changes can yield an enormous outpouring of new resources for the social sector.”  Doug Guthrie, “An Accidental Good,” Stanford Social Innovation Review, Fall 2004.  And with CRA, there’s no lobbying required.

Now, I’m an experienced regulatory lawyer, but I’ve never worked with CRA before.  The statute has more than a few technical hoops to jump through that keep bank legal departments plenty busy.  The statute is short, but the regulations are long, and the regulatory examination process is exacting.  

All that being said, however, the question of whether SIBs are eligible for CRA credit seems to be a fairly straightforward.  Subject to the particulars of specific transactions, SIBs are just the kinds of investments that the CRA wants banks to make.

Section 802 of CRA provides as follows:

“(a)  The Congress finds that – (1) regulated financial institutions are required by law to demonstrate that their deposit facilities serve the convenience and needs of the communities in which they are chartered to do business; (2) the convenience and needs of communities include the need for credit services as well as deposit services; and (3) regulated financial institutions have a continuing and affirmative obligation to help meet the credit needs of the local communities in which they are chartered.

(b)  It is the purpose of this title to require each appropriate Federal financial supervisory agency to use its authority when examining financial institutions, to encourage such institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions.”

Please allow me to translate:  The CRA requires banks and other regulated financial institutions to meet the credit needs of all of the communities in which they’re authorized to conduct business, rich and poor alike, and federal financial regulators can use their examination authority to enforce that requirement.

Section 804(a) prescribes, in very broad terms, how regulators are to use that examination authority:

“In connection with its examination of a financial institution, the appropriate Federal financial supervisory agency shall – (1) assess the institution’s record of meeting the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of such institution; and (2) take such record into account in its evaluation of an application for a deposit facility by such institution.”

Again, in plain English, whenever a regulated financial institution applies for permission to open a new branch – something that hyper-competitive big banks do all the time – regulators must check to see if they’re making loans to low- and moderate-income customers in their host communities.  If not, the regulators can deny the application, which is an exceedingly strong incentive for banks to lend money to customers in those neighborhoods.  A bank that wants to take deposits from a certain community must also make loans to that community.

The obvious follow-up question is:  what kinds of lending activities count toward a bank’s “record of meeting the credit needs of its entire community”?  The answer is found in a “Questions and Answers” document jointly published in the Federal Register by all of the federal financial regulators, which provides official “guidance for use by agency personnel, financial institutions, and the public.” [Editor’s note:  This is a 40-page, single-spaced, 3-columned document with about 8-point type.  I read this stuff so you don’t have to.  You’re welcome.]

First, what counts?  To make a very long story as short as humanly possible, the CRA regulations and Q&A document broadly define a qualified investment as any lawful investment, deposit, membership share, or grant that has as its primary purpose “community development” to support the following endeavors: (1) affordable housing; (2) community services targeting low- and moderate income individuals; (3) activities that promote economic development by financing small farms and small businesses; and (4) activities that revitalize or stabilize low- and moderate-income geographies.
Second, how’s the counting carried out?  When federal regulators consider a bank’s application, they evaluate the performance of its qualified investments based on: (1) the dollar amount of qualified investments; (2) the innovativeness or complexity of qualified investments; (3) the responsiveness of qualified investments to credit and community development needs; and (4) the degree to which the qualified investments are not routinely provided by private investors.

We can already see encouraging signs for SIBs.  Community development loans for affordable housing, community services, economic development, and revitalization all qualify for CRA credit.  Banks gets points for the amount and innovativeness of loans, as well as for making loans when other private investment isn’t available.  Sounds a lot like SIBs.

But all qualified investments are not created equal:  “Examiners will consider the responsiveness to credit and community development needs, as well as the innovativeness and complexity, if applicable, of an institution’s community development lending, qualified investments, and community development services. These criteria include consideration of the degree to which they serve as a catalyst for other community development activities.” 

In fact, banks get points for applying “special expertise and effort on the part of the institution [that] provide a benefit to the community that would not otherwise be possible.”  So SIBs are likely to receive extra credit “when they augment the success and effectiveness of the institution’s lending under its community development loan programs,” including “a technical assistance program under which the institution, directly or through third parties, provides affordable housing developers and other loan recipients with financial consulting services.”  It would seem that banks that use SIBs creatively to expand the range of loan products, combined with advice about how to enhance their “success and effectiveness,” would be furthering the objectives of the CRA.

Even better, the Q&A provides specific examples of loans that are similar to SIBs.  Thus, “community development” includes “community- or tribal-based child care, educational, health, or social services targeted to low- or moderate-income persons, affordable housing for low- or moderate- income individuals, and activities that revitalize or stabilize low- or moderate- income areas, designated disaster areas, or underserved or distressed nonmetropolitan middle-income geographies.”  Revitalization and stabilization activities include “creating, retaining, or improving jobs for low- or moderate- income persons.”

Qualified technical assistance activities provided to community development organizations include “assisting in fund raising, including soliciting or arranging investments.”  “[M]unicipal bonds designed primarily to finance community development generally are qualified investments.”  Qualified investments also include “investments ... in ... [f]acilities that promote community development by providing community services for low- and moderate-income individuals, such as youth programs, homeless centers, soup kitchens, health care facilities, battered women’s centers, and alcohol and drug recovery centers,” as well as “job training programs that enable low- or moderate-income individuals to work.”  

Investments in community development “funds,” including “nationwide funds,” also count for CRA credit.  “[I]nstitutions may exercise a range of investment strategies, including short-term investments, long-term investments, investments that are immediately funded, and investments with a binding, up-front commitment that are funded over a period of time.”

I’ll refrain from pummeling the deceased equine:  SIBs are indistinguishable from the kinds of traditional and not-so-traditional lending activities that expressly qualify for credit under CRA.  The services they invest in, the reasons for issuing SIBs, the nature of the instrument itself, and the ways they are created all comprise “community development activities” within the meaning of CRA.

But, wait, you say.  What about that pesky language in sections 802 and 804 about “consistent with the safe and sound operation of such institutions”?  Does this mean that, in addition to geographic and income-related requirements, there’s a “safety and soundness” test that SIBs must pass?  If so, do banks need an official interpretation from regulators before they can claim CRA credit for these new-fangled “social investments” in “social innovation” by “social entrepreneurs” that are still completely experimental?  How can something be considered safe and sound if no one has ever done it before, successfully or otherwise?  

At least some risk-averse banks have questions.  As Godeke and Resner report, “[b]anks would like to have their CRA regulators signal that PFS financings would earn CRA credit before committing time and resources to specific transactions....  PFS financings are subject to the same investment committee ‘safety and soundness’ underwriting standards as other bank investments. Underwriting social service intervention based on social science research is difficult and will require the banks to assess new risks. ‘This is new work for the banks,’ was a common theme at a recent meeting of financial institutions to discuss SIB opportunities.”

The implication is that SIBs don’t count because they’re too new and risky.  But I think this reflects a fundamental misinterpretation of the language.  First, as we’ve already seen, CRA specifically encourages banks to make innovative and complex loans.  

Second, and more important, the safe-and-sound language doesn’t restrict banks, it protects them from overzealous regulators who might want them to engage in reckless lending practices.  It’s not a criteria that individual loans must satisfy.

Banks had long used phony creditworthiness arguments to take deposits from customers in poor communities and invest them in only in wealthier communities, an unlawful practice known as redlining.  The legislative history of CRA leaves no doubt that the statute was enacted because “of amply documented cases of redlining, in which local lenders export savings despite sound local lending opportunities.”  To expose this flimsy excuse, the Senate sponsor emphasized that “[t]he bill is not intended to force financial institutions into making high-risk loans that would jeopardize their safety.” 

Thus, the purpose of the “safety and soundness” language is simply to make clear that CRA didn’t require banks to make irresponsible loans in order to fulfill its community development obligations.  It means exactly the same thing as if the law read, “nothing in this act requires financial institutions to engage in unsound or unsafe lending practices.”  It’s a limitation on the CRA mandate, not an expansion.

Nonetheless, some politicians have tried to blame CRA for the 2008 financial crisis.  A November, 2008 staff analysis submitted to the Federal Reserve Board of Governors refuted critics who contended that “the law pushed banking institutions to undertake high risk mortgage lending.”  Rather than mandating reckless loans, the analysts said, “[t]he CRA emphasizes that banking institutions fulfill their CRA obligations within the framework of safe and sound operation.”

Safety and soundness simply isn’t a loan-by-loan determination.  Rather, according to the regulations, “[a] bank’s performance need not fit each aspect of a particular rating profile in order to receive that rating, and exceptionally strong performance with respect to some aspects may compensate for weak performance in others.”  Safe lending practices are examined in the context of a bank’s entire operations, not for each and every loan, which would be impossible to carry out.  Instead, “[t]he bank's overall performance ... must be consistent with safe and sound banking practices and generally with the appropriate rating profile ...”  

In other words, an otherwise safe-and-sound bank is perfectly free to invest in a SIB that raises all kinds of new and challenging questions.  Needless to say, it’s highly unlikely that even a basketful of dubious SIBs could disturb a bank’s business.  For example, even without the Bloomberg Philanthropy guarantee, the complete and total bust of the $9.6 million SIB investment Goldman Sachs made in New York City, or even an investment 10 times the size, would be completely inconsequential to a financial institution that, in the words of Time magazine, “only made [a] $1 billion profit last quarter.”  If JP Morgan Chase could suffer a $6.2 billion loss from bad trades and still earn a record $21.3 billion in 2012, it could probably invest a few hundred million in SIBs and not lose much sleep. 

To be sure, the CRA is a complex statute with a rich regulatory nimbus, and the compliance requirements for SIBs are no less tricky than for other community investments.  Consult a lawyer, your mileage may vary, and so on.  But assuming that banks continue to apply the same basic compliance standards they already follow, and nothing more, the question of whether SIBs can already be considered qualified CRA “community development” investments without further guidance from federal financial regulators does not appear particularly iffy.  

They can.