Putting bank regulations on non-bank lenders will stifle innovation

According to a Wall Street Journal report, when Federal Reserve Chairman Powell recently spoke at a National Community Reinvestment Coalition event, he telegraphed his view saying, “like activities should have like regulation.” Powell’s speech argues that Community Reinvestment Act (CRA) reforms are needed to ensure that “everyone can contribute to, and share in, the benefits of prosperity.” Perhaps, but the Fed’s push to expand CRA regulation is likely just the first step toward expanding federal regulatory powers over non-bank lenders.

To date, the Fed, the Office of the Comptroller of Currency and the Federal Deposit Insurance Corporation have been unable to agree on a set of common revisions to CRA bank regulations. Notwithstanding chairman Powell’s stated concern for equity and inclusion, CRA regulatory reform is more likely to be catalyzed by an unholy alliance between Congress, bankers and federal regulators that targets growing competition from non-bank financial institutions.

Congress passed the CRA in 1977 to address systemic inequities in credit access that contributed to disinvestment and poverty in minority and low-to-moderate income urban neighborhoods. The CRA requires banks supervised by federal banking regulators to meet the credit needs of the communities that they serve, including the needs of low and moderate income areas. Regulators must take CRA compliance into account when evaluating applications for new banks and mergers.

Community activist organizations use the CRA to extract special lending programs and other below-cost services from banks seeking merger approval. To receive approval, a bank’s CRA strategic plan must meet the convenience and needs of the impacted community and generate “public benefits”. Organized opposition to bank mergers can cause significant approval delays, a tactic frequently used to extract formal commitments from banks to provide special CRA loan programs. According to one estimate, over time, these CRA agreements have generated $6 trillion in loans for affordable housing, small business, economic development and community facilities in low-and moderate-income communities.

Congress values the CRA because it allows them to subsidize favored community activist agendas through the banking system without impacting the federal government budget deficit. For many in Congress, CRA is a proverbial goose that lays golden eggs. For banks, CRA programs are an implicit tax they must pay to enjoy deposit insurance and other government financial safety net protections. 

Progressives in Congress will echo chairman Powell’s “equity and inclusion” justification to legislate banking-style CRA regulations on non-bank intermediaries. But if legislation is introduced, it is unlikely to stop with CRA. Many progressive interest groups and regulatory officials have long argued that non-bank lenders, so-called “shadow banks,” need to be subject to bank-style regulations because they are a growing threat to financial stability.     

There is little doubt that many bankers would welcome a new “regulatory tax” to slow the growth of non-bank financial intermediaries. According to an FDIC study, banks’ share of consumer lending fell from 52 percent in 1990, to 42 percent in 2018. A Washington Post article claims that “banks’ share of middle-market [business] lending has been nearly cut in half” by non-bank lenders who make loans that banks are unable or unwilling to make in the post-2008 regulatory environment. Home Mortgage Disclosure Act data from 2020 shows that 63 percent of all residential mortgages were originated by non-bank lenders.

Fintech firms have also become important competitors for banks in business and consumer lending in addition to providing digital payments services. The 2020 Federal Reserve Small Business Credit Survey shows that non-bank lenders are an increasingly important source of small business credit, especially for smaller higher-risk businesses. Businesses choose non-bank lenders for several reasons including a higher perceived likelihood of approval, a faster decision process, lower collateral requirements and more flexible product terms compared to bank lenders.  

For its part, the Federal Reserve has been unwavering in its aspiration to extend its regulatory powers to non-bank lenders. Indeed, Governor Daniel K. Tarullo announced the Fed’s intentions in a 2012 speech on the dangers of “shadow banking.” The push to extend the Fed’s powers, slowed by the Trump administration, is likely to gain steam under the new administration, especially with Janet Yellen as secretary of the treasury. The imposition of banking regulations like CRA on non-banks would create new opportunities for elected officials to steer off-budget funds to their activist voter base.

For the rest of us, foisting bank regulations on non-bank financial intermediaries is unlikely to generate benefits that out-weigh the costs. Non-bank intermediaries have grown in importance because they fill the financial needs of business and consumers, needs that are no longer being provided by the highly-regulated banking system. Non-bank intermediaries do not benefit from deposit insurance or any other implicit government guarantee. Yet, without the benefits of government subsidized funding and associated regulations, non-bank intermediaries have been leaders in developing new technologies to streamline lending and payments services that are especially beneficial for small businesses and consumers. 

The benefits of maintaining the current separation between bank and non-banks regulation are tangible. The promised benefits of shared prosperity and reduced systemic risk from applying bank regulations to non-banks — not so much. 

Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.