Federal regulators step in when US banks are badly managed or take on excessive risk. And if informal efforts to address issues such as risky lending or inadequate capital fail, banking authorities may issue an enforcement decision and order (EDO), a measure of last resort, to force banks to take corrective actions. An EDO lays out a road map to compliance, and an institution that fails to follow it may be forced to close.
These orders have an unintended benefit: they result in increased mortgage lending to historically disadvantaged categories of borrowers such as members of minority groups and women, according to University of Utah PhD student Byeongchan An, University of North Carolina’s Robert Bushman, the Federal Reserve’s Anya Kleymenova, and Chicago Booth’s Rimmy E. Tomy.
EDOs generally do not address issues related to fair-lending regulations, and yet 17 years of data covering 1,350 disciplined banks indicate that after going through the course-correction process, lending institutions cranked up residential mortgage loans to minority borrowers and to women who were primary or solo borrowers, according to the study. And they did so without taking on more risk.
“Improvements in internal policies and procedures initiated by bank supervision can lead to very real changes in lending, which could potentially affect the local economy, growth, and employment,” Tomy says. “When new loan policies are introduced and documented, and employees follow best practices in lending, it reduces subjectivity and improves lending outcomes for minorities and women.”
The researchers focused on banks that received the most common and severe types of EDOs, from 1997 through 2013, from the Federal Deposit Insurance Corporation, the Federal Reserve, and the Office of the Comptroller of the Currency. They excluded orders that referenced fair lending and analyzed the three years before an enforcement action, the period when the order was in effect, and the five years after. They also studied transaction-level Home Mortgage Disclosure Act data on mortgage loan applications, including applicants’ race and ethnicity, underwritten loans, and denial reasons. In the study, minority borrowers were those who identified as Black or African American, Asian, American Indian or Alaska Native, Native Hawaiian or other Pacific Islander, or nonwhite Hispanic.
They find that before an EDO, banks were 9.6 percent more likely to deny loan applications from minority borrowers than from white borrowers. But after banks made the changes demanded by federal regulators, that number dropped to 4.6 percent. After going through the enforcement action, banks also expanded lending to women who were primary or solo borrowers.
Women and minority borrowers tend to have lower overall wealth, which makes it harder for them to borrow and build credit histories. They are also more prone to credit-damaging income shocks. All this typically makes banks more likely to deny these borrowers’ mortgage loan applications on the basis of credit scores.
However, after a period of federal oversight, banks were 3.4 percent less likely to reject loan applications from minority borrowers because of their credit history, the researchers find. This is most likely because banks improved their credit-risk assessment.
“If improving banks’ operations allows them to process information better, they may be able to use additional sources of hard information and rely less on credit histories or credit scores, which disproportionately disadvantage minority communities,” Tomy says.
Because federal regulators often require stricter internal governance and documentation procedures, banks may also rely less on the discretion of individual loan officers, the research suggests. “Banks might have to properly document their internal audit processes and loan policies, reducing loan officers' subjectivity,” Tomy says.
The severer an enforcement action, the greater the increase in lending to minority borrowers, the researchers find. The results were also stronger in counties with a higher proportion of subprime borrowers. Although the study focused on the most extreme examples of poorly managed banks, the findings emphasize the possibility that improvements in banks’ administrative controls can play an important role in enhancing access to credit for minority borrowers.
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