Lending Discrimination: The Unending Search

Creditworthiness, Not Race, Determines Loan Rejection Rates

This paper was delivered at the December 1993 Round Table at FEE.

H. L. Mencken once called politics “the art of looking for trouble, finding it everywhere, diagnosing it incorrectly, and applying the wrong remedies.” You don’t have to spend much time looking around to see just how right he was. Mencken’s characterization fits some recent regulatory follies to a tee.

One problem the politicians and bureaucrats set out to find was discrimination in lending. They found it in just about every rundown neighborhood in which mortgage lenders failed to extend credit because there wasn’t a sufficient probability of recovering money lent. This avoidance by lenders of certain areas, known as red-lining (so-called because red lines were supposedly drawn around areas where banks would not make loans) was outlawed by the Community Reinvestment Act of 1977. Other types of lending discrimination were forbidden under the Equal Credit Opportunity Act of 1974.[1] Interestingly enough, despite the current political climate, which encourages members of officially designated victim groups to make any of life’s little disappointments into a federal case, the Federal Reserve System’s office that deals with credit discrimination has received but a trickle of complaints, not one of which was found to entail illegality. The Fed’s response to this dearth of activity was to seek out complaints from civil rights activists. Even this had no discernible effect.[2]

The misdiagnosis was the idea that these areas were rundown because they couldn’t get loans. Dysfunctional families, public schools incapable of imparting the skills to prepare children for a productive adulthood, pervasive dependency on government largesse, high unemployment, and rampant crime which prevents those who are productive from enjoying the fruits of their labor get nary a mention as contributing factors. Certainly, the notion that these factors, which cannot help rendering a neighborhood rundown, might also make loans there a losing business proposition seems not to have occurred to those who are so quick to cry “discrimination.”

Indeed, the very existence of racial discrimination in lending is only plausible because of the misinterpretation of the available data. The finding by the Federal Reserve Bank of Boston that, in 1991, 15.0 percent of Asian, 17.3 percent of white, 26.6 percent of Hispanic, and 37.6 percent of black applicants for mortgage loans were denied credit is taken by regulators as proof of such discrimination.[3] Whether it is or not, however, depends on a number of factors which such summary statistics are incapable of revealing. Unless the members of each of these groups possessed identical levels of such characteristics relevant to creditworthiness as income, net worth, employment stability, and quality of the collateral they can post as security for the loan, to name a few, the numeric discrepancies mentioned above provide but the flimsiest of circumstantial evidence regarding the existence of discrimination.

Those studies which have taken such factors into account have discovered that Asians, whites, Hispanics, and blacks with similar levels of credit-worthiness do indeed have similar rejection rates. A study of lending behavior at a Detroit-area bank which controlled for factors related to credit-worthiness found no correlation between one’s likelihood of having his mortgage application approved and one’s race.[4] Even the study conducted by the Federal Reserve Bank of Boston, which has been held by many as evidence of widespread discrimination, shows that taking creditworthiness into account reduces the differences in rejection rates among racial groups. Its author, Alicia Munnell, has conceded that her study does not prove discrimination.[5]

Default Rates

If any statistic could shed some light on the presence or absence of discrimination among various ethnic groups, it would be the relative default rates among those groups. If lenders both made loans only on non-discriminatory profitability criteria and were able to avoid systematic errors, default rates would be identical for all groups. As a matter of fact, data cited by Ms. Munnell establishes the absence of any statistical relationship between race and default rates.[6] Any fair-minded observer would have to conclude from this evidence that lending discrimination, if it exists at all, is a non-problem. Indeed, the very regulators charged with enforcing Community Reinvestment Act guidelines have rated nearly 90 percent of commercial banks as “satisfactory” or “outstanding” regarding their fair lending records.[7]

Not only are the numbers incapable of supporting the charge of lending discrimination, but so are theoretical considerations. To the extent that loan officers’ incomes are based on the number and the value of the loans they generate, indulging whatever prejudices they may have against members of other races who in point of fact are fully qualified for loans would be a pricey indulgence indeed.[8] Furthermore, as long as such prejudices were not acted upon by all lenders, any qualified applicant turned down by one lender because of his race would represent a profit opportunity for those lenders not blinded by prejudice.

It should be noted that those who single-mindedly seek to find discrimination are not deterred by anything as pedestrian as the absence of evidence or logic on their side. Thus, Richard F. Syron, President of the Federal Reserve Bank of Boston, while realizing that loan rejection rates have more to do with weak credit histories than with race, nevertheless exhorts lenders and regulators to stop asking if there is a problem and begin to work to solve it.[9] Alicia Munnell continues to insist that lending discrimination occurs even though she had admitted that neither she nor anyone else has any evidence of it.[10] Indeed, some regulators, when they can’t find discrimination, are still not satisfied. Federal Reserve Board Governor Lawrence Lindsey, for instance, sought to prevent First Interstate Bancorp from acquiring another bank, not because there was any evidence that it discriminated, but because he did not think that it worked aggressively enough to make mortgage loans in particular low-income and minority areas.[11] Atlanta’s Decatur Federal Savings & Loan was put through the wringer for not advertising in black media and not giving special treatment to black borrowers, specifically not making loans at below-market rates to black borrowers who did not qualify by traditional banking criteria.[12]

Mencken Was Right

As Mencken realized, regulators would not be so hell-bent on finding problems unless they were itching to try out their (invariably counterproductive) pet solutions on them. One preferred solution is to foist on lenders the same types of affirmative action requirements which become so much a part of the business landscape. Regulators’ ability to withhold approval of new branches or acquisitions until their mandates are complied with in full is a potent threat indeed.

Shawmut Bank, New England’s third largest banking company, knows by painful experience just how effective it is. The bank has seen its efforts to expand through acquisition of other banks, a virtual necessity in today’s fiercely competitive environment, halted abruptly not because it has been convicted of, or even indicted for any violation of any law, but merely because of suspicion that Shawmut may be guilty of lending bias, which is being investigated by the Justice Department.[13] Until the banks’ officials comply with the commands of regulators, they will remain at a competitive disadvantage. Some of the actions which they have taken in an effort to placate the powers-that-be include requiring lower down payments of certain low-income applicants, earmarking $25 million for applicants whose unstable employment histories would not qualify for loans under traditional standards, and paying $100,000 to a left-wing community activist group which one would expect to otherwise make further accusations of discrimination.[14] Similar pressures forced Decatur Federal to “pay heavy fines, institute lending quotas, pay bonuses to people who didn’t qualify for mortgages, hold racial brainwashing sessions for Employees, and pay a hefty ransom to liberal community groups.”[15]

Another proposed “solution,” while less punitive, may set an even worse precedent. This is the Community Development Bank, (CDB) whose mission is to “stimulate the economy in areas where other bankers are loath to lend.”[16] The CDB is modeled on some private institutions which already exist—although these generally enjoy some subsidy either from the government or private foundations. (In any case, they have sufficient private capital invested that must seek out only the credit-worthy.) Government CDBs, on the other hand, are likely simply to depend far more on political criteria and to end up making mostly uneconomic loans. Critics hold up the federal Farm Credit System, which required $4 billion of government funds to cover the losses it incurred on agricultural loans in the early 1980s, as an example of the likely fate of these CDBs.[17] Of course, given that credit, as are all economic goods, is scarce, if the government makes loans to those who fail to meet traditional qualification criteria, it must be taking credit away from those who do meet them. Thus, it diverts credit from those more able to repay it to those less able to do so.

Ultimately, all of these proposed solutions constitute an attack on the rational economic calculation which Ludwig von Mises identified as the sine qua non of the market economy. Each of these measures replaces calculations based on expected profits and losses with those based on political criteria. Furthermore, such actions also erode the rights of property owners, specifically the right to use their property where it offers the greatest potential for gain.

What the government has been doing to lenders is not an isolated case. Government attempts to suppress decisions based on the profit motive in the name of some unattainable notion of fairness or equality are quite widespread in the United States today. The insurance industry has also come under attack for alleged red-lining. Community ratings statutes in a number of states have prevented health insurers from “discriminating” between good and bad risks. The Clinton Administration and several key Congressmen are now considering extending the Community Reinvestment Act to cover mutual funds and other financial institutions.[18] Even the use of information regarding prospective employees has come under attack by our courts, with the bizarre legal principle of “compelled self-publication,” under which your telling a prospective employer the official reason why you were fired by a previous employer, gives you standing to sue that previous employer for slander.[19] These examples are but the tip of the iceberg. And if our country does not shift course soon, that iceberg is likely to sink the Good Ship Capitalism. []


  1.   This act includes among its prohibitions a bank’s refusal to lend money to welfare recipients.
  2.   Statement by John P. LaWare, Chairman, Federal Financial Institutions Examination Council and Member, board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 24, 1993, Federal Reserve Bulletin, April 1993, p. 194.
  3.   Peter Brimelow and Leslie Spencer, “The Hidden Clue,” Forbes, January 4, 1993, p. 48.
  4.   Jonathan Chait, “Bad Examples,” Reason, December 1993, p. 58.
  5.   Brimelow and Spencer.
  6.   Ibid.
  7.   Dean Foust with Kelley Holland, “Taking A Sharper Look at Bank Examiners,” Business Week, April 19, 1993, p. 99.
  8.   Jack M. Guttentag, “Most Lenders Would Rather Profit Than Discriminate,” American Banker 158, January 6, 1992, p. 4.
  9.   “Statement of Richard F. Syron, President, Federal Reserve Bank of Boston, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 24, 1993,” Federal Reserve Bulletin, April 1993, p. 314.
  10.   Brimelow and Spencer.
  11.   Kenneth H. Bacon and Suzanne Alexander Ryan, “Shawmut Decision Shows Fed’s Division over Adequacy of Fair-Lending Records,” Wall Street Journal, November 22, 1993, p. A4.
  12.   Llewellyn Rockwell, Jr., “Fact,” Forbes, September 27, 1993, p. 86.
  13.   Kenneth H. Bacon and Gary Putka, “Shawmuffs Plan for Acquisition Rejected by Fed,” Wall Street Journal, November 16, 1993, p. A2.
  14.   Kenneth H. Bacon and John R. Wilke, “Fed Gives Bias Law New Clout As It Blocks a Bank Acquisition,” Wall Street Journal, November 17, 1993, pp. A1 and A9.
  15.   Llewellyn Rockwell, Jr., “Nader Aim at Banks—Unsafe at Any Rate? The Washington Times, August 24, 1993, p. F2. The fines in question amount to $1 million, paid to 48 black applicants who were denied loans.
  16.   Dean Foust with David Greising, “Banks That Believe in Many Towns Called Hope,” Business Week, November 30, 1992, p. 89.
  17.   Foust and Greising, p. 90.
  18.   Janet Novack, “What’s Ahead for Business,” Forbes, October 25, 1993, p. 39.
  19.   Junda Woo, “Quirky Slander Actions Threaten Employers,” The Wall Street Journal, November 26, 1993, p. 81.