CRA's more flexible yardstick.

The long wait is over for the nation's largest financial institutions. Five years in the making, the revised Community Reinvestment Act (CRA) rules became fully integrated as of July 1, 1997. The revised CRA regulation replaces the old 12 assessment standards with more performance-oriented standards.

Ever since President Clinton broached the idea of rewriting the CRA rules, bankers have been preparing for the transition. The federal banking regulatory agencies spent 1993 through 1995 reworking the regulation and phased in the new rules during an 18-month time frame.

Institutions with assets of less than $250 million have been operating under the new rules since January 1, 1996. The streamline exam uses four examination criteria to evaluate deposit and lending results.

For institutions defined as "large banks" under the regulation (those with assets in excess of $250 million), CRA's new rules became effective in July. Comprised of three performance tests (i.e. Lending Test, Investment Test and Service Test), the large bank examination procedures, like their small bank counterparts, challenge financial institutions to produce results. With this number-driven challenge, significant opportunities exist for institutions.

Sen. Carol Moseley-Braun (D-Illinois), in an interview for this article, said she noted challenges and opportunities for bankers when the four regulatory agencies testified before the Senate Banking Committee on proposed changes in the regulation. "One of the opportunities the new rules created is the ability for financial institutions to define themselves based on the products they offer and communities they serve that did not exist under the old rules," she said.

Rep. Jesse Jackson, Jr. (D-Illinois), a member of the House Banking Committee, cited the benefit that the performance context will serve in that it will require banks to listen more closely to their community's concerns. In an interview for this article, Jackson said that bankers have not always taken into account community concerns when it has come to their business strategies, and that the performance context provision will require both examiners and bankers to give more weight to community concerns.

Sen. Braun and Rep. Jackson's comments are both legitimate observations. Under the old CRA rules a "one-size-fits-all" examination process existed. The statute did not distinguish in terms of examination guidelines by giving consideration to an institution's asset size, location or lending focus. However, the new rules permit bank examiners to judge a financial institution's CRA performance in the context of information about the institution, its community and its competitors. This is done through the compilation of certain information described in the interagency examination procedures as "performance context" data.

Warren Traiger, a New York-based attorney specializing in CRA, said at a PCI, Services CRA/HMDA Fair Lending Colloquium ("PCI Colloquium") in June in Newport, Rhode Island, "Under the notion of performance context, each bank is acknowledging that it cannot and does not provide all products and services to all people, even people who live and work nearby."

This article focuses on the role of performance context data in new CRA exams. Beginning with an examination of what comprises performance context data, the first half of the article also analyzes what the data means and how it's determined. The second half addresses how performance context data will be used by the regulatory agencies as well as what financial institutions can do to affect the data's interpretation and impact.

What is performance context data?

When I was an examiner, you were not required to look at performance-type data. That is not to say that we didn't look at demographics and make use of some community contacts to get an idea about a bank's delineated community, but nothing as formalized and structured as the new regulation provides. Under the examination procedures released on November 13, 1995, by the Federal Financial Institutions Examination Council (FFIEC), examiners must review performance context information as part of their overall CRA analysis. A summary of that information follows:

* Community demographic and economic data about an institution's assessment area.

* Lending, investment and service opportunities in an assessment area.

* Institution's product offerings and strategy.

* Institution's capacity and constraints to lend or invest in its community.

* Institution's performance data.

* Performance data for similarly situated lenders.

* Public comments and CRA file.

* Any other information the agency considers relevant.

The source of some of this information is based on objective statistics while other information is subject to interpretation. For example, community demographic data, as far as percentage of low- and moderate-income people and the designated geographic area, is an objective statistic. The percentage of minorities in each geographic area is also an objective statistic. But the lending, investment and service opportunities in an institution's assessment area are not objective statistics. Nor is performance information from similarly situated lenders. This type of information is subject to interpretation in terms of its meaning and impact on CRA examinations.

The weight assigned each information source and the method used to determine it may be a point of contention between banks and examiners. For example, how peer banks are selected is significant in terms of comparing one institution's performance with another. The particular sources of information that are relied on to develop conclusions about lending, investment and service opportunities in a bank's assessment areas can have serious repercussions on a bank's CRA rating.

Different conclusions between a bank and an examiner regarding lending, investment and service opportunities in an assessment area may lead to different conclusions about a bank's CRA performance. If an examination team identifies credit needs that a bank has not identified, the bank's CPA program may be considered deficient even before the CPA exam begins. This is why the way that performance context data is determined is so significant.

How is performance context data determined?

According to the FFIEC's examination procedures, regulatory agencies will facilitate the collection of performance context information from the following four sources:

* Examinations of other institutions serving the same or similar assessment areas.

* Information developed cooperatively between the different agencies.

* Community contacts.

* Although not required to do so, the agencies will also consider information generated by an institution in terms of lending, investment and service opportunities in its assessment area(s).

The agencies will use the examinations of other institutions, shared agency data and community contacts to determine the following performance context information: community demographic and economic data; lending, investment and service opportunities in an assessment area; and the performance record of similarly situated lenders.

Prior CPA examinations will probably be the most useful means of collecting this information as long as the report used as a source of information is of an institution in the same or similar assessment area. Because one of the four agencies will have already gone through the process of creating a performance context for another large institution in the same area, the collection and analysis of information will be easier.

Shared agency information, for the most part, will involve demographic and economic data from verifiable sources such as the U.S. Bureau of Census, state and county statistical data and interagency database information. Additionally, shared agency data may also involve information prepared by an institution's competition.

The FFIEC examination procedures state that information from community contacts can provide valuable insights to examiners, regarding a community's economic base and local community development initiatives. In an ideal situation, I would agree that community contacts are an insightful resource. Unfortunately, it was my experience as an examiner that more often than not community contacts were rushed due to examination time constraints and, therefore, the information was not as useful as it might have been in evaluating an institution's CRA performance.

In my experience, there has been a direct relationship between the effectiveness of community contacts and the time spent in preparing for and researching community contacts. When there is sufficient time to prepare, community contacts can serve as an insightful resource.

Several sources of information are available regarding an institution's product offerings, business strategy, lending capacity and regulatory constraints, and performance data. An institution's own performance data serves as the most effective source of this type of information. Individual institutions are obviously in the best position to describe their product offerings, business strategy and the like.

According to the preamble to the CRA regulation that appeared in the Federal Register on May 4, 1995, the agencies will request any information that the institution has developed on lending, investment, and service opportunities in its assessment area(s). The preamble states that the examining agencies will not expect more information than what an institution would normally compile when developing a business or marketing plan to penetrate underserved markets. But because institutions are under no requirement to generate performance context data for an examining agency under the new CRA rules, examiners must be prepared to determine this information from other alternative sources.

Some of these alternative sources are cited in the FFIEC examination procedures and include Consolidated Reports of Condition (Call Reports)/Thrift Financial Reports (TFRs), annual reports, supervisory reports, prior CRA examinations, CRA public files, and where possible, information developed by an institution's competition. The information compiled may not accurately reflect an institution's current credit composition or statutory, regulatory, economic or other constraints, but that is a risk that an institution takes when it does not develop its own performance context data.

Finally, if an institution chooses to provide information about the lending, investment and service opportunities in its assessment area, examiners will review it. Examiners will also consider information provided by a bank concerning its own credit composition, legal impediments and performance.

When evaluating performance data generated by an institution, the examining agency will consider how reliable the information is for evaluating an institution's CRA performance. The issue of reliability has not been addressed in the statute nor in any of the supplemental commentary accompanying the rulemaking. But it is my contention that the agencies will only rely on information generated by banks that is independently verifiable.

Information that the agencies can independently verify is public information. Public information includes for example, aggregate Home Mortgage Disclosure Act (HMDA) data. Institutions may provide aggregate HMDA data to demonstrate their superior mortgage lending performance. Agencies will consider this type of information because they can independently verify its accuracy. Consequently, institutions should consider how verifiable their performance context data is before providing it to examiners.

The inclusion of performance data by regulators signifies an appreciation that an institution's capacity to help meet community credit needs is influenced by many factors. The old regulation did not recognize that factors such as financial condition, size, location and resource constraints could affect the demand and supply of credit. The new regulation considers the differences between institutions as important as their similarities in determining the sufficiency and variety of CRA-related products an institution offers in its assessment area.

Why performance context data is important

In my experience as a consultant, I've found that bankers appreciate the importance of positioning their institution in terms of complying with CRA by the collection and internal analysis of data about its community and competitors. For example, I have a client in the suburbs of Chicago who was examined last year as a small bank under the new CRA rules. My first day at the bank the owner grabbed me as I walked into the bank's lobby and said he wanted to see me in the board room immediately. For the next two hours all the owner talked about was how essential it is to explain to the regulators how competitive the bank's market is and the number of private mortgage companies the bank competes against. Without knowing it, the owner was thinking in terms of performance context data.

Bankers understand that complying with CRA under the new rules is as much about competition as anything else. Performance will be judged on competitive results. An institution's performance in terms of lending penetration in a given assessment area will be evaluated in comparison with how a competitor or series of competitors performed in the same area.

The fact that market conditions are determined by competition as well as performance is one of the reasons why an institution's development of performance context information is vital to its overall CRA evaluation. Performance context information makes it possible for the performance of foreign-owned branches to be evaluated in comparison with the performance of other foreign-owned branches. The old regulation did not contain this comparative feature, and having examined foreign branches in the past, I think it will have a positive effect on how they are evaluated in the future.

The performance context section of the new regulation also takes into account the capacity and constraints of institutions. For example, statutory limits on investments will be taken into consideration for thrift institutions. The new rule modifies the capacity and constraints section of the performance context to make clear that examiners are required to consider an institution's investment authority when evaluating an institutions performance under the investment test.

Whether it's safety and soundness concerns, peer performance data, institutional capacity and constraints or another performance context factor, the development of a thorough performance context is one of the most important functions an institution should perform in preparing for an examination under the new CRA rules.

Institutions have a certain level of control over how they establish their performance context data. For example, an institution controls the selection and presentation of peer data, and the identification of lending, investment, and service opportunities in its assessment. However, an institution does not have control over how an examination agency will interpret and analyze performance data. Therefore, it is essential that institutions understand how the agencies, through the FFIEC examination procedures, will evaluate performance context data.

Performance context examination procedures

FFIEC examination procedures require that examiners analyze certain information when developing a performance context for an institution. This information is itemized below along with how examiners will apply their findings:

* Examiners will review standardized work sheets and other agency information sources to obtain relevant demographic, economic, and loan data, to the extent available, on each assessment area under review. They will compare the data to similar data for the metropolitan statistical area (MSA), county or state to determine how similarities or differences will help in evaluating lending, investment, and service opportunities and community and economic conditions in the assessment area. Examiners will use this information to determine census tract characteristics in terms of minority population figures and income classifications to evaluate the geographic distribution of an institution's lending performance relative to their assessment area, including low- and moderate-income geographies. Finally, examiners will use this information to determine an institution's record of lending to individual borrowers of different income levels.

* Examiners will review Consolidated Reports of Condition (Call Reports)/Thrift Financial Reports (TFRs), annual reports, supervisory reports, and prior CRA evaluations of the institution under examination. They will use this material to help understand the institution's ability and capacity, including economic or other constraints, to respond to safe and sound opportunities in the assessment area(s) for lending, investing or providing services.

* Examiners will consider any information the institution may provide on its local community and economy, its strategy or its lending capacity that may otherwise assist in the evaluation of the institution. As noted, institutions are not required to furnish examiners with information, but when they do, examiners will use this information in evaluating an institution. Notwithstanding the assurances in the regulation that examiners will not judge an institution on the type of information it supplies, it is reasonable to assume that conclusions will be drawn about the quality and utility of furnished information.

* Examiners will review community contact forms prepared by the other regulatory agencies to obtain information that assists in the evaluation of the institution. These documents contain information about community activists organizations, the community and the organization's responses to examiner questions, such as, "What credit product is needed in this community?" Examiners will contact local community, governmental or economic development representatives to update or supplement this information. Examiners will use the results of community contacts to determine existing credit needs in an institution's assessment area, product availability in the area and institutional performance.

* Examiners will review an institution's public file and any comments received by an institution or the agency since the last CRA performance evaluation. Examiners will consider an institution's record of taking action, if warranted, in response to written complaints about performance in helping to meet credit needs in its assessment area. The timeliness of the response and level of assistance will be considered.

* Examiners will review public evaluations and other financial data to determine whether any similar institutions (in terms of size, financial condition, product offerings and business strategy) serve the same or similar assessment area and would provide relevant and accurate information for evaluating an institution's CRA performance. Examiners will consider, for example, whether the information could help identify:

* Lending opportunities in the institution's assessment area(s) that are compatible with the institution's business strategy and consistent with safe and sound banking practices.

* Constraints affecting the opportunities to make safe and sound loans and qualified investments compatible with the institution's business strategy in the assessment area(s).

* Successful CRA-related product offerings or activities used by other lenders serving the same or similar assessment areas.

* Examiners must document the performance context information gathered for use in evaluating an institution's performance.

Most of this information will be gathered at an agency's regional or field office and not at the institution being examined. As a result, examiners may develop conclusions about an institution and its assessment area even before a CRA exam begins. There is a danger that examiners may draw advance conclusions that represent an inaccurate description of an institution's community needs and or business strategy. That's why institutions need to be in contact with their regulators long before a CRA examination is scheduled.

Karen Alnes, director of community reinvestment programs at Norwest Corporation, a $84 billion dollar Minneapolis-based financial institution, said in her speech on performance context information at the PCI, Services Colloquium, "I think it is very important that you sit down with your examiners right now to establish your performance context in advance of your exams, to understand what they are likely to do."

When developing a performance context, an institution should incorporate the participation of the institution's primary regulator. But in the end, Attorney Traiger said at the PCI Colloquium, "Unless you have provided a performance context or worked with your regulator to provide a performance context that distinguishes among the areas, you're likely to be penalized for not providing service in certain census tracts." Therefore, he says, the data provided must explain capacious gaps in an institution's lending record to avoid incurring penalties.

Traiger described the voluntary aspect of banks providing performance context information to examiners as being a somewhat disingenuous concept. "The examiners are saying you can give us information, you don't have to, but that information is only stuff that we expect you to provide in the regular course of business." Traider added, "Well I have yet to run into a bank that has something on the shelf that addresses such things as the volume and distribution of distinct categories of loans to low- and moderate-income persons and geographies. You are only going to do that for CRA and fair lending purposes."

The bottom line is that financial institutions cannot afford to not develop performance context information. The risks of not doing it outweigh the burdens involved in terms of time and money. The real question concerning the development of performance context data is no longer whether to develop it, but how.

Performance context developed by financial institutional data

Sen. Braun said in her interview that she did not believe that the agencies were in the best position to collect performance-type data. "I don't think the agencies should gather the information, banks should," she said. "Banks are in a better position to get the information, not the regulators."

Norwest's Alnes believes it's the most important thing a CRA manager can do. "I would argue that developing a thorough performance context is probably the single most important thing any department can do in the next two years," she said.

Any institution interested in developing a performance context must begin by establishing a strategy similar to that of a business plan. To be effective the strategy must have clear and attainable objectives and a mechanism in place to evaluate its development. An institution should make no assumptions when undertaking the development of its performance context. The bank should gather information as if no one, including examiners, has any knowledge about the institution or its community.

Although each performance context will be driven by the characteristics of the particular institution, there are shared elements that should be part of each performance context. These shared elements include:

* For institutions with assets in excess of $250 million, the performance context must include all three tests - Investment, Service and Lending. The performance context should identify opportunities under each test. For example, if there are small business opportunities in an institution's assessment area, then this fact should be brought out in the performance context. The same with lending and investment opportunities.

* Under lending analysis. Review the bank's performance based on credit demand as well as supply. Consider the geographic distribution of loans among different census tracts and to borrowers of different income levels. Analyze major loan categories for penetration in terms of number of loans and dollar amount of loans extended in the bank's assessment area versus outside the assessment area. Also consider affiliate lending where appropriate and any lending done by a consortium or a third party.

* Under investment analysis. Review the number and dollar amount of qualified investments. Additionally, make sure the performance context focuses on how these qualified investments help the credit needs in your institution's assessment area.

* Under service analysis. Review the availability and effectiveness of the institution's system for delivering retail banking services and the extent and innovativeness of the institutions community development activity. To do this you should describe the institution's branch distribution network, telephone banking, ATM distribution and other retail services the institution offers throughout its assessment area. In addition, this section should describe the community development activity of bank employees.

* The performance context should identify the organizations with which the institution has relationships and partnerships. The performance context should summarize what is the primary function of these organizations. For example, some organizations concentrate on small business lending, others mortgage lending and so on. A profile of each organization should include a description of what the organization does and the commitment level of the bank.

* The performance context should include a description of an institution's assessment area. Included in that description should be the racial demographics of the area; census tract characteristics in terms of the four income classifications; median family income data and housing stock. Additionally, this section of the performance context should describe the business sections of the assessment area in terms of past, present and future lending patterns. Other economic trends also should be brought to light in this section. Finally, this section should describe the geographic radius of the assessment area, including the cities and towns that comprise the area, as well as highways, cemeteries, schools and airports. This is important because loans will not be made in cemeteries or airports, but they can still represent census tracts. For example, in the city of Chicago, Midway Airport accounts for two whole census tracts. An examiner may not know this and it will be up to the bank to explain why there are no loans in those two tracts.

* The performance context should include information on similarly situated lenders. As mentioned earlier, an institution's CPA performance will be evaluated in comparison with what other institutions have done in the same or similar area. Bankers know more about their competition, the products and services they offer and their capacity and constraints than the examining agencies. This includes traditional institutions, such as banks, thrifts and so on, and nontraditional competition such as mortgage companies, finance companies and insurance companies. Therefore, institutions should include in this section all the competitive elements that affect an institution's ability to make loans.

* The performance context should include any capacity or constraints under which an institution is operating. For example, as cited earlier, thrift institutions are limited by regulation in the amount of investments they can make. This restriction affects their performance under the investment test. As a result, this type of constraint needs to be reflected in the performance context. Foreign-owned banks also face constraints in what type of return on investment is allowed. As such their ability to invest in nonprofits that traditionally limit their return on investment is significantly affected. Again these types of constraints need to be highlighted in the performance context.

In the final analysis, all performance context information can do is tell an institution's story. But having the ability to set the agenda and determine in some measure what the examiners will consider in their CRA evaluation is significant. The elements identified in this discussion are not all inclusive, but are a good starting point for any institution interested in developing a performance context.

The new battleground

Karen Alnes identified what she believes to be the future of the performance context at the PCI Colloquium in June. "It is my prediction that the performance context is going to be the new battleground between banks and examiners," she said.

Yet, Sunsan Cournoyer, a community affairs specialist in the Public and Community Affairs Department of the Federal Reserve Bank of Boston said at the PCI Colloquium that her agency clearly understands the utility of the performance context "the data collection, the data analysis with an on-the-ground review of what is happening in those communities."

My hope is that the collection and analysis of performance context data proves to be more cooperative than confrontational. Both sides, banks and examiners, need to be prepared. The burden is clearly on the examining agencies to gather the information, but financial institutions just as dearly benefit when they develop their own performance context data.

As the Federal Reserve's Cournoyer suggested, regulatory objectives should dovetail neatly with institutional objectives in that both are trying to determine what is going on in a particular market. An understanding of the data, as well as each other, will be key to making the performance context section of the new CRA effective.

Kevin T. Kane, is a consultant to the Financial services industry, and author of A Banker's Guide to the Community Reinvestment Act: Case Studies of 33 Institutions.