Impact of the Community Reinvestment Act on New Business Start‐Ups and Economic Growth in Local Markets*

Economic growth in the United States has historically bypassed many minorities and low-income communities. Some researchers and community advocates assert that the deterioration of these communities is in part caused by financial institutions' redlining and neglect. To rectify the situation, the government introduced the Community Reinvestment Act (CRA) for the purpose of encouraging banks and saving institutions to become more socially responsible and help meet the credit needs of communities in which they are located. The CRA was the government's response to bank lending discrimination. However, when passing the Act, Congress was equally concerned with reversing or at least halting disinvestment from inner-city communities and in turn revitalizing local economies. Many believe that the availability of credit to establish, refinance, and improve small businesses is critical to the well-being of local communities. Therefore, through the provision of small business loans, the CRA could be envisioned as a catalyst toward achieving that goal. Thus the aim of this paper is to investigate potential relationship between banks' CRA lending activities, and new business start-ups and economic growth in local markets. The paper proposes that new start-ups will have spillover effects that will consequently contribute to community development. After controlling for several potential variables that could have an impact on business start-ups and community developments, the study found a strong positive effect. Beside its social and economic implications, the study also considered policy implications associated with the CRA regulation as a welfare improving initiative in low-income communities. It offers ground for certain government intervention in the loan market. Introduction Many communities in the United States have been plagued with chronic poverty, unemployment, unskilled labor force, high crime rate, and poor infrastructure (Somaya 1996). Their lagging development has had an adverse effect on economic growth (Matasar and Pavelka 2004). Many believe, however, that corporations can play a revitalizing role especially in inner-city communities where exist the greatest concentration of social problems and the greatest proximity to the corporate sector (Porter 1995). One industry that has historically been associated with creating or exacerbating some of these problems is the banking industry (Matasar and Pavelka 2004). Some researchers and community advocates assert that the deterioration of inner cities is in part caused by banks neglecting their local and low-income communities (Canner and Passmore 1995a). In 1977, motivated by mounting concerns and perceived shortfalls in banks' investment in inner-city communities, the government introduced the Community Reinvestment Act (CRA). The Act required all federally regulated banks to demonstrate that they served the convenience and credit needs of their entire communities, including low and moderate-income neighborhoods and minority customers (Johnson and Sarkar 1996). Since its introduction, the CRA has attracted many opponents who criticize it by arguing that it forces banks to engage in unprofitable and unsafe investment practices in order to gain favorable regulatory evaluation (Lacy and Walter 2002; Macey and Miller 1993). However, it has also attracted many supporters who defend it by arguing that the shortage of capital in inner-city neighborhoods is a major stumbling block for any investment activities and cite "redlining" (1) by banks and financial institutions as a significant factor (Etsy 1995; Porter 1995). These supporters consider the CRA a necessary regulation in order to influence banks' services and investment in deteriorating inner-city communities. The above debate about the CRA has been ongoing for the last 30 years. It has been sustained by the differences of opinions regarding the costs and benefits of the regulation (Barr 2005) and exacerbated by the lack of empirical research evaluating its impact (Hylton 2000). …