By Robert E. Wright, Nef Family Chair of Political Economy, Augustana University for the ASHE/NEA Conference in Polson, MT, June 2018
America’s financial history is rife with examples of financial exclusion, discrimination, and predation. Exclusion occurred when women or people of certain ethnicities, races, religions, or sexual orientations were as a group denied access to portions of the financial system. It was outlawed, more or less, and is relatively rare today because it is costly to work around even for the most committed bigots.
Discrimination, whereby specific individuals are denied credit, insurance, or other financial service despite being objectively qualified for it, is more subtle and hence difficult to detect. Sometimes, instead of outright denial, it takes the form of higher interest or premium rates but always for ostensibly objective reasons. Its extent is difficult to discern statistically and real world experiments, whereby people with practically identical qualifications but different genders, ethnicities, skins colors and so forth apply for financial services at the same provider, cannot, for legal reasons, go all the way to the formal application stage.
Predation is the inverse of discrimination, occurring when an individual who objectively does not qualify for a financial service, usually a loan, is allowed, even encouraged, to contract under the expectation of default and a windfall for the lender. Again, pinning down exact numbers is fraught in our messy real world, but predation certainly occurs and of course was common in the subprime mortgage and payday lending markets of the early Third Millennium AD. Determining the extent of predation is difficult, too, because high rates of interest are not prima facie evidence of it, as it is costly to make small, short term loans and of course annualizing rates can be deceptive. Most people balk when they hear a loan has a 1,000% interest rate but when that loan is described as costing $23 and was taken out to avoid a $50 late fee, it suddenly seems like a mutually beneficial transaction.
Three ways of reducing financial discrimination have been tried in the U.S. The worst approach was implemented in the 1990s, when regulators began to encourage lenders to lower credit standards. That approach encouraged predatory lending by granting lenders ample access to borrowers with poor or no credit histories, few assets, and relatively little secure income. In other words, targeting borrowers most vulnerable to predatory lenders became acceptable, even mainstream. Lowering credit standards also encouraged mortgage securitization and ultimately led to the subprime mortgage crisis and resultant financial panic and global recession, the negative effects of which are still being felt.
Lowering credit standards was the regulatory response to failed attempts to mandate an end to financial discrimination via laws like the Community Reinvestment Act or CRA, which, regulators had hoped, would be as effective as outlawing outright financial exclusion had been in the 1960s. Alas, it was much easier to enforce a law stating that banks and insurers could not reject the applications of all women, African-Americans, Hispanics, Native Americans and so forth than it was to cajole them into not discriminating against individual members of those same groups. Lenders and insurers had to have the last say in who they would lend to or insure and of course the government itself did not want to directly enter the loan business. Various U.S. colonies and states had tried that game and gotten burned more often than not, even when making loans to presumably prime borrowers.
Traditionally, the U.S. had handled discrimination not with top-down regulations like the CRA, but rather via markets. This third approach is not a panacea for reasons I will explain later but it was more effective than eroding standards or trying to regulate institutions that have proven themselves both too big to fail and too big to regulate. It was called self-help and entailed regulatory gatekeepers allowing groups that felt discriminated against to form their own financial institutions. The logic was that if a group that felt discriminated against was really not, if it was composed of individuals who should not receive loans or insurance or whatever, or if group members could indeed obtain service at existing companies, the new institution would soon fail. That would impose a cost on the regulatory safety net but a light one. If members of the group were actually being discriminated against, then the new institution should succeed, thrive, grow, and so forth, thus reducing if not ending the discrimination. Self-help, in other words, was a market test of discrimination and a way of allowing Gary Becker’s insight that competition destroys discrimination to work itself out in the real world.
The Lumbee Guaranty Bank, for example, charges its borrowers a higher interest rate than the local bank run by Euroamericans. So Dobbs Oxendine, a Lumbee entrepreneur, borrows from the latter. The very fact that he can do so suggests that the Lumbee Guaranty Bank may not be necessary. Regulatory approaches that rely on markets have a far better chance of success, of actually helping those groups that regulators purport they would like to help, than those that try to repress markets.
The self-help approach worked amazingly well throughout U.S. history. Early in the nation’s history, commercial banks catered mostly to wealthy merchants. When artisans, farmers, and manufacturers complained, lawmakers allowed them to form their own commercial banks. They did, and it was good, as the new entrants thrived and the established institutions began to re-think their prejudices. Then philanthropists created new institutions, called mutual savings banks, that allowed another unbanked group, the poorest of the poor, to safely earn market returns on any pennies they were able to save. Members of the working classes took note and, excluded from both the savings banks by maximum deposit regulations and commercial banks, which would not cater to consumers until the twentieth century, they gained permission from lawmakers to form their own financial institutions, which they called building and loans. Later, the working classes would form and join credit unions, Morris Plan banks, and industrial banks. Their fraternal organizations competed with industrial life insurers in the provision of low-cost burial and life insurance.
Members of the immigrant groups that streamed into America over the course of the nineteenth century also found it difficult to gain access to established financial institutions. In case you aren’t aware of this history, many Americans considered Irish Catholics to be almost simian. But when they wanted to form their own commercial and savings banks, building and loans, credit unions, and life insurers, lawmakers allowed them to, setting a precedent followed by all the subsequent waves of European immigrants, from the German Forty-Eighters fleeing political persecution to Eastern Europeans seeking a better life.
Some of those immigrants were Jews who found themselves discriminated against on Wall Street. So they established their own investment banks, including Kuehn Loeb and Goldman Sachs. Well after World War II, various big investment banks, brokerages, life insurers, and investment funds were associated with different religious groups, some Jewish, some Catholic, some WASP. The rhetoric of free enterprise meant that any group that could put up their own capital and/or find financial backers had the right to enter and compete for business on any basis. There were even African-American brokerages by the 1950s.
Blacks, Hispanics, women, and even some American Indians joined the self-help bandwagon and formed their own banks and insurers. Black-owned life insurers were particularly successful, as were black-owned banks where ever African-American businesses thrived, as they did in Tulsa until the infamous white riot there in 1921.
In 1943, Edwin Embree, a high ranking executive in several important philanthropic foundations, summarized the state of black financial enterprise prior to World War II as follows:
The insurance companies, which grew out of the widespread burial and mutual societies, have flourished because of the discrimination against Negro policyholders by the large white companies. Banks, which despite a number of failures rank close to insurance in financial importance, have as one of their chief reasons for existence the refusal of general banking institutions to give credit on equal terms with others to Negro individuals and businesses.
Self-help was less effective when levels of bigotry were high, however, because the self-help institutions themselves were discriminated against. In early postwar Chicago, for example, 21 lending companies with assets of almost $8.9 million were run by African-Americans but they found raising adequate capital “all but impossible” because “non-Negro institutions” would not buy, or lend on the collateral of, their mortgages. Savers therefore tended to eschew them for the higher rates or greater safety afforded by lending institutions run by whites. At the same time in Philadelphia, however, a black banker named Edward C. Brown leveraged his reputation for financial wizardry to obtain loans on favorable terms from institutions run by whites.
So some banks owned and operated by African-Americans, women, Hispanics, and other oppressed groups did manage to survive and even thrive. And new ones continued to form, though at a rate barely above the rate of exit, a few from bankruptcy but most from mergers. The great merger waves that swept the life insurance and banking industries, the latter following the deregulation of first intra-state and then interstate branching in the final three decades of the last century and the first decade of the present one, greatly reduced the salience of self-help. Between 2000 and 2014, for instance, the number of banks owned and operated by American Indians increased from 14 to just 19 on net. Regulators apparently did not find the stagnation of self-help problematic as they believed that the CRA and/or lowered credit standards had, or would, virtually eliminate discrimination. They were wrong about that but enough time has passed since its heyday that few regulators remember the historical importance of the self-help approach.
And it hasn’t helped that de novo banking went extinct for everybody following the Panic of 2008, when I was part of a group, led by a wealthy paraplegic, just starting to develop a proposal for a bank to service people facing a wide range of physical and psychological challenges. Yes, a handi-bank for lack of a better term. Discrimination comes in many forms, which is why we should prefer market responses. Markets, after all, are usually much more nimble and subtle than top down regulations.
The effectiveness of self-help can also be reduced when few members of the group being discriminated against possess the human capital, the skills, education, and experience, needed to successfully enter banking, insurance, or other financial services. Thankfully, commercial banking is not rocket science. One does not need an MBA from a top tier business school to become a good community banker. In fact, such a pedigree would probably be a disqualification.
Actuarial work is rocket science -- almost literally as many actuaries trained as physicists -- but actuarial and other highly technical services can be outsourced, at least at first. Where you need members of the group being discriminated against is in the trenches were loan and insurance applications are received, processed, and decided. That is where their understanding of their own group can do the most good, first by enticing people to apply and second by providing more nuanced judgments about applicants’ ability to repay or minimize claims.
A banker from off the Reservation, for example, may think that an applicant’s income is too low but a fellow American Indian might realize that the applicant has significant income that he can’t show as it may come from the applicant’s own subsistence activities or in-kind aid from members of his clan. An outside banker also doesn’t understand land tenure systems on Reservations and has little incentive to, but an Indian banker would. An outside banker won’t make a loan on a car that she can’t find an approximate market value for on the Internet, but an Indian banker can estimate the value of a Rez car. And so on and so forth. And similar scenarios can be imagined for every group that can’t get loans or insurance, from members of the LBGTQ community to rednecks to African-Americans.
None of this means that regulators should allow just anyone to enter any financial service and completely wing it. Philanthropies and regulators can help jumpstart self-help success by supplying start up capital and subsidizing the education and maybe even some work experience for members of groups underrepresented in the financial services sector and work with them to help build their businesses. But they need to step aside at some point and allow the bank or insurer to sink or swim on its own merits.
Recently, the Minneapolis Fed and the Philadelphia Fed, implemented programs designed to help African-Americans and American Indians to create their own financial institutions. Much more remains to be done but regulators need to combat the inclinations of incumbent financial institutions, which would rather face ineffective top-down regulations like CRA than additional competition.
Regulators should also work to minimize business-to-business discrimination. A bank owned and operated by American Indians or, I don’t know, Furries, should not have to pay a higher interest rate for overnight funds than any other bank of its size, region, and longevity. Insurers should be able to obtain reinsurance on rational terms, and so forth.
I cannot stress enough that self-help is not a panacea. It cannot overcome systemic racism. But it is a more market-oriented approach than top down regulations and much less of a systemic risk than lowering application standards. Throughout U.S. history, it frequently worked completely but even where its success was limited we have to remember that self-help banks and insurers still helped their customers to obtain needed financial services, even if it was just for a few years or decades, or in just a few places. Moreover, some groups may be able to make more headway with self-help than in the past as bigotry and prejudice, while still lamentably powerful, are perhaps not quite as ubiquitous as in the past. There is only one way to find out and that is for regulatory gatekeepers to once again encourage new entry by any group that believes it is being discriminated against.Thank you!