Buoyed by formidable models and mountains of data, Virginia’s traffic gods recently decreed a new “smart toll” for a major commuter highway (I-66) rising to well over $40 for just a few rush-hour miles.  Did this lead commuters to head dutifully to the carpool lane, squeeze into Metro, or telecommute no matter what the boss demanded?  Of course not.  Instead, the rush hour became hours and neighborhood-street traffic became – and is – a nightmare.  Which brings me to a new study from the Philadelphia Federal Reserve of rules designed to help low-income households that instead led to a sharp increase in subprime, non-performing auto lending imperiling low-income workers now without a car who can’t get to work even if they could foot the toll.  As it turned out, regulatory expectations became regulatory arbitrage, with low-income households and community banks paying the price.

As we noted in our initial assessment of this paper, the National Credit Union Administration (NCUA) in 2008 issued a nobly-intentioned rule to increase the number of low income credit unions (LICUs) eligible for big breaks from the agency’s common-bond rules.  The idea here was to stimulate more deposit and lending services where they are most needed, presumably because credit unions had already done so much for so many within the common bond that the public good was best served by waiving it.  The NCUA never made clear why the common bond is a barrier to equality-enhancing finance, especially given how flexible all its rules already are.  Instead, it just dropped a barrier to expansion and hoped that credit unions would be inspired thereby. 

The Philadelphia Fed paper isn’t, alas, focused on economic equality or even unintended consequences; instead, it looks at a question well-beloved of economists the world over:  what new competition does to established business practices.  In this case, more LICUs created greater credit-union risk capacity – what the NCUA hoped.  Indeed, one might deem LICUs a success if one just looked at how the charters fared after NCUA allowed them to do business outside of the common bond in 2008.  By 2016, LICU assets had grown about 800 percent to total nearly $400 billion.

However, all this capacity then went searching for profit.   LICUs didn’t start a whole lot of community-development lending; they instead went big into so many subprime auto loans that nonbank auto lenders lowered their prices and what was left of their risk tolerances.  LICUs then competed with nonbank auto lenders in a classic race to the bottom that left community banks by the side of the road and vulnerable borrowers in the default ditch. 

Notably, the study also found little difference in credit unions before or after LICU designation other than a lot more risk with no demonstrable link to low-income customers.  One might posit that latitude to LICUs did not affect increased risk via lots more auto lending by noting that very small banks in an LICU’s market were as adversely affected by expanded LICUs as community banks subject to full force regulation.  The study in fact uses this finding to argue that competition, not regulation, has identifiable risk and distributional impact.  But, as much as competition drove risk realignment, regulation clearly played a mighty role defining who competed how – even small banks come under vigorous examination and real charter-revocation threat from the FDIC; one cannot say the same of the NCUA.  Indeed, it turns out that small banks in LICU markets are more likely to fail than other small banks, suggesting that banks which follow their worst instincts fare badly while those who led them astray – i.e., the LICUs – grow exponentially. 

 In short, increased competition by barely-regulated (LICU) or unregulated (nonbank) auto lenders drove some community banks to ruin and led others to exit auto lending.  The more LICUs and shadow banks competed for auto loans, the more loans were made to the highest-risk borrowers even as origination volume for quality borrowers barely budged.  As a result, more bank regulation does not make the financial system safer or better for social welfare.  Instead, faced with high-octane competition that creates a downhill credit slalom, efficient banks move on to other markets such as wealth management and vulnerable borrowers come under still more risk than naturally befalls them. 

Does this mean that banks should be freed to match LICUs and nonbanks in high-risk, high-return businesses?  Of course not.  It is to point out that asymmetric rules do not make finance safer unless those under the rules control the market and are otherwise impervious to arbitraging competitors.  In the U.S., banks, even the very biggest ones, enjoy no such immunity.  Thus, asymmetric regulation defines the winners – lightly- or un-regulated financial institutions – and the losers – those most vulnerable to high-cost, ill-underwritten credit.