Bookmark and ShareSargon Nissan is a researcher in nef’s Access to Finance team

Whos to blame?

As the financial crisis continues to unfold, one myth keeps getting repeated: the crisis was caused by poor people defaulting on sub-prime loans.

In short, if only they hadn’t been so feckless then the great edifice of sub-prime debt need not have brought the financial system crashing down upon us.

This isn’t just wrong, it’s dangerous and wrong.

Though regulators and poor legislation enabled banks’ lending, the hand holding the smoking gun is wearing a gold watch, not holding a foreclosure notice. But now amidst the calls for re-regulation, a counter-attack in defence of banks has been launched.

It reached our shores this month when the Spectator ran a story exonerating bankers, blaming the crisis on the Clinton administration and ‘idealists’ using a little-known piece of legislation called the Community Reinvestment Act (CRA). This Carter-era legislation sought to end the practice of red-lining by banks which had excluded whole neighbourhoods from credit and mortgages. Banks literally put a red line through the post codes of predominantly black communities when deciding who to lend to.

The ‘blame the poor’ view implies that good credit shouldn’t have been forced to go chasing after bad debt.

So what’s the real story?

Blaming the credit crunch on the CRA or the efforts to combat financial exclusion is not borne out by the facts. Only 25% of all sub-prime loans related to CRA requirements.

When Clinton amended the Act to give it teeth in 1995 he enabled local regulators to rate banks’ performance by their transparency, lending practices and investment in local communities. Hardly revolutionary stuff.

It was in 1999 when a Republican-controlled Congress insisted on excluding banks’ investments in securities from CRA oversight that the rot set in. Banks sought new ways to bypass supervision and hit upon the clever wheeze of packaging up the dodgy debt and selling it on through so-called Collateralised Debt Obligations.

Banks did this in part to avoid CRA controls which penalise reckless lending. They subverted the regulatory system by using CRA-exempt mortgage brokers, often owned by the banks themselves, making exorbitant profits in the process. Ratings agencies inflated the value of these unsupervised mortgages – the infamous sub-prime debt – with a wink to their bank clients who then profited from re-selling them. The fateful chain of events leading to today’s crisis was set off.

By 2003 less than 30 percent of all home purchase loans were subject to intensive review under the CRA. In 2005 the Bush administration pushed through another amendment further weakening oversight of banks’ lending. The result? Sub-prime lending doubled from 2001 to 2006.

What lessons does this story hold for the UK?

Firstly, banks will stretch and subvert the rules as far as they can to maximise profits. Lax regulation means reckless lending if there is money to be made. Even a believer in homo economicus can understand that. The lesson is that we need clear, rigorous rules that spell out the terms on which banks should operate.

But how do we build a finance system that provides appropriate finance for all? At nef we’ve backed the pioneering use of community finance to provide appropriate and affordable credit to people and businesses in disadvantaged communities. Community Development Finance Institutions (CDFIs), Credit Unions and even good old fashioned building societies all represent an alternative to rapacious and reckless lending. Banks need to reconnect with their clients, maintain branches and re-build relationships to small businesses.

Rather than following the example of a Northern Rock, financial institutions need to rediscover their communities, not abandon them.