This is the third part of a series of briefs making the case for expansion of the Community Reinvestment Act. The others covered non-bank mortgage companies, credit unions and insurance companies.
Congress should extend the Community Reinvestment Act (CRA) broadly throughout the financial industry. If it is not applied more broadly, evolution in the financial industry will erode the statutory purpose of CRA to increase access to credit and capital for low- and moderate-income (LMI) communities.
Banking and bank-like services are increasingly being offered by other kinds of companies, including securities firms that enable their customers to buy and sell publicly-traded stocks and bonds. Securities firms have a backstop that is similar to Federal Deposit Insurance for banks. The Securities Investor Protection Corporation (SIPC) protects investors up to $500,000 in the event of the bankruptcy of a securities firm. Since 1970, SIPC has recovered more than $141 billion in assets for about 773,000 investors. Since the securities industry relies on federal protection, a reinvestment obligation is a fair quid pro quo.
If it remains confined to banks, CRA will miss opportunities to make sure that securities services are offered equitably to LMI communities. The mutual fund industry holds $21 trillion in assets – a resource base that could dramatically increase investments in LMI communities if a reinvestment obligation is applied to the industry. Racial inequalities in wealth would be more adequately addressed if the securities industry had an obligation to offer its products to modest-income customers and people of color.
How the Securities Industry Currently Serves Modest-Income Customers
The securities industry includes investment banks, which help companies raise capital by selling stocks and bonds, and brokerages and financial advisors that help individuals buy and sell securities. Investment banks either make investments in companies and/or make equity investments on behalf of customers. Brokerages and financial advisors, such as Fidelity Investments and Vanguard, help customers invest in publicly-traded stocks, bonds and other instruments that earn a return and grow wealth over time. Stocks are equity investments in companies while bonds are more like long-term loans to corporations or governments. Stocks are generally riskier investments than bonds.
Generally speaking if a customer has more than $100,000 to invest, they will have access to a financial advisor that will recommend a mix of stocks and bonds depending on the goals of the customer and the customer’s time horizon. If the customer is starting out in their career, the investment mix could be on the more aggressive side, which earns higher returns but entails more risk. If the customer was closer to retirement, the investment mix would be more conservative with a greater proportion of bonds since the customer has less time with which to recover from sudden or significant losses. Financial advisors help the customer choose funds and execute trades or the advisor will do the investing and trading after receiving consent from the customer.
In the case of customers with more modest investment sums, the major source of advice from securities firms are robo advisors. Robo advisors operating from a firm’s website will collect financial information from customers, query customers about their goals and will then select a mix of investments for customers. Firms using robo advisors tout their services as superior to firms that help modest-income customers make investments and trades for themselves. Reinvesting dividends earned from stocks, for example, is executed in a more timely manner by robo advisors, according to companies that use them.
Betterment is one such firm that offers robo advisors for modest-income customers. It also offers checking accounts for customers. Betterment is one of the more reputable robo advisor firms, yet the application of CRA would be reasonable since it is offering an investment service geared towards modest-income investors, and since it is offering bank-like products that have been traditionally covered by CRA.
Some brokerage firms like Edward Jones are oriented to the meat-and-potatoes investor as opposed to the well-heeled. On its website, Edward Jones touts its services to gig workers. Edward Jones also touts its involvement in the community, its support for recycling and carbon reduction, and its $13 million annually in philanthropy. While this is laudatory, a CRA requirement applied to Edward Jones would insure that at least a portion of this philanthropy would be targeted towards communities most in need of affordable housing and economic development.
How the Securities Industry Could better Serve Modest Income Customers and Communities under CRA
A CRA for the securities industry is more straightforward than it would seem. Data would be collected on retail customers by income level, race/ethnicity and gender. The dollar amount of their investments could also be collected. Data collection and dissemination could be similar to that of the Home Mortgage Disclosure Act (HMDA). With data on retail customers, a CRA exam would examine the performance of a securities company based on the number and percent of accounts for LMI and people of color. Comparisons would be made to peer companies and the demographics of areas served by the securities firms.
The CRA exam could also contain a community development (CD) test that would ensure that investments and community development services were benefiting LMI and people of color and their communities. Securities companies could further develop funds that would invest in small businesses that are located in LMI communities and communities of color. The CD test would scrutinize the level of investments in these funds and their innovation and responsiveness to community needs.
The CD test would also assess the level of CD services, which could include the number and types of financial advisor services offered to modest-income customers and people of color. As mentioned above, personal advice is offered to affluent customers whereas people with modest investments are served mainly by robo advisors. Part of the reason for this is the level of fees and profitability is higher for serving the more affluent. While robo advisors can serve many needs, in-person advice is still needed by many customers. For example, the COVID-19 pandemic caused a crash in the financial markets that rarely occurs. It is reassuring for many customers to have advisors that can assist people through these difficult times. Advisors can also suggest to customers when a loan or withdrawals from their mutual funds are most appropriate to finance sudden needs or large-scale purchases.
A CRA for the securities industry would likely encourage the industry to develop innovations, which could increase the types of financial advice (robo and in-person) for customers with modest means. In some cases, a firm could finance nonprofit organizations that serve as financial advisors. In other cases, a firm could make offering advice economically feasible by designing funds in which a number of modest-income customers from a specific community or institution like a church could invest together. Finally, cross-subsidizing services for lower-income customers from the fees earned by serving affluent customers is an approach used in the mortgage industry that could be applied in the securities industry.
Identifying and Stopping Abuses
As well as increasing access to capital for communities, applying CRA to the securities industry could be a means of increasing enforcement against abusive and fraudulent practices. Investment banks were a major investor in high-cost and abusive subprime loans in years leading up to the financial crisis of 2008. The investment bank Bear Stearns imploded in large part due to its investments in mortgage-backed securities backed by subprime loans. The New York Federal Reserve Bank bailed out the firm and arranged its sale to JP Morgan Chase.
More recently, Robinhood, an online brokerage firm, has come under intense scrutiny because of its aggressive sales tactics luring unsophisticated consumers to invest in risky transactions. It is possible that Robinhood engaged in these aggressive tactics because of the compensation from funds in which its customers invested.
A CRA for the securities industry could include a component similar to CRA for banks that examines violations of laws designed to protect consumers and communities. Banks can be downgraded based on the extent of legal violations and abusive practices – a procedure that could be applied to securities firms. In general, CRA also encourages safe and sound investments by emphasizing community development including affordable housing and economic revitalization targeted to LMI and underserved neighborhoods.
A number of securities firms are not only offering bank-like products but also want to become banks. Robinhood applied but then withdrew an application to become a bank. Edward Jones is now in the process of applying for a bank charter. If securities firms want to become banks, they must have an obligation to serve all communities responsibly.
Banks, on their part, engage in investment banking as well as retail banking. CRA should apply to their investment operations so that they are directed towards activities that benefit communities instead of abusive financing that extracts wealth from communities. In the years running up to the financial crisis, oftentimes investment arms of banks were financing abusive subprime lending that was undermining neighborhoods while the retail arms of banks were trying to extend safe and sound loans as required by CRA to these very same communities.
On the one hand, CRA applied to the securities industry could be a tremendous source of credit and capital for underserved communities because of the asset size of the industry. On the other hand, if years pass by without any reinvestment obligation for the securities industry, CRA as applied to banks will become increasingly constrained in its effectiveness as resources continue to leak out to the securities industry and the other parts of the non-CRA covered financial sector. This will not only be to the detriment of underserved communities but to the nation as a whole as inequality and division would increase.
Josh Silver is NCRC’s Senior Policy Advisor.