Parallel banking institutions have gained access to numerous industry-driven (yet banking- dependent) insurance protections and federally guaranteed loan programs. While these industry insurance programs are generally financed by aggregated industry premiums, a majority of the programs can borrow from the U.S. Treasury for additional liquidity. In addition, finance companies and other issuers of commercial paper rely heavily on back-up lines of credit from conventional banks to cover periods of temporary illiquidity. Financial firms become especially dependent on conventional bank loans when their profitability wanes and their commercial paper is downgraded by raters and becomes difficult to sell in the money market. In this way, banks' support of parallel bank institutions seems to increase as the internal stability and competitiveness of financial firms decreases. (Chart D illustrates how some of these federal protections extend both directly and indirectly to nonbank institutions). By using federal guarantees and Treasury lines of credit as the ultimate safeguards against some nonbank insolvencies, the conventional system incurs substantial unanticipated risks that could overburden the safety-net system. Compounding these risks is the fact that financial protection can create a form of "moral hazard" on the part of beneficiaries. If beneficiaries are supported more by conventional banks as their own financial soundness decreases, their incentive to control losses and restore profitability will inevitably be weakened because they know that their losses will be covered by a third-party. In this way, financial risk becomes socialized and spread among many as the discipline in lending is removed. Supporting struggling institutions indirectly through bank guarantees and credit lines thus often exposes the banking system and its ultimate backers, taxpayers, to mounting levels of risk and significantly higher support costs over the long run.

The following sector-by-sector analysis of parallel bank dependence on government and/or governmentaided financial supports explains that parallel banks could not operate without taxpayer assistance, thereby demonstrating the case for extending community reinvestment requirements to the parallel banking industry. Mutual Funds

As private investment vehicles, mutual funds and other nonbank savings funds do not have access to FDIC insurance. Rather in economic downturns, individual investors must share market losses as the value of their investments simultaneously decreases to reflect changes in the market. Private protections do exist, however, to cover large institutional insolvencies. The Securities Investor Protection Corporation (SIPC), a non-profit guarantee association, was created in 1970 to insure the securities accounts of customers up to $500,000 if a securities broker or dealer fails and cannot meet outstanding obligations. While SIPC operates as a private-sector agency that is financed internally by member firms (all registered securities dealers must join), it has the ability to borrow up to $1 billion dollars from the U.S. Treasury during times of need. As some of the largest buyers of protected commercial paper, money market mutual funds also derive indirect benefits from the lines of credit that banks provide to issuers of commercial paper.

Pension funds:

Pension funds benefit from similar government-sponsored safety net programs and tax advantages. As described earlier, all defined-benefit pension plans are required under ERISA to purchase federal Pension Benefit Guarantee Corporation (PBGC) insurance. Like SIPC, PBGC insurance is funded with industry premiums from pension fund sponsors as well as with recovered assets from terminated plans. In addition,

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the program operates with a $100 million dollar line of credit from the U.S. Treasury. Examination of PBGC's growth highlights that the pension fund safety net extends remarkably far and deep. As of December 1993, PBGC specifically protected the benefits of nearly 41 million Americans or about one-third of the United States labor force". As the demands on the system continue to grow, PBGC's economic future remains relatively precarious. By 1993, PBGC had already accumulated a cumulative deficit of at least $2.6 billion". Most of this deficit resulted from massive underfunding by pension program sponsors. Underfunding occurs when a company increases benefits but then makes risky investments or fails to take the necessary precautions to ensure that it will be able to cover outstanding liabilities when they arise. PBGC's deficit reduction efforts have been further thwarted by the fact that many sound pension plans have chosen to modify their benefit structure in order to move outside PBGC governance and effectively avoid subsidizing other plans' accumulated losses. The widespread prevalence of defined contribution plans such as 401(k)s is evidence of this fact.

Insurance companies:

The supportive strings of the federally-backed safety net are even more apparent in the relationship between taxpayers and insurance companies. As described earlier, state insurance guarantee funds provide compensation to policyholders of insolvent insurance companies by gathering resources from within the insurance industry after a company fails. While these guarantee funds are generally governed and financed by industry representatives, the ultimate burden of funding the state guarantee pools is often reflected in forgone state tax revenues. In 41 states, insurance companies are permitted to offset their fund assessments (contributions) through amortized credits against their state premium taxes. While this arrangement does force companies to bear some up-front costs, the credits effectively reduce their net cost to zero over the long run. While facilitating household savings has been an important part of insurance company activities, many insurance companies also provide consumer loans such as student education loans to their policyholders. For example, in 1991, three insurance companies ranked among the top 100 originators of guaranteed student loans. As a result, these institutions benefited from the government insurance programs that loans.

protect these

Finance companies:

While many different types of institutions are becoming significant nonbank lenders, finance companies remain the primary private-sector non-bank lenders. Not surprisingly, they are also, therefore, some of the largest beneficiaries of federal loan guarantee programs. In 1993, finance companies reportedly originated more than 84% of all FHA and VA government-insured mortgage loans". In addition, finance companies have become active in the student loan market and are some of the largest beneficiaries of the federal small business administration (SBA) loan guarantee program. Only 10 nonbank finance companies are allowed to participate in the SBA loan guarantee program for Small Business Lending Companies; in spite of this small pool, three finance companies ranked among the top five small business lenders in 1993. The fact that these loans have government guarantees boosts lenders' sales of these loans in the secondary market and generally expedites the lending process. Secondary market investors need not concern themselves with the collateral and repayment ability of original borrowers when they know they will be compensated regardless of the circumstances. Government guarantee programs thus ease the flow of funds and benefit all of the participants in a lending deal. Moreover, loan guarantees benefit any company that prefers to hold onto loans it has originated rather than sell them in the secondary market.

Finance companies have also benefited from the bank lines of credit that are now relatively standard in money market transactions. As some of the primary issuers of commercial paper, issuing more than 60% of all outstanding commercial paper in 1993, finance companies depend on bank lines of credit to sustain their

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money market activities. Virtually all commercial paper finance companies issue is backed to some degree by lines of credit since most institutional investors will not purchase the short-term notes without a formal liquidity guarantee. While banks receive a fee for performing these credit substitution activities, the fact that nonbank paper is backed by the credit of conventional banks makes commercial paper essentially interchangeable with bank loans and moreover, places banks in the position of supporting their competitors”. In a financial catastrophe, the parallel banking system may also have the ultimate protection of the Federal Reserve lender-of-last-resort provision. The lender-of-last-resort provision of the Federal Reserve System allows the Fed to save financial institutions from insolvency crises by issuing emergency, federally guaranteed loans to institutions that are facing short-term liquidity crises because of investor runs. This emergency liquidity provision is enacted only in the most drastic fiscal situations and is a contingent provision that exists to protect institutions from insolvency. A series of statutory and regulatory changes have recently expanded the scope of institutions that have access to the lender-of-last-resort, positioning the Federal Reserve as the ultimate protector of American financial market stability. For example, many analysts contend that government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac have retained their privileged status in the secondary mortgage market in part because investors believe that the government will not let the agencies fail. Fannie Mae has subsequently been able to generate more than $2.1 billion dollars in profit for its stockholders while paying nothing for the federal backing it receives".

In addition, when banks provide back-up lines of credit to issuers of commercial paper, the responsibility of covering impending illiquidity ultimately devolves to the Fed. In this way, many non-bank institutions continually receive indirect access to the Fed and the lender-of-last-resort provision. Conventional banks have had access to federal deposit insurance and emergency liquidity provisions since the early 1930s, but their access has been conditional upon their ability to remain within certain financial soundness guidelines. Access to the Fed's discount window is subsequently not a truly subsidized benefit because the protection is coupled with significant risk premiums. Federal protection for parallel banks, however, involves a substantial taxpayer subsidy because non-bank institutions are given federal protection without any of the same conditional provisions or soundness requirements. This suggests that nonbank institutions may take on significantly greater institutional risks yet benefit from having equal or near-equal access to federal protection and emergency loans. These inconsistencies highlight that by exempting non-banks from local reinvestment and soundness requirements, the government and the public are inadvertently supporting the development of a risky financial system that operates devoid of any regulation and social obligations.

D. Recommendation: A National Forum on the Community Reinvestment
Responsibilities of Parallel Banks

NACDLF strongly supports the extension of community reinvestment requirements to the non-bank institutions that make up the parallel banking industry but recognizes that simply extending CRA in its current form would not work. While parallel banking reinvestment policies need to accommodate the institutional diversity that makes up the parallel banking industry, they must also be grounded in a clear substantive commitment to the needs of low-income communities. This can take either or both of the following approaches:

Where appropriate, non-banks should be encouraged to develop viable vehicles for their own direct involvement in low-income communities. For example, direct investment by parallel banks could be promoted through income “distribution" requirements on nonbank investment and loan portfolios— e.g., finance companies might be required to target a percentage of their total lending at affordable rates to low-income households meeting certain income requirements. In turn, favorable ratings of finance companies' commercial paper issues could reflect a company's demonstrated ability to consistently target affordable loans to low-income populations". This effort would be aided by industry-wide in-depth

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analyses of the distributional lending patterns and affordability of finance companies and other non-bank lenders' products.

Savings instruments such as mutual funds and pension funds could similarly be tailored to meet the specialized savings and investment needs of low-income individuals. Individual development accounts (IDAs) are a possible model. These specialized savings accounts help low-income individuals accumulate wealth and direct savings towards high-yield public purpose investments such as education, business creation, and home ownership. The creation of similar “asset-building” mutual funds for low wage earners could help lower income households not only save for their future but also provide them with an entry point for participating in the parallel banking system. In addition, the development of more flexible "wealth" accounts which address low-income households' tendency to keep their savings in relatively illiquid assets would help individuals build viable bases for their future.

♦ In other cases, parallel banking institutions can participate in community reinvestment via indirect partnerships with CDFIs which specialize in financing revitalization efforts in low-income and other economically disadvantaged communities. By partnering with CDFIs, parallel bank institutions can substantially increase the leverage of their initial investment. Many CDFIs have already demonstrated significant creativity in collaborating with conventional financial institutions to distribute credit to unconventional markets. For example, some NACDLF Member CDFIs receive investments from, borrow debt from, co-invest with, and manage lending pools for conventional institutions. Several options for supporting even greater collaborations have been proposed:

◊ The practices of some socially-responsible mutual funds which invest a percentage of their total mutual fund shareholder base as common stock in companies that operate with a demonstrated social awareness suggest one model. While investments in non-profits cannot be in the form of common stock, aggregated savings instruments such as pensions and mutual funds could make equity-like investments in non-profit CDFIs or true equity investments in for-profit CDFIs and earn consistent positive returns.

◊ The Southern Finance Project has proposed creation of a National Reinvestment Fund, capitalized with levies on parallel banks, which would provide a capital base for CDFIs. The Fund would operate through the Federal Reserve System.

These approaches and proposals demand greater discussion, revision, and refinement. For that reason and to encourage greater attention to the community reinvestment effects of the structural shift in the financial services industry, NACDLF plans to convene a national forum in early 1997 that will seek a workable policy to extend community reinvestment obligations to the entire government-aided financial services industry. In addition to NACDLF and its Members, this forum will invite participation by community reinvestment advocates, conventional and parallel banking representatives and regulators, CDFI practitioners, academics, and others. In promoting a comprehensive discussion about the parallel banking system, NACDLF aims to raise local and national awareness about the subsidies that benefit nonbank institutions and develop an achievable agenda for bringing about greater social, political, and economic justice in America's low-income communities.