Impact Investing | March 29, 2023

How the U.S. can boost community financial institutions to counter bank consolidation and bridge racial wealth gaps

Beth Bafford

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Guest Author

Beth Bafford

Guest Author

Bulbul Gupta

The collapse of Silicon Valley Bank and Signature Bank sent depositors fleeing into the arms of large “Systemically Important Banks,” even after the federal government stepped in aggressively to restore confidence and calm markets. 

Too-big-to-fail banks may help individuals and businesses feel better about the safety of their accounts in the short-term. But the shift will be devastating for lower-income families, small businesses, and communities of color if the federal government doesn’t counterbalance their emergency efforts with major, long-term commitments to the community finance sector. 

Such support is not only good policy. It is essential to build trust with communities who feel that large banks – which often exclude community members from financial inclusion and access to capital – are always bailed out at their expense.

The community finance sector – including minority depository institutions, community development financial institutions, credit unions, and others – was formed more than four decades ago after the passage of the Community Reinvestment Act. It has been largely bootstrapped ever since. The sector, by some estimates, is less than 2% of the U.S. financial system despite the fact that it serves millions of un- and under-banked Americans.

The bootstrapping is not for a want of effort, but due to lack of intentional support for market development functions that enable greater scale and reach.

The federal government has a critical role to play in addressing and supporting these functions given the contribution of the community finance industry to the public good, including equity-centered CRA reform this year, and fully funding the industry. Without these resources and functions, the community finance field will remain a critical but very small portion of the overall U.S. financial system and millions of Americans will remain unable to access credit, services, and, ultimately, opportunity.

We should note that community finance entities do not share many of the risks that led to the most recent bank failures. The sector is coming out of the pandemic in the strongest position in decades, partly due to the injection of capital from the Emergency Capital Investment Program and the interest in supporting Black- and BIPOC-owned banks after the murder of George Floyd. Instead of leveraging this strong position to grow in activities and assets, they are – once again – being set back by risks in the system that they cannot control.

Underfunded market infrastructure

The community finance industry, by the nature of its mission orientation and roots in the Civil Rights movement, is not a profit maximizing industry. It operates with the primary purpose of providing affordable, quality financial products and services to every American, regardless of zip code, gender, race, ethnicity, or disability status. Because of the intentional moderation of profits, the industry has not had the excess margin to support or invest in long-term market development.

By “market development” we mean the functions, resources, or activities that contribute to the health of a market and all of its actors, but are not the responsibility of any one particular actor. 

What’s needed to put the industry on a different trajectory? It’s instructive to examine three main market development functions that underpin the for-profit U.S. credit markets but have been under-resourced in community finance. They include:

  • Market data and analysis: information aggregated and normalized about the actors, activities, and assets across the market;
  • Secondary market development: structures and vehicles that can pool and securitize assets to create liquidity for originators and investors;
  • Technology: lender and market-level technology improvements that enable better internal controls, facilitate a greater connection between credit supply and demand, and support an excellent customer experience.

Federal agencies and the Federal Reserve already offer many market-making functions that provide invaluable support to the mainstream financial system – for example, by offering liquidity through the discount window, deposit insurance, loan guarantees, and the new Bank Term Funding Program. This support is often limited to deposit-taking institutions and leaves behind thousands of non-depository nonprofit lenders who are certified and overseen by the federal government.

Educating the market on activities and outcomes

There is very little aggregated, up-to-date market-level data on the state of the community finance sector, particularly the non-depository institutions. The CDFI Fund produces an “Annual Certification and Data Collection Report” each year by compiling reporting from each CDFI – a helpful snapshot, but not frequent or timely enough to have an impact on decision making. The data cannot be easily disaggregated, analyzed, and manipulated (it comes in a PDF, not a spreadsheet). 

It is also focused on activities only, instead of an analysis of risk or performance. Assessing performance likely requires the entrance of rating agencies or third-party analysts that can aggregate market-level data to provide commentary on market-wide performance and results.

There has been exciting progress with a few large non-profit CDFIs that have received credit ratings from a nationally recognized statistical rating organization (NRSRO). But there has not been sufficient data access or volume for the NRSROs to create a business line tracking the industry or its assets. A general lack of focus and understanding of the community finance sector also poses a challenge. 

Supporting and growing an industry resource like impact ratings agency Aeris Insight, Inc. – or forging a partnership between community finance industry intermediaries and NRSROs – is critical to ensuring that a baseline of market data and information is available to analysts, advisors, and investors. This is particularly important for small and midsize CDFIs and MDI, and those who are BIPOC-led and historically under-capitalized, to ensure that those with deeper impact outcomes into intended communities are able to access increased liquidity and capital to scale without having to bear the cost burden of educating the market.

The same is true for impact performance and evaluation. The industry has largely been focused on reporting outputs (such as number of housing units built). There has not been sufficient research on how those activities translate into the impact or equity outcomes the industry seeks (such as healthier communities, meaningful living-wage jobs, wealth creation, etc.), particularly in historically excluded or marginalized communities where MDIs and CDFIs can have the deepest equity impact. Armed with resources to develop this evidence base, individual lenders within the industry could more effectively focus their efforts and attract individual and institutional investors who are increasingly looking for integrity of impact.

Understanding assets and supporting liquidity

Scaling community finance also requires the development of active and liquid secondary markets. Every other segment of the credit markets – mortgages, auto loans, credit card receivables, commercial loans, even loans for private jets – has heavily relied on secondary markets to reach scale, but there has been limited liquidity within the community finance sector.

Secondary markets support scale by taking assets off the balance sheet of the originating lender so their originations volume is not reliant on their capital base. Capital-constrained lenders cannot increase their loan originations unless assets that they originate can be purchased and their balance sheets recycled.

Calvert Impact, Pacific Community Ventures, and approximately 40 CDFI partners have been working to create loan purchase vehicles for CDFI-originated small business loans throughout the pandemic to begin facilitating a secondary market. These programs include the New York Forward Loan Fund, the California Rebuilding Fund, the Southern Opportunity and Resilience (SOAR) Fund, the Washington State Small Business Flex Fund, and the Connecticut Small Business Boost Fund.

The programs have collectively purchased more than 5,500 small business loans totaling approximately $350 million, of which more than 80% of the borrowers qualify as “Socially and Economically Disadvantaged Individuals.” 

This collaborative is now working on a program facilitated by funds from the State Small Business Credit Initiative (SSBCI) to warehouse and securitize small business loans. Other efforts like the Entrepreneur-Backed Assets (EBA) Fund are similarly making a market for CDFI-originated small business loans, driving significant value for CDFI originators and banks.

The main ingredients to support secondary markets for CDFI-originated assets are transaction-level data, standardized asset aggregation, and affordable credit enhancement.

The federal government is uniquely positioned to help foster a robust secondary market for these assets by creating programs that provide credit enhancement or risk capital to securities backed by CDFI- or MDI-originated loans. Agencies like the Treasury Department could create “qualified issuance” standards that, if met, would have access to a government guarantee. This would reduce the complexity and administrative burden of loan-level guarantees that already exist (e.g., SBA, USDA) and dramatically drive down the cost of capital – savings that would be passed along to consumers of the community finance products and services.

In addition, the Treasury Department could create definitions for transaction-level loan terms that the industry can coalesce around, and include those definitions in any federal programs that collect transaction-level data. Such transaction-level data exists in pockets across the federal government but has never been aggregated or shared in a format that is conducive to analysts. It is our hope that SSBCI’s transaction-level data reporting requirements will make the practice of collecting this de-identified data more common and allow the industry to start building asset-by-asset datasets that benefit everyone.

Bridging human-centered approach and operational efficiency

Underpinning these market development functions is a necessary investment in industry- and lender-level technology. Consolidation within the banking sector has created a bifurcated universe of technology “haves” and “have-nots.” The large financial institutions invest billions of dollars a year in their technology infrastructure and have created tools that make it easier for them to find and manage their customers as well as cybersecurity and other risks. 

Similarly, for-profit online lenders have raised billions to invest in their ability to quickly acquire customers, make near-instantaneous credit decisions, and manage a seamless customer experience.

Investments in technology across the customer lifecycle would enable community lenders to increase their operational efficiency and scale without losing the integrity of their human- and relationship-centric approach.  

For example, we have been leveraging the Connect2Capital platform built by Community Reinvestment Fund, USA (CRF) for our COVID recovery programs. This platform creates a streamlined and user-friendly customer experience for small businesses and easily matches them with the appropriate community lender based on their pre-application. Market-wide technology like Connect2Capital – or lender-level technologies like loan servicing or credit analysis software – are the foundation that will enable the community finance industry to grow.

Federal investments in market-tailored technology solutions, similar to how the Department of Energy invests in scaling new technologies that support the clean energy transition or the Defense Advanced Research Projects Agency (DARPA) invests in new technologies to support America’s military, would be game-changing. This public, non-dilutive source of funds – with a requirement to offer products and solutions back to the sector – would vastly accelerate the creation and adoption of technology across the industry.

Hundreds of private sector organizations are working hard to support community finance and improve economic outcomes for un- and under-banked communities and communities of color across the U.S. Smart government policies focused on market development for the common good can amplify and multiply these efforts, build wealth, and create jobs in our communities.

Beth Bafford is Vice President of Strategy for Calvert Impact. Bulbul Gupta is the President & CEO for Pacific Community Ventures.