Community Development Financial Institutions: Promoting Economic Growth and Opportunity

Federal Reserve System Chairman Ben S. Bernanke spoke about community development financial institutions (CDFIs) at the Opportunity Finance Network's Annual Conference on Nov. 1, 2006, in Washington, D.C. Following are excerpts from his speech.

Improvements in Economic Opportunity and Some Challenges

In the past decade or so, U.S. households overall have experienced notable gains in terms of some key indicators of economic opportunity. Three such indicators ... are access to credit, rates of home ownership and small business development. Moreover, as measured by these indicators, recent improvements in traditionally underserved markets appear to have been as great as or greater than those in middle- and upper-income households and communities. At the same time, however, the gaps between lower-income households and other households with respect to these measures of opportunity remain wide ...

CDFIs as a Solution to Market Failures

Many factors have contributed to the economic gains that I have cited, including broad macroeconomic forces and advances in the delivery of financial services. CDFIs have also played a valuable role by analyzing the economic potential of lower-income markets and developing strategies and marshaling resources to tap that potential ....

Standard economic analysis tells us that when competitive conditions prevail in a market, the resulting prices induce firms and individuals to allocate resources in a manner that tends to maximize social welfare. However, economists also recognize that various deviations from idealized market conditions, termed market failures, can inhibit the efficient allocation of resources. In one type of market failure, called a neighborhood externality, the actions of one person affect the well-being or economic welfare of others in the local area, but the individual taking the action neither bears the full costs of nor reaps the full benefits from those actions. Because the individual does not bear the full consequences of the actions taken, he or she may act in a way that is not in the best economic interest of the neighborhood as a whole. For example, the failure of some owners to maintain their properties can lower the value of well-maintained properties in the same neighborhood. Ultimately, such spillover effects from neglected properties can lead to underinvestment in the whole community, potentially harming all neighborhood residents and businesses.

A related type of market failure studied by economists is known as an information externality. An information externality may arise when information about economic opportunities in an area has the potential to benefit many investors but is costly to gather. As a result, no single potential investor may find obtaining the data to be profitable. For example, on average, lower-income areas have fewer owner-occupied homes and record fewer home-purchase loans than higher-income areas do. Lower transaction activity makes accurately gauging property values and evaluating credit risks in those areas more difficult, which may inhibit the extension of credit. Alternatively, lower-income people may have shorter and more-irregular credit histories, making an evaluation of their individual creditworthiness more difficult and costly. Because a potential investor who bears the costs of obtaining data about underserved neighborhoods may be able to obtain only a portion of the full economic benefits, these data may remain uncollected.

One purpose of CDFIs is to help overcome these and other market failures that inhibit local economic development. For example, by facilitating larger-scale property development projects, coordinating public and private investment efforts, and working to improve amenities and services in a local area, CDFIs may help to solve collective action problems and reduce neighborhood externalities. CDFIs can counter information externalities by assuming the cost of learning about their local communities and developing specialized financial products and services that better fit local needs. In general, CDFIs provide coordinated development activities and community-specific information that the market may not supply on its own.

Among other benefits, the familiarity with each community that CDFIs develop can help to gauge and control risk. For example, the use by CDFIs of appraisers who specialize in evaluating properties in a particular community produces more-reliable estimates of the value of the loan collateral. Likewise, CDFIs structure loans and use public and private credit enhancements both to increase borrowers' ability to qualify for loans and to spread the associated credit risk among a mix of private creditors and other providers of funds.

Although these specialized techniques can reduce credit risk, they are labor-intensive and, consequently, expensive. Most private lending institutions reduce costs by adopting processes that are highly standardized and automated. Such systems are not necessarily compatible with lending to borrowers who require substantial screening, counseling and monitoring or with acquiring specialized information about community development lending. Part of the explicit mission of CDFIs is to assume the costs of conducting such research and analyses in underserved communities. CDFIs have also developed techniques and strategies-such as flexible underwriting criteria, specialized loan products and intensive financial education programs-to meet the financial circumstances of their communities ...

Is Community Development Lending Profitable?

Can private-market participants profit from community development lending? Data based on Community Reinvestment Act (CRA) examinations tell us much about the volume of such loans but less about their performance and profitability. However, a Federal Reserve survey found that nearly all banks reported that their community development activities were profitable, at least to some degree. About two-thirds of the banks also reported receiving some benefit from their lending unrelated to loan profitability, such as an improved image in the community.

Since the Federal Reserve report, studies undertaken by the CDFI Data Project show that, for 2004, charge-off rates for CDFI portfolios were similar to those for the banking industry as a whole. These studies and market data suggest that banks and other private organizations may become an increasingly significant source of competition for CDFIs. That is good news, not bad news. Indeed, the surest sign of a CDFI's success is that private investors see viable investment opportunities in the neighborhoods in which the CDFI has been operating.

To read the entire speech, go to www.federalreserve.gov/newsevents/speech/bernanke20061101a.htm.