This article originally appeared in American Banker on April 21, 2017. Link.
BankThink: Killing CDFIs would make a bad situation worse for small business
By Trevor Dryer
Small-business growth and job creation positively impacts the U.S. economy, but a gap exists in small businesses’ access to cost-effective credit, hurting their ability to subsist, much less thrive. When faced with unexpected expenses, limited credit options for a small business puts its survival in question.
A recent Trump administration budget proposal would widen the credit gap for small businesses even more.
Unfortunately, traditional lenders have not always been able to meet these credit needs. More than 70% of small businesses seek loans under $250,000, but these relatively small-dollar loans are often the least cost-effective for banks to lend. Traditional lenders are often wary of these types of loans due to high default risks and the significant cost of underwriting.
When small businesses are not able to quickly access capital from their banks, they often turn to high-cost lenders. Some lenders will charge interest rates ranging from 25% to over 70% based on the applicant’s information. Their terms are often obscure and filled with egregious fee structures, trapping small-business owners in a dependency cycle and limiting the positive impact they can have on economic development.
Another option does exist, one often overlooked by small businesses. Community development financial institutions are able to lend to borrowers that do not meet traditional lenders’ “bankability” metrics. Particularly in the impact lending space, CDFIs are creating access to credit for borrowers that would otherwise turn to alternate lenders. Instead of excessively high fees and confusing terms, CDFIs offer accessible rates, transparent terms, and even education and other support to enhance the likelihood of a business’ success.
But under the White House budget blueprint released earlier this year, the Trump administration recommends ending federal funds to CDFIs as a cost savings measure for the federal government. Unfortunately, without CDFIs serving as the lender of last resort, more small businesses will move to high-risk, high-cost lenders. Additionally, since banks can earn Community Reinvestment Act credit for providing capital to CDFIs, ending the federal subsidy program will take another option for satisfying CRA requirements — already a costly burden — off the table.
Under the CRA, regulators require financial entities to address the credit needs of the communities they serve, particularly in disadvantaged areas of their geographic footprint. Through this transaction with a CDFI, the small-business owner gets a loan and the bank’s investment counts toward satisfying CRA requirements. With direct investments from banks and the backing of the government, CDFIs have capital available at a low cost to small-business borrowers.
Historically, the Treasury Department invests over $200 million annually into local communities through the CDFI program, and every one dollar of federal funds is leveraged 10 times through a CDFI. Rather than defunding the program, finding a way to expand CDFIs and encourage more private-sector investment and involvement in the program seems like the better solution. Regulators should consider giving more CRA credit to direct investments by a bank to a CDFI, encouraging more capital from the private sector. The solution is to do more for small business, not less.
Cutting off funds and resources for our nation’s CDFI network and taking away a lender of last resort for small-business owners will not help the economy.