Changing Capital Markets And Their Implications for Community Development Finance
By Kirsten Moy and Alan Okagaki

(Editor's Note: An expanded version of the following article recently appeared in the "Capital Xchange" and is posted on the Brookings Institution Web site: www.brookings.edu/urban/capitalxchange/article5.htm. The authors encourage readers to visit the site for more about the issues and ideas expressed here.)

Economic restructuring, the emergence of telecommunications and information technology, and other national and global trends have dramatically changed the environments in which community development takes place. Capital gaps have changed, capital itself is becoming less "localized," and the financial services industry has evolved new ways to transact business and service customers. These changes have significant implications for Community Development Financial Institutions (CDFIs). The CDFI industry needs to re-engineer, reposition and re-tool itself. In particular, the CDFI industry must critically examine its structure and invest in its supportive infrastructure if it is to be an effective conduit for the flow of capital to low-income communities.

A Brief History

The current CDFI industry began taking shape in the late 1960s and early 1970s. Some of the earliest community development loan funds and venture-capital funds were launched by first-generation community development corporations (CDCs) supported by the federal Office of Economic Opportunity "Special Impact Program."

In the later 1970s, new community development finance organizations were formed, capitalized with a broader range of public and philanthropic funds. Many business-development loan funds were launched with federal funds from the Department of Housing and Urban Development, the Economic Development Administration, or the Department of Agriculture. Community development credit unions and banks were started in the 1970s, such as South Shore Bank in Chicago (1973) and the Santa Cruz Community Credit Union (1977). The Neighborhood Reinvestment Corporation (NRC), a national intermediary that supports local Neighborhood Housing Services offices, was created in 1973 and began financing affordable housing in 1978.

Another strand of early CDFIs consisted of grassroots organizations that recruited their capital from individuals, churches and local institutions rather than federal agencies. Some examples were the Fund for an Open Society (Philadelphia) which made mortgage loans to promote racially integrated neighborhoods, and the revolving loan fund of the Institute for Community Economics (ICE), which financed community land trusts.¹

Industry Changes and Their Implications

While the CDFIs of the 1970s were well-adapted to their time, subsequent policy shifts and financial industry restructuring have undermined their early conceptual foundations. Policy changes in the 1970s and 1980s catalyzed formation of many housing CDFIs, but also brought the industry into a new relationship with the private sector. Prior to the 1980s, the federal government played a dominant role in supporting and creating affordable housing for low-income persons. Federal support for affordable housing contracted during the Reagan administration between 1981 and 1989, total federal support for subsidized housing fell more than 70 percent.²

As direct federal funding was reduced, the task of financing affordable housing development fell on local communities and states. By combining local public and private funding resources, a subsidized, financing "package" could be created that enabled non-profit and for-profit housing developers to reduce rents into the "affordable" range. Two federal policies were critical to these local packages: the Community Reinvestment Act (CRA), passed by Congress in 1977, to curb redlining and put regulatory pressure on banks to make more loans in low-income communities, and the Low-Income Housing Tax Credit, a provision of the 1986 Tax Reform Act, that provides incentive for corporate investment in low-income rental housing projects.

Over time, local and state-wide affordable housing finance "systems" evolved supporting non-profit (CDCs) and for-profit housing developers.³ Affordable housing CDFIs became the institutional vehicles for assembling project financing, for underwriting and delivering "gap" financing for housing developments, and for generally organizing and improving local finance systems.

The proliferation of housing CDFIs was enhanced by national community- development intermediaries: the Enterprise Foundation, the Local Initiatives Support Corporation (LISC) and the NRC. The national intermediaries articulated a vision of community development centered around community-based non-profits as developers, managers, and financers of affordable housing. They raised hundreds of millions of dollars in grants and loans for community development. They were pioneers in syndicating low-income housing tax credits for corporate investors and successfully increased investment for affordable housing. Thus policy change set the stage for many new CDFIs serving the affordable-housing industry.

In addition to policy-induced changes, CDFIs have been profoundly affected by trends in the financial-services world.⁴ The most obvious trend has been the wave of mergers and consolidations. Approximately 8,000 bank mergers occurred between 1980 and 1998 involving almost $2.4 trillion in acquired assets.⁵ In addition to mergers within the banking industry, consolidation occurred across industry lines.

The second major trend has been increased functional specialization and the growth of securitization (secondary markets). Traditionally, conventional depository institutions originated loans, booked the loans, collected interest and principal, serviced their own loans and held loans to maturity. Now, these functions are "broken up" among multiple institutions or sites instead of residing in a single location.

When CDFIs started, securitization was in its infancy. Now, it accounts for trillions of dollars of transactions. Using financial "engineering" techniques, almost any pool of assets can be securitized and sold. This has had several implications for CDFIs.

First, securitization of low-quality assets has turned sub-prime lending into a big business. Second, with the prevalence of financial engineering, a very high level of financial sophistication has become the norm in the capital market. Third, functional specialization and securitization have made the self-contained, vertically integrated financial institution out-dated.

Finally, technology has profoundly affected financial services. Automated loan processing reduced transaction costs enormously. However, an even more significant change might be the "de-localization" of capital. Telecommunications - instantaneous transmission of data across distances - make managing national and global financial companies possible. Loans and other financial products are available anywhere in the country from national and international corporations.

Retooling the Industry

If one were to compare the present CDFI industry with the CDFI world of 1980, one would observe the following:⁶

• The number and size of CDFIs have grown enormously. A recent study identified 365 certified CDFIs with an estimated $4.6 billion, in total assets.⁷
• There are arguably fewer capital gaps now than anytime in the last 30 years. CDFIs are reporting more competition from banks and non-banks in what had been their most dependable lending niches; e.g., business loans too small for a bank to bother with and entrepreneurs with poor credit histories.
• Lending niches are defined less and less by geography.
• In an era characterized by transaction efficiency and precise risk management, the primary CDFIs niches tend to be: 1) products with high transaction costs; 2) customers who require a lot of handholding; and 3) capital needs that are further out on the risk spectrum. These niches drive up CDFI expenses as CDFI funders expect them to be financially self-sufficient.
• The financial needs in today's low-income communities are primarily in equity (note the rise in community development venture capital), personal savings products (note the interest in Individual Development Accounts), and consumer financial services (note the prevalence of check cashing and "pay day" loan services). However, few CDFIs are positioned to do equity investing and few have the infrastructure to offer a wide spectrum of savings products, investment products and consumer financial services.
• As more assets are securitized and sold, CDFIs specialize in customized financing and generally hold their loans in portfolio.
• The technology gap between CDFIs and the mainstream economy appears to be widening.
• CDFIs remain largely vertically-integrated, self-contained, retail institutions; mainstream institutions have moved away from this model.
• Although the CDFI industry has grown in scale and numbers, it has segmented into a small number of "star" institutions and a large number of marginal or low-performing organizations.

Taken all together, this constitutes a precarious position for the CDFI industry. We believe the fundamental issue for CDFIs is not just growth (as measured by size and number of institutions), but also enhancement of core capabilities, niches and positioning vis-à-vis conventional capital markets. The CDFI industry has moved in this direction by trying to: 1) professionalize itself as an industry with the mainstream financial services industry as a model; 2) copy specific tools and techniques from mainstream capital markets to access larger amounts of capital; and 3) work with mainstream institutions to channel private investment into community-development projects.

While these efforts are promising, their scale is still minuscule compared to conventional investment markets. We believe these efforts to access capital markets are constrained by several fundamental issues that have not been adequately addressed. These problems are rooted in CDFI industry's structure (an artifact of the CDFI's history) and the growing gap between CDFIs and mainstream institutions resulting from the trends identified earlier. They are:

• Volume and Standardization*
• Technical Sophistication and Scale Efficiencies*
• Greater Conformity with Capital Markets*
• Technology*

Conclusions

As CDFIs move forward, three overarching points stand out. First, the issues of industry structure remain. The CDFI industry remains a group of small, geographically based, autonomous, vertically-integrated institutions generating small volumes of customized products for local markets. In other words, they are like the community banks of 30-40 years ago. The gulf between CDFIs and mainstream capital institutions continues to grow in size, sophistication, the range of financing tools and instruments, use of technology and degree and complexity of the supporting infrastructure. Even though CDFIs have grown, their mainstream financial counterparts have grown faster. As one CDFI practitioner observed, "We used to be small, now we're microscopic." Because their structure envisions each organization performing all functions in-house, it is far more difficult for CDFIs to develop top-level, specialized expertise across all functions. As a result, there are few top-tier organizations.

Second, today's retail financial institutions are supported by a highly developed infrastructure. This is partly institutional - investment bankers, brokers, traders, salespersons, investment advisors, institutional investors, research firms, ratings agencies, and other industry-wide resources. Part of this is the technology that makes quick transactions possible. And, part of it lies in standardized documents, procedures, protocols, methodologies, investment vehicles and products. Financial institutions can match users of capital with suppliers of capital accurately, quickly and efficiently.

By comparison, financial infrastructure in the CDFI industry is grossly underdeveloped. Partly, this is a function of industry structure; autonomous, vertically-integrated CDFIs rely less on external supporting infrastructure. More fundamentally, the language of "creating infrastructure" is foreign to the non-profit world. The private sector talks about roll-out and infrastructure, while the non-profit sector talks about model-testing, best practice, and replication. "Replication" assumes the merits of new innovations will be self-evident and that individuals, organizations or communities in one location will copy the innovation discovered or initiated in another situation. By contrast, "roll-out" assumes that widespread change must be fostered through incentives, systems and the supporting infrastructure to facilitate and institutionalize the change. The CDFI industry has many "best practices" but far fewer generally-accepted standards, protocols, methodologies, or technology applications, all of which would support and in turn be supported by appropriate infrastructure. Development of new infrastructure is the codification of new ideas into widely available systems, products and services. Without supporting infrastructure, lasting change does not occur. The existence of infrastructure is a benchmark of wide-spread implementation of an idea. Without enabling infrastructure, promising demonstrations are nothing more than a series of "one-offs."

Finally, CDFIs need to innovate in conjunction with the mainstream financial industry, not in isolation. There are several new initiatives to promote innovation that do connect the CDFI industry with private-capital institutions: e.g., The Capital Markets Access Program (CMA), housed within the New School University's Robert J. Milano Graduate School of Management and Urban Policy, the Financial Innovations Roundtable (FIR) of the School of Community Economic Development (CED) at Southern New Hampshire University, and The Milken Institute's Emerging Domestic Markets (EDM) project.

In sum, it is difficult to underestimate the significance of the changes that have swept the financial-services industry over the last 30 years. While the community development finance industry is rightly concerned with increasing scale and impact, fundamental questions of structure, supportive infrastructure and specialization have not been part of the debate. Industry re-tooling along these lines should be explored as an alternative to incremental approaches (e.g., demonstration and replication of best practices) more commonly proposed to build the field.

Notes:

¹ The Institute for Community Economics. The Community Loan Fund Manual. Greenfield, Massachusetts: 1987. p 1-13.

² Ford Foundation. Affordable Housing: The Years Ahead. New York. 1989.

³ We acknowledge Daniel Leibsohn for his research and analysis of affordable housing systems.

⁴ We are indebted to Steve Davidson, America's Community Bankers, for this analysis.

⁵ Stephen A. Rhoades. Bank Mergers and Banking Structure in the United States, 1980-98. www.federalreserve.gov/pubs/staffstudies/174/default.htm

⁶ This picture of the CDFI industry is based primarily from interviews in the CDIII project.

⁷ Brody, Weiser & Burns. US CDFI Resource Study. CDFI Fund Presentation June 29, 2000

* For further discussion on these topics, go to www.brookings.edu/urban/capitalxchange.

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