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Wednesday, November 26, 2014

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Cascade: No. 83, Fall 2013

Spotlight on Research: The Impact of Government Subsidized Lending: Community Development Financial Institutions Fund*

Access to credit in all segments of the population not only enhances the financial viability of individuals and their communities but also contributes to a robust economy. However, for various reasons, the private sector might not supply an adequate amount of credit or capital to meet the demand in certain areas. In these instances, the government might step in and bridge the gap. One approach taken by the federal government is to provide funds from the Community Development Financial Institutions (CDFI) Fund to financial intermediaries such as community development financial institutions (CDFIs), which in turn supply the credit and capital to the populations in need. While the federal government’s effort to correct an imbalance is laudable, questions might be raised as to its effectiveness and possible undue political influence. These concerns are addressed in a study by Kristle Romero Cortés and Josh Lerner.1 The following is a summary of their paper.

Background

Marvin M. Smith, Ph.D., Community Development Economic AdvisorMarvin M. Smith, Ph.D., Community Development Economic Advisor

Cortés and Lerner noted that financial institutions are instrumental in the growth and development of economies. But to maximize the economy’s growth potential, financial institutions should fulfill the credit needs of the population. Yet, some sectors of the population might not have their credit demand satisfied. This might require the intervention of the federal government. According to Cortés and Lerner, “In theory, public efforts which enable (and indeed require) financial institutions to extend credit to underserved portions of the population may ease some of these constraints.” However, the efficacy of such efforts on the part of the government is suspect and could fall prey to political manipulation. Cortés and Lerner considered these concerns by examining the effectiveness of the government using the CDFI Fund “to grant awards to financial institutions that target certain borrowers.”

The CDFI Fund was established in 1994, and its “mission is to expand the capacity of financial institutions to provide credit, capital, and financial services to underserved populations and communities in the United States.” It has lent over a billion dollars since its establishment. The authors chose to study the CDFI Fund because of its relatively long-term existence (as opposed to many of the government’s short-lived programs), and its “core program, awarding Financial Assistance (FA) and Technical Assistance (TA) grants, has followed clear-cut, well-documented procedures from its inception.” Cortés and Lerner focused on the grants to credit unions2 “because they make up a large and relatively homogeneous part of the CDFI industry.” FA awards can range up to $2 million and can be used for “financing capital, loan loss reserves, capital reserves, or operations.” TA awards can be made up to $100,000 and used “to purchase equipment, materials, or supplies; for consulting or contracting services; to pay the salaries and benefits of certain personnel; and/or to train staff or board members.”

Data and Methodology

Cortés and Lerner used data from the CDFI Fund for years 2000 to 2009, which contain information on CDFIs that applied for grants, the amounts requested, and the amounts awarded. The authors’ study sample included all credit unions that applied for grants during the study period; the credit unions that received funding made up the treatment group, and those whose applications were rejected comprised the control group.3 Cortés and Lerner noted that credit unions applied for funding twice, on average, during the study period, which resulted in 362 applications. They also included data from the National Credit Union Administration (NCUA), “an independent federal agency that charters and supervises federal credit unions.” The NCUA compiles information quarterly on the financials and specific characteristics of credit unions.

Since CDFIs focus their efforts on underserved populations, they often find themselves conducting business in impoverished areas. The authors pointed out that “CDFIs on average serve the bottom three-fifths of the income distribution.” Thus, to capture the nature of these areas in their analysis, Cortés and Lerner used some macroeconomic controls, such as median income and unemployment and poverty rates. The data are on the local level, with the unemployment rates coming from the U.S. Bureau of Labor Statistics and the median income and poverty rates coming from the U.S. Census Bureau.

First, the authors used regression analysis to determine which factors are influential in the award decision process and which ones enhance a credit union’s prospects of receiving an award. Next, they investigated whether politics influences the award process. Finally, Cortés and Lerner examined what effects a CDFI award had on a credit union’s loan growth.

Results

Cortés and Lerner investigated the grant decision process and found that the most significant factor contributing to a credit union’s, receiving a grant is whether its “loan portfolio grew in the year previous to the award.” According to the authors, “this suggests that the CDFI Fund is interested in awarding grants to CDFIs that have already demonstrated a strong inclination to loan to low-income borrowers.” The authors also found that median income growth in the region increased the probability that a credit union would receive a grant, while “local poverty and unemployment rates [were] either insignificant, or negative.” Moreover, credit unions whose borrowers had a history of high default rates were less likely to receive grants.

The authors also examined the possible influence of politics in the award decision. Given that the CDFI Fund was established under a Democratic administration, they included a variable in their regression analysis that indicated whether a credit union was located in an area where the congressional representative was a Democrat.4 In addition, Cortés and Lerner tested whether the award decision would be affected if the Congress member had the same political affiliation as the presiding President. In both cases, the authors found no effect, which led them to “interpret these findings as evidence that politics [did] not seem to play a role in funding.”

Cortés and Lerner finally estimated the impact of the CDFI Fund’s grants on credit union activity. They found that total loan growth for credit unions that received an award increased by 45 cents in the first year for each dollar awarded. Moreover, “after three years, one dollar of funding translate[d] into $1.60 of total loan growth.” Thus, the authors observed that “CDFI grant money does in fact increase lending but it takes some time to ramp up.” Cortés and Lerner also discovered that CDFI Fund grants did generate some delinquent loan growth. Namely, “for each dollar awarded, 12 cents become delinquent over three years.” But they hasten to point out that “it is a small portion of the additional generated loans.”

While Cortés and Lerner studied the effects of CDFI Fund grants on credit unions and found that the awards increased their lending, they noted that “much remains to be done in understanding the consequences for borrowers and communities.”

  • * The views expressed here are those of the author and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  • 1 Kristle Romero Cortés and Josh Lerner, “Bridging the Gap? Government Subsidized Lending and Access to Capital,” Review of Corporate Finance Studies, 2 (2013), pp. 98–128.
  • 2 In addition to credit unions, there are three other types of CDFIs — banks, venture capital firms, and loan funds. According to the authors, credit unions make up the second-largest portion of CDFIs (behind loan funds), are regulated, and “have received twice the amounts of grants over the last decade than banks.”
  • 3 In their analysis, Cortés and Lerner use the control group as benchmarks to gauge the change in the credit union activity of those that receive grants (treatment group).
  • 4 Since the activities of CDFIs are generally local, the authors reasoned that the ”Congressional Representative is the correct way to proxy for political connection because Senators would be too removed from the individual concerns of the diverse communities.”