creating capital, jobs and w emerging domestic markets · additional loans, thus increasing the...

JANUARY 2003

Glenn Yago

Betsy Zeidman

Bill Schmidt

P o l i c y B r i e fN um b er 3 4

CREATING CAPITAL, JOBS

AND WEALTH IN EMERGING

DOMESTIC MARKETS

FINANCIAL TECHNOLOGY

TRANSFER TO LOW-INCOME

COMMUNITIES

CREATING CAPITAL, JOBSAND WEALTH IN EMERGING

DOMESTIC MARKETS

FINANCIAL TECHNOLOGYTRANSFER TO LOW-INCOME

COMMUNITIES

January 2003

by

Glenn Yago

Betsy Zeidman

Bill Schmidt

ACKNOWLEDGMENTS

The authors wish to acknowledge the generous support of the Ford Foundation, particularly MicheleKahane, in the research and development of this report. We also appreciate the many individuals whocontributed important information and insights, as well as valuable time, through participation in WorkingGroup sessions in Los Angeles, New York and Washington, DC, through interviews with our staff, and byreviewing and commenting on drafts of the report. In addition, we thank our editor, Judith Gordon,researchers Liya Brook and Deana Carillo, administrative support Muriel Poussin and Megan Sharpless, andgraphic designer and print production coordinator, Sallylynn James.

Copyright © 2003 by the Milken Institute

The Milken Institute is an independent economic think tank whose mission is to improve the lives andeconomic conditions of diverse populations in the U.S. and around the world by helping business and publicpolicy leaders identify and implement innovative ideas for creating broad-based prosperity. We put researchto work with the goal of revitalizing regions and finding new ways to generate capital for people withoriginal ideas.

We do this by focusing on human capital – the talent, knowledge and experience of people, and their value toorganizations, economies and society; financial capital – innovations that allocate financial resourcesefficiently, especially to those who ordinarily would not have access to it, but who can best use it to buildcompanies, create jobs and solve long-standing social and economic problems; and social capital – the bondsof society, including schools, health care, cultural institutions and government services, that underlieeconomic advancement.

By creating ways to spread the benefits of human, financial and social capital to as many people as possible– the democratization of capital – we hope to contribute to prosperity and freedom in all corners of the globe.

We are nonprofit, nonpartisan and publicly supported.

The Ford Foundation is a resource for innovative people and institutions worldwide. Our goals are to:strengthen democratic values, reduce poverty and injustice, promote international cooperation and advancehuman achievement. This has been our purpose for more than half a century.

A fundamental challenge facing every society is to create political, economic and social systems that promotepeace, human welfare and the sustainability of the environment on which life depends. We believe that thebest way to meet this challenge is to encourage initiatives by those living and working closest to whereproblems are located; to promote collaboration among the nonprofit, government and business sectors, andto ensure participation by men and women from diverse communities and at all levels of society. In ourexperience, such activities help build common understanding, enhance excellence, enable people to improvetheir lives and reinforce their commitment to society.

Creating Capital, Jobs and Wealth in Emerging Domestic Markets Milken Institute - January 2003

ii

EXECUTIVE SUMMARYThe United States experienced such an extraordinary surge in wealthduring the 1990s that even after the stock market decline of 2000-2001,Americans’ total net worth in 2002 remains almost 75 percent greaterthan it was just 10 years ago. As with previous episodes of economicexpansion, entrepreneurship and innovation, both technological andfinancial, fueled much of this growth. However, this growth wasunbalanced, with higher-income entrepreneurs more easily accessing thefull array of financial technologies and a wider range of sources ofcapital than smaller firms in emerging domestic markets (EDM).

This circumstance is ironic, since small businesses represent the vastmajority of all firms and a driving force behind economic output and jobcreation. Ethnic-owned firms grew at twice the rate of all firms duringthe past decade, yet face capital gaps that limit their ability to expandand generate jobs in urban and low-and moderate-income (LMI)markets, home to a disproportionate amount of the increasingly diverseU.S. population.

Resolving the EDM capital gap is critical to national economic health aswe experience a seemingly jobless recovery from a recession threatenedby the constriction of consumer demand. Closing this gap necessitatesthe transfer of financial technologies and market-based public policyinnovations from mainstream applications to emerging domesticmarkets, carving channels of capital from investors to entrepreneurs.

Low- and moderate-income, minority- and women-owned businesseshave always faced greater challenges to accessing capital than themainstream. Some are due to blatant discrimination, but others arisefrom imperfect information about the firms and the nature of theirbusiness models and environments. These include:

■ Lack of performance data on loans to these borrowers, leadinglenders to perceive them as riskier and beyond their legal risktolerance.

■ Smaller-sized loans, leading them to be more expensive for lenders toservice.

■ Firms’ need for mentoring and technical assistance services inaddition to financing, increasing costs to lenders.

■ Lack of professional and social networks linking borrowers andfinancial institutions.

■ Historical concentration of business in the retail and servicesindustries, with little collateral to secure loans.

Milken Institute - January 2003 Creating Capital, Jobs and Wealth in Emerging Domestic Markets

The United Statesexperienced such anextraordinary surge inwealth during the 1990sthat even after the stockmarket decline of 2000-2001, Americans’ totalnet worth in 2002remains almost 75percent greater than itwas just 10 years ago.

■ ■ ■

This growth wasunbalanced, withhigher-incomeentrepreneurs moreeasily accessing thesources of capital thansmaller firms inemerging domesticmarkets (EDM).

■ ■ ■

Resolving the EDMcapital gap is critical tonational economichealth as we experiencea seemingly joblessrecovery from arecession threatened bythe constriction ofconsumer demand.

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■ Lack of a viable secondary market for small-business loans.

Nonetheless, EDM and LMI areas offer many features desirable to aninvestor seeking a market with quantifiable risk and return oninvestment.

■ There is a large, untapped market for financial institutions servicingLMI populations. Advances in technology have made it moreaffordable to access the market.

■ The lower cost of real estate – land and buildings – in LMI areas,whether urban or rural, offers a major advantage to businesses andinvestors.

■ By partnering with Community Development Financial Institutionsthat have an extensive knowledge of their local market, mainstreamp roviders of capital can evaluate, mitigate, and price riskappropriately and expand into LMI markets with new products.

Several major trends in legislative and regulatory policy, financialservices industry development, demographic shifts and economicconditions provide the backdrop for considering and inventing thefuture.

■ The U.S. is shifting from a bank-based to a capital-market basedfinancial system, disproportionately impacting small businessesbecause they have fewer nonbank options than larger companies.

■ Servicing EDM communities can be difficult for large, mainstreambanks. The information asymmetries, and banks’ segmentedorganizational structure separating wholesale and retail productsinto separate divisions, run counter to the flexibility required to buildrelationships with small firms in LMI areas.

■ Over the next 50 years, 90 percent of U.S. population growth willoccur among ethnic groups, reducing white Americans to less than 50percent of total population. With their growing rates of businessownership, ethnic entrepreneurs and consumers significantly impactthe overall economy.

■ A slowing economy, uncertainty, and regulatory changes tightencredit and reduce business formation among all groups. Reducedentrepreneurial activity translates into reduced job creation andretention rates, and polarizing income and wealth distributionaltrends. The current slowdown in the economy is likely to impactsmaller banks, and hence smaller firms, more severely.

Adapting financial innovations to EDM/LMI small-business financingcan help overcome many of the challenges to serving these markets, andenable a range of investors to tap into the opportunities. Examples of


EDM and LMI areasoffer many featuresdesirable to aninvestor seeking amarket withquantifiable risk andreturn on investment.

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With their growingrates of businessownership, ethnicentrepreneurs andconsumerssignificantly impactthe overall economy.

■ ■ ■

The currentslowdown in theeconomy is likely toimpact smaller banks,and hence smallerfirms, more severely.

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financial innovations that could increase capital flows fall into threebroad categories:

A. Systemic innovations: Innovations that affect the financial sectorbroadly, e.g., changes in business structures, new types of financialintermediaries, new legal or regulatory frameworks. Systemicinnovations include securitization, consortiums, nonbank financialinstitutions, government programs, liquidity vehicles, and newownership models.

B. Product innovations: Innovative financial products that better servethe market, including both the suppliers and the users of theproducts. Product innovations include credit enhancements, blendedfund stru c t u res, angel pools and networks, equity equivalentinvestments, and tribal bonds.

C. Process innovations: Innovations that introduce new businessprocesses, which may increase efficiency and expand markets usingtools such as information technologies. Process innovations includecollecting data, credit scoring, and mentoring and pro v i d i n gbusiness advisory services.

This report provides a compendium of best practices in addressing thegap between capital supply and demand among small businesses in low-to-moderate income communities. The systematic piloting and rollout offinancial innovations would address the mismatch between the nation’ssources of job creation and capital formation, and enable the financialservices industry to expand its reach into new markets. The reportconcludes with several practical, scalable pilots that would addressspecific financing obstacles, leverage existing resources, expertise andinterest and incorporate incentives for all relevant parties to participate.

REPORT RECOMMENDATIONSModel One: EDM Data Network A comprehensive, integrated, reliablerepository of information on EDM/LMI businesses and their loanperformance, intended to help researchers track market activity andfinancial services providers price risk and finance entrepreneurs.

Model Two: Securitization and Credit-Enhancement The pooling andpurchase of individual small-business loans from multiple lenders andpackaging these loans into a security to be sold to a third party, reducinglenders’ credit risk by providing liquidity and freeing them to makeadditional loans, thus increasing the size and scope of EDM/LMIlending by mainstream institutions.

Model Three: EDM-targeted Mezzanine Fund A privately managed,public purpose equity/mezzanine fund targeting business and project


Financial innovationsthat could increasecapital flows fall intothree broad categories:Systemic innovations,Product innovationsand Processinnovations.

■ ■ ■

Systematic pilotingand rollout offinancial innovationswould address themismatch between thenation’s sources of jobcreation and capitalformation, and enablethe financial servicesindustry to expand itsreach into newmarkets.

■ ■ ■

Scalable pilots wouldaddress specificfinancing obstacles,leverage existingresources, expertiseand interest andincorporate incentivesfor all relevant partiesto participate.

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financing in LMI areas and among EDM firms, offering much-neededflexibility to the capital structure of small businesses.

Model Four: Financial Innovations Lab & Learning Consortium Astructured approach to adapting financial technologies and sharingindustry and community expertise, intended to advance innovation,increase learning and build relationships to facilitate EDM/LMI lendingand investment by diverse financial services providers.

Model Five: Bank/Community Lender Exchange A continuous flownetwork through which registered banks, community-based lenders(including CDFIs) and service providers (such as technical assistancep roviders) would exchange information, deal flow and expertise,intended to grow customer bases, improve deal quality, appropriatelymatch investors/lenders with entrepreneurs and reduce financing risk.

Traditionally, government programs and philanthropic donors have beenthe primary sources of capital for EDM and LMI communities. Asgrowing deficits reduce federal, state and local agency budgets, andstock market losses shrink foundation portfolios, the size of thesecontributions will fall accordingly. Private capital must step in to fill thevoid, and can do so most effectively using market-based, risk-pricedmechanisms. Financial technologies facilitate funding sustainability bymatching investors with investments based on risk-tolerance. As a nextstep, the report’s authors recommend initiating one or more of the abovepilots, each of which is elaborated upon more fully herein.


A Bank/CommunityLender Exchangewould enableregistered banks,community-basedlenders and serviceproviders to exchangeinformation, dealflow and expertise,intended to growcustomer bases,improve deal quality,appropriately matchinvestors/lenders withentrepreneurs andreduce financing risk.

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Traditionally,government programsand philanthropicdonors have been theprimary sources ofcapital for EDM andLMI communities.

■ ■ ■

As growing deficitsreduce budgets,private capital muststep in to fill the void,and can do so mosteffectively usingmarket-based, risk-priced mechanisms.

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INTRODUCTION

The U.S. experienced a surge in wealth during the 1990s. Even after therecent stock market decline, Americans’ total net worth is almost 75percent greater than it was just 10 years ago ($40 trillion up from $23t r i l l i o n ) .1 As with previous episodes of economic expansion,e n t re p reneurship and innovation fueled much of this gro w t h .Technological innovations helped generate new products and processes,and financial innovations (e.g., private equity and venture capital,mezzanine financing, securitization) helped broaden access to capitalamong entrepreneurs.

Too often, these financial innovations did not adequately reach theprimary drivers of job creation. Small businesses (those with fewer than500 employees) represent the bulk of businesses in the economy (99.7percent of all firms) and are a driving force behind overall economicgrowth (50 percent of private sector output). These businesses constitutemore than 50 percent of private sector workers and create 75 percent ofnew jobs annually).2 Yet, small business’ share of measurable businessfinancing is less than 10 percent.3

In the 1990s, income inequality grew by 17 percent, five times the rate ofgrowth in the 1980s. In 1998, 90 percent of the U.S. population heldbarely 30 percent of the country’s net worth.4 While the vast majority ofthe low- and moderate-income (LMI) are white, greater percentages ofnon-whites live below the poverty line, and households headed bysingle mothers (white and non-white) predominate in low-incomecommunities.5

Though the rate of total U.S. workforce growth is declining, falling from2.7 percent in the 1970s to between 1.0 and 1.5 percent today,6 minoritiesrepresent up to 70 percent of expected growth over the next 20 years.7

Research demonstrates that minority- and women-owned firms are mostlikely to hire this emerging workforce.8 Ethnic-owned firms grew overtwice as fast as all firms in the nineties,9 but still face critical capital gapsthat impede their ability to expand and create jobs in urban and low-income markets. Thus, a fundamental mismatch exists between thesources of capital formation and job creation. Without effective market-based patterns of job creation, retention and capital formation among therapidly diversifying labor and entrepreneurial force, declines in laborsupply, productivity and the investment levels necessary to supportbusiness growth, will act as a brake on the national economy.

The resolution to the mismatch requires mobilizing a continuum offinancial technologies and market-based public policy innovations thatcan carve channels of capital from investors to emerging domesticmarkets (EDM). EDM refers to people, places or enterprises facing


As with previousepisodes of economicexpansion,entrepreneurship andinnovation fueledmuch of this growth.

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Too often, thesefinancial innovationsdid not adequatelyreach the primarydrivers of jobcreation.

■ ■ ■

Small business’share of measurablebusiness financing isless than 10 percent.

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constraints in accessing capital due to systematic undervaluation arisingfrom imperfect market information. Emerging domestic markets includeunderinvested small- and medium-sized firms, urban and ru r a lcommunities, companies serving low-to-moderate income populations,and ethnic- and women-owned or operated businesses. Resolving theEDM capital gap is critical as we experience a seemingly jobless recoveryfrom a recession that is threatened by the constriction of consumerdemand. The situation makes the economic security of lower-incomeAmericans even more precarious.


EDM refers to people,places or enterprisesfacing constraints inaccessing capital dueto systematicundervaluationarising fromimperfect marketinformation.

■ ■ ■

Emerging domesticmarkets includeunderinvested small-and medium-sizedfirms, urban and ruralcommunities,companies servinglow-to-moderateincome populations,and ethnic- andwomen-owned oroperated businesses.

■ ■ ■

Resolving the EDMcapital gap is criticalas we experience aseemingly joblessrecovery from arecession that isthreatened by theconstriction ofconsumer demand.

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THE CONTEXT

Low- and moderate-income, minority- and women-owned businesseshave always faced greater challenges to accessing capital than themainstream. Some are due to blatant discrimination, but others arisefrom inadequate information about the firms and the nature of theirbusiness models and environments. These challenges include:

■ Lack of performance data on loans to these borrowers, leadinglenders to perceive them as riskier and beyond their legal risktolerance

■ Smaller-sized loans, leading them to be more expensive for lenders toservice

■ Firms’ need for mentoring and technical assistance services inaddition to financing, increasing costs to lenders

■ Lack of professional and social networks linking borrowers andfinancial institutions

■ Historical concentration of business in the retail and servicesindustries, with little collateral to secure loans

■ Lack of a viable secondary market for small-business loans

EDM/LMI businesses have traditionally relied on equity infusions fromtheir owners, friends and family, debt products in the form of bank loans,credit lines, leases, trade credit, credit cards and factoring, and internallygenerated cash. As the 21st century begins, the market for small businessfinance is changing. Several major trends in terms of legislative andregulatory policy, financial services industry development, demographicshifts and economic conditions provide the backdrop for consideringand inventing the future:

■ In the late 1960s, the federal government began to address the capitalgaps confronting the underserved, ultimately enacting theCommunity Reinvestment Act (CRA) and giving birth to a networkof Community Development Financial Institutions (CDFIs). Between1977 and 2000, banks operating under CRA committed more than $1trillion to minority and LMI communities, 45 percent in small-business loans.1 0 H o w e v e r, while a 2001 survey of depositoryinstitutions reported that 86 percent found CRAsmall-business loansat least as profitable as non-CRA small business loans,11 servicingthese communities can be difficult for large, mainstream banks. Theinformation asymmetries, and banks’ segmented org a n i z a t i o n a lstructure separating wholesale and retail products into separate


Low- and moderate-income, minority- andwomen-ownedbusinesses havealways faced greaterchallenges toaccessing capital thanthe mainstream.

■ ■ ■

Some are due toblatantdiscrimination, butothers arise frominadequateinformation about thefirms and the natureof their businessmodels andenvironments.

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EDM/LMI businesseshave traditionallyrelied on equityinfusions from theirowners, friends andfamily, debt productsin the form of bankloans, credit lines,credit cards andfactoring.

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divisions, run counter to the flexibility required to build relationshipswith small- and medium-sized firms in LMI areas.

■ The U.S. is shifting from a bank-based to a capital-market-basedfinancial system, disproportionately impacting small businessesbecause they have fewer nonbank options than larger companies.With the passage of the Gramm-Leach-Bliley Act, commercial banksare consolidating at a rapid pace, decreasing the number of smallbanks, historically the lenders to small businesses. While large banksare increasing their small business activity, and a niche is developingamong new community and de novo banks, the adequacy of thisactivity is still unclear.

■ Over the next 50 years, 90 percent of U.S. population growth willoccur among ethnic groups, reducing white Americans to less than 50percent of total population. With their growing rates of businessownership, ethnic entrepreneurs and consumers significantly impactthe overall economy.13

■ A slowing economy, uncertainty, and regulatory changes tightencredit and reduce business formation among all groups. Reducedentrepreneurial activity translates into reduced job creation and


■ ■ ■

The U.S. is shiftingfrom a bank-based toa capital-market-basedfinancial system,disproportionatelyimpacting smallbusinesses becausethey have fewernonbank options thanlarger companies.

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Figure 1Percent of U.S. Assets Owned by Institutions12

retention rates, and polarizing income and wealth distributionaltrends. The current slowdown in the economy is likely to impactsmaller banks, and hence smaller firms, more severely.

Given this context, small businesses in LMI communities face dauntingchallenges to finding financing products that would enable them tobuild the best capital stru c t u re for their size, phase and market.Innovative investors and lenders willing to innovate with such productscan find unique opportunities in the EDM/LMI market. A 2002 study bythe National Community Capital Association found CDFI lending assafe as commercial bank lending, with comparable net charge-offs anddelinquency rates, and investors in the sampled CDFIs (representing $4billion in cumulative financing) not having lost a penny of capital. It iscritical to the national economy for these businesses to access thefinancial technologies that have provided reasonably priced capital andcredit to larger, established businesses.


Small businesses inLMI communities facedaunting challengesto finding financingproducts that wouldenable them to buildthe best capitalstructure for theirsize, phase andmarket.

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Innovative investorsand lenders willing toinnovate with suchproducts can findunique opportunitiesin the EDM/LMImarket.

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A 2002 study by theNational CommunityCapital Associationfound CDFI lendingas safe as commercialbank lending andinvestors in thesampled CDFIs nothaving lost a penny ofcapital.

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INNOVATIONS

In any industry, innovation occurs best under certain conditions: theability to experiment, ample access to information, opportunities forpartnerships, replication and scale, cost-effectiveness and stro n gleadership. Financial innovation is no different. Examples of financialinnovations that could increase capital flows to LMI communities fallinto three categories:14

■ Systemic innovations: Innovations that affect the financial sectorbroadly, e.g., changes in business structures, new types of financialintermediaries, new legal or regulatory frameworks

■ Product innovations: Innovative financial products that better servethe market, including both the suppliers and the users of theproducts, and

■ Process innovations: Innovations that introduce new businessprocesses, which may increase efficiency, expand markets, etc., suchas information technologies.


Innovation occursbest under certainconditions: the abilityto experiment, ampleaccess to information,opportunities forpartnerships,replication and scale,cost-effectiveness andstrong leadership.

■ ■ ■

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Figure 2The Flow of Financial Innovations to LMI Markets

Applicable financial innovations exist in both mainstream institutionsand community-based organizations. In addition, several interestingconcepts are in development. Examples follow.

A. SYSTEMIC INNOVATIONS

SECURITIZATION & SECONDARY MARKETS

Securitization involves the pooling and purchase of individual small-business loans from multiple lenders and packaging these loans into asecurity, or a Collateralized Loan Obligation (CLO), which is then sold toa third party. This process, often called a secondary market transaction,converts illiquid individual loans into more liquid, marketablesecurities. The purchasers of the CLO are able to hedge against the riskof default on any one of these loans as they own just a small percentageof each loan in the security.


A secondary markettransaction, convertsilliquid individualloans into moreliquid, marketablesecurities.

■ ■ ■

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Figure 3Minority Business Finance Model

Securitization of small-business loans has been slow to develop – of theestimated $675 billion small-business loan market, only $2 billion (0.3percent) was securitized in 1999. The small-business lending marketlacks many of the characteristics key to successful securitization: pools ofs u fficient size and similarity; uniform loan underwriting criteria;standardized loan documents; sufficient performance data on loansreflective of the pool; information technology to estimate defaultprobabilities and prepayment patterns; credit enhancement mechanisms,and robust secondary markets. In addition, many banks prefer to holdtheir small-business loans. This is particularly true for LMI-targetedloans, for which lenders receive CRA-credit as long as they remain on thebooks.

Despite these challenges, securitization remains an innovation critical tothe growth of small business lending in EDM and LMI communities. Thetechnology offers financial institutions the advantage of increasing thevelocity of circulation of bank loan assets on their balance sheets, whichcould increase bank profitability over time. Much innovation isunderway to make it workable for community development financeapplications. The Community Reinvestment Fund, Self-Help Ventures,Barclays Capital and Nonprofit Capital have all successfully securitizedcommunity-based loans. They have used a range of credit enhancementvehicles, such as foundation Program Related Investments (PRIs) ando v e rcollateralization, to obtain investment-grade ratings for certaintranches of the security. Some of the most interesting models ofsecuritization for community development finance are in development atthe Financial Innovations Roundtable, including:

■ Community Development Financial Guarantee Corporation: Raisedcapital would credit enhance pools of CDFI loans to be issued asinvestment grade (“A” or better) private placements.

■ Pooling Mechanism for CDFI loans: A cooperative or aggregationvehicle would join several separate CDFI issuers into a large pool ofmulti-issuers, to sell or collateralize a private placement in exchangefor liquidity at a negotiated rate.

■ CDFI “Mini-Federal Reserve” System: A peer-to-peer short-termlending capacity managed by a custodian bank and supported byfoundation credit. Funds in the system would be provided by CDFIsand RLFs with excess liquidity and lent to those with short-termliquidity crunches (30, 60, 90 and 120 day loans). While this wouldnot increase the pool of total small business lending, it could increasethe efficiency of delivering capital to those most in need of it at anygiven time.


Securitizationremains aninnovation critical tothe growth of smallbusiness lending inEDM and LMIcommunities.

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The technology offersfinancial institutionsthe advantage ofincreasing thevelocity of circulationof bank loan assets ontheir balance sheets,which could increasebank profitabilityover time.

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The CommunityReinvestment Fund,Self-Help Ventures,Barclays Capital andNonprofit Capitalhave all successfullysecuritizedcommunity-basedloans.

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BREAKING UP THE VALUE

CHAIN

Financial institutions are moving away from in-house management of allelements of the financing value chain (product development; marketingand origination; underwriting; funding; servicing and monitoring;packaging, and generating liquidity). CDFIs and other communitylenders have been slow to cede control of the full range of functions. InLos Angeles, four organizations – CalFed Bank, two foundations and atechnical assistance provider – have developed an innovative pilot inwhich entre p reneurs who complete a training program re c e i v etraditional bank financing, with the bank’s risk mitigated by foundationsupport and the borrower’s education and mentoring experience.

INTERMEDIARIES – CONSORTIUMS ANDPARTNERSHIPSLarge banks, such as JP Morgan Chase, Citigroup, Wells Fargo and Bankof America, have well-developed intermediary programs, targeted atareas in which they have strong customer bases, and have placedsubstantial sums with high-performing private equity funds aiming fordouble bottom lines. Small banks join multi-bank communitydevelopment corporations – independent community developmentlender entities funded with debt or equity from multiple financialinstitutions. Other consortium and partnership models include:

■ CEDLI (California Economic Development Initiative) is a multi-bankfor-profit community development corporation whose shareholdersinclude 45 major financial institutions and four corporationsthroughout California. CEDLI provides credit to businesses that donot have adequate collateral to qualify for banks’ normal lendingprograms.

■ NYCIC (New York Community Investment Company), aninvestment firm created in late 1995 by the then-member banks of theNew York Clearinghouse Association to provide long-term capital tohard-to-finance small businesses in New York. NYCIC’s structureenables its investing banks fund companies under terms they couldnot offer in their mainstream systems, e.g., longer repayment terms,customized products, additional technical assistance. NYCIC alsopartnered with Industrial Technical Assistance Corporation (ITAC) tocreate “Bridge to Capital,” which makes short-term loans to qualifiedrecipients to cover the cost of professional services, with “Bridge toCapital” investors receiving equity in addition to debt service.


Financial institutionsare moving away fromin-house managementof all elements of thefinancing value chain.

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In Los Angeles, fourorganizations havedeveloped aninnovative pilot inwhich entrepreneursreceive traditionalbank financing, withrisk mitigated byfoundation supportand the borrower’seducation andmentoring experience.

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Large banks, havewell-developedintermediaryprograms, targeted atareas in which theyhave strong customerbases, and haveplaced substantialsums with high-performing privateequity funds aimingfor double bottomlines.

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■ Bank-CDFI Partnerships: Boston Community Capital (BCC), soldparticipation interests in certain qualified loans to PNC Bank andother regional banks. This enabled BCC to finance larger deals andpass on the lower transaction costs resulting from working withfewer lenders. KeyBank and Coastal Enterprises, both Maineinstitutions, used a HUD tax credit program to capitalize a RevolvingLoan Fund.

CORPORATE PARTNERSHIP INITIATIVES

Through the Shell Community Banking Initiative, Shell Oil makes a$250,000 passive preferred stock investment, deposits $1 million in aninterest-bearing money market account, and extends $7.5 million topurchase participations in community development loans made bypartner community-based banks, developing a participation portfolioreflective of the bank’s general portfolio, in terms of risk distribution.

FAITH-BASED PARTNERSHIPS

FAME Renaissance, an economic development initiative of Los Angeles’First African Methodist Episcopal Church, operates a $5 million venturecapital fund, professionally managed by an outside firm. Financialpartners, including Wells Fargo, Washington Mutual and State FarmInsurance, view the faith-based oversight as a risk mitigator.

NONBANK FINANCIAL INSTITUTIONS

INSURANCE COMPANIES

Recent pressure and the threat of CRA-type regulation have spurrednonbank financial institutions to address the issue of communitydevelopment finance. Impact Community Capital (IMPACT) is a limitedliability corporation owned by eight major insurance companiesrepresenting in excess of $14 billion in annual California direct writtenpremiums. The firms’ shares in IMPACT mirror their proportionate shareof the California market. IMPACT purchases loans of all sizes(individually or in pools) made by banks, nonbank financial institutions,and nonprofit organizations in LMI and underserved communities andpackages them into loan pools, which are rated by a major agency. StateCertified Capital Companies (CAPCOs) have become incre a s i n g l ypopular methods of allocating tax credits to encourage and leverageinvestment by insurance companies in traditionally unbanked smallbusinesses.


Through the ShellCommunity BankingInitiative, Shell Oilextends $7.5 millionto purchaseparticipations incommunitydevelopment loansmade by partnercommunity-basedbanks.

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FAME Renaissance,an economicdevelopmentinitiative of LosAngeles’ First AfricanMethodist EpiscopalChurch, operates a $5million venturecapital fund.

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Recent pressure andthe threat of CRA-type regulation havespurred nonbankfinancial institutionsto address the issue ofcommunitydevelopment finance.

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FACTORS AND RECEIVABLE-BASED FINANCING

Factoring and receivable-based financing converts customer invoicesinto lines-of-credit, enabling cash-constrained small businesses toborrow against expected revenues. Innovative approaches based on thefactoring model include corporate procurement financing by whichcompanies use their credit record and bank relationships as the basis fortheir minority and women subcontractors’ receivable financing. Thisreduces the vendors’ financing costs and enables them to participate inpotentially lucrative procurement contracts.

DE NOVO BANKS

De novo banks tend to focus a proportionately larger share of theire n e rgies on financing small businesses. 1 7 The Community’s Bank,formed from three branches sold by Fleet Bank in the course of itsmerger with Bank Boston, is the only independent, ethnic-owned bankin Connecticut, with a mix of African-American, Asian, Hispanic andCaucasian ownership and management. Its branches serve a racially,ethnically and economically diverse population, with the higher-incomesuburban area subsidizing the more urban Hartford and Bridgeportmarkets.

GOVERNMENT PROGRAMSFederal and state government programs can provide cre d i tenhancement and bridge financing support to leverage private capital.

NEW MARKETS TAX CREDIT

The New Markets Tax Credit (NMTC) provides investors a federal taxcredit for equity investments in qualified Community DevelopmentEntities (CDEs). The infusion of private capital will enable theseorganizations to increase loans, investments and support, and leverageadditional capital support. As the NMTC develops, innovative capitalmarkets applications will develop.

FAMILY SELF-SUFFICIENCY PROGRAM

Under current public housing assistance programs, families pay 30percent of their income for rent. As each family’s income goes up, its rentrises. With the Family Self-Sufficiency Program (FSS), a portion of therental increase is deposited into an escrow account, matched by fundsf rom the Housing Authority and available for home purchase orbusiness capitalization upon graduation from FSS.


Innovativeapproaches based onthe factoring modelinclude corporateprocurementfinancing by whichcompanies use theircredit record andbank relationships asthe basis for theirminority and womensubcontractors’receivable financing.

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De novo banks tendto focus aproportionately largershare of their energieson financing smallbusinesses.

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The New Markets TaxCredit (NMTC)provides investors afederal tax credit forequity investments inqualified CommunityDevelopment Entities(CDEs).

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COMMUNITY REINVESTMENT ACT CREDIT SWAPS

CRA “voucher” trading would work in a manner similar to emissionsrights trading. Regulators could require banks to acquire a certainnumber of vouchers annually, representing a certain level of investmentin CRA-eligible products. Vouchers could be traded among banks muchlike firms trade carbon emissions credits. CRA credit swaps wouldencourage market-based specialization and niche lending among thosemost expert in community finance, maintaining or increasing the totalpool of CRA investment, but in a more efficient and accountable fashionthan currently.18

LIQUIDITY VEHICLE – PUBLICLY TRADED HOLDING COMPANY

Boston Community Capital has designed a publicly traded holdingcompany for CDVCs. Much in the same way that holding companiessuch as Berkshire Hathaway invest in several different companies withdiverse lines of business, the community development holding companywould own shares of stock in targeted double-bottom-line companies(such as businesses owned by LMI entrepreneurs.)

OWNERSHIP MODELS

EMPLOYEE STOCK OWNERSHIP PLANS

ESOPs are powerful mechanisms to increase the wealth of LMI workers.Two to three thousand dollars of additional wealth is created per personper year in ESOPs. By making workers owners, the retirement benefits ofemployees in an ESOP, on average, increase threefold. Hourly earnings ofowner-workers in ESOPs are eight percent higher than in non-ESOPcompanies.19

FRANCHISES

Franchise stru c t u res can help mitigate risk among emerg i n gentrepreneurs – their proven business model, known brand and ongoingassistance help reduce the risk inherent in launching a new firm.Recognizing that urban entrepreneurs are often best able to reach thiscustomer market but lack the capital to launch businesses, severalmainstream banks (e.g., Deutsche Bank, Fleet) have developed programsto lend capital to such enterprises at reduced cost or with flexiblerepayment terms.

MINORITY-OWNED BANKS

Many LMI minority entre p reneurs are uncomfortable appro a c h i n gmainstream firms for reasons such as culture, language, and expectation


CRA credit swapswould encouragemarket-basedspecialization andniche lending amongthose most expert incommunity finance.

■ ■ ■

Boston CommunityCapital has designeda publicly tradedholding company forCDVCs.

■ ■ ■

Franchise structurescan help mitigate riskamong emergingentrepreneurs

16

of rejection. Minority-owned banks provide a unique path into thelargely under-banked, and often LMI, minority niche markets. With itsrecent acquisition of Family Savings in Los Angeles, OneUnited Bank(formerly Boston Bank of Commerce) is the largest black-ownedfinancial institution in the country, with products tailored to the diverseneeds of its multi-ethnic and multi-national customers.

COMMUNITY OWNERSHIP

Residents of Columbia Heights, a LMI neighborhood in WashingtonD.C. recognized the need for a local coin laundromat. With $100 sharessold throughout the community, and investment from churches andfoundations, they were able to secure a $300,000 loan from Riggs Bankand launch B.I.G. Wash. The laundromat did not miss a single loanpayment, shares now sell for $6,000, and B.I.G Wash provides theneighborhood with vital services and part-time jobs.

B. PRODUCT INNOVATIONS

NEW MARKETS/NEW PRODUCTS FROMMAINSTREAM BANKS

During the economic boom, customer competition increased and creditwas often extended “down market.” In fact, many banks serviced LMIcustomers previously regarded as only Community Bank or CDFIcandidates. While the current downturn is leading many institutions topull back, several innovative banks recognize the market potential andhave partnerships, products and business lines targeting thesecustomers.

Fleet Bank has long approached community investment as a businessopportunity rather than a compliance obligation, through FleetCommunity Bank, Fleet Development Ventures (equity fund) and Fleet’sTechnical Assistance Program, a five-year $17.5 million research anddevelopment effort identifying profitable CRA-related long-termbusiness opportunities. Recognizing the hidden market in potentialcustomers currently using fringe banking services, Union Bank ofCalifornia entered a formal partnership with Nix Check Cashing of LosAngeles. The bank purchased partial ownership of Nix, and isestablishing dedicated Union Bank teller windows and direct phonelines in Nix locations. After receiving a “needs to improve” rating by theCommunity Reinvestment Act (CRA), University National Bankre d i rected its efforts to St. Paul’s lowest-income, racially mixed,immigrant neighborhoods, and increased LMI-related loans areas from14 percent to 79 percent of total portfolio.


During the economicboom, customercompetition increasedand credit was oftenextended “downmarket.”

■ ■ ■

While the currentdownturn is leadingmany institutions topull back, severalinnovative banksrecognize the marketpotential and havepartnerships, productsand business linestargeting thesecustomers.

■ ■ ■

Fleet Bank has longapproachedcommunityinvestment as abusiness opportunityrather than acomplianceobligation.

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PENSION FUNDS

U.S. pension fund assets total $7 trillion,20 the largest single source ofcapital in the world and a growth of almost 4,000 percent in the last 30years. With public equity return rates declining, and the ongoing need tomaintain growth to meet their obligations to retiring beneficiaries (agrowing pool as the baby-boomer population ages), funds increasinglylook to alternative asset classes for investment opportunities. A sinvestors’ concerns about corporate governance grow, double-bottom-line investments offer funds the ability to generate financial and socialreturns.

Emerging domestic markets, effectively a new asset class, provide suchopportunities. Several public and private pension funds have allocatedassets to urban real estate projects, private equity managers targetingminority- and women-owned businesses and other innovative debt andequity vehicles targeting these markets. In 2000, the California PublicEmployees Retirement System (CalPERS) committed $500 million to the“California Initiative,” including a $10 million allocation to Silicon ValleyCommunity Ventures, a community development capital venture fund.


U.S. pension fundassets total $7trillion,20 the largestsingle source ofcapital in the worldand a growth ofalmost 4,000 percentin the last 30 years.

■ ■ ■

18

Figure 4California Initiative Funds Support Companies in Each Stage of Life-Cycle

The California State Teachers Retirement System’ (CalSTRS) cre d i tenhancement program uses the Fund’s strong credit rating and liquidbalance sheet to generate fee income while facilitating school, housing,municipal and industrial development financing in California.

CREDIT ENHANCEMENT

Credit enhancements are used regularly in conventional finance and arean appropriate mechanism to make community development finance“market ready.” In addition to the CalSTRS program mentioned above,innovations include:

STATE CAPITAL ACCESS PROGRAMS

State-run Capital Access Programs (CAPs) encourage small businesslending programs by banks. CAPs establish a reserve account in eachparticipating bank that enables banks to make riskier loans thanconventional underwriting would support. Total loan loss nationally hasbeen 3.7 percent. Reserve sizes net of these losses were 4.1 percent ofcumulative volume, generating a loan dynamic multiplier estimated at24 times. The credit enhancement in a CAP not only incentivizesmainstream financial institutions to make loans, but would enable theloans to be securitized. An illustrative model appears in therecommendations.

SUBORDINATE-LIEN LOANS – BRIDGENOTES™

BridgeNotes™, developed by Capital Access Group, are subordinate-lien, “companion” loans designed to “bridge” the gap between theamount a bank is willing to lend a small business and the borrower’stotal financing need. Loan loss reserves funded by borrowers andsocially motivated lenders provide credit enhancements forBridgeNotes™ and would allow them to be sold to investors in the formof asset-backed securities.

BLENDED FUND STRUCTURES

MEZZANINE FUNDS

A mezzanine security represents the layer of capital between senior debtand equity. In general, covenants are more flexible than those for seniordebt and enable the firm to withstand greater economic variability inmarket conditions and staying power to execute competitive strategies.Mezzanine fund structures can blend investors seeking different levelsof returns, allowing the fund to take a risk position and leverage othersources of capital. A model fund appears in the recommendations below.


Credit enhancementsare used regularly inconventional financeand are anappropriatemechanism to makecommunitydevelopment finance“market ready.”

■ ■ ■

The creditenhancement in aCAP not onlyincentivizesmainstream financialinstitutions to makeloans, but wouldenable the loans to besecuritized.

■ ■ ■

Loan loss reservesfunded by borrowersand sociallymotivated lendersprovide creditenhancements forBridgeNotes™ andwould allow them tobe sold to investors inthe form of asset-backed securities.

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BAY AREA COMMUNITY EQUITY FUND

The Bay Area Community Equity Fund, a new privately managedcommunity development venture fund will invest in profitable growingbusinesses capable of generating jobs and wealth in 46 target LMIneighborhoods in the Bay Area. Ninety percent of investments will bemade in emerging growth-companies and are expected to makemarket-rate returns. The remaining 10 percent of the fund will beinvested in patient capital investments in neighborh o o d - o r i e n t e dbusinesses that offer measurable social returns, though may generate aslightly lower financial return.

REVENUE ROYALTIES

SUSTAINABLE JOBS FUND

Seeking a repayment structure for the subordinated debt that matches acompany’s stage of growth and ability to make cash payments, TheSustainable Jobs Fund (SJF), a community development venture capitalfund, designed a royalty agreement for one of its investments. With thefirm paying a percentage of its top-line revenue, the company couldmake relatively larger payments to SJF as it grew. The model faltered ina declining economy, but the concept is worth continued exploration.

ANGEL POOLS AND NETWORKS

Angel networks bring together groups of wealthy investors to source andconsider deals more cost-effectively than single investors could do alone.The Minnesota Investment Network Corporation (MINCorp), acommunity development venture capital fund, established an angel fundnetwork, the Regional Angel Investor Network (RAIN), to invest incompanies located in rural LMI areas in Minnesota. RAINstreet, theapplication service provider, acts as a virtual hub where investors canstore and track deal flow, due diligence, engage in member-to-membercommunication and conduct similar business transactions. TheMINCorp RAINs have had several successful exits, selling theirinvestments to strategic partners.

EQUITY EQUIVALENT INVESTMENTS

The Equity Equivalent (EQ2) is an equity-debt hybrid capital productdeveloped by Citibank and National Community Capital Association tofinance CDFIs. The EQ2 works much in the same way as a convertiblepreferred stock with a coupon would in the for-profit finance world – itprotects its investors from losses and must be repaid, like debt, but actsas collateral to further leverage senior debt, like equity.


Angel networks bringtogether groups ofwealthy investors tosource and considerdeals more cost-effectively than singleinvestors could doalone.

■ ■ ■

The EquityEquivalent (EQ2) isan equity-debt hybridcapital product

■ ■ ■

The EQ2 works muchin the same way as aconvertible preferredstock with a couponwould in the for-profit finance world –it protects itsinvestors from lossesand must be repaid,like debt, but acts ascollateral to furtherleverage senior debt,like equity.

20

TRIBAL BONDS

By leveraging natural and other resources, Native American Indiantribes can access the capital markets. Tribes rarely receive the mostfavorable rating when they issue the bonds independently – theSouthern Ute tribe is the only one to independently receive a AAArating(highest rating). However, A-rated municipal bonds achieved with thebacking of insurance companies are an alternative that can save tribesmillions annually in financing costs. Three tribes – MashantucketPequot, Grand Ronde and the Cow Creek Band of the Umpqua Tribeof Indians – received A A A ratings through AAA-rated insurancecompanies acting as guarantors.

C. PROCESS INNOVATIONS

DATA

The data on small businesses, and EDM firms in particular, is neitherc o m p rehensive nor reliable. Eliminating information asymmetrieswould allow for appropriate product development, extended customeroutreach, real risk-based pricing, liquidity mechanisms, and reducedlikelihood of discrimination.

Two areas of data collection are necessary: loan performance data andfirm-level data. While many current private, nonprofit, and publicinstitutions have initiatives in place to collect this information, many fallshort of what is necessary for EDM businesses to reach optimal financinglevels.

■ Despite the promise inherent in accessing information on such alarge group of small business loans, CRA-required data is insufficientin a number of respects: it does not measure the credit demand; itdoes not provide firm-level information, and it may, in fact, begeographically inaccurate.21

■ Dun and Bradstreet (D&B) maintains the most compre h e n s i v einformation on firms’ revenue, employment, industry, location, andcredit history. However, D&B tends to undercount firms, especiallywomen- and minority-owned businesses, smaller ones, those lesslikely to seek credit, or those operating in the informal economy, andprovides insufficient historical data to track growth rates.

■ The U.S. Census Bureau data on minority- and women-ownedbusiness is often outdated by the time the reports are released (everyfive years), and is not firm-level. An earlier Census survey providedmore detailed firm information, but is no longer produced due tobudget cuts.


The data on smallbusinesses, and EDMfirms in particular, isneithercomprehensive norreliable.

■ ■ ■

Eliminatinginformationasymmetries wouldallow for appropriateproduct development,extended customeroutreach, real risk-based pricing,liquidity mechanisms,and reducedlikelihood ofdiscrimination.

■ ■ ■

Two areas of datacollection arenecessary: loanperformance data andfirm-level data.

21

■ The CDFI Data Project is collecting data on financing in thecommunity development finance field, but collects information at thelevel of the individual CDFI fund and does not include loanperformance data.

FAIR ISAAC AND COUNT-ME-IN FOR WOMEN’S ECONOMIC

INDEPENDENCE

Count-Me-In for Women’s Economic Independence (“Count-Me-In”) isan innovative online “lending and learning” microloan organizationserving women entre p reneurs, many of whom run home-basedbusinesses. Count-Me-In’s breakthrough concept in providing capital toLMI entrepreneurs involved two elements that mainstream institutionscommonly use to reduce the cost of lending: processing all applicationsover the Internet, and adapting a standard credit scoring model to apopulation that would not qualify for loans under the traditionalapplication.

Count-Me-In’s Internet application system simplifies the process ofcollecting and tracking applicant data, including income, businesshistory and performance and loan performance. The organization’snonprofit status allows it to obtain information otherwise prohibitedunder Federal Reserve Regulation B, i.e., gender, race and ethnicity.Engaging Fair Isaacs (the nation’s leading credit-scoring developer) inthe design process enabled Count-Me-In to build an analyticalframework which would accumulate data useful in assessing the truecapital needs and lending risks of its target entrepreneurs, and in aformat applicable to other, more mainstream lenders. Using Internettechnology reduces the cost of collecting information, and enables theorganization to collect larger pools of data.

CREDIT SCORING

Credit scoring derives a single quantitative measure – the score – from avast statistical sampling of past borrowers in order to predict the futurepayment performance of an individual loan applicant – the applicant’spropensity to repay. With the increase in disintermediation, and therapid improvement in technology, lenders find credit scoring a cost-effective means of offsetting the information asymmetries of the modernfinancial services environment.

R e s e a rch has demonstrated that an entre p re n e u r’s personal cre d i thistory is the single best predictor of business loan repayment – far morethan such financial factors as debt burden, cash flows and revenuegrowth. Critics of credit scoring argue that it reduces lending to LMIborrowers, since many LMI individuals have not had credit records, orhave experienced payment gaps due to cash crunches. Furthermore, LMIloans may be underrepresented in data samples, weighting the pools in


Count-Me-In forWomen’s EconomicIndependence (“Count-Me-In”) is an innovativeonline “lending andlearning” microloanorganization servingwomen entrepreneurs,many of whom runhome-based businesses.

■ ■ ■

Count-Me-In’s conceptin providing capital toLMI entrepreneursinvolved two elementsthat mainstreaminstitutions commonlyuse to reduce the cost oflending: processing allapplications over theInternet, and adapting astandard credit scoringmodel to a populationthat would not qualifyfor loans under thetraditional application.

■ ■ ■

Research hasdemonstrated that anentrepreneur’s personalcredit history is thesingle best predictor ofbusiness loanrepayment.

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favor of higher income individuals and discriminating against LMIapplicants.

In fact, recent studies reveal that applying credit scoring increases LMIlending. One study estimates that large banks using small-businesscredit scoring lend $16.4 million more, on average, to LMI census tractsthan non-scorers (controlling for community and bank characteristics).23

Credit-scorers actually originate a larger number of loans in LMI areasthan in higher-income markets, while non-scorers issue fewer. Finally,the existence of an LMI-based bank branch has no impact on the level ofsmall-business credit available from credit scorers, but significantlyincreases the level of lending from non-scorers.24 Non-scorers may,however, discriminate against certain LMI borrowers who have little orno experience with mainstream financial institutions.

Fair Isaac has agreed to review the credit scoring system and loanhistories once Count-Me-In has made 2,000 loans. It will then determinewhich of the model’s unique questions are predictive of women’slending risk. This could set the standard for a mainstream alternativeproduct.

TECHNOLOGY

Small-business lending has traditionally been an expensive activity dueto the relative size of loans, but advances in technology can drive downcosts and make the market more appealing.

FleetBoston’s CommunityLink aims to stimulate wealth cre a t i o nthrough digital inclusion and greater access to online financial servicesin LMI communities. Initially, 3,000 Fleet customer participants,including individuals and small-business owners, will receive fre ecomputers, online content, and in-home or community-center-basedtechnical assistance.

ACE-Net, an online marketplace, posts the securities offerings of small,growing companies located throughout the nation that are then viewedanonymously by accredited investors. ACE-Net also attracts specialinterest investors from across the country seeking woman- or minority-owned companies.

MENTORING/BUSINESS ADVISORY

Increasingly, financial institutions see training and mentoring as a riskmitigator, as the activities increase a business’ likelihood of success andloan repayment.

The Community Express Loan Program (CommunityExpress) pilotcombines small-business loan guarantees from the U.S. Small Business


One study estimatesthat large banks usingsmall-business creditscoring lend $16.4million more, onaverage, to LMIcensus tracts thannon-scorers.

■ ■ ■

Small-businesslending hastraditionally been anexpensive activity dueto the relative size ofloans, but advances intechnology can drivedown costs and makethe market moreappealing.

■ ■ ■

FleetBoston’sCommunityLink aimsto stimulate wealthcreation throughdigital inclusion andgreater access toonline financialservices in LMIcommunities.

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Administration (SBA), targets lending by select banks (including Fleet asnoted earlier), and requires technical assistance from local NationalCommunity Reinvestment Coalition (NCRC) members. SBA is willing toraise its guarantee level for the pilot (from the normal SBA Express levelof 50 percent to the to 7(a) level of 75-80 percent, depending on loan size)to test the link between increased training and decreased default.25

California Resources and Training (CARAT) is piloting its TechnicalAssistance Certification Program (TACP), aimed at establishingperformance standards for technical assistance providers. PacificCommunity Ventures (formerly Silicon Valley Community Ventures), aBay Area CDVC, requires participation in its business advisory programprior to considering any firm seeking investment from its equity funds.


Increasingly, financialinstitutions seetraining andmentoring as a riskmitigator, as theactivities increase abusiness’ likelihood ofsuccess and loanrepayment.

■ ■ ■

SBA is willing to raiseits guarantee level forthe pilot from thenormal SBA Expresslevel of 50 percent tothe to 7(a) level of 75-80 percent, to test thelink betweenincreased training anddecreased default.

■ ■ ■

California Resourcesand Training (CARAT)is piloting itsTechnical AssistanceCertification Program(TACP), aimed atestablishingperformance standardsfor technical assistanceproviders.

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RECOMMENDATIONS

The innovations described in this report are all examples of financialtechnologies that could help redress the information asymmetries andcapital gaps between the key providers of capital in the U.S. and theincreasing diverse users of capital, particularly those in the LMI andemerging domestic market communities. They may be systemic, productor process innovations, and they may emerge from the mainstream oralternative sectors. If refined and adapted to the LMI arena and scaleda p p ro p r i a t e l y, they could re p resent market-based solutions to themismatch between the nation’s sources of job creation and capitalformation.

It is clear that community development finance organizations and LMIentrepreneurs would be interested in exploring these innovations – theycould bring needed support to a resource-constrained field. But there arealso strong motivators for financial services firms:

• The shift in the financial services industry, from a bank-based to acapital markets-based stru c t u re, is producing both dislocation anddynamism, all amidst a slowdown in national economic growth. AsJoseph Schumpeter noted, these periods of turmoil bring “creativedestruction” – the replacement of old products and technologies withnew ones.

■ Small businesses represent the vast majority of American companies,and a large pool of potential customers. New technologies andfinancial innovations provide cost-effective means of reaching themarket.

■ Emerging domestic markets are the fastest growing segment of thepopulation, and EDM firms are growing far faster than the nationalaverage.

■ As with all new markets, information asymmetries provide anopportunity for profit to those who craft innovative solutions.

■ First-movers will have a significant competitive advantage given thesize and diversity of the market.

■ The recent business scandals in American corporations will bringgreater scrutiny of the industry from government and the public.Proactive exploration of the opportunities in emerging domesticmarkets will not only yield valuable business opportunities, but maylimit new regulatory controls. It will also appeal to consumers andinvestors seeking good corporate citizens.


The innovationsdescribed in thisreport are allexamples of financialtechnologies thatcould help redress theinformationasymmetries andcapital gaps betweenthe key providers ofcapital in the U.S. andthe increasing diverseusers of capital,particularly those inthe LMI and emergingdomestic marketcommunities.

■ ■ ■

New technologies andfinancial innovationsprovide cost-effectivemeans of reaching themarket.

■ ■ ■

As with all newmarkets, informationasymmetries providean opportunity forprofit to those whocraft innovativesolutions.

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Below are several recommendations for pilot projects, based on thefindings in this report. The choice of these pilots is based on severalcriteria:

■ They address specific, identified obstacles impacting LMIentrepreneurs’ access to capital.

■ They are based on tested concepts, even though the concepts mayhave been applied in different situations.

■ They are not applied wholesale, but tailored to account for both themarket demands of mainstream firms and the public purpose of thecommunity finance field.

■ They leverage existing resources and expertise.

■ They have attracted interest from both the mainstream financialservices companies and community finance organizations.

■ They incorporate incentives for all parties to participate.

■ They are easily scalable.

■ They can be implemented in a reasonable period of time.

■ They will increase capital flows to small businesses in LMI andemerging domestic market communities.

MODEL ONE: EDM DATA NETWORKCollecting comprehensive, reliable, usable data is critical to enabling thefinancial services industry to price LMI risk and finance entrepreneurs.As this report documents, the current pools of data are fragmented, withmany insufficient in size and/or format for this purpose. An EDM DataNetwork (Data Network) would create a repository of information on theEDM businesses and their loan performance, and share that informationwith financing institutions (masked to preserve confidentiality).

Once this pool is of sufficient size, the data could be used to create creditscoring mechanisms reflective of the EDM market. Fair Isaac, the leadingdeveloper of credit scoring, is interested in working on this project. Apool must contain at least 1,000 “bad” loans before Fair Isaac considers ita statistically significant sample (assuming a five-to-eight perc e n tdelinquency/default rate, this requires a pool of 12,500 to 20,000 loans).Once the 1,000 “bads” have been collected, Fair Isaac could analyze thepool and create a reliable EDM credit scoring model. By identifying thosewhose repayment likelihood falls below acceptable levels, the processalso identifies the non-investment grade tranch of a securitization.


Collectingcomprehensive,reliable, usable data iscritical to enablingthe financial servicesindustry to price LMIrisk and financeentrepreneurs.

■ ■ ■

An EDM DataNetwork (DataNetwork) wouldcreate a repository ofinformation on theEDM businesses andtheir loanperformance, andshare that informationwith financinginstitutions

■ ■ ■

Once this pool is ofsufficient size, thedata could be used tocreate credit scoringmechanisms reflectiveof the EDM market.

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Creating the Data Network would facilitate critical data assembly,generate a continuous learning process for lenders supplying the data,standardize the process and reduce the cost of information management,and potentially, create a pool of loans that could be securitized. There areseveral potential approaches:

GOVERNMENT-AFFILIATED SYSTEM

Both the SBA and the CDFI Fund have existing programs that supportlarge numbers of small-business loans. Many of these loans (all loans inthe case of the CDFI Fund) would be representative of the EDM marketexplored in this report. In conjunction with the Data Network and FairIsaac, these agencies could develop a standard reporting protocol tocollect the information needed to develop credit scoring andsecuritization, and require all participating lenders to file on a regularbasis. (As an initial incentive, lenders could be compensated for filing.)

BANK-MANAGED SYSTEM

Recognizing the challenges in launching a new program within agovernment entity, an alternative would be to create an independentnetwork of participating banks, both large and small. These banks wouldagree to: make loans to borrowers at the lower end of the credit scale, usea standard loan application, and regularly provide specified data in astandard format on loan applicant and performance data. The DataNetwork would collect the data and, initially at least, compensate thebanks as an incentive to participate. In addition to the incentive fee andthe loan fees, participating banks would benefit by obtaining CRAcredit,receiving continuously updated data on new markets, and gainingaccess to a new risk assessment tool – the EDM credit scoring model.

Data Network data could be used to develop other products, creditenhancements and liquidity mechanisms for this market. The loans inthe Data Network could be securitized. At a later stage, the DataNetwork could possibly expand to receive EDM loan applications, andbased on their credit score, send them out to “bid” among participatingbanks.

Conceivably, banks could structure their transaction and default costs asa CRA investment by making a contribution to the Data Network, orissuing a long-term note for the amount of expected losses. These funds,plus foundation contributions, could support the Network’s operations.


Creating the DataNetwork wouldfacilitate critical dataassembly, generate acontinuous learningprocess for lenderssupplying the data,standardize the processand reduce the cost ofinformationmanagement, andpotentially, create apool of loans thatcould be securitized.

■ ■ ■

The SBA and the CDFIFund have existingprograms that supportlarge numbers ofsmall-business loans.

■ ■ ■

Recognizing thechallenges inlaunching a newprogram within agovernment entity, analternative would be tocreate an independentnetwork ofparticipating banks,both large and small.

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MODEL TWO: SECURITIZATION AND CREDIT-ENHANCEMENTSecuritization – the pooling and purchase of individual small-businessloans from multiple lenders and packaging these loans into a security, ora Collateralized Loan Obligation (CLO), to be sold to a third party – hasplayed a key role in increasing access to capital in the home mortgage,auto loan, and consumer finance markets. Offering lenders a path toliquidity dramatically decreases their risk in issuing credit, and freesthem to make additional loans. While small-business loans, andcommunity development finance loans in particular, are less easilysecuritizable, opportunities do exist and could increase the size andscope of EDM lending by mainstream institutions. Several genericstructures and some specific examples appear in this report.

A viable securitization in this market requires several factors:

■ Performance data: Model One presents an approach to collecting thenecessary data.

■ Loan pool of sufficient size and homogeneity (although completeuniformity is not necessary): Pools could be created from severalprograms targeting LMI and EDM borrowers, including the non-guaranteed portion of SBA 7(a) loans, Capital Access Programs,community development loans backed by state and federalguarantees, community development credit unions and loan funds.

■ Strong credit enhancement to offset the added risk: Several modelsare presented in this report. The reserve funds in loan programs suchas the CAPs above serve this purpose.

As noted earlier, Capital Access Programs (CAPs) serve EDM borrowers.The mission, size, scope and structure of this program make it anexcellent model for LMI-related securitization. Mainstream lenders issuemost of the loans, which reach borrowers who would not otherwise haveaccess to capital. CAPs have facilitated over $1.6 million in loans in over20 states and cities around the country, demonstrating a pool acrosswhich to diversify risk. The size of the state-held reserves continuallyexceeds the actual loan loss, providing credit enhancement and enablingan investment-grade rating for the security. States manage their ownCAPs, but legislation authorizing a National Capital Access Program hasbeen introduced in Congress. The sample CAP securitization structurebelow is based on the California Capital Access Program (CalCAP), butcould be replicated in or pooled with other states.

When a loan is made under CalCAP, the borrower and lending bank eachpay 2 percent into the loss reserve account, and the state adds 4 percent,for a total reserve of 8 percent of the loan amount. Loans can be up to $2.5million, with short or long terms, have fixed or variable rates, be secured,


Offering lenders apath to liquiditydramaticallydecreases their risk inissuing credit, andfrees them to makeadditional loans.

■ ■ ■

A viablesecuritization in thismarket requiresseveral factors:performance data,loan pool and strongcredit enhancement tooffset the added risk.

■ ■ ■

CAPs have facilitatedover $1.6 million inloans in over 20 statesand cities around thecountry,demonstrating a poolacross which todiversify risk.

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and bear any type of amortization schedule. The economics forsecuritization of these loan products are compelling:

■ Verifiable 12-year history of defaults averaging 3.7 percent, 3.5percent in California

■ Bank underwriting and servicing standards

■ Lucrative spread of six-to-eight percent for warehouse facility duringloan accumulation

■ Off-balance sheet, riskless 20 percent profit return to CAP lender oneach deal after all expenses

■ One-to-three percent high-yield profit margins for investment bankeron high-grade bonds

■ Lending underwriting standards superior in quality to SBArequirements.

In order to create a private capital market link to the CAP program, theState of California passed legislation in 1999 permitting thesecuritization and sale of CalCAP loans as asset-backed bonds.Additional legislation created by the Milken Institute and others in 2000opened the door to most classes of small-business borrowers andincluded some finance companies in the lending class. A regionalfinancial institution has structured a deal to securitize these loans inpools of at least $100 million.

The securitization of this product offers institutional investors a highlyattractive investment vehicle. The bond structure accommodates anAAA investment grade rating backed by a 25 percent level of bondprotection that is maintained throughout the life of the bond. The bondcoupon could be fixed or float with investor call protection and provideapproximately 200 basis points of spread to a benchmark U.S. Treasurysecurity. CRA credit would be available on 30-to-50 percent of the bondsissued, as further inducement for institutional purchase.

Under the model, the loans would be real estate or plant and equipmentbased, with an 80 percent recovery history, 25-year maturity, five yearsnon-refund, 7.75 years average life and float at prime+1. The loanswould be 85-to-90 percent LTV and have coverage of 1.2 times. Noworking capital loans would be securitized. The bonds would float atapproximately 30 day Libor +75-80. It is expected that 90 percent of theloans would be rated AAA and the remaining 10 percent rated A.


In order to create aprivate capital marketlink to the CAPprogram, the State ofCalifornia passedlegislation in 1999permitting thesecuritization and saleof CalCAP loans asasset-backed bonds.

■ ■ ■

Additional legislationcreated by the MilkenInstitute and others in2000 opened the doorto most classes ofsmall-businessborrowers andincluded somefinance companies inthe lending class.

■ ■ ■

The bond structureaccommodates anAAA investmentgrade rating backedby a 25 percent levelof bond protectionthat is maintainedthroughout the life ofthe bond.

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MODEL THREE: EDM-TARGETED MEZZANINE FUNDA privately managed, public purpose equity/mezzanine fund couldtarget business and project financing in LMI areas and among EDMfirms. By bringing private management to investments with a publicbenefit (e.g., job creation, capital access), mezzanine funds introducemuch needed flexibility to the capital structure of small businesses, andcan stru c t u re transactions that capture the risks unique to theseinvestments (e.g., management constraints, debt service capacity).

With an asset composition of debt and equity instruments, a fund canemploy liabilities consisting of both equity and long-term debt tomagnify return on contributed capital. The diagram on the followingpage illustrates a hypothetical mezzanine fund model (Fund). (NOTE:return rates and asset allocation are for illustrative purposes only.) TheFund could receive investments from investors seeking risk-adjustedmarket rate and/or double-bottom-line returns, e.g.:

■ Financial institutions and private equity investors

■ Other banks seeking Community Reinvestment Act (CRA) credit

■ Insurance companies

■ Foundations interested in mission-related or pro g r a m - re l a t e dinvesting

■ Corporations with EDM business strategies

■ Socially motivated investors

■ Other pension funds

■ Government or government-sponsored enterprises

■ Native American Tribal Councils

Additional sums could be raised by an investment grade (Single A)issuance at Treasury plus 150 basis point return, and a high yieldissuance (BB-) at 600 basis points above Treasury yields. The asset side ofthe Fund balance sheet could include senior secured debt issued at oneinterest rate, mezzanine investment yielding a higher rate return, anddirect equity yielding the highest return rate. Equity might also bereturned in the form of an ongoing “royalty” payment.

The Fund’s investors accept different levels of risk, and associated levelsof return. Those that are less risk-tolerant or more double-bottom-lineoriented, such as foundations, governments and social investors,subsidize the higher returns demanded by others, such as banks andinstitutional investors. The Fund could enhance its deal flow and impact


Mezzanine fundsintroduce muchneeded flexibility tothe capital structureof small businesses,and can structuretransactions thatcapture the risksunique to theseinvestments.

■ ■ ■

With an assetcomposition of debtand equityinstruments, a fundcan employ liabilitiesconsisting of bothequity and long-termdebt to magnifyreturn on contributedcapital.

■ ■ ■

The Fund couldreceive investmentsfrom investorsseeking risk-adjustedmarket rate and/ordouble-bottom-linereturns.

30

by linking with one of the networks described as Model Four and ModelFive below.

MODEL FOUR: FINANCIAL INNOVATIONS LAB & LEARN-ING CONSORTIUMThere are a number of information challenges involved with linkingfinancial innovation to community development finance, including:

■ The ongoing refinement of financial technologies, and theirapplication to ever more areas, information that is not likely to reachthose involved with LMI businesses;

■ The lack of contact between mainstream financial professionals andEDM businesses and communities; and

■ The lack of re g u l a r, stru c t u red learning sessions for thoseprofessionals engaged in meshing financial technologies with EDMand LMI financing opportunities.


There are a number ofinformationchallenges involvedwith linking financialinnovation tocommunitydevelopment finance,including the ongoingrefinement offinancial technologies,and their applicationto ever more areas,information that isnot likely to reachthose involved withLMI businesses; thelack of contactbetween mainstreamfinancialprofessionals andEDM businesses andcommunities; and thelack of regular,structured learningsessions for thoseprofessionals engagedin meshing financialtechnologies withEDM and LMIfinancingopportunities.

■ ■ ■

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Figure 5EDM-Targeted Mezzanine Fund Model

Community investment lenders at major institutions (e.g., Wells Fargo,Bank of America, Goldman Sachs) note that they rarely have theopportunity to discuss these issues among themselves, much less withthe businesses and communities seeking financing. A formal structure –a Financial Innovations Lab & Learning Consortium (Lab/Consortium)pursuing innovation and linking those active in the relevant fields –would advance innovation, increase learning and provide networks tofacilitate increased lending and investment.

Institutions, investors, entrepreneurs, CDFIs and policymakers couldjoin the Lab/Consortium. Some programs would be open to all membersregardless of their field, allowing for cross-fertilization; and some wouldbe reserved for specific subsets, enabling peers to share information.Certain discussions would be established as confidential to encouragetransparency. As it evolved, the Lab/Consortium could collaborate onp rojects along the lines of the models described above, e.g., datacollection, pooling loans for securitization, jointly funded mezzaninefunds. The Lab/Consortium could consist of several components, suchas:

FINANCIAL INNOVATIONS LABORATORY – Brings together expertsin structured finance, community lenders, entrepreneurs, researchers,regulators, etc., to work through specific challenges limited the flow ofcapital into EDM communities. Once problems were identified, a smallgroup would build a market-solution by considering the appropriatefinancial technologies and the relevant adaptations needed for it to workin the LMI market. The solutions would be piloted, most likely by aparticipating financial institution, and deployed more broadly asapplicable. Engaging financial institutions in the pilot design wouldincrease their sense of ownership. Access to a potentially lucrative newproduct would incentivize them. Engaging both the potential suppliersand users of capital would maximize the likelihood of developing aviable product serving the interests of both parties.

CRA INVESTMENT SYMPOSIA – A regular meeting among thoseresponsible for CRA at financial institutions would enable them to sharechallenges and solutions. Researchers and innovators would presentc u r rent data, new models and applications to build the gro u p ’ sknowledge base, and to generate joint approaches to achieving CRAgoals in a market-responsive fashion.

INSTITUTIONAL INVESTOR EDUCATIONAL ACTIVITIES – EDMbusinesses, and LMI firms in particular, are extremely challenging forlarge institutional investors. They do not have the regulatory incentivethat CRA offers banks. Their interest in the EDM market must derivefrom the investment proposition. Yet these entities represent the singlel a rgest source of capital globally. With the data gaps discussedthroughout this report, most investors are at a loss to evaluate the marketeffectively. The Lab/Consortium could develop informational tools,


Community investmentlenders at majorinstitutions note thatthey rarely have theopportunity to discussthese issues amongthemselves, much lesswith the businessesand communitiesseeking financing.

■ ■ ■

A FinancialInnovations Lab &Learning Consortiumpursuing innovationand linking thoseactive in the relevantfields would advanceinnovation, increaselearning and providenetworks to facilitateincreased lending andinvestment.

■ ■ ■

Institutions, investors,entrepreneurs, CDFIsand policymakerscould join the Lab/Consortium.

32

products and programs tailored to the needs of institutional investors,and engage them in ongoing learning. This would be quite valuable,especially at the public pension funds which, despite their extensiveassets nearly (nearly $3 trillion), operate lean staffs with little room forniche expertise and in-house education. As noted above, a few fundshave taken leadership positions in exploring the EDM arena, but manymore will be seeking information.

MODEL FIVE: BANK/COMMUNITY LENDER EXCHANGEWithin the LMI small-business finance world, firms seek funding, banksseek deals, community lenders and investors seek deals and funding,and each could provide value to the others. However, most often, thereis little crossover. With bank consolidation, territories are expanding andbanks are reaching into unfamiliar communities. A Bank/CommunityLender Exchange (Exchange) would break up the community financingvalue chain to increase information sharing, leverage expertise and riskand match funders and businesses more appro p r i a t e l y, ultimatelyincreasing capital flow to LMI businesses. The Internet would allow theExchange to operate as a virtual entity, enabling direct contact withminimal management and cost.

There are excellent examples of Bank-CDFI partnerships, several ofwhich are described in this report. There are also new models of Bank-Technical Assistance partnerships, the most extensive of which isCommunityExpress. A national network would bring these activities toscale and maximize impact.

An Exchange could include several functions, such as:

■ Banks that could not fund applicants due to credit quality could referthem directly to CDFIs or other community-based lenders in theappropriate location. While this is often done on a local basis, it ismore difficult for national institutions. Additionally, local banks haveonly the local CDFI to tap. Given the number and diversity ofcommunity finance organizations, pooling the information couldenable more appropriate referrals. Incentives for participation andreferrals could be provided to launch the effort.

■ Banks or CDFIs or other community lenders could tie loanacceptance to the entrepreneur receiving technical assistance (asCommunityExpress bank participants now do). The Exchange couldinclude a national pool, and use a system such as CARAT’s TACP tocertify approval. Ensuring quality technical assistance is part of theloan package would mitigate lender risk.

■ Once an applicant is referred to a CDFI, the CDFI could track theentrepreneur’s progress and direct him to the bank when he iscreditworthy. Without networks, the borrower’s relationship to the


A Bank/CommunityLender Exchange(Exchange) wouldbreak up thecommunity financingvalue chain toincrease informationsharing, leverageexpertise and risk andmatch funders andbusinesses moreappropriately,ultimately increasingcapital flow to LMIbusinesses.

■ ■ ■

The Internet wouldallow the Exchange tooperate as a virtualentity, enabling directcontact with minimalmanagement and cost.

■ ■ ■

A national networkwould bring theseactivities to scale andmaximize impact.

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mainstream sector might be lost, and the bank might lose a potentialcustomer.

■ Members could go directly to the Exchange to obtain interest in adeal, sources for deals, suggestions for or E-Bay-like ratings of serviceproviders’ (e.g., technical assistance, CDFIs or banks, other vendors),products and services, co-investors, etc. The extensiveness of thesystem would provide a valuable directory, and its transparencywould support re l i a b i l i t y, both of which are likely to expandfinancing activity.

■ With a sufficient membership size, the Exchange could develop datacollection processes (as in Model One), securitize loan pools (as inModel Two), invest in common funds (as in Model Three), or extendon-line learning programs (as in Model Four).


Members could godirectly to theExchange to obtaininterest in a deal,sources for deals,suggestions for or E-Bay-like ratings ofservice providers’products and services,co-investors, etc.

■ ■ ■

The extensiveness ofthe system wouldprovide a valuabledirectory, and itstransparency wouldsupport reliability,both of which arelikely to expandfinancing activity.

■ ■ ■

With a sufficientmembership size, theExchange coulddevelop datacollection processes,securitize loan pools,invest in commonfunds, or extend on-line learningprograms.

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REFERENCES

1Board of Governors of the Federal Reserve System. June 6, 2002. “Flow of Fund Accounts of the UnitedStates,” Federal Reserve Statistical Release.

2U.S. Small Business Administration Office of Advocacy. July, 2001. “The Economic Impact of SmallBusiness,” U.S. Small Business Administration Office of Advocacy.

3Yago, Glenn and Aaron Pankratz. September 25, 2001. The Minority Business Challenge: Democratizing Capitalfor Emerging Domestic Markets. Santa Monica: The Milken Institute.

4U.S. Census Bureau. September, 2000. “Money and Income in the United States,” Current Population Reports:Consumer Income.

5Cantave, Cassandra, Melissa Vanouse and Roderick Harrison. September 1999. “Trends in Poverty,” JointCenter for Political and Economic Studies.

6Yago, Glenn and Aaron Pankratz.

7Percentages derived from data from the Bureau of Labor Statistics, U.S. Department of Labor and the U.S.Census Bureau, U.S. Department of Commerce.

8In fact, Caucasian business owners employ a predominantly and often entirely Caucasian workforce evenwhen their businesses are located in inner-city minority communities. Only 3.2 percent of African American-owned firms employ a work force that is 50 percent or more white. (Bates, Timothy. 1999. “ViewingMinority Business Assistance as a Job Creation Strategy,” The Black Worker in the 21st Century, ed. WilheminaLeigh & Margaret Simms. Washington, DC: Joint Center for Political and Economic Studies.)

9U.S. Census Bureau. July, 2001. “1997 Census: Survey of Minority-Owned Businesses, Company SeriesStatistics,” U.S. Department of Commerce, Economics and Statistics Administration.

10The Federal Reserve Board. Spring, 2001. “Evaluating the Profitability of CRA Loans,” Capital Connections,3(2).

11Board of Governors of the Federal Reserve System. January 21, 2000. “Survey of the Performance andProfitability of CRA-Related Lending.”

12Board of Governors of the Federal Reserve System. June 6, 2002. “Flow of Fund Accounts of the UnitedStates,” Federal Reserve Statistical Release.

13Yago, Glenn and Aaron Pankratz.

14National Community Capital Association. November 2002. “CDFIs: Bridges Between Capital andCommunities.” www.gdrc.org/icm/finnovation.html

15Board of Governors of the Federal Reserve System, U.S. Securities and Exchange Commission. 2000.“Report to Congress on Markets for Small-Business and Commercial-Mortgage-Related Securities.”

16Greg Stanton, Director, Capital Markets Access, Financial Innovations Roundtable

17Goldberg, Lawrence and Lawrence White. 1998. “De Novo Banks and Lending to Small Businesses: AnEmpirical Analysis.”

18Interview with Michael Klausner, Professor of Law, Stanford Law School.

19Logue, John and Jacqueline Yates. 2001. The Real World of Employee Ownership.


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20Shipman, William. December, 2001. “Is the Stock Market Too Risky for Retirement,” National Center forPolicy Analysis.

21Canner, Glenn B., 1999. “Evaluation of CRA Data on Small Business Lending.” Published in Proceedings ofFederal Reserve System Research Conference: Business Access to Capital and Credit, Arlington, VA. March8-9, 1999, (53-84).

22Federal Reserve Bank of Atlanta. 1999. “The Score on Credit Scoring in Small Business Lending,” EconSouth,1(3).

23Frame, Scott, Padhi, Michael, and Woosley, Lynn. April, 2001. “The Effect of Credit Scoring on SmallBusiness Lending in Low-and Moderate-Income Areas.”

24Federal Reserve Bank of Atlanta. 1999. “The Score on Credit Scoring in Small Business Lending,” EconSouth,1(3).

25NCRC Summary of “CommunityExpress,” www.ncrc.org


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APPENDIX I:

RESEARCH METHODOLOGYThe following methodology was employed in researching this report:

■ Literature Review: An examination of relevant research regarding the history and current trendsin financial innovations, the financial services industry, and small business and communitydevelopment finance.

■ Data analysis: An analysis of data sources such as Federal Reserve Flow of Funds, U.S. EconomicCensus data, Dun and Bradstreet data on women- and minority-owned companies, SBA/FederalReserve Survey of Small Business Finance, data on minority and women targeted private equitydata, thrift financial reports, bank call reports, and credit union data.

■ Interviews: Interviews of those who borro w, lend, and invest on a regular basis, EDMentrepreneurs, researchers, and regulators. The interviews typically lasted one to three hours, andin some cases, group interviews were conducted (see Appendix II for a full list of interviewees).

■ Roundtables: A series of roundtables were held in Los Angeles, New York, and Washington DCwith representatives of depository institutions, nonbank lenders, community developmentfinancial institutions, financial and business trade associations, academic and policy researchorganizations, governmental and regulatory bodies, investment banking firms, private equity andventure capital firms, institutional investors, minority entrepreneurs, minority business leadersand community experts. The roundtables were held to test the viability and scalability ofinnovations.

Based on the described research conducted for this study, the Milken Institute determined thoseinnovations that would most likely to be successfully implemented and brought to significant scale.


37

APPENDIX II:

INTERVIEWEES AND WORKING GROUP PARTICIPANTSCecil Adams Chief Operating Officer Founders National Bank

Rebecca Adamson President First Nations Development Institute

Henry Alford President & CEO National Black Chamber of Commerce

Avis R. Allen Vice President National Community Reinvestment Coalition

Frank Altman President Community Reinvestment Fund

A. Bernard Anderson Managing Principal Andercorp International Inc.

Brian Argrett President & CEO Fulcrum Capital Management

Shawn D. Baldwin President & CEO Capital Management Group Advisors

Michael J. Banner President & CEO Los Angeles Local Development Corp.

Michael Barr Dep. Asst. Sec., US Department of TreasuryCommunity Development

Marva Smith Battlebey Executive Director Vermont Slauson Economic Dev. Corp.

Shari Berenbach Executive Director Calvert Community Investments

David Berge President Underdog Ventures LLC

Nitin Bhatt Executive Director USC Business Expansion Network

Betsy Biemann Assistant Director, The Rockefeller FoundationWorking Communities

Joseph Blair Exec. Vice President, Advest Inc.Capital Markets

Francisco L. Borges President & Managing Partner Landmark Partners Inc.

Sandy Bourne President Pasadena Enterprise Center

Rodger Boyd Program Manager Community Dev't Financial Institutions

Jeffrey Brenner Man. Director, Community NCB Development CorporationVentures Team

Julia Brown District Community Comptroller of the CurrencyAffairs Officer

Rodger Brown President Bright Horizons Family Solutions

Patricia Brownell Executive Director National Credit Union Foundation

Ambassador John Bryant Founder, Chairman & CEO Operation Hope Inc.

Beth Bubis Vice President, Community Bank OneRelations

Kathryn Bushkin President AOL/Time Warner Foundation


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Douglas J. Bystry President & CEO Clearinghouse CDFI

Phyllis Caldwell Sr. VP, Comm. Development/ Bank of AmericaPrivate Equity

Roger Campos Executive Director Minority Business Roundtable

Shaw Canale Executive Director Cascadia Revolving Fund

Len Canty Chairman National Monetary Fund

James H. Carr Senior Vice President Fannie Mae Foundation

Joy Chen Board Commissioner, City of Los Angeles Housing Authority

Elyse Cherry President Boston Community Capital Venture Fund

Kurt Chilcott President & CEO CDC Small Business Finance Corporation

Chingyin Chu VP, Small Administrative Cathay BankBusiness

William H. Chu President & CEO Los Angeles Community Development Bank

Della Clark President West Philadelphia Enterprise Center

Todd Cohen President CRAFund Advisors

Linda Cole VP, Community Development Cal FED BankingManager

Christopher Conley President Nonprofit Capital, LLC

Margot Copeland President & CEO Greater Cleveland Minority Business Roundtable

Mary Cosgrove Director, Ctr. for Comm. CitigroupDev. Enterprise

Jamir R. Couch Vice President M.R. Beal & Company

Courtland Cox Former Director/Minority US Department of CongressBus. Dev. Agcy

Gregory Craig Chief Executive Officer Cook Inlet Energy Supply

Lemuel L. Daniels First Vice President, Investments Salomon Smith Barney Inc.

Stephen Davey First Vice President Valley National Bank

Steven Davidson Senior Financial Economist America's Community Bankers

Don J. DeBolt President International Franchise Association

Christina Brooks DelDonna Principal Allied Capital SBLC Corporation

Gilbert E. DeLorme Attorney Greenstein DeLorne & Luchs PC

Real Desrochers Director, Alternative Investments CalSTRS

Bob Devereux Public Affairs Specialist State Farm Insurance

Andy Ditton Director, CCDE Citigroup

Catherine E. Dolan Senior Vice President First Union Bank

Amy L. Domini Managing Principal Domini Social Investments


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Annie Donovan Managing Director National Cooperative Bank

Penelope Douglas President Silicon Valley Community Ventures

Lucy Drafton CRA Program Analyst District of Columbia Government

Jane Drake Chief Operating Officer Women's Equity Mutual Fund

Ed Dugger President UNC Partners Inc.

Brenda Ross Dulan VP, Corporate Community Wells FargoDevelopment

William Dunkelberg Chief Economist Nat'l Federation of Independent Business

Denise Fairchild Executive Director Community Development Technologies Center

Robert H. Forsythe Senior Vice President CNL Finance Inc.

Michael S. Frankel Managing Director Southern California Community Ventures

Michelle Garcia Director, Operations & Emerging Venture NetworkInvestor Outreach

Richard Gentilucci Senior Vice President, Shamrock HoldingsReal Estate

Donna Gilding Chief Investment Officer Progress Investment Management

Garrett Gin VP, Community Development Merrill LynchManager

Bob Gnaizda General Counsel & The Greenlining InstitutePolicy Director

Michael Golden Vice President Shared Equity Strategies

Darius Goore Legislative Aide Senator Jon. S. Corzine

Andrew W. Gordon President Arizona MultiBank Community Dev. Corp.

Bernell K. Grier Senior VP & Director Fleet Community Banking Group

Gloria Guerrero President Rural Development & Finance Corporation

Michael Gunning Senior Legislative Advocate Personal Insurance Federation of California

Sharon G. Hadary Executive Director Center for Women's Business Research

Richard Hartnack Vice President Union Bank of California

Penne Hasson CRA Officer Mellon First Business Bank

Richard Hayes Senior Principal Investment CalPERSOfficer

Shelly Herman Senior Managing Director Shorebank Advisory Services

Victor Hoskins Vice President, Strategic Urban AmericaAlliances

Thomas P. Hourican President & CEO Hourican & Associates

Susan Howard Community Affairs Officer Office of the Comptroller of the Currency

Giles Hunt Advisor Business Loan Marketing Association

Peter F. Hurst Chairman & CEO The Community's Bank


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Rick Jackson Vice President, Business Actrade Financial TechnologiesDevelopment

Carlton Jenkins Partner Yucaipa Corporate Initiatives Fund

Erik C. Johnson Director Community Lending Group

Ron Johnson Associate Director, Standard & Poor'sCorporate Ratings

Maurice Jones Acting Director CDFI Fund

Micardo Jones Director Enron Investment Partners

Mary F. Kaiser President Cal Community Reinvestment Corp.

Mary Grace Karonis CRAManager Cathay Bank

Gale K. Kaufman Senior VP, Finance New York City Investment Fund

Michael J. Kelley President Intrust USA

Clifton Kellogg President CityFirst

Donald Kincey Vice President Comerica Bank, California

Lynn Sheri King Director, Legislative Affairs National Community Reinvestment Coalition

Michael Klausner Professor of Law Stanford Law School

Kay Koplovitz Principal Koplovitz & Company

Deborah J. La Franchi President & CEO Genesis LAEconomic Growth Corporation

James P. Laffargue Vice President Union Bank of California

Henry Lanier Managing Director Lehman Brothers

Jim Laurie Consultant Legg Mason

Daniel Letendre VP, Community Development J.P. Morgan Chase & CompanyGroup

Andrea Levere Vice President Corporation for Enterprise Development

Judd Levy President Community Development Trust

Reta J. Lewis VP, Counselor to the President US Chamber of Commerce& CEO

Haddon Libby Vice President Bank of America Corporation

Dan Liebsohn Consultant Community Development Finance

John Logue Director Ohio Employees Ownership Center

Nigel L. Long President Dilworth Companies Inc.

Sandra Long Deputy Secretary Maryland Dept. of Business & Econ. Dev.

R.D. Lottie President & CEO Pacific Coast Regional Small Business Dev. Corp.

Joe Lumarda Executive Vice President California Community Foundation

Doug Martin Government Affairs Fireman's Fund Insurance Company

Victor L. Maruri Managing Partner Hispania Capital Partners, LLC


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John May Managing Partner New Vantage Partners

Jim Mayer Executive Director Little Hoover Commission

George McDaniel President & CEO Community Bank of the Bay

Reuben McDaniel President & CEO Jackson Securities, Inc.

Dan Meiri Executive Vice President Bank Leumi

Fred Mendez Community Investment Federal Bank of San FranciscoSpecialist

Ray Mendoza Vice President (CEDLI) Calif. Economic Dev. Lending Initiative

Steve Mercil President & CEO MINCorp, Minnesota Investment Network Corp

Nell Merlino Co-Founder & President Count-Me-In for Women's Econ. Independence

Clara Miller President Nonprofit Finance Fund

Saunders Miller Senior Policy Advisor, US Small Business AdministrationInvestment Division

Amy Millman President Springboard Enterprises

Karen A. Mocker External Affairs Officer CDFI Fund

Betsy Mongrain Senior Vice President & COO Neighborhood National Bank

Bill Boler Vice President Business for Social Responsibility

Laurence C. Morse Partner Fairview Capital Partners, Inc.

Kirsten S. Moy Dir, Community Development The Aspen InstituteInnovation

Thomas Nagel President Urban Development Resource Corp.

Eric Natwig President New West Partners, Inc.

John Eric Nelson Director, Corp. Partnership Nat'l Congress for Community Economic Dev.Program

Dominic Ng Chairman, President & CEO East West Bank

James Nixon Chair, Board of Directors Sustainable Systems Inc.

Jack Northrup Consultant New England Market Research

Jeremy Nowak President & CEO The Reinvestment Fund

Ken Oliver Senior Vice President Development Credit Fund, Inc.

Karen A. O'Mansky Director, Community Self-HelpFacilities Fund

Nina Orville Vice President New York Community Investment Co.

Erik R. Pages Policy Director National Commission on Entrepreneurship

Michael A. Pfeifer Senior Manager Fair, Isaac & Company, Inc.

Penny K. Pickett Business Director Telecommunications Development Fund

Mark Pinsky Executive Director National Community Capital Association


42

Jean Pogge Sr. VP, National Accounts Group Shorebank

Marcel R. Portmann Vice President, Emerging International Franchise AssociationMarkets

Ed Powers Senior Vice President Bank of America

Michele Prichard Director, Special Projects Liberty Hill Foundation

Roy O. Priest President & CEO Nat'l Congress for Community Econ. Dev.

Mike A. Provencio Senior Vice President & City National BankCRA Manager

Paul L. Pryde Jr. President & Managing Director Capital Access Group

Luther M. Ragin Jr. Vice President, Social Investing FB Heron Foundation

Gregory Ratliff Director, Economic Opportunity John D. & Catherine T. MacArthur Fnd.

Charles Raymond President Citigroup Foundation

Tarrus Richardson Managing Director ICV Capital Partners, LLC

Lisa Richter Fund Advisor National Community Investment Fund

Janice Cook Roberts Senior Vice President New York City Investment Fund

Richard Roberts Managing Director Goldman Sachs & Company

Steven Rogers Professor Kellogg School of Mngt/Northwestern Univ.

Forecee Hogan Rowles President & CEO Community Financial Resource Center

Julia Rubin Ph.D. Candidate Harvard University/Harvard Business School

Jun Sakumoto Vice President Jackson Securities

Ruth M. Salzman Senior Vice President JP Morgan Chase & Company

William Sayles Managing Director The Center for Credit Union Innovation LLC

Adria Graham Scott Community Investment Advisor Federal Reserve Bank of San Francisco

Jack Shakely President & CEO California Community Foundation

Daniel Sheehy President & CEO Impact Community Capital

Brenda Shockley President Community Build Inc.

Robert Shoffner Citibusiness Regional Manager Citigroup

Andrea Silbert CEO Center for Women & Enterprise

D. Wayne Silby Chairman Calvert Foundation

Terry Simonette President & CEO NCB Development Corporation

G. Winston Smith Supplier Diversity Director AT&T Corporation

Shelly Smith President L.A. City Employee Retirement Services

Gail Snowden Executive Vice President FleetBank Boston NA

Howard Sommer President New York Community Investment Company

Marianne Spraggins CEO ALIC Investment Advisors

Michael Springer Office of Economic Policy US Department of Treasury


43

Reginald T. Stanley Senior Vice President Calvert Foundation

Gregory M. Stanton Director Capital Markets Access Program

Joseph Stark Senior Managing Director Bear Stearns

Anne Stausboll Chief of Staff & General Counsel State of California

Kathy Stearns Director, Financial Services National Community Capital Assoc.

Michael Stegman Director, Ctr. For Community Kenan InstituteCapitalism

Beatrice Olvera Stotzer President New Economics for Women

Michael Swack Prof & Dir, Community New Hampshire CollegeEcon. Dev. Program

Scott Syphax President & CEO Nehemiah Corporation

Richard N. Tambor Sr. Vice President & CCO American Express Small Business Services

Wilson Tang Regional Vice President Cathay Bancorp Inc.

Charles Tansey Senior Policy Advisor Neighborhood Reinvestment Corp.

Blair Taylor President Inner City Development Corp.

John Taylor President & CEO National Community Reinvestment Coalition

Selma Taylor Executive Director California Resources & Training - CARAT

Kerwin Tesdell President Community Dev. Venture Capital Alliance

Stanley Tucker President Meridian Management Group Inc.

Paul Turner Project Manager Southern California Edison

Lauren Tyler Managing Member Quetzal/Chase Chase Partners LLC

Fidel Vargas Vice President Reliant Equity Investors

George Vradenburg Sr. VP, Global & Strategic Policy America Online

Larry Waddell Managing Director Sustainable Jobs Fund LP

Orson W. Watson Vice President, Research Initiative for a Competitive City& Strategy

Phillip J. Weber SVP, American Communities Fannie Mae FoundationFund

John Weiser Partner Brody, Weiser & Burns

Robert Weissbourd Senior Advisor, Urban Logic RW Ventures

Anita Cooke Wells Chief, Office of Financial Access MBDA, US Department of Commerce

Lynn Reilly Whiteside President & CEO Social Compact

Mark Whitlock Executive Director FAME Renaissance

Alma Williams VP, Community Development California Commerce BankOfficer

Ruth Lopez Williams President Latin Business Association

George Williamson President (CEDLI) Calif. Economic Dev. Lending Initiative


44

Mark W. Willis Executive Vice President JP Morgan Chase & Company

Lee E. Winslett VP, Community Lending Wells Fargo

Brenda Wright Sr. VP, Regional Manager, Wells FargoComm. Dev.

Jim Yacenda VP & CIO, Community Federal Home Loan Bank of San FranciscoInvestments

Nancy Ylvisaker President Merrill Lynch CDC

Erika Y. Young CRAManager District of Columbia Government

Jeffrey Zinsmeyer President Doorway to Dreams


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ABOUT THE AUTHORS

GLENN YAGO is Director of Capital Studies at the Milken Institute. Hespecializes in financial innovations, financial institutions, capital markets, andenvironmental finance. Yago is creator of the Milken Institute Capital AccessIndex, an annual survey that measures access to capital for entrepreneurs acrosscountries and initiated establishment of the Center for Emerging DomesticMarkets at the Milken Institute. He is the author of five books includingRestructuring Regulation and Financial Institutions, and the forthcoming BeyondJunk Bonds, and is series editor for the Milken Institute Series on FinancialInnovation and Economic Growth, published by Kluwer Academic Publishers.Yago received his Ph.D. from the University of Wisconsin, Madison.

BETSY ZEIDMAN is director of the Center for Emerging Domestic Markets atthe Milken Institute. Zeidman oversees the Center’s resource network, researchand publications, roundtables and conferences, advisory services and financialinnovations lab. She is a frequent speaker on issues of emerging domesticmarkets and double-bottom-line investments. She also works with the Instituteon issues of strategic philanthropy and environmental finance. She remainsprincipal of Zeidman & Associates, a strategic management advisory firmspecializing in issues of social responsibility and financial performance.Zeidman earned her MBA at the Yale School of Management.

BILL SCHMIDT was a Research Analyst at the Milken Institute focusing onresearch, analysis and application of data and information to emerging domesticmarkets and Latin American economies. Schmidt earned his MBA at theUniversity of California, Los Angeles.


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