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in community and economic development
Federal Reserve Bank of Atlanta
Volume 8, Number 2
l'lwtosrnl'I, ln1 C11111/1rid,c /c11ki11 ,, IV Age '/3
Seeing Things in Black and White
At fi rs t glan ce, things frequently
a ppear to be so clear. It's ri g ht o r
it's wrong. It works or it doesn't.
It' s bankable o r it's not. But the
truth is, th ere is a lot of g ra y ou t
there. What may have been ri g ht,
or would work, o r was bankable in
the past, ma y not be so in the
future. Upo n fur ther review, we
som etimes discover a little less
blac k a nd white and a w hole lot
more gray.
Commun ity Development professionals recogni ze that the issues
we con front, w he the r th ey are
social , po litica l, or economi c, are
often e motionall y cha rged and
contain treme ndous obs tacl es,
Som etimes we spend so mu ch time
"putting out fires" that we lack the
time a nd expertise to thoroug hl y
researc h the issues that we confront. Fortunately, a great deal of
resea rch has now been comple ted
to help foc us our attention on the
significant issues we d ea l with
every day.
And w hil e the results are very
in teresting, not everything is black
and white.
For exa mpl e, there is no one reason w hy approx imately twelve
milli on U.S. househo lds are
"unban ked ," and have no tran saction acco unts wi th a mainstream
financial institution , But resea rch
Summer 1998
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Federal Reserve Bank of St. Louis
by Courtney Dufries
conducted by Jeanne M. Hoga rth
and Kevin H. O'Donnell, at the
Fed eral Reserve Board, helps shed
li g ht on who is unbanked , w hy,
an d w hat the impl ica ti ons <1rc,
especiall y as it relates to the new
focus on electronic benefit transfer
pa yments.
Perhaps it' s no t surprising that
many minority app lica nts choose
to apply for loans from minority
banks becau se they feel a sense of
cu ltura l affin ity. But a re they more
likely to be a pproved or denied the
Joa n?
Federa I Reser ve Boa rd
Econom ists Raphael W, Bostic a nd
G le nn 8, Can ne r present so me
interesting res ults in their stud y,
some of whic h is excerpted here,
experts working with the Federa l
Reserve System, a nd we s incerely
appreciate th e authors allow in g us
to present short excerpts from the
Of course, the
research papers.
views expressed are so lely th ose of
the au thors a nd do not necessarily
re fl ect those of the Board o f
Governors of the Federa l Reserve
System, or of this Reserve Bank.
And to get the w ho le s tory, to get
beyond the g ray, you s hould rea d
the entire report. For your free
copy of the papers excerpted here,
write to l~artners at the address
shown o n the back cover of this
i ss u e. ♦
Final ly, whe n we revi ew s mall
bu siness loan prog rams and eva lua te w here entrepreneurs get their
mon ey, we d iscover som e surprising resu lts. A tremendous amo unt
of research condu cted by Allen N.
Berge r at the Federa l Rese rv e
Board and G regory F. Ud ell , Ste rn
School of Busin ess, New York
University provides considerable
insig ht to the economics of finan cing small bus iness,
This newsletter presents a small
sa mple of the ex tensive resea rch
projec ts recentl y undertaken by
macliKuted
...
t t t It I It I I I I I
Federa l R,eserve Bnnk of Atlnnta
9
2
Being Accountable:
A Descriptive Study of Unbanked
House holds in the U.S.
by
Jea nn e M. Hogarth, Senior Anal yst, Consumer Po li cy, Federal
Reserve Board and Kevin H . O'Donnell, Research Ass istan t,
Federal Reserve Board
Nm rl y 13 percent of households arc
"u nb,mkcd;" that is they do not have
transaction accounts offered by the
nation's mai nstrea m banking system. This eq uates to nearly 12 million
U.S. household s. With the passage o f
the Debt Coll ecti on Improveme nt
Act o f 1996, significa nt numbers of
the unbanked will be drawn into the
mainstream ba nking system over the
next few yea rs. However, we kn ow
little about these household s- w ho
they are and why they ha ve no bank
accounts. And, as a consequence, we
know little about how to stru cture
new types of accounts fo r these
households and w hat can be done to
case thei r trans itio n into being
accou nt holders.
Background
The Debt Collection Improveme nt
Ac t requires that all recurring federa l
benefit pay ments be made via electronic funds transfer (e.g. Socia l
Security, VA benefits, Government
Pensions, Military Pay / Pensions). In
response, the U.S. Department of the
Treasury has crea ted the Electronic
Funds Transfer, 1999 prog ram
(EFT99), culminating in the establishment of an "all electronic" Treasury
by January 1, 1999.
Most certai nl y some of the 12 milli on unbanked households have
members w ho are recipi ents of federa l bene fit payments a nd w ho
w ill be d raw n into th e ma in stream
bank in g sys tem as a res ult of
ETF99 . Many of these ind ividuals
w ill be dra w n from th e ra nks of the
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low-to-mod erate income household s
that ha ve relied heavily on the
Alternati ve Fina ncia l Sector- check
cashers, pawn brokers, ctc.- for their
banking and credit need s. These
individ uals wi ll benefit from the
increased access to and ava ilability of
ba nking a nd credit serv ices and
lower fee strn cturcs of the mainstrea m finan cial sector (M FS) and
corresponding redu ced reliance on
the AFS.
The MFS w ill benefit from ETF99
over the next few years in terms o f
improved efficiency of payments
delivery and redu ced costs of electronic fun ds transfers compared to
current check clea rin g processes.
Reductions in pa perwork wi ll also
redu ce the admi nistrati ve costs of the
banks thus contributing to great cost
efficiencies. Improve ments in the
secu re deli very of funds w ill cu t
down on fraud w hich will result in
cost savings fo r the ind ustry, as a
w hole. Banks currentl y lose $70 million annuall y from forged Treasury
checks (U.S. Treasury, 1996).
Jn return for th ese admi ni strative
cost savings, ba nks wi ll need to
provid e accounts for recipi ents of
fede ral benefit pa y men ts covered
under ETF99. In ·1989, the American
Bankers Association estimated tha t
more than 50 percent of co mm ercia l
banks already offered some sort of
basic banking or life line accounts
(low fee, low balance requirements,
limited service acco unts), prima ril y
fo r low-to-modera te income household s. Given that substa ntia l num-
n11d Eco 110111ic Oevelop111e11t
bers of lo w-to- mod era te income
house ho ld s
are
currently
unbankcd, it appears that there has
been ve ry li tt le marketi ng of these
accounts and m a ny households
rema in unin for m ed about them .
In o rd er to fo rmul ate a more comprehe nsive p icture regardin g the
key a ttributes o f the unba n ked, the
objective of this paper is to explore
th e demog raphi c characteristi cs of
unba nkcd hou sehold s a nd som e of
the main reasons they cite as to
w hy they do no t have checking
accou nts. This w ill provide a
fr amewo rk for future resea rch and
studies related to th e banking of
unbanked house ho lds over time
and the correspondin g ease or diffi cu lty w ith w hi ch thi s tra nsiti on
will be accomplis hed.
Results
Of those household s without bank
accounts, about half (49o/c ) also did
not use banks on a regu lar basis.
Hig her p roportions of minoriti es
(Hispa nics, Africa n Americans, and
others) were among those w ho did
not use banks. Unbanked females
were more li kely to not use banks
than unbankcd males. Unban ked
household s w ho do not use banks
were slig htl y you nger, had slightl y
less educa ti on, and had lower
incomes than their counterparts w ho
use banks. Un marri ed, unbanked
household s were more likely to not
use banks than their married counterpa rts. Unbankcd, non-employed
household s were more likely to not
Co11ti1111cd 011 next page
3
Unbanked
Co 11ti1111ed fro111 previous ///ISC
use banks th;in employed or retired
households.
1997 Profile of Bc1nk Account Ownersh ip
To better und erstand these "hard
core" unb;i nked household s (households with neither a checkin g nor
savings ;iccounts and who do not use
banks o n il regular b;isis), we
explored the reasons they g;ive for
not having a checking account. TI1e
three ma in rmsons cited for not having a checking account were: 1) don' t
write enoug h checks (21 % ), 2) don' t
like dea ling with banks (21 %), ;i nd 3)
don' t have enough money (32%.). It is
interesting to note that a larger proportion of persons who do use banks
(versus those who do not use banks)
say that the reason they don' t have
an account is that they don' t like
dealing w ith ba nks.
Relative to the overall proportions
of households citing a given reason,
Hi spa nic household s we re more
likely to cite economic rmsons while
Africa n America n households cited a
combina tion of not h;i ving enough
money ;ind not writing enou gh
checks. Whites and others were more
likely to cite "don' t h;ivc enoug h
money" and "don' t like d m ling with
banks." Wo men were more likely to
give economic reasons (not enough
money) for not having an ;iccount
while men were more likely to say
they don' t like dealing w ith banks.
Married household s were more likely to say they don' t like d m ling with
banks wh ile unmarried households
were more likely to say they d on' t
have enough money. Old er persons,
persons w ith lower cdu c;i tions, a nd
persons with lower incomes were
more likely to say they d on' t have
enoug h money or they don' t write
enough checks.
Discussion
The profile of households without
bank accounts that emerges from
these da t;i is that they a rc minori ty,
female, young, low income, less educated , unm;i rried , no n-empl oyed
with a slig htl y higher prob;ibility of
living in the South or South-Central
regions. r:urthcrmorc, households
without accounts w ho a lso do not
use ba nks ;i re even more likel y to be
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Federal Reserve Bank of St. Louis
No Accounts 12.6%
Have Acco unts 87.4%
I louseholds Who 11c1vc No Bc1nk Accounts
White (7 .4%)
Hispanic (29.7%)
■ Have Bank Accounts
■
Black (36 .9%)
Do Not Have Bank Account s
Most Crn rnnon Rec1srn1s Cited by Households
Without B<mk Accounts
D
Not Enough Money
■
Don't Like Banks
□
Don't Use Many
Checks
D Too Expensive
No Desire
■ No Office Nearby
Source: Survey of Consumer Finances , 1995
Fedeml Reserve Bank of Atln11tn
4
Unbanked
Co11ti1111cd fro/I/ /111;,;C 3
minori ty, female, young, low income,
less educated, unmarried , no nemploycd , and living in the South .
strea m finan ciil l institutions.
The majority of respondents in the
1995 Survey of Consumer Finances
who do not have accounts and do not
use banks cited "don't have enoug h
money" or "don' t write enou g h
checks" as the main reasons for not
ha ving a checking acco unt as
opposed to "don't like dea ling with
banks." Thus, it may not be difficult
to draw these individu il ls into the
mainstrmm bi1nking system with the
es tilbli shment of bilsic bilnking
il ccounts. Given thilt these households currentl y are unbilnkcd despite
the fa ct that many bilnks a lready
offer such accounts, ed uca tional
efforts ilre needed to in form
unbilnked recipients of fedcrnl bcnc~
fit pilymcnts abou t the need to open
up bilnk ilccounts and the i1Vi1 ili1bility
of these lower cost types of bank
accounts.
The advent of ETF99 has impliciltions for fin anciill cduciltors, counselors, and resm rchers. Finiln cial
planning educiltors wi ll hilvc their
work cut out for them ilS fcdcrill benefits recipients begin to set up their
EFT99 accounts. As with a ny new
prod uct, consumers ma y need some
help and guida nce in learni ng obout
accou nt features il nd which ilccount
best su its their needs. 1lclping
household s sort throu gh the features
,rnd fee structures of these accounts
will be key ed ucational objectives for
finm1cial educators in the next ymr.
Fu rthermore, these new ilccmmt
holders will need to be edu cil tcd on
how to manage their new ilccounts.
Opportunities for publi c/ pri va te
pilrtncrships between community
orga ni ziltions a nd finiln cial institutions (e.g. trained volunteers to help
new ilccount holders bi1 lancc their
accounts a t the end of the month ) ilrc
i1ppi1rent. This educationill effort will
require coopera tion and the joint
shilring of information on the pilrt of
federa l agencies, state gove rnments,
consumer odvocacy groups, community bilscd orgilnizations, and milin-
Conclusion
Equa ll y important will be information on using and manag ing these
accoun ts. Some ilccounts ma y only
be accessible throu gh ATM ilnd / or
point o f sa le terminals. Consumers
will need to ICil rn not only how to
use the technology, but il lso how to
lTack their withdrawals il nd about
their rights - and liabilities - under
the Electronic Funds Transfer Act.
Counselors need to be prcpilred to
help new account holders milnage
these accounts. Sessions on how to
ba lance your acco unt (w hether with
or without a checkbook ), how to
tro ck your spending, or w hil t to do
when you ' re overdrawn arc li kel y to
be needed. Some agencies il nd organi za tions ma y want to wo rk with
fin ancia l institutions in their communities to train volunteers w ho Cil n be
ovailable to ETF99 pa rticipants to
help them during their first fe,-v
months of lcilrning ho1-v to use their
accounts.
Given w hilt we know obout the
audience (low-income, low ed ucation
levels, young, fcmillc, with a large
proportion for w hom English is a second langtrngc), outreach efforts and
ed ucation ma terials need to be specially targeted to these households.
This may mciln working in conjunction with commu nity groups, parent
organizations, churches, and established progrilms such as W IC and
Cooperative Extension's Ex pand ed
Food a nd N utrition Education
Program to reilch and teach these
clients.
Researchers will need to monitor the
prog ress of EFT99 and help policy
makers and finan cial institutions finetune the process ilnd the products
associated with the tra nsi tion. EFT99
will not affect il ll unbanked households, so there will be a continuing
need to update the profiles we've presented in this paper.
This descripti ve exploration of the
unbanked has shed some light on
these households. Those who will be
drawn into the banking system due to
EFT99 arc only a portion of a ll
unbanked househo ld s, however.
Additional anal ys is is need ed to id entify other unbankcd hou sehold s and
to understand a nd address the barriers to ban king for these fami lies.
Federal Reserve System
Conference on Business Access to Capital and Credit
Conference Date: March 8-9, 1999
1,,,
Conference Location : Sheraton National Hotel
(just minutes from downtown Washington, DC)
The Community A ffairs Officers of the Fe d era l Reserve System are join tly sponsoring a con ference on
topics about various aspects of businesses' access to capita l and credit.
The acade mic co nference is
intended to bring together interested parties from academia, financial insti tutions, non p rofit org a niza tions,
foundations, government, and various regulatory agencies to learn abou t recen t researc h and to
exchange views on directions for future research . Th e confere nce wi ll include both pa ne ls and individu a l
research papers, wi th presentations intended for a b road aud ience. Mark you r cale nd ars!
Pnrt11crs i11 Co11 11111111ity
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Federal Reserve Bank of St. Louis
n11rl Econo111ic Develop111ent
5
The Economics of Small
Business Finance:
Roles of Private Equity and Debt Markets
in the Financial Growth Cycle
by
All en N. Berger, Boil rd of Governo rs of the Federn l Reserve
System ,llld Whm ton Fi na ncia l Institutions Center, ,1 11d Gregory F.
Udell, Ke ll ey Sc hoo l of Business, Indi ana University.
Tl,is 11 rliclc is 11 11 cxcc,pl fro111111111pcr //,11/ ,l'ill 111111C11r in ii., c11t ircl_11 in
//,c Journal of B,1 nkin g ,llld Finance, Vo/11111c n , 1998, 1111gcs 613 -7.3.
1''111fogmph l1 11 Tra1 1111Ulc Coll1cr/ 1',"I' Ii
The ro le of the entrepreneuri a l
e nte rprise as an eng ine of eco nomic growt h has ga rn ered considerab le public attention in the 1990s .
Much of this focus stems from the
belief th<lt inn ovation - particul arly
in the high tech, informa ti o n, and
biotechno logy areas - is vit,1lly
dependent on a flourishing e ntrepreneuria l sector. The spectilcul ilr
success s tori es of Microsoft,
Ge nc n tec h, and Federal Ex press
embod y th e se nse that new venture crea ti o n is the key to future
productivity g,1i ns .
Other recent phenomena have
further foc used publi c concern a nd
awilreness o n s mall bus in ess,
including the cen tral role of ent rep rene urs hip to the emergence of
Eas tern Europe, fin ancia l cri ses
that have threatened cred it availa bility to small business in Asia a nd
elsewhere, and the growi ng use of
the entrepreneurial a ltern ati ve fo r
those who have been disp laced by
corpor,1tc restructuring in the U.S.
Accompa nying thi s heig htened
popu lar interest in th e genera l area
of sma ll bu si ness has been
increased interest by policy m ake rs, regulators, and acade mics in
the nat ure and behavio r of th e
financ in g grow ing compa nies need
,i nd rece ive at va ri ous sta ges of
their grow th, th e nature o f the private equity and d ebt contrilcts
associated with this financing, and
the connections and substi tutability among these a ltern ative so urces
of finance.
The private markets that finance
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sma ll businesses are different from
the public markets that fund large
businesses. The priv,1te equity and
debt markets offer highl y structured,
complex contracts to sma ll businesses
that a re often ilcutely informatio nally
opaq ue. (Informational opacity refers
to the li mited reports, dctili ls, statistics, a nd news av,1 ililble on sma ll
businesses.)
Data on Small Business Finance
Sma ll bu sinesses a rc ge nera ll y not
publi cly traded and , th erefore, arc
no t required to release financia l
information on l0K forms , a nd
th ei r data are not collec ted on CSRP
tapes or oth er datil sets typ ica ll y
emp lo yed in co rpora te finance
resea rch. Some dat;i a rc collected
on le ndin g by reg ulated financ ia l
institutions like co mmercia l ba nks
a nd thrifts, but th ese d a ta tradition a ll y we re not broken down by the
size of th e burrower. The l,1 ck of
detai led micro dat;i is one of th e
reasons th at sm a ll b us iness fin;incc
has been o ne of th e most undcrrcsearched are;is in fin;i ncc. However,
seve ra l data sets have recently
beco me ava ilable, includin g th e
Natio n;i l Survey of Small Business
Fina nce, the Na ti o nal Federation of
Independent Bu siness sur vey, th e
Survey of Consumer Fina nces, th e
Su rvey of Terms of Bilnk Le nding,
th e bank Ca ll
Repo rt, a nd
Comm unity Rein vestment Act da ta
sets that all have useful information
on sma ll business finance.
The Financial Growth Cycle
as h,1ving il financ i,1 1grow th cycle in
w hich fi na nci;i l needs and options
ch;inge as the businesses grows,
ga ins experience, ;i nd becomes less
in formation;ill y op;ique. As outlined
in the cha rt on page 6, sm;i ller, more
op,1que firm s must rely on initia l
insider finan ce, tr;idc credit, ;ind / or
angel fi na nce. As firms grow, they
gain ;iccess to intermediated fin ance
on the eq uity and debt sid e and,
ewntu;i ll y, they m;i y ga in ;iccess to
public eq uity ;ind debt m;irkets.
Angel Finance
Ang el fin;in ce is private investm ent from hig h net wor th indi vid u a ls. It differs mmkcdly from most
other ca tegories of extern;i l finance
in th a t the ;i ngel m;irket is not
interm ediilted. lnstmd , it is ;in inform;il m;i rkct for direct fina nce where
indi vidu;ils invest directly in the
sm ;i ll comp,mics through a n equ ity
contract, typic;i ll y commo n stock.
Because an ge ls by defini ti on a nd
SEC regulation are hi g h net wor th
individu a ls, the in crement of funds
th;it an a ngel w ishes to invest in ;i
sm a ll firm is often consistent w ith
the ;imount that th e fir m needs typ ic;i ll y in il r;inge of ;ibout $50,000
to $1,000,000, below th;i t of a typica I
venture capital in ves tment.
Angels do not ;i lw;iys ;ict a lone,
however. They sometimes work ;is
a sma ll investment gro up w here
they coordinate their investment
activity. Someti mes this is done in
conjunction with a "gatekeeper" such
Small businesses m;iy be thou ght of
Fedem / Reserve 81111k of At/1111tn
6
Sma ll Busin ess Fina nce
Co11ti1111cd fro111 pase 5
.is il l.iwycr or .iccount.int w ho brings
dml flow to the g roup .ind helps
structure contracts. The angel m.irkct tend s to be loc.i l, where investor
proxim ity ma y be import.int in
.iddressing information problems.
Angels someti mes .ict .is ,ictive
in ves to rs, tc1king on the consulting
role
of
venture
c.ipit.ilists.
Frequentl y, however, c1ngel de.ils
invo lve il close g roup of co inves tors led by il s u ccess ful entrepreneur who is fomili c1 r with the
vcnture's tec hn o lo gy, produ c ts,
c1nd mMkets. The advice ,1 nd
cou nsel they provid e to e ntrep rene urs c;in be quill' importc1nt.
A nge ls often invest in multipl e
round s ,it different stc1gcs ,i s the
co mp;inics they M l' inves tin g in
mo ve throu g h the c,1rl y st.iges of
financi;il growt h. In co mp.iri son to
ve nture rnpitc1\ists, they demand
less co nt rol .ind, on ,wcrngc, bring
less finan ci,11 ex perti se to th e t1ble.
Some attempts h.ive been m ,1d e to
forma li ze th e 111.irkct, perh,1ps to
redu ce th e sea rch ,rnd inform,1ti o n
costs th,1t <1rc perceived to be s ignifican t impediments to the efficiency
of the .ingel market. One thrust has
been to create pri v,1te angel networks in wh ich entrepreneur~ ca n
solicit equity inves tm ents by ,1ngcls
who .ire members of the network .
Typic,1lly, th e net wo rk is opcr,1tcd
by a no n profit, such .is il un ivers ity, somet imes referred to .is the
"switch ". The entrL'preneurs soli cit
priv.itc equity by di s playing s ummary in formc1tion .ibout the ir firm
.ind the ir finc1nc ic1l needs in the
form of term s heets on the network. A ngels who h.ivc been qu;ilifi ed by the sw itc h c.in then se.i rch
th e term sheets c1nd identify compc1nies of inte res t. The .ingel is then
put in tou ch wit h th e entrep reneur
to di sc uss the inves tment opportunity. Recentl y, the Smc1ll Bus iness
Adm ini striltion h.is linked .i number o f .ingc l c.ip it;il networks
toge the r to for m il system c.illed
ACE- net. Thi s sys te m pe rmi ts
.ingels to search te rm sheets from
e ntrep reneu rs c1c ross the U.S.
The v.i lue of .i ngcl ne tw or ks in
gcnern l, c1nd ACE-Net in pa rticular
is an unresolved issue. The networks a rc ty pica ll y subsidized ;ind
.ire predica ted on the assumption
that the re is some deg ree of m c1rket
foi lure in the c1ngel m Mket.
Howeve r, the inform.ii nature of the
.ingel mMket may be the optim.i l
solution to the ac ute info rm c1tion
proble m s .issoc i.i tcd w ith eMly
st;ige new venture fin.inc ing. The
role plil ycd by g.itekeepers, for
ins tance, m.i y be qu ite import.int in
reducing info rm.it ion-driven co ntr.i cting costs. For example, ,lll
.iccount.int ma y have both a n entrepreneu r .ind .in a ngel ilS clie n ts. In
co nnectin g th e two, the c1ccount.int
has re put,1tion.il ca pit,1 1.it stake ,ind
thu s provides some of th e services
.issoci.ited with cl;issic intermedi.ition. Whether a more formal m.irkc t
for angel finc1nce c.i n pro vi de ,in
economicZJ lly significc1nt substitute
or c1ddition to the current inform.ii
.ingel mMket remZJ ins to be seen.
Venture Cap ita l
Unlike the ange l m,1rket, the \'Cnturc ca p itill market is intermedi ated.
Venture c.1pitalists perform the
quintesscntic1! fun ctions of fin ,1ncia l
intcrmed i,1ri es, takin g fund s from
one group of investors and redeploying those funds by investing in
informiltion,1lly opaque issuers. In
,iddi tion to screenin g, co ntrc1cting,
,rnd monitoring, venture cap it,1li sts
,1lso determine the tim e .ind form of
in vestment exi t. They are ,1Ctive
in ves tors, often p,irticipating in
s tr.itegic planni ng ZJnd occc1sion.illy
in operiltional decis ion makin g.
Abo u t 8ll'/r of a ll venture cilpitill
in the U.S. flows th rough ind epend e nt limited p.irtncrs hips, with
mos t of the remaining 20 '/r provid ed by subsidic1r ies of finZJn cia l
in s titut io ns. In the partnerships,
the ge ner,11 partners usually cons is t of sen ior manc1 gc rs of venture
ci1pitc1 l m ;i nage m c nt firms c1 nd the
li mited pilrtners ZJre institu tional
investors.
Th e b iggest ca tegories o f ins titutio nc1 l in vestors arc publ ic pension
fu nds (26 '/r ), cor p or.ite pe ns io n
fu nds (22'/r ), co m me rcia l ba n ks c1nd
li fe insurZJ ncc com pc1 nies (1 8',:; ), ilnd
e ndow m e n ts a n d fo un da ti ons
(12'/r ). Th e li m ited pil rtners ty p icc1 l-
Pnrt11crs i11 Co111 1111111ity n11d Eco110111ic Ocvclop111c11 t
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Federal Reserve Bank of St. Louis
ly put u p 98'/r or more of the funds
;ind receive 80'/c of the par tn e rsh ip 's
profits. T he ge neral p.irtners receive
20'/r of the partnersh ip's profi ts plus
a fee for mZ1nc1 g ing th e fund.
The ty picZJI ve nture capitc1l fund
hZJs a 10 yeZJ r life spc1n. Contra ct fea tures that ch.irac ter izc ve ntu re cc1 pit.il investing include the stc1ging of
investments, the co ntrol .ind c hoi ce
of equity / d eb t ins trum e n t, entreprene ur co mpensc1tion, restricti ve
cove nc1nts, board represe ntati o n,
c1nd the il lloc.ition of \'oting ri g hts .
Venture capital ists often tend to
Firm Continuum
Fi rm Size - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Firm Age - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Information Availability - - -- - - -- - - -- - - - --- --
1 Very small firm s, possibly
Small firms, possibly will
growth potential but ofte1
limited track record
with no collateral and no
track record
14
Initial Insider Finance
H
~I
l ► I ..
Angel Finance
I
Venture Capita
I..
Trade Cr
Short Term Financial Institution
I..
Intermediate Tern
Mezzanine Fund
Financing
specia lize in particulilr indu s tri es
wlwre they d evelop expertise.
T he Hole of Pr in 1tc D e bt
Marke ts in Sm a ll Bu siness
Finance
As d isc u ssed a bove, the c.ipita l
s truct u re decis io n between equity
.i nd deb t is different for s m c1 ll firms
thc1 n fo r lil rgc firms in p.ir t bccc1 u sc
s m a ll bu s inesses c1 rc usu a ll y m ore
in fo rm c1 ti on Z1 ll y o paq ue th il n large
fir ms. In ad dit ion, s ince sma ll busi-
7
nesses a re usuall y owner-m a na g ed ,
the owner / managers often ha ve
s tron g incenti ves to iss ue external
d ebt rath e r th a n ex ternal equity in
order to keep o w ners hip ilnd con trol of their firm s.
Fin il ncia l in s titution s account for
26.66 '/c of the total fundin g of s milll
bu s inesses, or s lightly more th,1n
hill f of th e lotill debt fundin g of
50 .37 '/c , w ith comm e rci,il b ,rnk s
providing the lion 's shilre at 18.75'!, .
N on fi nil nCiil I bu siness / governme nt
debt pro v ides 19. 26 '/c of s m a ll bu s iness fundin g (mostl y tra d e credit),
1-sized firms. Some
cord. Collateral availnecessary.
ing, which pro v id es onl y slightl y
more credit to sma ll business.
Although relilti vely expensive, il
smilll amount of trild e credit ma y be
optim,1! from the viewpoint of
transactions cos ts, liquidity, and
ca sh milna gement and ma y he lp
g ive the borrowing firm ami suppli er information that he lps predict
ca sh flow s.
It is not necessaril y cle,1 r, howe ver, whether w ork in g cap ital
finan ce is bes t provided by suppli e rs vers u s b y il finan c iill in s titution
through a line of credit. In some
ca ses, suppliers have ,1dvanta g es
o ver finan cial institutions becau sL'
th ey ma y have better pri v,1te informiltion about the small bu s iness'
industry ilnd production process,
o r ma y be able to use le ve ra ge in
te rm s of w ithholding future sup plies to sol ve ince ntiVL' problem s
more effec tivel y. Suppliers m,1 y
ill so be be tter pos itioned to repossess and resell th e s upplied good s.
Tr,1de credit m ay al so pro v ide a
cu s hion durin g credit c runches,
monetary poli cy contra ctions, or
othn shocks that leaVL' financ i,1!
in s titutions less w illin g or less abl e
to pro v id e s m a ll b us im•ss finance .
Durin g these tim es, large b us inesses ma y te mporaril y rai se fund s in
publi c m a rkl'ts, su ch ,i s commercia l p;ipe r, ,i nd lend these ,1dditiona l fund s to s m a ll bu s inesses
throu g h trade credit.
Jtion Loans
,1nd d ebt owed to indi v iduals
accounts for onl y 5.78 '/, of s m il ll
bu s iness fundin g .
Tracie Credit
A s iza ble 15.78'/c of total s milll bu siness il ssets are funded by trilde
credit, as meas ured b y a ccounts
p,1 y,1ble at the end of the prior ymr.
Clearl y, trade credit is extremely
important to sma ll business fi nan ce,
but has rece ived mu ch less research
interest thiln commercial bilnk lend
S 11111111cr 1998
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Federal Reserve Bank of St. Louis
Trade credit th a t ex te nd s beyond
il few Lfa ys of liquidity, ho w ever, is
often quite e xpen sive . !\ ty pi cal
trade credit ,11-ran ge nll'nt makes
pil y nll'nt due in full in 30 Lfa ys, but
g ives il 2 % d iscount if paymen t is
made w ithin the first 10 d .iys . The
implicit interL'St rate of 2'I for 20
cfa ys (although it is not alwa ys
s tri c tl y e nforced) is mu ch higher
thiln rates on mos t lo,1n s from
financiill in s titutions, .ind so
wou ld likel y onl y be taken in cases
in w hich credit limits at finan cial
ins titutions arc exha u s ted. Sin ce
on ly about half of s rna ll bu s inesses
lrnve loans from fina nci,11 ins tit u tions, it ma y be that very e xpen s ive
trade credit ma y often be the bes t
or on ly ava il ab le source of external
fund in g for w or king Cil p ital.
In the U.S., as il sma ll business ages
and its relations hips with finiln cial
institutions mature - and it presumc1bl y becomes more inforrnationall y
trc1ns parent - it tend s to p,1 y off its
a ccounts p ay able sooner il nd
become less dependent on trade
credit. Recent ev idence from Ru ssi,1
s u gges ts
thilt
in
d evelopin g
economies, trade credit pruvid es ,1
sign.ii that leads to more bank cred it. This sugges ts th a t in economi c
en vironme nts w ith we,1k inforrn,1tional infrc1 stru cture and less developed banking sys tems, tr,1de credit
lllil)' plil y an even more importil nl
role becau se of its s tren g th in
addressing information problems.
Other Funding Sources
Small business debt held by individu.ils ilccounts for ius t 5.7 1'4 of
sm il ll business finan ce. Mos t o f thi s
(4.10'/, ) represents debt fundin g from
the principal o w ner in addition to his
or her equity interest in till' firm . In
some c,1ses, th ese pcrso n,1I ll l,1 ns m ,1y
be ju st il con ve nient way of provid ing s hort term finan ce to th e firm ,
w hile in other c,1scs, these lo.i ns ma y
create ta x benefits by substitutin g
interes t for dividend s.
The amount of fundin g ra ised
throu g h credit ca rd finan cin g whi c h ha s rece ived mu c h press
atte ntion a s a potc nti,1! a lte rn a ti ve
to con vention ,1I ba nk lo,1n s appe,1rs to be quite s m il ll , ju s t 0. 14'/c
of totc1 ! s m a ll bu s in ess fin a nce.
Ho wever, this fi g ure ma y be und e rstated becau se it includes onl y thL'
amount of debt Cilrried ,1fte r the
rnonthl y pa y ment is m ade, neg lec ting s hort-term flo a t bl't\\'L'l'n th e
purcha se d a te ,ind the munthl y
payme n t. Finall y, 1.47'/, of s milll
bu s iness fundin g is prm·id ed by
loans from oth e r indi v idu,1 b , mos t
of w hi ch is likel y from f,1mil y and
fri e nd s or other ins id e rs .
Financia l Institution Deht
Onl y a little over h,1lf of sma ll
bu s inesses, 54. 2:l'i, , ha ve ,1n y loans
or lea se s from finiln c i,1I in s tituti ons. Sma ll firms tend to ,1lso s pecia lize their borrowing at ,1 sing le
finan cial institut ion - on ly about
one third of the borrowing firm s
have loa ns from two or m ore ins ti tutions. In 86.95 '/, of the cases, s mall
businesses identify commercial
C1111/11111t"d 1t11 11n1
1111:,:.1·
Fcrfcml Rcseruc 81111k of !1t /1111t11
8
Sma ll Business F inan ce
Cu1 1ti1111ed fro11 1 prcuio11~ pngc
banks as their "primary" financial
institution, since banks dominate
other institutions in providing
transactions / deposit services, and
also provide most of the loans to the
small businesses that receive fin a ncial insti tution credit.
Small businesses tend to stay with
their financial in s tituti o ns. On
average, sma ll firms have been
with their current fin.incial institutions for 6.64 yea rs, .ind 9.01 years
for their primary ins titution.
Most of the funds, 52.03'!, , .ire
drawn und er lines of credit. Such
loa n commitme nts Me promises by
the financial institution to provide
future credit, and may be used to
reduce tra nsaction costs, provid e
insu rance against credit rat ioning,
.ind ot her p urposes desc ribed
be low. Mortgage loa ns, the next
largest ca tego ry ilt 13.897' , may be
secured by e ither commercia l
property or personal property of
the ow ner. For most eq uipment
loans, motor vehicle loa ns, and capit.i l leases, the proceeds of the lo.in or
lmse are used to purchase the assets
pledged .is collatcr.i l. Secured debt
represents 9·1.94o/c of all small bu siness debt to financial institutions.
This very high percentage implies
the vast majority of virtually all
types of financia l institution lo.ins
and leases to sma ll busi nesses including lo;i ns d r,1 w n unde r lines
of credit - .ire backed by collater.il.
In addition, 51.63'/, of financia l
institution debt is gu.ira nteed , usu;illy by the owners of the firm . The
data suggest that financial institutions use a number of contra cting
method s like collatera l a nd guarantees, lines of credit, and re lationships ex tensively to dml w ith the
information and incentive problems
of sma ll businesses.
Colla tera l anct Guarantees
Colla tera l and g uara ntees arc
powerful too ls that allow fim1n cial
institution s to o ffer credit on favorable term s to s ma ll bus in esses
whose
in for m a tion.ii
opacity
might o the rw ise result in either
cred it rationing o r the exte nsion of
credit on ly on re latively unfa vo r-
able term s. These contrac t fea tures
add ress ad ve rse se lection problems at loan orig ination a nd moral
hazard problems that arise after
cred it ha s been gra nted. Collatera l
and g uara ntees may also reduce
the cost of intermediation because
a financia l in stitution ma y be able
to assess th e va lue of pled ged or
guara nteed asse ts .i t il lower cost
than it can assess the value of the
business as a goin g concern .
Guarantees give the lende r general recourse aga ins t the asse ts of
princ ipa l ow ner o r ot her p.irty
issuing the g uara ntee fo r defi cie ncies by the fi rm in repay ing the
loa n. A guara ntee is simil a r to a
pled ge of outside personal colla tera l, but differs in two importan t
ways. First, a guarantee is a broader cla im tha n a pl edge of collateral,
since the li abili ty of the g uarantor
is no t limited to an y s pecific assets.
Second , a g uarantee is a weaker
clain1 th ,rn a pledge of colla tera l
aga ins t any give n set of assets,
since a g uara ntee docs not involve
specific li ens that prevent these
assets from being sold or consumed.
Both g uara ntees and outside personal coll ateral may provide powerful incenti ves fo r the entrepreneur to
behave in a way that benefits the
beneficia ry cred itor (often to the
detriment of other cred itors) when
the business is in distress. Th is
incenti ve depends mo re on the
import;ince to the entrepreneur of
losing the assets than on the va lue of
the assets to the lend er in the even t
of defau lt. Therefore, a guarantee or
pled ge of persona l collateral from an
entrepreneur with only a modest
;i mount of persona l wealth ma y still
provide a strong incenti ve that benefits th e lend er, even if recourse
agai nst these persona l assets represents onl y a small fra cti on of the
va lue of the loan. r crsonal outside
collate ra l and gua ra ntees, w hile
common ly used by sma ll businesses, are rare for large firms . An owner
of a large corpora tion rarely has
enough wea lth to back the debt of
the firm or owns a large enoug h
share of the firm to wa nt to back the
debt personally.
Many sma ll businesses p ledge
accou nts receivable a nd / or invento-
Pnrt11ers i11 Co1111111111ity n11d £co110111ic Oevelop111e11t
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Federal Reserve Bank of St. Louis
ry .is insid e collateral to secu re lines
of cred it in which the amou nt of credit granted flu ctuates with the va lue of
qualifying receivables / inventorv.
This ma y be especially useful to tl{e
lender w hen the borrower is an informationally opaque firm because the
lending institution's risk exposure is
not as closel y tied to the uncertai n
future cash flows of the firm as in
other types of lending. The monitoring of receivables and in ventory ma y
a lso produce va luable information
about future firm performance as
well as in form;itio n about the v;ilue
of the collatera l and, therefo re, be
used as part of an overall rela tionship
that ma y lead to more favorab le credit terms in the future.
Outsid e personal collatera l and
guaran tees arc a lso im portant to the
financing of sma ll firms that have
few p ledgeablc bu s iness assets.
Abou t 40'!, of small bus iness loa ns
and close to 60'7c of loan do ll ars arc
g uara nteed and / or secured by personal assets. rcrsonal guara ntees and
pledges of personal assets may be
seen as substitutes for an injection of
additio na l equity by the owners.
Under most circumsta nces, finan cial
institutions would offer better terms
if the sa me amount of equity were
added to the firm , w hich wou ld save
the costs of pursuing recou rse against
personal assets in the event of financia l losses. However, these extra costs
may be offset by some benefits for the
owner of personal coll il teral a nd
g u;i r;intees, such as better convenience, lower tra nsactions costs, or
better diversifica tion, rather than liquid ati ng personal assets and investing the proceeds in the business.
Loan Commitments/Lines of
Credit
Most small busi ness debt held by
finan cia l ins titutio ns is under lin es
of credit, which is a form of lo;i n
co mmitme nt. The finan cia l institution is obliged to provid e the credi t
unless th e borrower 's condition has
suffe red "material adverse change,"
or if the borrower has violated a
covena nt in the contract. Lines of
credit are genera ll y pure revolvi ng
fa cilities that a llow the firm to borrow
as much of the line as needed at ;i ny
g iven time during the specified term.
9
Small Business
Co11ti1111ed fro111 previous page
Flexible and conven ient for the borrower, lines of credit arc usuall y
used to provid e working capital,
rather than to fund specific large
in ves tments.
Loan commitments provid e protection for the borrower against
ha ving the ir credit withdrawn in
in s t.:in ces of credit rationing or
credit crun ches that arc based on
ge nera l market condition s, rather
than specifi c, id entifiab le, lega ll y
defe ns ibl e dete rioration s in the
indi v idual borrowe r 's condition .
ally stri cter than those in private
pla cements a nd much stricter than
those in publi c bonds. In part, thi s
reflects the compara tive .:id va nta ges
of fi nancial institutions in renegoti ating and selectively rel.:i xing these
covenants. The covenants in bank
loa ns and priva te pla cements arc
usually set suffi ciently tightly tha t
renegotiation is likely. One stud y
found that 57',i; of private plil ccmc nts required rcnegotiilti on one or
more times over the maturity of the
con tril ct. Wh il e no hard d a ta is
avil ilable on the frequen cy of rcncgo ti.:ition for bilnk loans, .:i necdotill
ev idence suggests thilt bilnk loilns
w ith covena nts a re rcn cgo tia ted
even more frequentl y.
Debt Covenants and Maturity
Restri cti ve covenants a nd choice
of maturity dates a rc othe r tools
finan cia l in stitutions use to solve
the informational op.:icity problems of small busin esses. In part,
cove na nts arc d esigned to g ive the
finan cial in stitutio n more control
by req uirin g the borrower to
return to the in s titution to renegoti.:itc cove na nts when s trategic
opportunities a ri se or w hen the
fin.:incial co ndition of the firm
chan ges. The strictest covena nts
arc usua ll y pla ced on firms with
the g rea test credit ris k a nd g rea test
mora l ha za rd incentives.
A borrower ca n reques t a waiver
w he n a covena nt prevents the firm
from engaging in a new activity.
Ren egotiation around the waiver
allows th e lender cons id erable
co ntrol over whether the new
ac ti vity w ill be und erta ken a nd
und er w hc1t terms . This control c.111
be .:in effecti ve mo nitorin g and stabili z in g tool , although it ca n put
the financial in stitution in a position of negoti a ting for hi g her ra tes
o r other concessions. The market
limits the control by the finan cia l
institution, ho weve r, beca use most
commercial bank loan s c.:i n be prep.:iid wi thout penalty, so borrowers
ha ve the option o f obtaining more
accommodating finance elsewhere.
In .:iddition, a financ ial institution
ha s an in centive and ab ility as a
re peat player to mainta in a reputation for fairness in renego tiation .
Covena nts arc common in commercial bank loa ns and a re ge ner
S11111111er 1998
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Federal Reserve Bank of St. Louis
While the use of covcnil nts on
smilll bu siness loilns is il ve ry und er
-rescilrched field , the evidence of
the use of covenants in b.:ink le nd ing to larger firm s confirms the positi ve rol e of cove nants in bil nk loiln
ag reem ents in makin g ex ternal
funding avai lab le at reasonably lo w
cost. Bank loan s and commitments
to mid -sized and large firm s tha t
were sy ndicated most broadly tend
to carry the most covenants, suggesting that covenants play a positive role
in assuring other syndiciltc members
that sufficient controls on firm beh,ivior .:ire in place, or that members will
be informed of changes in borrower
condition when covenant waivers arc
negotiilted .
The choice of debt maturity is s imilarl y used by financi,il institution s
as il contract fcilture to ilddress control a nd informiltion probl ems. The
longe r the ag reement, the g rea ter
the opportunity for the burrower to
a lter its risk profile ilnd /o r suffer
financ ial distress; hence, maturity
ca n be viewed as a particu lar ly
s trong type of covena nt. With il
sequence of short-maturity credits, il
lender ca n force renegotiiltion frequently. By contrast, with covenants
renegotiation c,in only be triggered
by those covenants ou tlined in th e
loa n agreement. One rea so n that
smaller firm s typically hilve less
access to lo nger ma turity deb t is
that they tend to be more informilti o nil ll y opa qu e and ri sky th il n
large firm s. In ,iddition, because
sma ll firms do not h,ivc audited
sta tements, it is difficult to impose
ra tio-related finan cial covenants
that ty pica ll y acco mpan y intcrmcdiiltc ,ind long term bank debt.
Relationship Lending
A final tool used by finiln ciill institutions to address the information
problems of sm,i ll busi ness is relationship lending. lnform,ition is
ga thered throug h continuou s contact
with the firm and entrepreneur, often
throu g h the provision of multiple
finan cial services. The information
ga thered in conjun ction w ith il series
of loa ns ma y includ e a repayment
his tory, periodi c submissions of
finan ci,il statements, rencgotiiltions
and other visits with milnagement.
Deposit accounts provid e informiltion in the form of balance informiltion, transactions activity, pa yro ll
data, etc. lnform.ition abo ut the quality of the entrepreneur ca n illso be
culled from the provision of personill
loans, credit ca rd s, d eposit .:iccounts,
trust ,iccotmts, invcsh11cnt services,
etc., a nd from other business d ea lings or person,il contact outsid e the
firm. Know ledge of the Joe.i i communi ty ga ined over time may also
allow the bank to judge the market in
which the bus iness oper,itcs, to
obtain references and feedba ck on
borrower perfo rmance, and to eva luate the quality of the firm's receivables. This information is then used
to help make decisions over time
about contract terms and monitoring
striltegies. Relationship lending can
ha ve il number of benefi ts to small
business, including lower cost or
greater ilVa ilabi lity of credit due to
efficient gathering of information,
protection against credit crunches, or
the provision of implici t interest rate
or credit risk insurilnce.
Summary
While resea rch h.:is begu n on the
topic of small business finance, more
remains to be done. Our ilnalysis of
the financial growth cycle ilnd the
interconnectedness of sm.:ill firm
finan ce suggests that some of the
most exciting ilreas for future
research ma y in volve investi ga ting
how sources of small firm fin ance
ma y cha nge over the business cycle,
in re.:iction to changes in gove rnment
policy, during times of distress in priva te or public milrkcts, a nd as information processing technology continue to improve.
Federn l Reserve 81111k of Atlr111tn
10
Do Minority-Owned Banks
Treat Minorities Better?
An Empirical Tes t of the Cultural
Affinity Hypothesis
l'lwfugraplt IJy /\dria Wissi11::-- Age J6
Natio nal data on the disposition
of appli cations for home mortgages reveal w id e disparities in
rejection rates among racial and
ethnic groups. One theory offered
to exp lain these dispa rities is the
"Cu ltural affinity hypothesis," developed by Ca lomiris, Kahn, and
Longhofer (1994). This hypothesis
posits that lenders find it easier, and
therefore less costly, to eva lu ate
applican ts "like them " than applican ts with different backgrounds.
Rega rding mortgage rejection differentia ls, then, the cultural affinity
hypothesis suggests that lend ers at
white-owned banks reject minority
applica nts more often because they
have more difficulty precisely estimating the credit risks they represent.
Recently, Black, Collins, and Cyree
Cl 997) found that black-owned banks
arc more likely to reject black applica nts than white-owned banks with
similar characteristics. On its face,
these results appear inconsistent
with the cultural affinity hypothesis.
However, these findin gs do not necessa rily refute the notion of cultural
affin ity. Rather than occurring only
on the part of lend ers, cultural affinity might play out among applicants
as well.
Minority applica nts may feel more
comfortable applying for mortgages
at minority-owned banks, whi ch
cou ld result in a relatively large volume of marginally qualified minority app li cants at minority-owned
banks. In such a case, minorityowned banks could have hig her
Pnrtners in Corr1111 1111ity and
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Federal Reserve Bank of St. Louis
by
Rap hael W. Bostic, Econo mi st, and Glenn B. Canner, Senior
Advisor, Board of Governors of the Federa l Reserve System
rejection rates of minority applicants
than white-owned banks, even if
only minority lend ers exhibit cultural affinity or if lend ers of both races
appl ied the sa me w1derwriting standards.
This paper provid es empi rica l tests
which id entify and separate the
potentia l effects of applica nt-driven
and lender driven cultura l affinity.
Applicant-driven cultu ra l affi ni ty is
tested by searching for differences in
the applicant pools of minorityowned and white-owned peer
banks.
Our methodology for stud ying
lender-based cultural affinity is similar to that used in Black, Collins, and
Cyree (1997), but it differs from theirs
in important ways. First, we use a
sa mple selection methodology
whic h avoids the potential confounding of the two cultural affinity
effects which might arise if applicants across banks differ systemica lly
in their general characteristics. This
approach thus permits a more direct
test of the existence of lender-based
cultural affinity.
Second, we test for whether the theory applies differently across races
by conducting the analysis for both
blacks and Asians. Lender-based
cultural affinity among Hispanics
could not be eva lu ated due to a
s ma ll number of Hispani c-owned
banks.
We find strong evidence suggesting
that cultural affinity operates
through applicants as, after control-
Eco110111 ic Develop111ent
ling for non-ownershi p bank characteristics, black-owned and Asianowned banks arc significantly more
li kely to receive appli cants from
bla cks and Asians, respectively.
Interestingly, the data suggest no
affin ity between Hispanics and bank
owners at either black-owned or
Asian-owned banks.
The evidence also suggests that
affinities are individua l-based rather
than geography-based, as no relationship is observed between applica tion rates and the percentage of the
loca l population that is ITtinority. In
contrast to the result for applicantbased cultural affini ty, we find no
evidence that lend er-based cu ltural
affinity exists. After accounting for
differences in the applicants' pools,
whites, blacks, and Asians all largely
face the same likelihood of rejection
at black-owned, Asian-owned, or
white-owned peer banks.
Conclusion
The cultural affinity hypothesis has
been offered as one explanation for
observed racial disparities in mortgage lending. Accord ing to this theory, lenders are better able to assess
the riskiness of app lica nts with similar backgrounds, which results in
these applicants facing more favorable underwriting conditions relative to members of other ethnic
groups and backgrounds.
Add itionally, although the cultural
affinity hypothesis was introduced
in the context of lend er behavior, it
Co11li1111crl 011 lll'XI page
------------------------------··
Minority Banks
Co11ti1111ed fro111 prec>io11., page
mily il lso be more relcvilnt for ilppliCil nts. In pilrticulilr, ilpplicilnts mil y
be more likely to ilpply to bilnks
owned or operated by members of
their ethnic group, for comfort rmsons or because they believe their
chilnccs for ilcccptancc ilrc enhanced
ilt such institutions.
borhood-bascd" ilpplicilnt-drivcn
cultura l affinity. Application distributions at minority-owned and peer
banks do not Vilry significantly with
the minority composition of the
neighborhood. Regarding lenderdriven culturill ilffini ty, ho wever, the
evidence is not supporti ve of the
theory.
Like Bla ck, Co llins, ilnd Cy ree
(1997) we find no ev id ence thilt
In thi s pilpcr, these il rguments ilrC
cvilluilted by comparing the chilrilCtcristics of ilppliCil nt pools ilnd
ilppliciltion ilpprova l riltc piltterns
for minority-ow ned bilnks and
white-owned peer banks. The evidence is consistent with the v iew
thilt cultural ilffinity occurs among
mortgilge applicilnts, ilS minoriti es
ilrc sign ificil ntly more likely to file
app li Ciltions a t minority-owned
banks than at white-owned peer
bilnks. TI1is affinity appCilrS to be
quite specific among minorities, ils
on ly Asians arc more likely to apply
to Asian-owned banks ilnd only
blilcks are more likely to submit
ilpplica tions ilt black-owned banks.
No"ilcross- ril cc" ilffinity is observed.
Also, we find no evidence of "neig h-
bl ilck-owncd banks treilt b lilck
ilpp li ca nts better thiln their w hiteow ned peer b,mks do or th ilt
Asia n-owned bilnks trcilt As iiln
applicil nts better than their w hiteow ned peer bilnks do.
Unlike
those authors, however, we find
no ev idence thilt they sys tcmi cil ll y
trcil t minorities ilny worse e ither.
Co nsis tent le nder-driven culturill
affi nity d ocs not ilppea r to ex is t.
Overall, our results differ from
those of Hunter ilnd Willker (1996),
who find evidence consistent with
the existence of lcnder-bilscd cu lturil l affinity. However, their ilpproach
differs from ours in that they do not
attempt to control for d ifferences in
the applicant distributions or in
lender chilracteristics, both of w hich
we do using miltching procedures.
As we have shown, these differences
can hil vc an importilnt effect on
observed outcomes. In pilrticular,
they tend to ilttenuilte observed
behilvioral differences.
An important ex ante ilssum ption
und erlying our interpretiltion of the
results is thilt underwriting stilndards for institutions operilting in
the sil me market do not Vilry with
the rilce of the bilnk's owners. The
evidence offers general support for
this ilssumption. Within il g iven
market, ilpplicilnts with simililr
charilcteristics received the sa me
treatment on average, regil rdl ess of
the chilrilcteristics of a bilnk's ownership. This is consistent with the
notion thilt bank und erwriting sta nd il rds iln: based on objective meilsures of risk ilnd thilt more subjective factors which mig ht come into
plily, such as cultural affi nity, do not
signifiCil ntl y influence underwriting
deci sions. ♦
For copies of the research /!/IJ)('rs
idc11/ ified i11 this article, 11/c1N' m l/
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