1/4: Examining the Financial System to Build Community Wealth
Updated: Mar 9
A little over a year ago, Community Credit Lab launched with the goal of advancing economic equity for people that face systemic discrimination in our financial system. Since then we've taken the time to listen and learn from our partners, investors, and community to bring us closer to our goal of increasing equitable access to credit towards building communal intergenerational wealth. Learn more about some of our thoughts and research below.
Systemic Discrimination in the Financial System
According to Mehrsa Baradaran, author of The Color of Money, “the promise of free market capitalism is that it does not discriminate. Yet history reveals that, in fact, markets do discriminate -- the American economy has never born any resemblance to a free market.”
Markets implicitly discriminate by charging people with fewer resources more to access financial products and services. This inequity is known as the poverty premium. Under our existing financial system, the poverty premium equates to fees and interest rates increasing as income and wealth decreases.
When we look at wealth in the United States, disparities lie clearly along the lines of racial identity. Inequities in wealth reflect the multigenerational history of racially discriminatory behavior, practices, policies, and systems that denied and continue to deny wealth-building opportunities to Black people, Indigenous people, and People of Color. As a result, according to Visual Capitalist and the Federal Reserve’s 2016 data, the average family net worth was $171k for White families, $17.6k for Black families (10X less than White families), $20.7k for Hispanic families, and $64.8k for other non-White families. Since markets charge people with less wealth more to access capital, the poverty premium has an outsized effect on People of Color and, specifically, Black and Indigenous people in our country.
Both traditional and new approaches used to evaluate credit-worthiness need to be closely examined as they are deeply rooted in racist and gendered practices that created the inequities we see today. For example, the 5 C’s of credit evaluation is the most used evaluation method for commercial credit evaluation. Character equates to “knowing the borrower is honest and has integrity” – unless a pre-existing relationship exists, this is inherently subjective and naturally leads to bias based on discrimination. Even with new approaches to underwriting using data, it is easy to fall prey to criteria that seemingly track with the likelihood of repayment but inadvertently discriminate on the basis of race, gender, or other factors – a phenomenon called proxy discrimination.
Detrimental economic ramifications from the COVID-19 pandemic and increased awareness of systematic racism due to ongoing police brutality and the Black Lives Matter movement continue to shed light on the deep economic inequities that exist in our society. Americans are confronted with the reality that intersections of race, gender, immigration status, class, and sexual orientation determine which communities benefit from economic systems and which communities are harmed by them. There is finally a broader, collective acknowledgment of how racism plays a fundamental role in our systems and policies. With increased awareness, ongoing learning, and a growing desire to act in solidarity with people who perpetually face racism and discrimination, now is the time to commit to building toward an equitable financial system.
Beyond the Status Quo in the Financial System
Within the parameters of our existing financial system, there have been many solutions developed that aim to increase access to financial products and services for historically marginalized communities while providing investment returns to accredited investors.
We will continue to see many more access-oriented solutions as technology enables financial products and services to be offered at scale with lower operational costs than traditional brick-and-mortar financial institutions.
While access is important, it should be considered the minimum requirement with respect to equitable development; now is the time to think beyond access to capital and the existing investment return expectations of our current financial system.
Examining the Focus on Access
Firms and institutions that help low-income people get connected to banking products, access credit, or help people save through automated transactions often receive praise and attention for shifting capital at scale. While many of these solutions, as well as the teams and investors behind them, may have the best intentions in mind, it’s important to look under the hood and interrogate whether they ultimately build towards equity and systemic change. Now, more than ever, there is an urgency to dig deeper by asking questions about the true costs of financial products and services that seek to prioritize financially underserved communities. Access alone is no longer an acceptable end goal.
Clearly, the prospect of more products and services geared towards consumers who are traditionally excluded from financial markets is exciting. However, as investors and financial practitioners, we must recognize that there are also associated costs to these products and services. Due to the poverty premium, financially underserved consumers in the U.S. spent $189 billion in fees and interest on financial products in 2018, and this number is expected to increase in the coming years as “access” to financial products and services increases.
For perspective, $189 billion translates to extracting about $1,062 in fees and interest per financially coping or vulnerable adult in the U.S. These same adults are unable to cover a $400 cash emergency and have $0 or negative wealth to dip into. For financially underserved people, these fees and interest are the true costs of accessing financial products and services in our country. As we focus on increasing access, we cannot continue using traditional credit risk evaluations, fees, and pricing methods based on perceived financial risk and reward if we are designing to support financially vulnerable communities and build towards an equitable society.
Examining the Cost of Capital
Simply put, increases in investment return expectations typically equate to increases in the cost of capital for borrowers. While this fact may seem intuitive, it’s often ignored or misunderstood in evaluating investment allocation decisions, particularly among the impact investment community. If investors want to be allies and align investments with values to achieve the end goal of supporting borrowers to thrive, questioning current and future financial models and intermediaries is imperative to understanding if we are:
Perpetuating the same financial systems that have systematically excluded and extracted from communities with less power in our society; OR
Supporting models that aim to shift power and build towards an equitable financial system for all.
Unfortunately, the desire from investors to continue to maximize returns from models that seek to provide equitable access to financial products often drives solutions to override the underlying circumstances of borrowers. In the financial system’s current state, accredited investors are often earning 2 - 5% on their community investment portfolios each year, while underserved communities are being charged 6-20% each year to access capital.
With rising rents in many cities due to gentrification and exacerbating detrimental economic ramifications from COVID-19, charging people who face discrimination (wealth builders) higher fees and interest rates in order to pay accredited investors (wealth owners) 2% - 5% ultimately is not an equitable solution. What if wealth owners were willing to reduce their cost of capital to support their neighbors (i.e. wealth builders) on more equitable terms? Which solution above is more equitable?
Redefining Benchmarks in Community Investment
Redefining Benchmarks for Interest Rates to Borrowers and Investor Returns
At inception, Community Credit Lab benchmarked our return to investors using RSF Social Finance’s rate of 1% (now .5% due to COVID-19). RSF also offers a valid data point for benchmarking the cost of capital to borrowers. RSF Social Finance’s interest rate to borrowers was 5.25%; now 5% due to COVID-19. RSF Social Finance has shifted rates to a model that pays investors .5% and charges borrowers 5% -- as far as we're aware, this represents one of the lowest costs of capital available in commercial community investment currently.
If the goal is to build greater economic and financial equity by increasing access to affordable, equitable financial products and services for people, we need to redefine the benchmarks we use to evaluate community investments, both with respect to investor returns and with respect to interest rates and fees to people.
With this in mind, the Applicable Federal Rate (AFR) provides a proxy for the IRS regulated rate at which wealth can be transferred with intra-family lending above $10,000 in the United States. If this is the rate we benchmark against to transfer intergenerational wealth within families, why wouldn’t it be the rate that we benchmark against to build intergenerational wealth in our communities?
More specifically, the IRS regulates loans above $10,000 between family members by setting a floor (i.e. minimum interest rate) for short-term loans up to three years, mid-term loans between three and nine years, and long-term loans with terms up to nine years. As of June 2020, these rates were .18%, .43% and 1.01%, respectively. These loans are often used for down payments on mortgages or other wealth-building activities and have an ecosystem of advisors and service providers to accommodate them. This includes National Family Mortgage, which claims that mortgages using this approach to financing are “a win-win mortgage” for high net worth individuals.
If the Applicable Federal Rates are the interest rates used when transferring wealth to kin – shouldn't they also be proxy rates for building wealth and equity within our communities?
The core of the issue we see with the AFR rates is that it's acceptable for intergenerational wealth to be transferred within wealthy families at "below market" rates. However, due to the poverty premium, racism, discrimination, and traditional perceived risk/return analysis in our financial system, community lending that seeks to build intergenerational wealth within marginalized communities is often allocated at above-market rates. For example, credit cards and payday lending alternatives offer credit at 8% - 40%; not to mention payday lenders offer credit at up to 400% to financially underserved communities.
At Community Credit Lab, we believe that it's unacceptable that wealth is transferred in our financial system via credit at rates as low as .18% when using AFR rates, but wealth is "built" at interest rates that are exponentially higher than this. How can we ever have equity when this is the way we accumulate and share resources as a society?
While a common rebuke to reducing interest rate benchmarks is that community lenders will not able to cover costs if they lend at these rates, we must ask three questions:
1) Given recent technological advances, are all these overhead costs essential? Given a shift away from traditional brick-and-mortar lending and towards partnership-based models to distribute financial products and services that combine the infrastructure of banks with the technology of online lenders, there is an opportunity to rethink cost structures by leveraging technology on top of the regulatory compliance of deposit-based institutions.
2) How else can we cover essential costs? With philanthropic assets at all-time highs and corporate returns leading to inequality, how can corporations and philanthropy play an increased role to support equity in the financial system and communities that are rapidly being displaced? How can financial product and service providers think outside the box to generate revenue in new and different ways?
3) What are the appropriate benchmarks for investors? With awareness of wealth inequality growing and an increasing desire from foundations, family offices, and impact investors to focus on impact- first capital preservation (or even capital reduction in the case of many Foundations working to spend down their assets), is it possible to set investment return benchmarks at 0% or even negative interest rates? In a mid and post COVID-19 economic context, would a benchmark of 0% for community impact investors be unreasonable?
If investors were willing to reduce their cost of capital, could the Applicable Federal Rates then be used as benchmarks for community lending?
While this idea may sound restrictive to investors and financial intermediaries in the short term, long-term innovation often stems from increasing options, constraints, and reprioritizing goals. When there’s a collective will, there are many ways to accomplish our goals, and the above proposal is one option for consideration, not the only silver bullet.
The easiest first step is for investors to reduce benchmarks to the Applicable Federal Rates and lend to intermediaries (or invest) with a maximum return expectation that is aligned with these rates. Even reducing current investor return expectations to the AFR, would immediately allow community lenders to reduce their cost of capital to borrowers by between 2 – 4%. While these numbers may sound small in percentage terms, they are not small in aggregate terms to borrowers.
Transforming the financial system to prioritize individual community needs is possible through collective mobilization. The question lies more in, what’s the best approach towards making the financial system work for everyone?
Look out for our next blog next week where we continue to dive deeper into our research in hopes of answering that question.
This article is Part 1 of a 4 part series outlining our research, thoughts, and vision for Community Credit Lab to keep working with communities to make lending more equitable.
Thank you to everyone who contributed to this work, especially Boting Zhang and Meher Antia for their detailed reviews and feedback.
Note: Throughout this post, we reference underserved or low-income communities to encompass the diversity of identities of people that face discrimination within the financial system. We acknowledge these terms are imperfect and do not always convey who specifically is impacted. In using these terms, we hope to be inclusive, but also recognize that People of Color, Indigenous, and Black People, specifically, are disproportionately excluded from or extracted by our current financial systems.
 https://www.youtube.com/watch?v=aj6s2OL6Mp4  https://www.visualcapitalist.com/racial-wealth-gap/  https://www.brookings.edu/research/credit-denial-in-the-age-of-ai/  The Financial Health Network estimates that 178 million adults are financially coping or vulnerable as of 2018.  https://www.cnbc.com/2019/07/20/heres-why-so-many-americans-cant-handle-a-400-unexpected-expense.html  https://rsfsocialfinance.org/2020/04/02/rsf-rate-changes-interest-beyond-the-price/  https://www.npr.org/2020/07/07/888499021/cfpb-strips-some-consumer-protections-for-payday-loans?utm_medium=social&utm_source=twitter.com&utm_term=nprnews&utm_campaign=npr