The Community Development Financial Institutions (CDFI) Fund was created by the Riegle Community Development Regulatory Improvement Act of 1994 (P.L. 103-325) to promote economic development in distressed urban and rural communities. The CDFI Fund can certify banks, credit unions, nonprofit loan funds, microloan funds, and (for-profit and nonprofit) venture capital funds that can demonstrate having a primary mission of promoting community development. After certification, CDFIs become eligible for financial awards and other assistance provided by the CDFI Fund that promotes community development in markets comprised of economically distressed people and places.
CDFIs are essentially a type of public-private partnership established to advance financial inclusion, the policy goal designed to increase the accessibility of traditionally underserved populations and markets to affordable financial services and products. CDFIs accomplish this goal by serving people and businesses that traditional financial institutions cannot make their predominant focus. Higher-risk clients are more likely to have weak credit histories or face above-normal levels of income volatility, making them generally more costly to serve. Consequently, traditional institutions, which must manage their liquidity and other financial risks to support public confidence in the overall financial system, often focus primarily on markets consisting of higher credit quality borrowers rather than on higher-risk borrowers.
CDFIs are tasked with acquiring circumstantial and more granular information about customers with less traditional financial characteristics. CDFIs subsequently use this information to match their customers with suitable financial products. Because their portfolios consist of localized and highly customized loans made to higher-risk borrowers, CDFIs have limited access to the conventional markets where traditional financial institutions acquire the funds to originate loans. Instead, CDFIs rely on a combination of public and private funding that includes grants, awards, and donations. These subsidies are used to offset the heightened costs of loss mitigation efforts that CDFIs incur while advancing their financial inclusion mission. Consequently, these public and private subsidies arguably provide CDFIs a financial advantage over both traditional and subprime lenders that attempt to serve higher-risk clients.
The CDFI business model requires both public and private subsidies for several reasons. Private funding is needed to supplement any gaps in public funding, which may occur following government budgets cuts or modification of requirements. The ability to obtain private sector funding may also signal a CDFI’s expertise with respect to serving higherrisk clients or serve as an endorsement of a CDFI’s specific mission-related activities. Furthermore, a substantive share of private sector funding mitigates the risk that a CDFI would shift to the public sector the additional costs and elevated default risks that stem from serving higher-risk clients.
Public and private stakeholders are interested in the CDFI industry’s ability to help higher-risk clients gain access to capital and succeed, but measuring and evaluating that performance is difficult. Because CDFIs must engage in more default mitigation activities compared to traditional financial institutions, the interpretation of metrics used to measure their financial strength and performance is more ambiguous. Furthermore, data collection gaps and other issues complicate the ability to directly link CDFIs’ activities to their clients. Even if more data were available, however, CDFIs’ customers in underserved areas face greater income volatility and would be expected to fail more often than conventional borrowers. In short, measuring the extent that CDFI activities in underserved markets are advancing financial inclusion is challenging.
https://crsreports.congress.gov/product/pdf/R/R47217
