Financial Institutions (FIs) make substantial capital investments in CDFIs to further their sustainability agendas and enable social impact.
During the past few years, the social justice movement and economic impact from the pandemic exposed continuing inequalities in health and economic opportunity that exist across the country in rural, native and urban communities. Although the Community Reinvestment Act (CRA) was enacted in 1977 to address the credit needs of underserved communities, in 1994, Congress established community development financial institutions (CDFIs) to help revitalize economically distressed communities.
The CDFI Fund, administered by the U.S. Department of the Treasury, certifies CDFIs and makes capital grants, equity investments and awards for technical assistance to CDFIs, investing federal dollars alongside private-sector capital. CDFIs serve underserved communities and come in many forms, including community development credit unions (CDFUs) and banks that provide retail banking services, small-dollar loans that help combat predatory lending, loan funds that provide financing and technical assistance to borrowers, and venture funds that provide equity to small and medium-sized business.
In 2020, Congress approved a historic, bipartisan US$12 billion investment in CDFIs and Minority Depository Institutions (MDIs). The funding included US$9 billion for the Emergency Capital Investment Program (ECIP) and another US$3 billion in grant funding through the CDFI Fund. These investments were intended to allow CDFIs to sustain lending and investing in underserved communities and expand their financing activities over time.
One consistent problem for the industry illustrated by this historic emergency funding is that demand continually exceeds supply, with this increased growth further exacerbating CDFI fund constraints.
But growth continues at a rapid pace because recent events and the corporate drive to support sustainability, social impact, a purpose-driven culture and the economic mobility of financial institutions (FIs) have substantially increased FIs’ support of CDFIs to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods.
CDFIs become part of impact investment strategies
Foundations, institutional investors, wealth and asset managers, and big tech include CDFIs as part of their impact investment agendas.
CDFIs and impact investing strategies
Interest is mounting, and a number of very large FIs have made multimillion-dollar grants and financing available to CDFIs. With a broad spectrum of capital investments, one FI recently announced a US$50 million community finance innovation fund, while another large FI is delivering over US$500 million in community financing.
Foundations and institutional investors that want to make an impact by directly investing in their communities as part of their growing environmental, social and governance (ESG) principles and investment strategies are finding investing in CDFIs attractive, as they can deflect financial risk by spreading investments over a diversified portfolio of loans, as well as monitor and manage risk and hold loan reserves.
Some of the world’s largest wealth and asset managers have also increased focus and attention on their impact agenda, with initiatives that include the buildout and further refinement of corporate social responsibility programs; innovative financing structures; and ESG and impact investing products, offerings and education. Given the broad umbrella that these initiatives span, it is often necessary for FIs to partner and align across their organization’s compliance, trading, operations, legal, marketing and distribution functions.
In addition, interest in CDFIs has expanded beyond FIs to include big tech. For example, in 2020, a large social media company invested US$100 million in the Opportunity Finance Network’s (OFN) new Finance Justice Fund to help close the racial wealth gap and accelerate the work of OFN member CDFIs serving rural, urban and native communities.
Metrics and measurement
The rapid growth of impact investing in the financial services industry spurs the opportunity to refine measurement.
Measuring the impact of funding CDFIs
Increased public scrutiny for transparency and accountability has made it vital for FIs to measure the impact of the funding that they have disbursed/are disbursing through their philanthropic foundations and equity investments in CDFIs.
Although it is a challenging task, impact measurement begins with defining the positive social, economic and environmental impact that a CDFI seeks to create. Measurement can be accomplished by developing a framework that shows the intended relationships between investments and results. For example, a framework that shows that, if certain resources are available for a program, then the activities can be implemented; and if the activities are implemented effectively, then certain outputs and outcomes are the results or changes that occur from participation in a program. The outputs/data can be collected, compared and tracked against baseline data; they can be used to demonstrate the impact of the community programs that the CDFI is supporting and be subsequently reported out to investors and the public.
Common activation challenges across the CDFI technology landscape
CDFIs begin a technology transformation journey to increase efficiencies, better serve clients, and monitor financial and social impact
Common data and activation challenges
Advancing technologies are fundamental for CDFIs to increase efficiencies, better serve clients, and monitor financial and social impact. In the last few years, increased demand for services has fueled an industry call to start transforming the technology landscape to meet the expanding CDFI market.
Technologies designed for mainstream financial institutions do not meet the specific needs of CDFIs. Even customized solutions for the industry offer limited options or cannot be utilized for all phases of the lending cycle, including document storage, loan origination, underwriting, closing, servicing loans and monitoring impact. Additionally, the cost to implement new technologies has historically been too high for these organizations that prioritize raising capital and supporting their operations.
To meet their technology needs, CDFIs have implemented a wide range of systems and technologies for accounting, loan management, impact measurement and customer relationship management. In 2017, OFN published a survey, CDFI Loan Fund Technology Landscape, with the findings showing that common software packages utilized by CDFIs include “loan management systems geared toward community development finance, customized spreadsheets and databases, and popular mainstream software packages, such as Excel, QuickBooks and Salesforce.”
In addition, when the pandemic took hold, the need for CDFIs to invest in new technologies became urgent, as they faced an increased demand to disburse emergency Paycheck Protection Program (PPP) loans to small business and improve their lending capabilities. Technologies that they utilized could not support these programs, and, in many cases, PPP applications had to be handled manually, with some organizations not having the capacity to effectively provide these emergency loans.
To assist CDFIs with their mission, some technology companies are stepping in to help. In 2020, a large FinTech, in partnership with a big tech firm, committed to bringing low-cost technology solutions to CDFIs to improve customer onboarding and support digital transactions. And, in 2022, another big tech firm invested US$4 million for OFN to launch a new “CDFI Technology Grant program,” aimed at supporting investment in technology innovations. At present, some CDFIs have started their technology transformation journeys toward more robust loan management systems, integrated systems, enhanced analytics, trend identification, workflow automation and impact monitoring. However, the technology transformation revamping journey has just begun for these organizations, providing impact investors with the opportunity to support an industry at the beginning of its transformation that aligns with their own mission and values.
Investments that generate both financial returns and social good, like funding/investing in CDFIs, support corporate ESG principles and philanthropy, and help attract/retain talent within corporations themselves. With Congress approving a US$12 billion investment in CDFIs, FIs making multimillion-dollar grants and financing available, and a new proposed bipartisan amendment⁶ to the CRA rule offering incentives for bank investments, it is clear that the CDFI market will continue to expand and serve critical needs. Considerations and solutions around data recording, measurement, performance tracking and analytics are required to accelerate the CDFI market, for borrowers and lenders alike.
Courtesy EY. By Harish Arora, Phillip Andriyevsky, Mariana Ippolito and Valerie Oseguera Full report available here