Abstract
Limited access to financing restricts the ability of minority business enterprises (MBEs) to achieve viability, to generate new jobs, and, generally, to reach their full potential to contribute to the economic development of the communities and regions in which they operate. Although MBEs rely more heavily on financial institutions for loans than all other borrowing sources combined, they experience higher costs than White firms when they borrow, receive smaller loans, and have their loan applications rejected more often. For MBEs in minority neighborhoods, these borrowing problems are compounded. Action is needed. The federal government needs to prosecute financial institutions that discriminate against MBEs on the basis of borrower race. Local governments can assist by weighing bank-lending activity in local minority communities when choosing the local banks with which they do business. Prompt payment of MBE vendor invoices by public-sector clients is needed.
This commentary explores the multiple challenges facing minority business enterprises (MBEs) as they seek to raise finances in order to enter into and operate viable businesses. Whether large or small in scope of operations, whether start-ups or well-established ventures, MBEs generally—and firms owned by African Americans and Latinos, specifically—have greater difficulty accessing loans from financial institutions than comparable White-owned firms. MBEs experience higher interest costs when they borrow, they receive smaller loans, and more often have their loan applications rejected.
Financing small-firm creation is particularly challenging. Greater capitalization serves as a buffer to protect start-up and very young ventures from the liabilities of newness. New firms are struggling to establish administrative procedures, define their institutional identity, and gain credibility with customers and suppliers. This process of experimentation is characterized by iterations of trial and error. Greater access to capital helps firms to survive this learning process; undercapitalization, in contrast, limits the new firm’s ability to withstand unfavorable shocks and to undertake corrective actions. Higher initial capitalization buys an entrepreneur time while he or she learns how to run the business efficiently. Lacking an adequate buffer, poorly capitalized firms may be forced to close down during difficult periods. This reality discourages some potential entrepreneurs from ever taking the plunge into business ownership.
Viable MBEs commonly possess two key characteristics. First, their owners have the skills, expertise, and experience necessary to operate successful small businesses. Second, they have enough capital to operate at an efficient scale and to pay their bills, as well as sufficient access to capital to cope with adversity and take advantage of opportunities when they arise. Viable MBEs are noteworthy because they are the firms that create most of the jobs found in the minority business sector. Fairlie and Robb (2008) have documented that greater capitalization characterizes the MBEs most likely to operate profitably, remain in business, and create jobs. Acs and Armington (2006) have shown that young small businesses are vitally important creators of net employment growth in the aggregate, accounting for a larger share of all new job creation than mature firms. Bates, Robb, and Parker (2011) analyzed young firms and found that net job creation was most rapid among those with larger financial capitalization. Specifically, the firms expanding at least fivefold in terms of number of workers employed during their first 5 years in business were those with greater capitalization.
Access to Financing
In 1992, the Roper Organization polled 472 Black business owners nationwide to gauge how they viewed their own firms and Black businesses generally. Asked why there were so few Black-owned firms, 84% responded, “black-owned businesses are impeded by lack of access to financing” (Carlson 1992, p. R16). Among firm owners identifying their businesses as unsuccessful and shutting down business operations in 1996, according to U.S. Census Bureau data, Black owners were nearly three times more likely than Whites to report “lack of access to business loans/credit” as a reason for closure. Controlling statistically for firm and owner traits affecting credit risk, Blanchflower, Levine, and Zimmerman (2003) found that Black owners of firms were far more likely than Whites to have their loan applications rejected by financial institutions. The evidence broadly indicates that firms owned by Latinos experience similar problems seeking credit, whereas Asian-owned ventures are less severely affected by these credit constraints.
Starting a viable business is most feasible for high net-worth individuals. Adults with household wealth exceeding $100,000 are particularly likely to enter into self-employment, compared with adults with otherwise identical education and demographic profiles (Bates, 1997; Bates, Lofstrom, & Servon, 2011). Relatively low levels of personal net worth typify Black American workers, note Fairlie and Robb (2008), partially explaining why less than 4% of them are self-employed business owners, compared with nearly 12% of White workers. Looking solely at Mexican American immigrants, Cobb-Clark and Hildebrand estimated that median household net worth was $6,792 (2006), about one twelfth that of the level for Whites. It is noteworthy that the relatively high-household wealth levels typifying Asians are an important source of their high rates of entry into business ownership: Mean values of household wealth among Asians and non-Hispanic Whites who are not self-employed are $73,222 and $68,768, respectively (Bates, 2011). Whether invested directly into small businesses or used as collateral to obtain loans, high wealth levels facilitate entry into small-firm ownership for aspiring Asians and Whites, but often frustrate the entrepreneurship ambitions of African Americans and Latinos.
Comparisons of the types of start-up financing used to launch new firms owned by African Americans, Asian immigrants, and Whites are summarized in Table 1. These measures of capital utilization are uniquely valuable because (a) they are drawn from nationally representative samples of small firms and (b) they are complemented by further data (Table 2) identifying sources and dollar amounts of borrowed capital. Although differing financing patterns are apparent across these racially defined groups, similarities are actually more prominent. Most start-ups—whether White-, Asian-, or Black-owned—used no debt financing to launch business operations. Among firms owned by nonminority Whites, 23.7% started out with zero financial capital; corresponding figures for Blacks and Asian immigrants were 28.9% and 16.2%, respectively. Zero-capital start-ups were largely zero-employee firms concentrated in service industries.
Financing Small Business Formation: Nationwide Statistics.
Source. U.S. Census Bureau, Characteristics of Business Owners database.
Sources of Borrowed Financial Capital Used by Small Business Start-ups, Nationwide Statistics on Borrower Firms.
Source. U.S. Census Bureau, Characteristics of Business Owners database.
Start-ups using borrowed funds stood out in the sense of being the larger scale businesses. Young firms employing paid workers commonly financed new firm creation using a combination of debt and owner equity financing. Start-ups using debt financing relied more heavily on financial institutions for loans than any other source (Table 2). Order of importance of debt sources—financial institutions, family, and friends—was the same for Asian immigrant, White, and Black business borrowers (Bates, 1997). Considering average loan size in conjunction with borrowing frequency, the importance of financial institutions comes into focus: Loans from banks provided more debt financing than all other sources combined. If a borrower applies for a business loan and is turned down, consumer-credit alternatives are also available from banks. Reflecting their restricted access to mainstream business loans, Black-owned businesses often relied on consumer credit—primarily credit card balances—to finance start-up.
Bank Lending Policies Limit Access to Credit for Minority-Owned Businesses
Lending discrimination practiced by financial institutions lessens the ability of Latino and Black entrepreneurs to leverage their household wealth by borrowing to finance entry into business ownership. Analyzing young firms owned by African Americans and Whites located in 28 large metropolitan areas, Bates (1989) compared loan amounts extended by banks with borrowing firms operating in minority neighborhoods as opposed to other sections of the metro areas. Neighborhood racial composition was measured at the level of individual zip codes: Nearly 68% of the Black-owned firms and 11% of the White-owned firms receiving start-up financing from banks were, in fact, located in minority neighborhoods. Controlling statistically for the human capital traits of firm owners, their equity investments in start-up ventures, and other characteristics, estimated loan amounts actually received by minority-area firms versus all other bank-financed start-ups indicated that minority neighborhood location resulted in smaller loans. The larger loan amounts went to the firms whose owners were college graduates making relatively large investments of equity capital into their start-up ventures, except in those instances of minority-area firm location. For Black and White owners alike, a minority-area location was penalized. The fact that Black-owned small businesses were heavily concentrated in Black residential areas contributed to their limited access to bank credit (Bates, 1993; Immergluck, 2004).
Studies of bank lending discrimination using the Federal Reserve Board’s Survey of Small Business Finances (SSBF) have consistently found that Black business borrowers pay higher interest rates and experience a higher incidence of loan denials than White borrowers, and large differences persist after firm and owner traits are controlled for statistically (Blanchard, Yinger, & Zhao, 2008; Cavalluzzo & Wolken, 2005). The evidence of higher rates of bank loan denials handicapping Hispanic business owners is somewhat weaker, perhaps because of smaller Hispanic SSBF sample sizes. Finally, both Black- and Hispanic-owned businesses needing credit often reported not applying for bank financing, fearing their applications would be rejected (Blanchflower et al., 2003).
For explaining small business access to debt financing, the arrival of SSBF data in the mid-1990s provided a variety of advantages. Comprehensive measures of loan demand forthcoming from established small firms having minority owners were previously unavailable. SSBF data describing 4,570 firms operating in 1993 included more than 1,000 minority-owned firms. Just more than 2,000 of the firms sought loans, and loan application outcomes were provided both for successful and rejected applicants. The Federal Reserve’s periodic SSBF surveys since 1993 describe firms that sought loans over the three previous years.
Firms in the SSBF database are an older, more established, larger scale subset of the nation’s small business community: median age among firms in the 1993 SSBF was 14.3 years; 4.1% had been in operation for less than 3 years (Cavalluzzo, Cavalluzzo, & Wolken, 1999). Among such established firms, financing comes predominantly from financial institutions. Many young minority-owned businesses most vulnerable to loan access difficulties were dead and gone before they were sufficiently mature to be likely candidates for inclusion in the SSBF database.
Cavalluzzo et al. (1999) highlight a key issue: “Businesses owned by African Americans were two-and-one-half times as likely to be denied credit on their most recent loan request than were businesses owned by white males” (p. 189). The question is whether Black-owned firms possessing identical firm and owner traits (other than race) and credit histories have less access to bank credit than matched White-owned firms. Studies based on the SSBF data unanimously answered this question affirmatively (Blanchard et al., 2008; Blanchflower, 2009; Blanchflower et al., 2003; Bostic & Lampani, 1999; Cavalluzzo & Wolken, 2005). A greater likelihood of loan denial among Hispanic small-business applicants was reported by Cavalluzzo and Wolken, and this pattern persisted when borrower risk factors were controlled for statistically. Blanchard et al. (2008) and Blanchflower (2009) similarly found that Hispanic loan applicants, after controlling for risk factors, were more likely than White loan applicants to have their loan applications turned down by banks. Federal Reserve employees Bostic and Lampani, in contrast, did not find higher rejection rates.
Common findings across all studies using SSBF data are twofold. First, Black-owned firms have significantly less access to that debt financing than White-owned firms. Second, financial institutions accounted for over 90% of the debt financing flowing to these established firms, whether minority or majority owned. These SSBF-based studies are methodologically similar in the sense that all controlled statistically for differences in traits of business owners, their firms, their credit histories, and the environments in which they operated.
Digging deeper into the SSBF data for 2003, we found among these typically large-scale, well-established small businesses that mean annual sales of minority- and nonminority-owned small firms were roughly equal; the former reported sales of $992,200 versus $1,043,200 for nonminority ventures. Their overall size and maturity explain why they are less reliant on family and friends for credit than smaller and younger firms: As firms mature and grow, reliance on financial institutions for loans rises substantially. Overall, denial rates among loan applicants for these groups were 12.3% for nonminorities and 31.5% among MBEs.
Over the time frame covered by the 2003 SSBF data, 23.6% of the minorities and 31.9% of the nonminority firms were loan recipients in a typical year; amount borrowed by the average recipient was $341,400 for nonminorities and $197,100 among minorities. These mean loan amounts were skewed, however, by a few very large loans. Looking solely at firms with annual sales under $500,000, average loan size was $89,833 among nonminority-owned firms and $53,843 for minority-owned firms. Corresponding loan mean interest rates were 6.9% and 9.1%, respectively for nonminority borrowers and MBEs.
Among the SSBF firms expressing a need for credit, fully half reported not applying for loans sometimes in the previous three years because they feared rejection. Controlling statistically for firm characteristics and credit histories of firms and their owners, Blacks were still 37% more likely and Hispanics were 23% more likely than White males to avoid applying for fear of rejection. Asian businesses actually expressed the highest need for credit—higher than Blacks, Hispanics, and Whites (Cavalluzzo et al., 1999). Yet this need coexisted with an apparent alienation toward banks, reflected by Asians being less likely than others to actually apply for loans. Fear of rejection, high credit needs coexisting with bank avoidance—it is against this background that one must interpret outcomes of the loan applications actually formally submitted by Asian-, Hispanic-, and Black-owned businesses.
Kauffman Firm Survey (KFS) data currently provide the only nationally representative scientifically designed database containing detailed firm-specific information on debt and equity capital being used by these ventures. KFS data track firms starting operations in 2004; their strength is inclusion of annual follow-up information on new equity and debt capital raised by individual firms in years subsequent to start-up. Examining subsequent capital inflows for 2004 start-ups still in operation in 2007, we found that 51.8% of nonminorities and 48.2% of MBEs raised new debt capital from external sources (banks most often) in a typical year; among loan recipients, average loan amounts were $48,900 for nonminority firms and $28,600 for MBEs. These loan size differentials exhibit the same patterns—larger loans for White owners, smaller loans for minorities displayed in SSBF data describing more established firms.
Examining recipients of loans from external sources for firms having African American and White owners, Robb, Fairlie, and Robinson (2010) analyzed KFS data to determine if Black-owned firms received smaller loans than White-owned firms in the years subsequent to venture start-up, 2005 through 2008. Controlling statistically for risk factors, including owner and firm characteristics and credit score, they found that large Black/White differences in actual loan amounts received by borrowing firms persisted. Lower credit scores indeed accounted for about 20% of the lower loan sizes received by Black-owned firms, but the racial characteristic itself was the strongest single determinant of loan amount. Controlling for owner personal wealth holdings did not alter this finding of substantially smaller loans for Black firms, relative to White ventures possessing otherwise identical firm and owner traits. These findings simply confirm the consistent pattern—lower loan amounts, higher borrowing costs, more frequent loan denials—of restricted loan access for Black-owned small businesses noted by every serious study of this topic since 1989.
Are Banks Actually Discriminating Against Minority Business Loan Applicants?
The short answer is yes. Scholars reviewing the totality of evidence regarding MBE access to debt financing—Holzer and Neumark (2000), for example—conclude that banks are engaged in discriminatory lending practices. Suggesting that existing evidence documents the presence of discriminatory lending practices is met by strong objections from the Federal Reserve System economists Bostic and Lampani (1999): Although the SSBF database is the most comprehensive data set on the demographic and financial characteristics of small businesses, there are still firm characteristics that are not collected by the survey. These missing variables may be relevant to a potential lender in assessing the expected profit and risk of a loan to small business. (p. 162)
The findings of Bostic and Lampani, like all other SSBF-based studies, revealed large, statistically significant disparities in Black/White loan approvals after controlling for risk factors and neighborhood characteristics; yet their implication is that no body of evidence can demonstrate conclusively that banks are engaged in lending discrimination.
The particular contribution of Bostic and Lampani (1999) to the findings emerging from SSBF studies of bank lending is, “that the economic and demographic characteristics of a firm’s local geography should be considered if a more accurate quantification of these racial disparities and understanding of their underlying sources is desired” (p. 149). They investigated loan denial patterns, using 102 explanatory variables, including 29 business characteristics, 15 owner traits, 20 most recent loan-application characteristics, and finally, 53 banking market and local geographic characteristics. They concluded that Black loan applicants were rejected disproportionately, in part, because their firms were often located in economically depressed African American residential areas.
By using neighborhood racial composition and economic deprivation variables, Bostic and Lampani (1999) provided little insight into actual small-business credit risk patterns because impacts of such factors had already been embedded in the balance sheets, credit histories, and income statements of the businesses located in inner-city minority communities. When firm location in a low-income inner-city neighborhood creates a net disadvantage for a business, that disadvantage manifests itself in the form of increased operating costs or reduced sales, or both. Lower sales and/or increased costs rooted in locational disadvantages, in turn, are reflected in the net income statement and credit history of the affected business in two forms—low profits and a history of credit problems. Over time, reduced profits reshape the firm’s balance sheet, hurting liquidity and net worth. Thus, a firm’s credit history, balance sheet, and profits accurately reflect applicable locational disadvantages affecting its operations.
Nonetheless, Bostic and Lampani (1999) are correct to observe that conclusions of individual studies of Black/White loan access do not produce decisive proof of discriminatory bank-lending practices. Each relevant study of credit demand, loan application outcomes, and small-firm borrowing patterns—whether based on SSBF, U.S. Census Bureau’s Characteristics of Business Owners (CBO), Community Reinvestment Act (CRA), or other data sources—has its own peculiarities, rooted in differing methodologies and databases that imperfectly represent the broader small-business universe. Findings of these diverse studies collectively gain credibility, however, because (a) they were conducted at various points in time, (b) they analyzed databases from diverse sources, and (c) despite their methodological differences, a pattern of extremely consistent findings demonstrated large and persistent Black/White gaps in access to small-business financing (Bates, 2011).
Federal Reserve Board Chairman Greenspan’s assessment of the consistent pattern of SSBF findings of Black/White loan approval disparities was straightforward: “Not all of these differences are readily explained by income, balance sheet factors, or credit histories, although considerably more work needs to be done to take account of possible factors not included in the studies to date” (Greenspan, 1999, p. 43). Subsequently, the Federal Reserve Board eliminated its oversampling of MBEs in the 2003 SSBF survey round; then it abolished the SSBF survey entirely and provided no substitute database capable of supporting the avenues of research made possible by SSBF data. Thus, Greenspan’s suggested “considerably more work” has not been forthcoming. Absent the SSBF survey data, no other government data source—Federal Reserve Board, U.S. Census Bureau, or otherwise—provides the data needed to investigate either inner-city business lending risks or bank lending to minority businesses. Not surprisingly, “neither the Department of Justice nor the bank regulators have been active in actually enforcing fair lending laws in the small business arena” (Immergluck, 2004, p. 198).
CRA data describing bank geographic lending patterns do still exist, but these data (unlike the SSBF and the CBO) do not specifically identify firm owner race or ethnicity; nor do they identify traits of individual borrowing firms. Immergluck (1999) used CRA data to analyze bank lending by census-tract racial composition to firms with annual sales less than $1 million in the Philadelphia area. He concluded that firms in predominantly White census tracts received, on average, 11.0 loans per 100 active businesses while those located in Black census tracts received 1.2 loans per 100 active small businesses. Controlling statistically for median family income, average business credit score, and other characteristics at the tract level, he found that going from an all-White neighborhood to an all-Black neighborhood resulted in a drop of 6.8 loans per 100 small businesses. One deficiency of the CRA data analyzed by Immergluck was the absence of firm credit card borrowings. More comprehensive CRA data describing geographic patterns of bank lending (including credit card balances) to small businesses in the Chicago area were analyzed by Smith (2003) to determine if loan availability in minority neighborhoods differed from availability in the rest of the region.
Smith’s (2003) findings replicated those of Immergluck (1999) and complement the findings of Bostic and Lampani (1999). The prevalent pattern in Chicago’s low-income minority neighborhoods was consistently one of low loan availability coexisting with high levels of credit card borrowing. Because banks are averse to lending to small businesses when firms are located in inner-city minority neighborhoods, they rely heavily on personal credit cards and informal lending sources rather than financial institutions.
The Role of Informal Loan Sources
Scholars studying “marginal” groups of MBEs consistently note their heavy reliance on informal sources of credit—friends, family, rotating credit associations (RCAs), and others. Studies examining types of financing used by small neighborhood firms operating in two low-income Chicago neighborhoods—Little Village (predominantly Hispanic) and Chatham (Black)—conclude “Credit from financial institutions is little used in the start-up phase” (Huck, Rhine, Townsend, & Bond, 1999, p. 485; see also, Raijman & Tienda, 2000; Townsend, 2005). Personal savings of business owners and loans from informal sources—particularly family and friends— provided most of the start-up capital used by the firms operating in these neighborhoods. The studies of business financing in Little Village and Chatham are valuable precisely because they describe capitalization sources used by the kinds of firms ignored by the SSBF—marginal inner-city firms owned primarily by minorities (Huck et al., 1999; Raijman & Tienda, 2000). Relative to the nationwide minority business community, those examined in the Chicago studies were a “disadvantaged” subset of firms. Findings from these studies collectively indicate that debt financing is provided overwhelmingly by financial institutions at one extreme of the credit spectrum and by informal sources at the other.
Available evidence regarding MBE financing points toward the presence of a credit access continuum. At the high end lie the business loans extended by financial institutions; lower down are consumer credit—particularly personal credit card borrowings--followed by loans from family, friends, and other informal sources (Bates, 2005). As one examines subsets of increasingly disadvantaged firms owned by minorities, the composition of borrowing sources changes predictably. Family and friends (informal credit sources) become common loan sources; business loans extended by financial institutions become less common. If bank loans are tapped at all, they are likely to be credit card balances. Townsend (2005) describes patterns of informal network reliance for fulfilling borrowing needs in Chicago’s largest Hispanic community—Little Village—thusly: The networks among Hispanics are lively and informal, with relatively small transaction costs. Yet, higher income, greater English proficiency, house ownership, and use of services outside the neighborhood are associated with increased access to the formal sector and diminished use of networks. (p. 181)
Traits that sort firms along the formal/informal credit continuum include (a) start-up status versus established firms, (b) nonminority versus minority-owned firms, (c) firms operating in minority neighborhoods versus those doing business outside of minority neighborhoods, (d) resource-poor (renters) versus resource-rich (homeowners) business owners, and (e) higher income (particularly college graduates) versus lower-income business owners. Broadly, the more advantaged firms tap mainstream borrowing sources; disadvantaged firms rely on informal sources (Bates, 2005).
Informal coethnic loan sources are mentioned often in sociological studies of immigrant minority entrepreneurship (Waldinger, Aldrich, & Ward, 2006).
Obtaining loan capital poses an obstacle for all small business ventures, but the problem is especially severe for immigrant or ethnic minority entrepreneurs, who lack credit ratings, collateral, or are victims of ethnoracial discrimination. Rotating credit associations reduce the severity of this financial obstacle. (Light, Kwuon, & Zhong, 1990, p. 35)
An instructive example of an informal ethnic lender is provided by Exim Capital, owned by Victor Chun, a Korean immigrant. Exim is an asset-based lender actively making small business loans to a clientele of established New York City Korean immigrant-owned firms. Exim Capital makes loans to “experienced, high net-worth borrowers. Approved loans must be secured by solid collateral so that payment will be forthcoming, whatever the viability of the small business under consideration” (quoted in Bates, 2000, p. 229).
Exim’s loan recipients are Korean immigrants, and sociologists have often suggested that Korean business owners often rely on loans from RCAs. The RCA is an informal lender consisting of acquaintances that pool their savings so that association members needing loans will have a pool of available capital from which to borrow (Light et al., 1990). Victor Chun confirmed that RCAs were active in the market he serves, but they offer no competition to Exim because the RCAs emphasize shorter term, more expensive credit: “High local demand for small-business loans creates a situation whereby business people belonging to the RCAs bid against each other for the right to borrow, and this bidding often drives annual interest charges into the 30% to 40% range” (Bates, 2000, p. 230). Yoon (1991) notes that borrowing from coethnics—including RCAs—typifies weaker Korean immigrant-owned firms in Chicago and results in reduced loan sizes.
In recent years, note Sanders and Nee (1996), “many immigrants from Korea, Taiwan, Hong Kong, and India arrive with substantial financial capital or have family members back home from whom capital can be obtained” (p. 232); this pattern of self-financing is clearly used most often by college graduate immigrants from elite backgrounds. The task of raising sufficient capital to finance venture start-ups is greatly eased for entrepreneurs attached to high net-worth households. Sanders and Nee observe that “education is positively associated with class advantage in the home country. Immigrant groups of middle class or elite origins have greater access to financial capital.” Beyond household net worth, class advantage facilitates raising capital from parents and relatives, and it affects one’s ability to qualify for loans from coethnic lending institutions.
Yet many other would-be business owners require loans: “We found that Chinese immigrants in Los Angeles obtain high-interest loans from Chinese-owned loan companies” (Sanders & Nee, 1996, p. 232). Existing studies of business lending by nonbank loan companies and RCAs emphasize the problems created by reliance on these informal credit sources: The cost of credit may simply replace access to credit as the borrower’s most pressing financial problem. There is a spectrum of borrowing sources for MBEs, and RCAs are part of that spectrum: Stronger borrowers rely heavily on banks for financing while weaker borrowers rely most often on personal credit card balances and informal sources, including RCAs. Absent loan sources such as family, friends, and RCAs, many weaker firms undoubtedly never would have come into existence.
Recession, Credit Crunch
Credit market conditions since 2008 have enormously complicated MBE borrowing efforts, both from banks and from informal sources. Tightening credit has weakened many stronger MBEs, lessening their growth and profitability. Loans from friends, family, and other informal loan sources—in addition to bank loans—became less available as falling household incomes and employment levels, along with tightening consumer credit, lessened the ability of these credit sources to extend loans to MBEs. Reduced credit access complicates firm efforts to take advantage of opportunities and it is often accompanied, during recessionary periods, by a slow payment of outstanding bills by clients. Thus, even strong MBEs selling to public-sector clients and stressed corporate sectors (e.g., auto companies) risked having their businesses destroyed by the combination of reduced credit access and slow payment for goods and services sold to their major clients.
Alleviating Minority Business Financing Constraints Is an Effective Local Economic Development Policy
While the payoff to easing the credit constraints affecting MBEs may not be high when measured by jobs created in minority communities in the short run, the long-term payoff may indeed be substantial. Greater access to more affordable loans would gradually enable MBE employer firms to strengthen their balance sheets and improve their credit ratings. Bank regulatory authorities and the U.S. Department of Justice need to start enforcing the small-business fair lending laws that are already on the books. If minority owners of small firms were treated like their White counterparts by financial institutions, they would be able to lessen their reliance on expensive forms of short-term consumer credit like credit card balances and rely, instead, on loans specifically designed to meet the financing needs of small businesses. If MBE borrowers were simply treated like White borrowers possessing identical firm and owner traits, then banks would be providing them with loans that were, on average, larger and less costly than those currently being used. More MBEs would then be applying to banks for small business loans, and a higher proportion of these applications would be approved. Expensive borrowing alternatives such as loans from RCAs would be used less often.
Greater access to more affordable bank credit would enable cash-strapped MBEs to pay their bills on a more timely basis, leading to gradual credit rating enhancement. Better credit ratings would improve their access not only to bank loans but to trade credit extended by suppliers as well. Fewer firms would be forced out of business by illiquidity problems and more would capitalize on opportunities to expand since their greater credit access would effectively increase their capacity to compete for new clients. A financially stronger MBE community would grow more rapidly than a credit-constrained one, thus creating additional jobs. Because new jobs forthcoming from MBEs are largely filled by minority employees, benefits of expanded credit access would often reach into minority communities plagued by high rates of unemployment and underemployment (Bates, 2006).
Census data indicate that 355,418 firms (reporting payroll) owned by African Americans and Latinos employed 2,817,713 paid workers nationwide in 2007, an average of 7.9 employees per firm (U.S. Census Bureau, 2011). What might expanded MBE access to bank loans look like in the aggregate regarding quantifiable employment impacts? SSBF data indicate that in a typical year, about 24% of the larger, more established MBEs borrow from external sources (largely banks), whereas KFS data suggest the corresponding figure for young MBEs is 48%. Assume that among MBE employer firms, 30% successfully borrow from external sources annually. The average MBE loan amount from external sources, according to KFS data describing young firms, is $28,600, whereas SSBF data indicate a corresponding average of $197,100 among the older established MBE loan recipients. In fact, the median MBE borrower is undoubtedly closer to the KFS borrowed amount since few possess the size of the mean MBE described by SSBF data. Assume, therefore, that MBE borrowers receive a mean loan amount of $30,000, a conservative estimate. Based on these assumptions—30% of MBEs borrow and mean loan size is $30,000—the average amount borrowed from external sources among all MBE employer firms (borrowers and nonborrowers) in a typical year would be $9,000. In a world of active enforcement of fair lending laws and less discriminatory loan access, assume a 20% increase in bank lending to MBE employer firms ($1,800 each). This per firm increment adds up to an additional $640 million in bank lending to MBEs nationwide, assuming the 2007 employer firm count of 355,000+ firms.
Undoubtedly, more MBEs would borrow in circumstances of nondiscriminatory credit access, causing the 30% assumed borrowing incidence to rise, and borrowers would often seek larger loans. The net result of an estimated 20% increment ($640 million) in loan proceeds accruing to firms that, on average, employ one worker per $45,000 in firm total assets is an estimated employment increment of over 14,000 jobs forthcoming from Black- and Latino-owned firms. This imperfect estimate of the positive impacts of expanded loan availability is conservative for three reasons. First, expanded loan availability would rescue an unknown number of MBEs from liquidity problems that might otherwise force them to close down; thus, expanded credit access would not only create new jobs but preserve existing ones. Second, nonemployer MBE firms faced with expanded credit access would be more likely to seek loans in order to capitalize on opportunities for growth and, in the process, many would become employers themselves. Third, potential entrepreneurs, observing expanded access to borrowing opportunities, would be encouraged to enter into small business ownership at higher rates than prevailed in a world of constrained credit access for MBEs.
Estimating employment impacts of bank lending in a nondiscriminatory environment, nonetheless, is inherently imprecise because of displacement issues. When new businesses are formed and existing ones expand operations, a portion of the resulting job gains is offset by shrinkage of some competing firms and by closure of others. Entrepreneurship generates local economic development through processes of both selection and competition. Selection involves replacing incumbents by entrants who are more efficient or better at meeting demand. Competition is often enhanced because entrants force incumbents to provide cheaper or more innovative goods to remain viable. Particularly among firms competing for clients in highly localized geographic areas such as urban minority neighborhoods, the processes of selection and competition involve strengthening the local business community by squeezing the higher cost, less-competitive ventures. Although local shoppers may benefit from the wider choices offered by a stronger array of neighborhood firms, the job gains produced by the expanding businesses are offset, in part, by employment shrinkage among contracting ones.
We believe these job losses would be minor for two reasons. First, the often-noted tendency of shoppers to venture outside of minority neighborhoods in search of greater selection and lower prices would tend to weaken as the local business community became stronger and offered a wider selection of products. Second, most small firms located in major metropolitan areas rely more heavily on citywide or regional markets for customers than on neighborhood clienteles (Bates & Robb, 2008). Even among minority-owned retail firms, actual customers often do not reside in the local area. Although new firm creation and the expansion of existing firms in minority neighborhoods indeed do create shrinkage of less competitive businesses, this is certainly not a zero-sum game. This process, instead, is the very nature of local economic development in a capitalist society.
Bank small-business discriminatory lending practices coexist with laws prohibiting such discrimination, but the bank regulatory authorities charged with enforcing these laws at the national level have chosen not to act. Those seeking new or revised legislation to address issues of restricted MBE access to credit must contend with the fact that government sees the issue as a low priority matter. The problem is less one of lack of laws or programs than that of the lack of political will. The Federal Reserve Board typifies this problem: It first produced and then abolished the SSBF data used to document discriminatory bank treatment of MBE loan applicants. Former Federal Reserve Board Economist Alicia Robb, who was assigned to the SSBF database project, observed that “inner-city credit availability and discrimination in business lending appear not to be priorities for the Federal Reserve” (quoted in Bates, 2010, p. 359). This pattern of indifference, unfortunately, is not limited to the Federal Reserve.
The construction industry has been a source of growth for MBEs generally, and Latino- and Black-owned firms have been major beneficiaries of opportunities to participate in public-sector procurement opportunities. Yet many have faced liquidity squeezes rooted in slow-paying government clients and limited access to bank lines of credit (Bates, 2009). The Short-Term Lending Program, run by the Office of Small and Disadvantaged Business Utilization Financial Assistance Division at the U.S. Department of Transportation (DOT) offers lines of credit up to $750,000 to “disadvantaged” (largely MBE) businesses pursuing contracting opportunities in DOT-funded projects. MBE owners meeting DOT’s household net worth threshold are theoretically candidates for these lines of credit if they are working on DOT-funded prime or subcontracts. Yet this appropriate and well-designed program to alleviate the financial constraints retarding MBE participation in public-sector construction procurement is rarely used. The reason is simple. The program is run by a very small staff and it is largely unknown. Since the federal government is apparently unwilling to act aggressively to alleviate the financial constraints hindering the development of the nation’s minority business community, cities and states need to step up.
Cost effective strategies for enhancing credit availability and reducing the burdens restricted loan access causes for MBEs are readily available. City governments, local public authorities, and special districts sometimes operate “linked deposit” programs, whereby their choice of the local banks with which they do business is shaped in part by bank track records regarding lending in local minority communities. The banks most actively lending in minority neighborhoods are chosen over their competitors when local governments with active linked deposit programs pick the banks where they will place their deposits and conduct related banking business. These programs can be implemented at little or no cost since these government entities maintain active business relationships with local banks quite irrespective of whether or not they choose to allocate such business on the basis of bank lending track records in local geographic areas. CRA data are readily available to assist localities in evaluating applicable bank lending patterns. Ideally, the incentives of attracting additional business from local government entities would encourage local institutions to lend more actively to firms operating in minority communities that seek bank loans.
State and local governments often choose to expand MBE vendor involvement in their procurement operations. The Metropolitan Pier and Exposition Authority (MPEA) of Chicago actively attempts to buy products from MBE vendors and, like many government entities, it sometimes has difficulty attracting MBEs capable of taking on the very large contracts it typically awards. When the MPEA surveyed its vendors seeking their feedback on barriers limiting their participation in procurement opportunities, respondents most often cited two specific barriers—overly large contracts and slow payment of invoices. Policy changes enabling MPEA’s minority vendors to handle larger contracts were (a) downsize the contracts (cited by 70.1% of respondents) and (b) pay vendor invoices promptly (58.3% of respondents), (Bates, 2009).
MBEs selling their products to state and local government clients most often work as subcontractors on construction projects, and the average size of those subcontracts has increased substantially over the past two decades. Most of the work is done by a small group of MBEs capable of handling subcontracts in the $500,000 to $5 million range. MBEs stretching to take on large subcontracts can perform the assigned task on schedule and according to specification and yet be driven out of business by mere slow payment for completed work. Prompt payment alleviates the constraining impact of limited access to bank loans, permitting MBEs to compete more effectively for larger contracts not only in the government procurement realm, but in corporate procurement as well. Their expanding involvement in corporate and government procurement has been a major cause of the rapid nationwide growth of large-scale MBE employer firms. MBEs generating sales revenues exceeding $1 million annually have grown at over twice the rate of smaller MBEs over the past two decades (Bates, 2006).
These large MBEs, in turn, have generated most of the job growth forthcoming from the minority business community. Black- and Latino-owned firms with sales exceeding $1 million in 2007 employed 1,747,232 paid workers, accounting for 62% of all jobs generated nationwide by employer firms having African American or Latino owners (U.S. Census Bureau, 2011). Declining discriminatory barriers have sustained this growth in recent decades and their further decline can enhance MBE growth and development in coming years (Bates, 2011).
The policy suggestions sketched above are not bold. They reflect, instead, a prevailing political environment in which most government entities—federal, state, and local—view the economic revitalization of minority communities as a low priority, an area more likely to experience spending cuts than commitment of new resources. Even the U.S. Census Bureau databases describing MBEs in detail, inadequate and dated as they are, are currently targeted for elimination. Thus, our proposals emphasize limited policies implementable without new resources. Prompt payment of MBE vendors, in fact, would probably generate cost savings in the public-sector procurement realm since slow payment practices lessen the ability of vendors to fulfill their existing contractual obligations and bid competitively for large-scale upcoming projects (Bates, 2009).
In the realm of inner-city underdevelopment broadly, and MBE development specifically, strong political leadership is currently the key missing ingredient. Bold and innovative policies attacking discriminatory barriers are currently in short supply; enforcement of existing laws designed to lessen discriminatory barriers is currently inadequate. The full potential of the minority business community will be realized only when the higher barriers facing MBEs are overcome and entrepreneurs, regardless of race/ethnicity, are fully allowed to compete on the basis of their skills, ingenuity, and resourcefulness.
Footnotes
Declaration of Conflicting Interests
The authors declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding
The authors disclosed receipt of the following financial support for the research, authorship, and/or publication of this article: Research reported in this study was funded by the E. M. Kauffman Foundation of Kansas City. Regarding the other editor queries, the information currently appearing in the galleys is correct in all cases.