Guess post from PEL’s Community Capital Working Group Member Sandhya Nakhasi of Community Credit Lab. Full post can be viewed here.
Summary
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.”[1]
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[2], 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.[3]
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.[4] These same adults are unable to cover a $400 cash emergency and have $0 or negative wealth to dip into.[5] 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:
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Perpetuating the same financial systems that have systematically excluded and extracted from communities with less power in our society; OR
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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?
To read more, please visit Community Credit Lab’s original post.
This article is Part I of a IV part series outlining Community Credit Lab’s research, thoughts, and vision to keep working with communities to make lending more equitable.
