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Closing the Gap: Improving Minority-Owned Small Firms' Access to Credit

May 2012

Harry Ford: Welcome to the Federal Reserve Bank of Atlanta's Economic Development podcast series. I'm Harry Ford with the Federal Reserve Bank of Chicago.

Some state and local programs can help to improve access to capital for minority-owned businesses, thereby increasing these companies' ability to grow and create new jobs. Tim Bates, professor of economics at Wayne State University, proposed this idea around adequate access to business loans and credit for minority-owned businesses as part of the "Big Ideas for Job Creation" project. The project, sponsored by the Institute for Research on Labor and Employment at the University of California at Berkeley, and supported by the Annie E. Casey Foundation, was a call to academics and economic development practitioners to design jobs programs for cities and states that would lead to net new job creation in one to three years. Bates's idea, "Regulatory Relief for Minority Owned Businesses," is one of five winning ideas we are featuring in this podcast series.

Today I'm speaking with Tim Bates, from Wayne State University. Tim, thank you for being here today.

Photo of Tim BatesTim Bates: Thank you for the opportunity.

Ford: Tim, could you tell us more about your "big idea" on regulatory relief for minority-owned businesses and what issues you address with it?

Bates: At the crux of the matter is improving small business access to credit, specifically, small businesses owned by African-Americans and Latinos. In terms of credit availability, minority-owned businesses, in comparison to small businesses generally, in seeking loans from financial institutions have three patterns of results that are somewhat problematic from the standpoint of maximizing the development and job creation potential of these firms. First of all, relative to small firms owned by whites, the minority borrowers receive smaller loans, for the loans they receive they pay higher rates of interest, and their loan applications are more likely to be rejected. A simple example of these differentials, the Federal Reserve System has created a database called The Survey of Small Business Finances. And as I am looking over the findings of that particular survey I know that minority business borrowers paid average interest rates of 9.1 percent, substantially above the average 6.9 percent rate of interest paid by the owners of white-owned businesses. The issue is why: Why higher interest rates? Why smaller loans? Why a higher probability of loan application rejection?

The response of researchers is to try to figure out how much of this is explained by the higher riskiness of the minority borrowers, and if higher risk doesn't explain it, then what might be going on here? So researchers control statistically for risk factors in a variety of ways. They envision two hypothetical business owners. They have the same credit ratings. The firm and owner characteristics are similar; we're talking about firms of similar size, similar age, with roughly comparable sales levels, profits, owners' personal net worth is comparable. So for these essentially identical businesses, the result we find—really after controlling for the credit risk factors—is that the minority borrowers get smaller loans, they are charged higher interest rates for the loans they receive, and they are more likely to have their loan applications rejected.

An interesting related finding is that after we control for credit risk, a number of black-owned and Latino-owned businesses, their owners claim that although they need loans, they need credit, in fact, they have not applied at some point over the last three years because of fear of rejection. OK, there is a need here, a need that can create jobs in a very effective way, and the need is to treat firms with identical risk profiles the same irrespective of owner race or ethnicity. Broadly, the need is to ease the credit constraints that are limiting the growth of viable minority-owned businesses.

Ford: Are minority borrowers seeking credit from the same types of institutions as nonminority borrowers, and can you point to the related research?

Bates: There are some differences in borrowing patterns. I believe the most obvious would be that minority borrowers often patronize banks owned by co-ethnics. This is most common among Asian immigrant-owned firms in major urban areas. The pattern is one of Korean immigrant business owners borrowing from Korean-owned banks, Chinese business owners borrowing from Chinese-owned banks. To some extent, too, the same pattern is observed among African-American business borrowers who borrow from black-owned banks.

A second example of differences, minority business borrowers gravitate rather heavily toward banks that are highly active in making SBA guaranteed loans. These are government-guaranteed loans whereby SBA takes 75 percent of the default risk. These tend to be larger banks. Often they are banks with many retail branches. In any major urban area, there's a grapevine whereby minority business owners tend to be aware of the banks where they will receive a less positive versus more positive reception.

In terms of the underlying research, this is not the type of issue that lends itself to questions that appear in nationally representative databases. Much of the research has been done by sociologists who've done case studies in cities like Los Angeles and New York, and have talked to many hundreds of business borrowers.

Ford: Tim, your paper notes that minority-owned businesses already employ a significant number of workers. How exactly does your idea create "new" jobs, how many, and what types of jobs do you believe it could create, and what would be the cost?

Bates: Not all types of businesses are credit constrained, so easing credit constraints would hugely impact, really, only the set of minority businesses that is most directly credit constrained. Two stand out, one is the construction industry and the other is manufacturing.

If minority borrowers were treated by financial institutions essentially identically, in terms of determining acceptance of loan applications and borrowing terms, the result would be larger loans, lower borrowing costs, and more loans flowing to minority businesses. In terms of job creation, actually, among businesses owned by African-Americans and Latinos, over 60 percent of all the jobs that are created are created by firms with annual sales exceeding $1 million a year. Very large firms, firms in the minority communities, firms in credit-constrained industries like construction, if we look at an immediate impact over the course of one year, the immediate impact is estimated to be only about 14,000 to 15,000 new jobs. But the impact over a three-year period is substantially bigger.

So, whereas initially there might 14,000 to 15,000 new jobs, by the end of a three-year period we could easily see that at a range of 25,000 to 30,000 new jobs annually. Now, nationwide that might not seem like a lot, but we're talking specifically about minority neighborhoods and cities, particularly large cities. And this process, once under way, would continue to build momentum with improved credit ratings, greater credit access, greater firm growth, more firms being created. So, we're not talking about a short-term solution that will have a huge impact, but longer term it really could.

Ford: Tim, in your brief, you describe the Short-Term Lending Program run by the United States Department of Transportation as one example of this type of program. Can you describe any other successful applications of this idea, and what are the results to date?

Bates: What is particularly useful in terms of the Department of Transportation program is the easing of credit. Now, throughout the United States there are thousands of local government entities, cities, districts, special authorities, that purchase products from small businesses. At the local and state level the type of products that government entities are most often purchasing is construction. Minority vendors are very heavily involved in local and state government procurement, and one of the major problems they have in being vendors to governmental entities is that a lot of governments pay their bills very slowly. The combination for a minority-owned business in a field like construction of taking on a large job, performing the work, and then having to wait for a month to be paid by the local government, this can easily create serious liquidity problems for the firm. In other words, it might not be able to pay bills, and firms could possibly even go out of business. Local governments need to adopt "prompt payment provisions," which a number already have. The city of Chicago is a large city that has an explicit "prompt payment provision" for minority vendors to eliminate this type of problem.

At the state level, the state of Maryland has been a pioneer, and for over 20 years an agency of the state government has been offering short-term working capital loans specifically to minority-owned businesses that win local and state government contracts. Receiving a loan is not automatic. The minority contractor first wins the contract, then minority contractors have to establish that they do have solid comprehensive accounting systems. If they meet these requirements, the state agency will allow them to receive working capital loans that are tailored to the size and duration of their contract with a state or local government in Maryland. The program is quite effective in terms of the state agency collecting on its working capital loans because the contracting authorities, for example, the city of Baltimore, agree as part of the loan agreement to send the necessary loan repayments directly to the state agency that has extended the loan to the minority contractor.

Working capital loans become available, illiquidity is therefore not a problem. The minority vendors can concentrate on fulfilling their contracts knowing that they have the working capital to do the job. Indeed, there are some defaults on some loans, but the interest charged by the state to the minority borrowers more than compensates for any of the losses due to credit risks, and pays the bulk of the operating costs of the program as well. So, for minimal expense we have more effective contractors, the ability of minority businesses to take on larger jobs, and over time Maryland has found that the minority vendors receiving financing under the state program gradually move over to bank financing after establishing a successful record on contract performance and repayment of loans. The program, therefore, has largely destroyed itself by the year 2012 because it is really no longer needed. The constraint has disappeared and Maryland is known nationwide as one of the states that has been most successful in cultivating large, viable minority-owned businesses that have created lots of jobs.

Ford: Well, Tim, thank you very much for joining us today.

Bates: My pleasure.

Ford: This concludes our podcast. We've been speaking with Tim Bates, Wayne State University professor of economics. For more podcasts on this topic and others, please visit the Atlanta Fed's website at www.frbatlanta.org. If you have comments or questions, please e-mail us at podcast@frbatlanta.org. Thank you for listening.