Agents of their own success: channeling private capital to promote financial inclusion
There are 45 million Americans who lack access to credit and are disenfranchised in today’s financial economy. Those excluded are more likely to come from historically marginalized groups — black, Hispanic, Native American, and low-income households — and reside in communities that are financial deserts unserved by traditional financial institutions.
Since these households are likely to be invisible to national credit rating agencies, lenders are much less willing to extend credit, which keeps these households on the periphery of the traditional financial economy. These households find themselves stuck on established pathways to wealth creation because it is difficult, if not impossible, for them to fund some of life’s greatest goals – education, buying a car, creating a business, buying a house.
Access to credit brings other financial benefits, such as lower borrowing rates, which help households through difficult times. For example, in 2020, the financial fragility of disenfranchised households was severely exposed when unemployment due to illness or pandemic-related policies left many households without their main source of income. Many households, especially those with variable monthly incomes, said they would not be able to cover their expenses for more than two weeks.
This state of fragility is aggravated by time. The longer a household remains in the financial periphery, the harder it will be to enter and be included in the mainstream financial economy, perpetuating the disenfranchisement of historically disadvantaged communities.
How can we break the cycle?
By leveraging the ability of the securitization market to raise significant private capital and channel that capital through community development financial institutions (CDFIs), for example, institutions can increase lending and expand their primary mission of providing capital and credit to low-income and underserved communities. households and businesses headed by minorities and women. CDFIs are locally controlled private sector financial intermediaries, founded on the idea that lenders at the local level are better placed to understand the nuances of their underserved communities, and therefore make better lending decisions. In 2019, 84% of CDFI’s clients were low-income, 60% were people of color, 50% were women, and 28% lived in rural areas, according to Opportunity Finance Network’s 2019 Annual Membership Survey. This is where securitization has a role to play in financial inclusion.
Securitization is a financing tool that has made credit more available and affordable. Originally designed to expand home ownership by making mortgages more accessible, securitization has become an important financing technique used by consumer and commercial loan lenders. In 2020 alone, securitization funded $3.7 trillion in loans to individuals, families, small businesses and large corporations. Approximately $15 trillion of existing consumer and commercial loans have been funded through securitization. When a lender uses funding from a securitization to make more loans, the multiplier effect of the securitization can significantly expand a community’s access to essential financial services.
Additionally, recent developments in credit rating have the potential to facilitate the securitization process. A credit score is traditionally derived from a person’s credit report and predicts the likelihood that a person will default on a loan. The score takes into account a person’s payment history on credit card, car or mortgage loans, as well as the incidence of bankruptcies and foreclosures. The score also looks at how long a person has been dealing with credit and the types of credit used, among other factors. Unfortunately, a person who has not been able to participate in the traditional credit economy cannot be graded in this way. Fortunately, that is changing. The rapid development of data technology has made it possible to calculate credit scores using a range of alternative data.
Alternative data goes beyond the traditional sources that can only be obtained with some kind of credit history and instead looks at non-traditional sources such as utility payments, home rental payment patterns and l savings and checking account activity, to name a few. A credit score with one of the national credit rating agencies is the key to unlocking access to credit and financial services for millions of Americans. A credit score derived from non-traditional sources would allow creditworthy individuals to take the first step towards financial stability and wealth creation.
Since a credit score helps quantify a borrower’s risk of default, a score facilitates a lender’s underwriting process and allows lenders to step up their socially responsible lending decisions. Quantifiable default risk also allows capital market investors to incorporate objective data into their investment analysis to make responsible investment decisions while supporting the lending efforts of community-focused institutions.
Securitizations partially or fully backed by CDFI loans also provide investors with investment opportunities that have a societal impact – an important investment component for structured finance investors and their pension plans, savings plans, family offices. and underlying bank customers. Socially responsible investing has experienced a meteoric rise creating strong market demand for investments with both financial and non-financial impacts.
Securitization and credit rating expansion can help CDFIs build a community from within, opening up access to the tools needed to build wealth and financial stability. Combined with complementary policy solutions, private capital invested with CDFIs can create a stable and sustainable source of funding for underserved communities and promote a financially inclusive economy.
Elen Callahan is Managing Director, Head of Research for the Structured Finance Association in Washington, D.C.