Introduction

The Community Development Financial Institutions (CDFI) Fund was created by the Riegle Community Development Regulatory Improvement Act of 1994 (P.L. 103-325)¹ within the U.S. Department of the Treasury to promote economic development in distressed urban and rural communities, particularly through certifying and supporting CDFIs.² The CDFI Fund is authorized to certify banks, credit unions, nonprofit loan funds, microloan funds, and (for-profit and nonprofit) venture capital funds as designated CDFIs. Financial institutions that wish to become CDFIs must meet specified eligibility criteria, such as demonstrating that their primary mission is to promote community development by serving economically distressed people and places.³ With the CDFI designation, these institutions are eligible to receive financial awards and other assistance from the CDFI Fund.⁴

Congress has formalized systems for various categories of financial intermediaries—such as banks, credit unions, the Federal Home Loan Bank System, and CDFIs—all of which facilitate linking borrowers with savers.⁵ When creating these formal systems, Congress usually encourages covered financial intermediaries—even if they predominantly serve more creditworthy borrowers—to provide financial services and products to underserved populations and markets when feasible to do so and in a prudent manner. The CDFI Fund and designated CDFIs, however, were established to focus predominantly on financially distressed borrowers and areas.⁶ CDFIs, which are essentially a type of public-private partnership, promote accessibility of traditionally underserved populations and markets to affordable financial services and products, the policy goal generally referred to as financial inclusion.⁷

Traditional financial institutions generally do not focus primarily on customers with higher default propensities, referred to as subprime borrowers, due to profitability and risk exposure concerns. Subprime customers often require more labor-intensive counseling, underwriting, monitoring, and servicing (e.g., loan workouts) to mitigate even costlier outcomes (e.g., defaults) that would negatively affect both borrowers and lenders. They also often require nontraditional financial products (e.g., loans for short-term emergencies, credit repair). Thus, financial intermediaries must limit their exposure to above-normal risks and additional costs that could threaten both their actual and perceived financial well-being.

If broad financial stability concerns precipitate the neglect of higher-risk customers' needs, the CDFI industry's public-private partnership structure may be able to help fill the void.⁸ CDFIs can absorb the increased risks and costs associated with subprime lending because they receive funding in the form of public and private subsidies, grants, and awards. Subsidized funds give CDFIs a cost advantage over both traditional and non-CDFI subprime lenders when offering financial services to higher-risk customers. This financial support also provides CDFIs with another funding source to meet cash flow (liquidity) needs typically faced by traditional financial institutions.

Measuring CDFIs' performance and effectiveness is challenging. Certain performance metrics are difficult to fully understand because the large volume of activity to mitigate default losses, which is essential when serving nontraditional borrowers, adds ambiguity to the usual interpretations. Data collection gaps also exist, particularly in regard to the lending activities of small institutions and small loans with nonstandardized (financial) characteristics.⁹ Furthermore, greater income volatility experienced in underserved communities can undermine efforts facilitated by CDFIs toward financial inclusion.

This report begins with an overview of the CDFI industry. It then explains the target markets served by CDFIs as well as the higher costs associated with serving these niche segments. Next, challenges related to evaluating the performance and effectiveness of CDFIs are discussed. The CDFIs' public and private funding sources are summarized. Finally, the report provides considerations for Congress.

CDFI Industry: Composition, Size, Product Lines

Depository institutions (i.e., for-profit banks and nonprofit credit unions), loan funds, and venture capital funds may become designated CDFIs.

• Depository institutions provide financial services to savers (via accepting checking and savings deposits) and borrowers (via providing consumer and business loans). The deposits, generally insured by the federal government (up to an account limit), are a low-cost and largely stable source of funds to provide loans. Depositories also have prudential government regulators monitoring their financial safety and soundness practices. For example, depositories must hold reserves to buffer against financial losses due to borrowers' defaults. Many CDFI depositories consist of small community banks (defined in this report as having $1 billion in assets or less) and similarly sized or smaller credit unions.¹⁰
• Nonprofit and micro loan funds, which tend to target specific projects, are nondepository financial entities without access to federally insured deposits.¹¹ Instead, loan funds rely on multiple fundraising strategies.¹² Loan funds borrow or accept grants and awards from public or private sources. Various types of private sector investors include pension funds, university endowments, various types of financial institutions, (philanthropic) foundations, and individuals. Some of these private sector sources may donate funds. Loan funds also adopt various types of business models. Revolving loan funds, which rely upon the repayment of principal and interest to replenish funds that were used to make loans, can reduce some dependence on ongoing grant support.¹³ Their ability to make new loans, however, may still be limited until after various percentages of the outstanding balances of existing loans are repaid.¹⁴ Some loan funds issue debt securities to investors (in exchange for cash) that must be repaid with interest, and some micro loan funds may use crowdfunding.¹⁵
• For-profit and nonprofit venture capital funds are non-bank financial entities that make equity investments rather than loans. When providing funds, venture capital firms do not receive repayments of principal and interest as in the case of a traditional loan obligation. Instead, they have ownership interests (equity stakes) and receive an unspecified return linked to the fluctuating value of a specific investment. A CDFI venture capitalist, for example, may invest directly in a startup or a small business located in an underserved area.

As of September 30, 2021, the CDFI Fund reported 1,271 certified CDFIs that were comprised of 566 (45%) loan funds and 16 (1%) of venture capital funds, which do not collect federally insured deposits; and 387 (30%) credit unions, 168 (13%) banks, and 134 (11%) depository institution holding companies, which collect federally insured deposits.¹⁶ Thus, loan funds make up the largest share of CDFIs. However, 689 (54%) of the CDFI industry consists of banks and credit unions that interact directly with the public. The CDFI Fund also reported that CDFI credit unions held 61.1% of all CDFI industry assets in 2020.¹⁷

The CDFI industry represents a small percentage of the overall U.S. financial system. In 2020, the 1,271 CDFIs collectively held $151.8 billion in assets (loans).¹⁸ By comparison, the credit union industry in 2020 consisted of 5,099 federally insured institutions that collectively held $1.16 trillion in assets, and 4,074 small community banks, defined as having $1 billion or less in total assets, collectively held $1.158 trillion in assets.¹⁹ The CDFI industry is approximately 13% of the credit union industry's size, 13% of the small community banks' size, or 6.5% of both groups combined. The CDFI industry size would fall to 3.5% if their total assets were calculated as a percentage of total assets held by credit unions and all community banks (if community banks are defined as having $10 billion or less in assets). Furthermore, if these calculations included assets held by all depositories and other nondepository financial institutions (without CDFI designations), then the percentage of CDFI representation in the U.S. financial system would be less than 1%.

The primary product lines of CDFIs are consumer, residential real estate, and small business loans. By the end of FY2020, the CDFI Fund reported that the consumer finance category accounted for 36.8% of the dollar amount and 83.2% of the products offered by CDFIs.²⁰ The consumer finance category includes loans for health, education, emergency, credit repair, debt consolidation, and other consumer purposes. These products are likely to consist of payday alternative loans, secured credit cards, prepayment cards, or installment loans.²¹ In addition, CDFIs provide mainstream financial products with longer-term maturities such as residential mortgages, automobile loans, and student loans. The residential real estate financing category, which represents 34.7% of the dollar amount but 6% of the products offered, includes loans for the purchase, construction, and renovation of single-family residential and rental housing as well as for multifamily housing. Credit cards, which are revolving loans that allow for continuous access to credit as long as borrowers make at least periodic minimum payments, are also considered a mainstream financial product despite being open-ended without a definite maturity date. (CDFI depositories can also offer mainstream checking and savings accounts.) The CDFI Fund, however, does not report a ratio of consumer products with more mainstream features relative to those without, which could inform about the extent CDFI customers are eligible to use traditional financial products to meet their needs.

Additionally, a Federal Reserve survey of CDFIs—which was conducted in 2021 and received 345 responses, representing 27% of all certified CDFIs—found that many CDFIs, particularly CDFI loan funds, reported small business lending to be their primary or secondary line of business.²² Although not as prominent, CDFIs provide credit products to finance multifamily (e.g., apartment buildings, senior residence facilities and nursing homes) and commercial (e.g., medical and healthcare facilities, educational facilities) structures.

CDFI Niche Markets

Financial institutions serve different market segments.²³ CDFIs serve a specific customer segment that is more costly for traditional financial intermediaries to serve, as explained in this section.

Defining and Reporting of Target Markets

CFDIs must have a primary mission of promoting community development to maintain certification and qualify for financial assistance awards. The CDFI Fund requires that 60% of a CDFI's financial products (e.g., loans) must be deployed in an approved target market or eligible market, which is defined as one or more (1) investment areas or (2) targeted populations.²⁴

• Investment area refers to a geographic area that meets requirements set forth in Title 12, Section 1805.201(b)(3)(ii)(D), of the Code of Federal Regulations and would have a significant unmet need for loans, equity investments, or other financial products or services or is wholly located within an Empowerment Zone currently in effect or Enterprise Community (as designated under Section 1391 of the Internal Revenue Code of 1986 [26 U.S.C. 1391]).²⁵
• For a specified geographic area, target populations consist of individuals from the following populations. First, low-income targeted population is defined as individuals whose family income, adjusted for family size, is not more than (1) for metropolitan areas, 80% of the area median family income in metropolitan areas; and (2) for nonmetropolitan areas, the greater of 80% of the area median family income or 80% of the statewide nonmetropolitan area median family income. Second, other targeted populations include African Americans, Hispanics, Native Americans, Native Alaskans residing in Alaska, Native Hawaiians residing in Hawaii, other Pacific Islanders residing in other Pacific Islands, and other groups with CDFI Fund approval.

The CDFI Fund administers the Bank Enterprise Award (BEA), which relies upon two definitions—distressed communities and persistent poverty counties (PPCs)—to define the market that a CDFI bank must serve to qualify for the award.

• A distressed community must be a continuous area of general local government that (1) has a population of at least 4,000 if located in a metropolitan statistical area; (2) has a population of at least 1,000 in nonmetropolitan areas; or (3) is located entirely within an Indian reservation.²⁶ Additionally, at least 30% of eligible residents in the community must have incomes below the national poverty level (as published by the U.S. Census Bureau), and the community must have an unemployment rate at least 1.5 times greater than the national average (as determined by the U.S. Bureau of Labor Statistics' most recent data).²⁷
• A PPC is any county, including county equivalent areas in Puerto Rico, that has had 20% or more of its population living in poverty over the past 30 years or any other territory or possession of the United States that has had 20% or more of its population living in poverty over the past 30 years, as measured by the U.S. Census Bureau.²⁸ PPCs do not need to be located in a CDFI's approved target market. However, only qualified activities that occur in areas determined by the CDFI Fund to be distressed communities will count toward eligibility for a BEA award.²⁹ The CDFI Fund adopted these administrative procedures to ensure that at least 10% of funds designated for the BEA are used to support PPCs.³⁰

The CDFI Fund also relies upon CDFIs to serve communities with specific needs. In addition to the PPCs, the CDFI Fund provides supplementary awards to support the following programs:

• The Healthy Food Financing Initiative is part of a multiagency effort to combat food deserts.³¹ The CDFI Fund provides grants to CDFIs that subsequently target organizations serving low-income neighborhoods with limited access to affordable and nutritious food.
• The CDFI Fund initiated a capacity-building program to expand credit and other financial services to people with disabilities. Disabilities may increase the difficulty to maintain gainful employment, thus increasing the difficulty to qualify for financial loan products provided by traditional financial institutions. The demographic characteristics for this program include people with autism, veterans, elderly, and generally people who may be impaired from working.³²
• The Economic Mobility Corps (EMC) is a joint initiative of the CDFI Fund and AmeriCorps designed to enhance the capacity of CDFIs to provide financial literacy, financial planning, budgeting, saving, and other financial counseling.³³ EMC volunteers receive training in financial counseling and financial literary and are then placed in various CDFIs to work with residents in target markets and eligible markets.³⁴ Any organization—and not just CDFIs—may apply for EMC awards to place AmeriCorps service volunteers in CDFIs.

Since October 1, 2012, CDFIs have been required to use the U.S. Census Bureau data, available from CDFI Information Mapping System (CIMS), to designate and reaffirm their target markets.³⁵ In 2016, the CDFI Fund required CDFIs to submit Annual Certification and Data Collection Reports (ACR).³⁶ The CDFI Fund uses ACRs to ensure that its awards are disbursed to intermediaries predominantly engaged with serving the people and communities consistent with its mission. ACR data may also facilitate better understanding of the types of financial products obtained by customers and the development of a policy map comprised of CDFI target markets.

In 2020, the CDFI Fund solicited public comments on proposed data modifications to ACR and to introduce the Certification Transaction Level Report, which is designed to standardize and automate the data collection process.³⁷ Additionally, CIMS, which maps census tracts and counties based upon the CDFI Fund's various program criteria, would identify the localities that either fully or partially qualify as distressed communities.³⁸ On October 1, 2022, the CDFI Fund temporarily paused the acceptance of new applications and target market modification requests to update and test its reporting tools.³⁹ The CDFI Fund announced that operations were expected to resume in the "fall of 2023."⁴⁰

The Higher Costs to Serve and Service Target Markets

Given the target market requirements, certified CDFIs are likely to be principally engaged in risk-based or subprime lending.⁴⁹ CDFI customers with impaired or limited credit histories typically conduct fewer transactions with traditional depositories.⁵⁰ Small business startups that lack comprehensive financial and performance data or sufficient collateral to secure loans may be considered subprime borrowers.⁵¹ Small businesses that operate in distressed communities may also be considered subprime borrowers that face less predictable revenues streams.⁵² For example, developers of multifamily projects in CDFI target-market communities may face greater difficulty generating the cash flows necessary to repay loans without raising future rents on low- and moderate-income tenants, thus defeating the purpose of building affordable housing.⁵³ A survey of CDFIs corroborates that income loss was the most significant challenge facing their clients in 2020 and 2021.⁵⁴

CDFIs, therefore, rely extensively on relationship lending, which allows lenders to better understand their customers' financial risks. Although relationship lending is also important for prime borrowers, it requires even more meticulous interaction with higher-risk consumers and businesses located in distressed communities—and also incurs more costs. Extensive relationship lending requires gathering soft information, which contains circumstantial details for borrowers with less traditional financial information and records.⁵⁵ By contrast, traditional data—such as credit scores, recent pay stubs or tax returns, business licenses for self-employed applicants, or other documentation pertaining to the ability to repay loans—is easily accessible and often convertible to a digital format.⁵⁶ For CDFIs, originating loans—evaluating lending risks, providing financial education programs, providing flexible underwriting criteria, offering less mainstream and more specialized financial products (e.g., credit repair, debt consolidation, and small-dollar loans for emergencies), and pricing loans—is typically a more manual process and generally more costly relative to automated processes that can be more readily adopted for traditional customers.⁵⁷

After origination, loans require servicing, which can be done by a lender or contracted to a third party for a fee. For performing loans, servicing entails collecting and remitting the principal and interest payments. For a nonperforming loan, meaning that payment is not made in full or behind schedule, servicing requires greater monitoring of and interfacing with borrowers. Servicers may have to deploy various loss mitigation strategies such as forbearance or restructuring the initial loan terms. Thus, as in the case of underwriting, servicing CDFIs' customers is also more costly due to greater interaction with higher-risk customers to avert defaults.⁵⁸

In small business lending, prospective clients sometimes lack the eligible collateral to secure a loan.⁵⁹ In these cases, lenders may require loan (debt) covenants, which are contractual requirements to assure that a borrower's initial financial standing at underwriting remains in place over the life of a loan.⁶⁰ For the duration of a loan, a borrower would be required to abide by one or more covenant terms such as providing audited financial statements, maintaining a minimum cash reserve, maintaining a constant debt-to-net assets ratio or other relevant financial ratios, or limiting new acquisitions or assets sales. Loan covenants, therefore, allow lenders to monitor changes in borrowers' financial conditions and better anticipate changes in default risk. Borrowers in violation of loan covenants typically risk paying penalties, having their loan rates increased, having to put forth more collateral, or having their loans terminated.

CDFI lenders, however, are likely to make greater use of loss mitigation strategies—rather than loan covenants with stringent financial consequences—to address higher default risks of small business borrowers operating in their target market areas. Furthermore, in comparison to non-CDFIs that deploy loan covenants that may contain financial consequences, CDFI lenders bear more costs following a rise in default risk especially with smaller size loans that are less likely to generate enough revenues to offset the additional servicing costs. In sum, CDFI lending costs more per transaction (relative to more traditional lending) given that the loan origination, servicing, and monitoring tasks are more demanding and labor intensive.

Evaluating Performance and Effectiveness of CDFIs

CDFIs fund a significant portion of their lending activities with financial awards from both public and private sector sources. By subsidizing the heightened costs and risks, the public and private sector funding allows CDFIs to facilitate the transitioning of nontraditional customers into mainstream financial markets, thus furthering financial inclusion goals. (In this report, the section entitled "Public and Private Funding Sources" summarizes the various funding awards and fundraising activities undertaken by CDFIs.) In view of the subsidies, public and private stakeholders want to better understand CDFI performance and effectiveness. Measuring these criteria is difficult as a result of various data issues, discussed in this section.

Evaluating the Financial Performance of CDFIs

Prudential regulators generally require their regulated entities to demonstrate various levels of resiliency to key financial risks linked to their product lines.⁶¹ Tailoring prudential standards for the CDFI industry is challenging because (1) CDFI financial institutions vary by type, and (2) each CDFI institution—including the ones that are of the same type—have portfolios consisting of localized and highly customized loans.⁶² Despite these challenges, the CDFI Fund has adopted a set of minimum and prudent standards (MAPS), some described in Table 1 at the end of this section, similar to the CAMELS composite rating system for prudentially regulated depositories.⁶³ Because CDFI depositories already have government prudential regulators, the MAPS are particularly useful to assess nondepository CDFIs such as loan funds that lack prudential regulators.⁶⁴

CDFIs are required to report and substantiate MAPS metrics to signal their expertise in risk-based lending when applying for awards and grants as well as when raising funds from both the public and private sectors. CDFIs must demonstrate financial health to the CDFI Fund as well as other sponsors to avoid what may be referred to as a misaligned incentive problem in public-private partnerships, in which one partner shifts larger shares of risks and costs to the other partner.⁶⁵ In this case, acceptable MAPS demonstrate that a CDFI is not merely making higher-risk loans that would require costly loss mitigation. Having acceptable MAPS arguably reflects best practices and possibly some innovation in serving the higher-risk market segment. The CDFI Fund, therefore, takes into account MAPS (along with factors such as past track record) when determining whether and how much financial support to provide CDFI applicants.

In addition, MAPS are important when CDFIs seek funding from other sources. Banks require CDFIs to exhibit tolerable levels of financial health before providing financial support.⁶⁶ The Federal Home Loan Bank system requires member depository institutions to have prudential federal or state regulators; nondepository CDFIs must comply with MAPS to become members.⁶⁷ MAPS, therefore, may provide CDFI sponsors with some indication of a CDFI's ability to manage risk.

Interpreting individual MAPS at face value may provide limited information about the specific circumstances of an individual CDFI. For example

• The deployment ratio, computed as the gross number of loans outstanding divided by total available funds for lending, measures the amount of a CDFI's available funds that have been lent or invested. Deployment ratios vary by type and among individual CDFIs.⁶⁸ A low deployment ratio may indicate that a CDFI may need to increase lending volume. Some CDFIs, however, may not deploy all of their available funding for various reasons. Some applicants in target market areas pose excessive amounts of financial risk, which could jeopardize future public and private funding awards. Some CDFIs may lack staffing capacity to quickly process a volume increase in loan applications. Some CDFIs may face greater competition with non-CDFI lenders. Some CDFI depositories may not have sufficient amounts of capital or net worth reserves as required by their prudential regulators to buffer against the higher amounts of risk. One study found that both banks and loan funds cited that some prospective deals pose too much risk, CDFI banks in the study were more likely to cite greater competition, and loan funds were more likely to cite lack of staffing capacity.⁶⁹ A 2021 CDFI Survey found that over 75% of surveyed CDFIs cited limited staffing and funding as preventing them from providing more services.⁷⁰
• The self-sufficiency ratio, the ratio of earned income to total operating expenses (over a year), can gauge a CDFI's need for financial assistance.⁷¹ Interpretation of the self-sufficiency ratio, however, may not be straightforward.⁷² The self-sufficiency ratio does not reveal information about a CDFI's default experience. A CDFI's other MAPS—such as its delinquency ratio, loan loss reserve ratio, portfolio at risk ratio, and change in portfolio at risk ratio—would also require examining. Nevertheless, CDFIs without prudential regulators would not be required to write-off nonperforming assets or halt lending following a wave of defaults.⁷³ Likewise, because CDFIs tend to quickly intervene to mitigate losses stemming from distressed loans, the efficacy of those outcomes would not necessarily be captured by those ratios and still require further scrutiny. Lastly, the self-sufficiency ratio does not distinguish between the types of financial products a CDFI offers or whether the CDFI relies more on awards or more traditional funding.

Using multiple MAPS to assess CDFI performance while fulfilling their missions is still challenging, which may be illustrated using CDFI credit unions as an example. The CDFI Fund reported that CDFI credit unions had the highest deployment ratios in FY2020.⁷⁴ In addition, the mean self-sufficiency ratios of the 223 credit unions reporting in FY2020 was 1.0, which is above the 0.40 target for nonprofit firms shown in Table 1 below. In FY2020, CDFI credit unions also reported the highest mean (per unit) amounts of total charge-offs, total recoveries, and loans 90 days or more past due. The funding awards to CDFI credit unions, therefore, subsidized the costs of loss mitigation activities that would have otherwise translated into large losses for traditional and subprime lenders without CDFI designations.⁷⁵ In other words, if the subsidies indirectly allow CDFIs to remain in compliance with their prudential reserve requirements, yet the higher costs and default losses incurred while serving these niche markets appear to be shifted onto sponsors rather than abated, then CDFIs may arguably benefit more from the subsidies than their customers.⁷⁶ Furthermore, determining the feasibility of expanding target markets arguably becomes more difficult when financial metrics have contradictory interpretations and information about CDFI profitability is limited.⁷⁷

Another performance interpretation issue can arise when calculating the percentage of funds used by a CDFI in its target market. For example, a CDFI must have at least 60% of its financial activities, measured either in number or dollar amount of its total activities, occur in at least one eligible target market.⁷⁸ Suppose a CDFI depository made numerous small dollar loans in its target market area but only a few large (e.g., mortgage) loans outside of its target market area. In this case, the percentage of dollars deployed in a target market could fall below 60% even though 60% or more products were provided to the target market.⁷⁹ For this reason, the CDFI Fund has proposed lowering the minimum dollar threshold to 50%.⁸⁰

Evaluating the Effectiveness of CDFIs

The ability to directly link CDFIs' activities to improvements in financial inclusion is difficult due to various data collecting and reporting issues.

• Target areas with CDFI depositories might contribute to declines in unbanked or underbanked households, which can lead to establishing formal credit histories and transitioning to mainstream financial products. Neither the Federal Deposit Insurance Corporation (FDIC) survey of unbanked households nor its survey of household use of banking services, however, ask respondents, who are likely to lack familiarity with the CDFI Fund, whether they rely upon depositories with CDFI designations.⁸¹ Furthermore, as previously discussed, a ratio of nontraditional to mainstream financial products that are included in the CDFI Fund's consumer finance category is not reported, which might also provide insight about the extent CDFI intermediation lowers transaction and information costs in target markets.
• The Home Mortgage Disclosure Act of 1975 (HMDA; P.L. 94-200, 12 U.S.C. §§2801-2809) requires originators to disclose mortgage information to facilitate the monitoring of lending activity. On April 16, 2020, the Consumer Financial Protection Bureau (CFPB) issued a final rule implementing modified loan-volume thresholds for reporting open- and closed-ended loans via Regulation C.⁸² Going forward, the revised thresholds are likely to have the greatest impact on HMDA data collected from less densely populated areas, although the overall impact on HMDA reporting may be minimal.⁸³ The specific effect of this change on CDFI mortgage reporting is ambiguous. Although raising the threshold would likely result in less reporting by rural CDFIs, it may not matter if these CDFIs were unable to provide enough traditional mortgages to higher-risk borrowers under the lower threshold.⁸⁴ Additionally, lenders that underwrite and make the mortgage credit decisions are responsible for HMDA reporting. Therefore, CDFIs that act as brokers on behalf of the ultimate lenders would not need to report.⁸⁵
• CDFIs report on numbers and dollar amounts of small business lending in target markets, but the CDFI Fund may not collect credit applications information that may be useful for comparing applicant experiences from non-CDFIs that serve similar small businesses. On September 1, 2021, the CFPB issued a proposed rule for Section 1071 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203).⁸⁶ Section 1071 requires financial institutions to collect data pertaining to credit applications for women-owned, minority-owned, and small businesses. The data would be reported annually to the CFPB, thus being conceptually similar to the HMDA database. Using CDFI Fund ACR data from FY2019, the CFPB estimates that 340 nondepository CDFIs are engaged in small business lending; 240 of these would meet the proposed reporting threshold of originating at least 25 covered credit transactions for small businesses in each of the two preceding calendar years. In addition, reporting financial institutions would likely be able to identify whether they are CDFIs, thus linking some small business lending activities to the CDFI industry. The CFPB received comments from stakeholders estimating that compliance with the rule (once finalized) may take up to three years, particularly for those nondepository CDFIs that were generally subject only to CDFI Fund reporting requirements.

For populations that lack access to the traditional financial system, income volatility may still undermine any progress made toward credit repair, reducing debt balances, increasing savings, and repaying small business loans—all efforts facilitated by CDFIs. In 2020 and 2021, CDFIs reported that the most significant factor facing their clients is the loss of income or revenue, which may arguably be considered an exogenous or random happenstance.⁸⁷ For this reason, measuring the effectiveness of this industry may still be challenging—even with greater data collection and reporting—given that their activities occur in areas characterized by above-normal levels of income volatility that CDFIs cannot control.

Public and Private Funding Sources

This section summarizes the public and private funding sources for CDFIs. For sake of comparison, the textbox below summarizes how traditional intermediaries obtain the funds to serve their clients with more standard financial risk attributes.

CDFIs—and particularly nondepository CDFIs—fund loans by relying considerably on net assets rather than short-term borrowing. Net assets are analogous to a bank's equity or a credit union's net worth, defined as the difference between assets (e.g., long-term consumer and business loans) and liabilities (e.g., short-term borrowings). CDFIs rely on net assets, which consist largely of subsidized and donated funds due to limited access to private funding markets, for the following reasons.⁸⁸

• CDFI loan portfolios and particularly CDFI loan fund portfolios, which are typically comprised of loans with above-normal default risk levels, frequently lack sufficient comparable historical performance data on loan repayment patterns (e.g., loan defaults and prepayment rates).⁸⁹ Payment history lapses and geographical concentrations, which require manual underwriting of loan originations (as opposed to automated underwriting that would rely on greater data observations), limit the ability to compare or understand the embedded financial risks of niche CDFI loans and, therefore, raises questions about the accuracy of CDFI loan pricing.⁹⁰ For this reason, wholesale lenders either will not accept CDFI loans as collateral for short-term borrowings or charge much higher rates.⁹¹ The pricing issues also limit the ability of CDFIs to sell loans in secondary loan markets. Thus, when providing funds to CDFIs, wholesale lenders must generally be willing to accept lower returns or longer investment horizons, which better suits the CDFIs' business model by alleviating the recurrent need to repay shorter-term loans.⁹²
• Small financial institutions typically lack loan portfolios sufficiently large enough to justify the expense to acquire funding from wholesale market lenders, where many large financial entities borrow cash funds from each other. Consequently, the higher costs typically incurred with equity funding may still be a less expensive alternative for financial institutions with small loan portfolios.

The net assets of CDFIs are often acquired via awards or grants from the CDFI Fund, other federally related sources, for-profit banks, and philanthropy.⁹³ The low- and no-cost funding allows CDFIs to better absorb the heightened loss mitigation costs that can reduce bad outcomes for borrowers.⁹⁴ The ability to deploy low- or no-cost funding to originate loans for higher-risk borrowers provides CDFIs with a financial advantage over both traditional and subprime lenders competing in this market.

CDFIs' Access to Federally Subsidized Funding

The federal government provides CDFIs with low- or no-cost funds to support their mission of financial inclusion. After certifying CDFIs, the CDFI Fund administers the funding programs described below.⁹⁵ CDFIs may apply for the following programs administered by the CDFI Fund.

• Financial Assistance (FA) and Technical Assistance (TA). The CDFI Fund provides FA and TA monetary awards to qualified CDFIs.⁹⁶ The monetary awards, however, are subject to restrictions. For example, CDFI applicants must generally demonstrate that any award can be matched dollar-for-dollar with a grant (as opposed to a loan) from a nonfederal source, and an entity (or its affiliate) cannot receive more than $5 million in awards within a three-year period. However, these restrictions may vary with congressional actions. For example, P.L. 111-5 waived the dollar-for-dollar matching requirement in FY2009, FY2010, and FY2011. The requirement was reinstated for FY2012. The CFDI Fund may specify other requirements in the applicable notice of funds availability.⁹⁷
• Native American CDFI Assistance (NACA) Program. Native American CDFIs may receive funding awards via the NACA component of the CDFI program. Native American CDFIs primarily serve (defined at 50% or more of an applicant's activities) Native Communities (defined as Native American, Alaska Native, and Native Hawaiian communities). The CDFI Fund certifies new Native CDFIs and issues financial assistance and technical assistance monetary awards to facilitate capital access in Native Communities via its authority.⁹⁸
• Bank Enterprise Award (BEA). CDFIs whose deposits are insured by the FDIC may apply for the CDFI Fund's BEA program.⁹⁹ The BEA provides formula-based grants to banks, including CDFI-designated banks, to provide loans, equity investments, grants, and technical assistance to CDFIs.¹⁰⁰ The CDFI Fund measures increases in an applicant's lending, investment, and service activities relative to a baseline of similar, qualified activities conducted by the applicant in the previous application cycle. In contrast to the CDFI Fund's awards based upon proposed future projects, BEA awards are retrospective, meaning that applicants receive awards for activities they have already completed.¹⁰¹ The retrospective awards allow bank recipients to offset some of the financial risks associated with making riskier loans and, therefore, satisfy prudential capital (equity) requirements.
• New Markets Tax Credits (NMTC) Program. CDFIs may acquire equity investments by participating in the NMTC program. After receiving the Community Development Entity (CDE) certification by the CFDI Fund, a CDFI may apply for NMTCs, also allocated by the CDFI Fund.¹⁰² The NMTC is a competitively awarded nonrefundable tax credit intended to encourage qualified investors to support CDEs that operate in eligible low-income communities.¹⁰³ Once awarded an allocation of NMTCs, CDEs that are CDFIs may award NMTCs to taxpaying entities in exchange for equity investments.¹⁰⁴ (A bank, for example, that makes equity investments in CDFIs can reduce its tax liabilities via obtaining NMTCs.)
• Capital Magnet Fund (CMF). The CMF was established by the Housing and Economic Recovery Act of 2008 (P.L. 110-289) to competitively award grants to CDFIs and other nonprofit housing organizations for the development, rehabilitation, and purchase of affordable housing and economic development projects in distressed communities.
• CDFI Bond Guarantee Program (BGP). The BGP was established in 2010 to provide CDFIs with access to long-term funding, also known as patient capital, to reduce conventional funding risk, which arises when intermediaries acquire funding via sequences of short-term loans and risk greater volatility in short-term rates.¹⁰⁵ Treasury was initially given the authority to guarantee up to 10 bonds per year, each at a minimum of $100 million with maturities not to exceed 30 years. Authorized CDFIs (referred to as qualified issuers) would sell the bonds to the Federal Financing Bank (FFB) in exchange for cash proceeds that would need to be repaid with interest (to the FFB).¹⁰⁶ The authorized CDFIs would subsequently use the cash proceeds to make short-term loans to other CDFIs. Stated differently, the BGP would allow qualified CDFIs issuers to acquire federally guaranteed funds and then provide long-term wholesale funding to other CDFIs. (The CDFI borrower of funds must have collateral to obtain a loan from an authorized CDFI, thus having similarities to a repurchase agreement.)
• Small Dollar Loan (SDL) Program. The SDL program, authorized by the Dodd-Frank Act (P.L. 111-203), provides funding for SDLs.¹⁰⁷ SDLs are consumer loans with relatively low initial principal amounts (often less than $1,000) with relatively short repayment periods (generally for a small number of weeks or months).¹⁰⁸ SDLs funded by grants from the SDL program cannot exceed $2,500, must be repaid in installments, and cannot have any prepayment penalties. Furthermore, SDL repayments must be reported to a least one of the consumer reporting agencies that compiles and maintains files on consumers on a nationwide basis, thus having similarities to payday alternative loans offered by credit unions.¹⁰⁹ The CDFI Fund also provides CDFIs with funds to defray the cost of establishing an SDL program.¹¹⁰

During emergencies, Congress has authorized the CDFI Fund to provide additional financial assistance. In response to COVID-19, for example, Treasury provided CDFIs with additional financial support pursuant to Sections 522 and 523, Division N, of the Consolidated Appropriations Act, 2021 (P.L. 116-260).

• Emergency Capital Investment Program (ECIP). Section 522 created the ECIP, which authorized Treasury to purchase up to $9 billion of equity shares in CDFI depository institutions and minority depository institutions (MDIs).¹¹¹ The ECIP investments would boost the capital buffers held by depositories against heightened default risks stemming from the pandemic.¹¹² As a result, these depositories would be able to remain in compliance with their prudential requirements and continue lending. Of the $9 billion, $4 billion is set aside for CDFIs and MDIs with less than $2 billion in assets, and of that, at least $2 billion is set aside for CDFIs and MDIs with less than $500 million in assets.¹¹³ In October 2021, Treasury announced that 204 institutions had requested almost $12.9 billion ($3.9 billion more than the program size limit) of ECIP investments.¹¹⁴
• CDFI Rapid Response Program. Section 523 appropriated an additional $3 billion of emergency grant funding for CDFIs to help their communities respond to the economic impact of the COVID-19 pandemic. Pursuant to Section 523, the CDFI Fund opened the first funding round for the CDFI Rapid Response Program in February 2021 to provide $1.25 billion to CDFIs.¹¹⁵ By June 2021, those funds were awarded to 863 CDFIs.¹¹⁶

CDFIs may apply and compete for financial awards provided by other departments in Treasury, other federal agencies, and federally related agencies or incentives. The list below provides examples of federal and federally related funding programs, but it is not all-inclusive.

• The State Small Business Credit Initiative (SSBCI), a Treasury program authorized by the Small Business Jobs Act of 2010 (P.L. 111-240), was initially created to provide assistance to small businesses following the Great Recession (2007-2009).¹¹⁷ In response to the pandemic, the American Rescue Plan Act of 2021 (P.L. 117-2) reauthorized the SSBCI, which will provide a combined $10 billion to small businesses in the states, the District of Columbia, territories, and tribal governments.¹¹⁸ CDFIs can provide loans or investments to small businesses supported by SSBCI funds.¹¹⁹
• The U.S. Department of Agriculture (USDA) has a variety of grant programs that CDFIs can apply for and subsequently provide loans in rural communities.¹²⁰ For example, the Intermediary Relending Program, the Rural Microentrepreneur Assistance Program, and Value-Added Producer Grants provide loans or grants to financial intermediaries to support businesses and economic development in rural communities.¹²¹
• Each Federal Home Loan Bank district has an Affordable Housing Program that provides grants on a competitive basis to membership institutions, which may include CDFIs.¹²² The grants can be used to support the acquisition, construction, or rehabilitation of affordable rental housing and for single-family housing programs for veterans, those with disabilities, or other designated needs.¹²³
• CDFIs may obtain financing from banking firms that are covered by the Community Reinvestment Act (CRA; P.L. 95-128).¹²⁴ By providing net assets to CDFIs that originate loans (particularly in the locations where they collect deposits), banks may obtain CRA credits that receive consideration when applying for branches, mergers, and acquisitions, among other things. Banks often provide funds to CDFIs through equity equivalent investments (EQ2s), which are debt instruments issued by CDFIs with a continuous rolling (indeterminate) maturity. EQ2s, from a bank's perspective, are analogous to holding convertible preferred stock with a regularly scheduled repayment.¹²⁵
• The Community Development Block Grant (CDBG) program, administered by the Department of Housing and Urban Development (HUD), allocates federal assistance to state and local governments to support neighborhood revitalization and community and economic development efforts.¹²⁶ CDFIs, particularly loan funds, may be eligible for CDBG funds to carry out activities that would create or retain jobs in their target market areas or be located within HUD-approved neighborhood revitalization strategy areas.¹²⁷
• Numerous federal government agencies (e.g., HUD, USDA, the Small Business Administration) and certain federally related entities guarantee loans for low- and moderate-income borrowers or for borrowers who reside or operate businesses in underserved locations. Federally insured loans may cover some or all of the default risk depending upon the specific federal guaranty program. After receiving subsidized funds, a CDFI (as well as other traditional financial institutions) can originate loans that meet the eligibility requirements for various federal guarantees, thus protecting the funds that were lent.

CDFIs' Access to Selected Private Funding Sources

Despite access to public funding, CDFIs still need access to alternative funding sources for the following reasons. First, many CDFIs have greater funding needs than is available in CDFI grants and awards, and they must raise private sector funds to even qualify for certain awards.¹²⁸ Some awards provided by the CDFI Fund (e.g., financial assistance, technical assistance) require CDFIs to raise private funds, which may lessen a misaligned incentive problem, namely, to engage in lending activities that would require costly loss mitigation. Second, CDFIs tend to request more funding than they typically receive, which is exacerbated when federal programs experience budget cuts or changes in eligibility requirements, as highlighted in the following examples.¹²⁹

• Contributions to the CMF, which must be made by Fannie Mae and Freddie Mac rather than through appropriations, were initially suspended in 2008 after Fannie and Freddie were placed under conservatorship.¹³⁰ Furthermore, when applying for CMF competitive awards, a CDFI must demonstrate in the application that the cost of the eligible activity equals at least 10 times the amount of the potential funding award.¹³¹
• Appropriations delays resulted in delays implementing the BGP. Congress also reduced the program's potential lending authority of $1 billion annually (for four years of authorization) to $500 million annually.¹³²

In short, CDFIs essentially compete with each other for limited subsidized funding awards and, therefore, must also rely upon private funding sources, discussed in this section.

Funding Sources for CDFI Depositories

The CDFI depository institutions, representing 54% of all CDFIs in 2020, can collect and pay interest on federally insured deposits, which are typically less expensive sources of funds relative to borrowing in the short-term financial money markets. Small depositories, however, collectively hold substantially fewer deposits (relative to large banks).¹³³ Furthermore, CDFI depositories that serve predominantly economically distressed markets are likely to collect even fewer deposits relative to comparable small depositories without CDFI designations. Nevertheless, CDFI depositories would collect low-cost deposits.¹³⁴

As previously stated, 30% of CDFIs are credit unions that collectively hold 61.1% of CDFI industry assets in 2020. The National Credit Union Administration (NCUA), the primary regulator of credit unions, sponsors initiatives to support the mission and liquidity of small credit unions (less than $100 million in assets), eligible low-income designated credit unions, and minority credit unions with various exemptions and grants.¹³⁵ CDFI credit unions are exempt from the statutory cap on member business lending.¹³⁶ Credit unions are also eligible for grants and low-interest loans from the Community Development Revolving Loan Fund.¹³⁷ In short, NCUA can provide CDFI credit unions with access to funding at a lower cost relative to other options outside of the credit union system, which can help alleviate liquidity pressures.

The Federal Home Loan Bank (FHLB) System

CDFIs can apply to become members of the FHLB system, a government-sponsored enterprise, to gain access to short-term funding.¹³⁸ Each district FHLB provides its members liquidity in the form of advances, which are cash loans. FHLB members may also receive discounted advances via the FHLB's Community Investment Program, which is designed to support residential and housing development in areas meeting certain eligibility requirements, as well as via the FHLB's Community Investment Cash Advance program, which is designed to support broader community and economic development.¹³⁹

As of the fourth quarter of 2020, 64 CDFIs were members of the FHLB system, representing 5% of all CDFIs in 2020.¹⁴⁰ Relying on FHLB advances may be a less feasible option for many CDFIs for the following reasons.

• Member institutions must place a minimum paid-in capital stock investment as a condition to become and remain members of their district FHLB. These capital requirements increase the costs for CDFIs, particular many of the smaller CDFIs that are loan funds, to join the FHLB system.¹⁴¹ Furthermore, joining the FHLB system may be more cost-effective for CDFIs with large asset portfolios but less so for those with much smaller lending portfolios.¹⁴²
• FHLB advances are collateralized by members' assets, such as mortgages, mortgage-related assets, and certain small business loans. By contrast, certain loans that may be suitable for underserved markets (e.g., chattel loans) as well as other nonstandard CDFI loans that cannot be quickly liquidated may be considered ineligible collateral for FHLB advances.¹⁴³
• CDFI loan funds may specialize in certain types of lending. For example, while some CDFIs have a primary focus on underwriting and raising funds for housing, others may focus on community and small businesses. FHLB membership eligibility, however, requires nondepository institutions to have mortgage-related assets that reflect a commitment to housing finance as determined by the discretion of a FHLB.¹⁴⁴ Nondepository CDFIs without a primary housing focus, therefore, may not be granted FHLB membership. Failure of a nondepository CDFI would likely not have a material financial impact on a regional FHLB.¹⁴⁵ However, an affected FHLB must incur additional costs if it must sell distressed assets (i.e., non-housing loans) held by a failed CDFI lacking both a primary housing focus and a receiver such as the FDIC or NCUA.¹⁴⁶

The Farm Credit System (FCS)

The FCS is a nationwide financial cooperative consisting of four district banks and member lending institutions that collectively operate as a government-sponsored enterprise.¹⁴⁷ After raising funds by selling bonds to private investors, the FCS acts as either a direct lender to eligible individuals and businesses (those unable to qualify for commercial loans from a depository) or as a wholesale lender to its member institutions. As a direct lender, the FCS has the authority to make certain agricultural and rural loans that can be used to purchase land, livestock, equipment, and other supplies as well as to construct buildings or make farm improvements.¹⁴⁸ As wholesale lenders, the FCS's district banks can lend funds to their member financial institutions, which subsequently provide similar agricultural and rural loans. In addition, the FCS provides loans to other financial institutions (OFIs), which are nonmembers that are significantly involved in lending to borrowers eligible to receive loans from the FCS. Some CDFIs—specifically some Native CDFIs, for example—participate as OFIs with the FCS to obtain the low-cost funding available to its member institutions.¹⁴⁹ As of December 31, 2020, the FCS reported providing 18 OFIs with loans of $839 million but did not report separately on CDFI-designated OFIs.¹⁵⁰

CDFI Securities Offerings

Some CDFI loan funds and CDFI venture capital funds may offer debt securities to the private sector in exchange for funding. CDFIs can use these funds to support impact investing—also referred to as environmental, social, and governance (ESG) investing—which involves providing financial support to firms focusing on environmental issues, social issues, and governance (e.g., a firm's self-governance and integrity when conducting business).¹⁵¹ If ESG or impact investment opportunities arise in a target market area, some CDFIs may issue either rated or unrated securities to meet certain funding requirements:

• Some CDFIs can issue short-term debt securities and subsequently use the funding to offer financial support for economic security, health and healthy food, environmental sustainability, women- and minority-owned businesses, and other causes.¹⁵² These CDFIs can raise funds either directly for their borrowers or for the benefit of other CDFIs.¹⁵³ Instead of relying on short-term borrowings to fund long-term loans, debt securities may be issued for maturities equal to or even greater than the maturities of customer loans retained in lending portfolios.¹⁵⁴ CDFI-issued securities can receive ratings based on the financial strength of a CDFI issuer to withstand changes in its operating environment. These ratings may be provided by independent rating agencies that specialize in assessing impact investments.¹⁵⁵ Although CDFIs under most circumstances would pay for ratings, a strong credit rating may increase the attractiveness of these debt issuances to investors and perhaps allow issuers to pay lower yields.¹⁵⁶
• Rather than issue investment-grade-rated securities, some CDFIs may choose to issue speculative (e.g., non-investment-grade rated or non-rated) securities that typically trade less frequently than higher-rated bonds. However, they may cost less to issue and be more suitable for small issuers or for financing small projects.¹⁵⁷ The Securities and Exchange Commission's (SEC's) Regulation D provides an exemption from the normal registration process for entities that want to raise funds using a nonpublic, private placement of (unrated) securities. Regulation D requires no general solicitation under most circumstances, the securities cannot be resold, and the issuance cannot exceed certain dollar amounts subject to specific restrictions.¹⁵⁸ Despite lower issuance costs, investors typically expect to be compensated at higher rates of return for agreeing to hold speculative securities. During periods of low interest rates on government securities, however, speculative securities may become more attractive such that investors may be willing to accept relatively lower compensation for holding more risk, resulting in access to cheaper funding for issuers during this particular period.¹⁵⁹

Crowdfunding on Behalf of Small Businesses

CDFIs may participate in crowdfunding, which refers to use of the internet by small businesses to raise funding through limited contributions from a large number of contributors and guided by Regulation Crowdfunding.¹⁶¹ For example, a CDFI may serve as a crowdfunding platform to raise funds on behalf of a small business operating in its target market, and the collected proceeds can be used for the Community Advantage program to increase access to loans guaranteed by the Small Business Administration (SBA).¹⁶² CDFIs can register with the SEC as funding portals, defined as crowdfunding intermediaries (rather than as brokers).¹⁶³ Afterwards, a CDFI can provide a crowdfunding platform, which is the internet website that provides the information about the project(s) in need of funding and electronically collects the proceeds contributed by crowdfunding participants. In 2012, the SEC finalized a rule implementing the Jumpstart Our Business Startups Act (JOBS Act; P.L. 112-106), increasing access to low-cost capital by allowing an exemption from the normal (and costly) registration and filing requirements for entities (meeting certain requirements) to make low-dollar security offerings via crowdfunding.¹⁶⁴ On November 2, 2020, the SEC increased the threshold limit from $1 million to $5 million over a 12-month period, thus allowing crowdfunding to become a more viable low-cost funding option for various businesses.¹⁶⁵

Congressional Considerations

The CDFIs' target markets are comprised of higher-risk customers that are more costly to serve in comparison to prime borrowers. CDFIs rely considerably on public and private grants, awards, and donations to obtain the net assets to fund their lending portfolios, which are comprised of higher-risk loans. By subsidizing the costs to provide extensive amounts of loss mitigation, CDFIs gain a financial advantage over both traditional and subprime lenders that enable them to serve higher-risk borrowers and promote financial inclusion.

Policies to mitigate societal costs that can arise if financial institutions make loans to borrowers who are more likely to have repayment problems inadvertently limit making credit available to some borrowers with the potential to become more creditworthy.¹⁶⁶ For example, prudential regulations for traditional depository institutions are designed to sustain sufficient liquidity and capital reserves to buffer against default losses, thereby mitigating widespread public pessimism and loss of confidence in the banking and financial system.¹⁶⁷ Frequent loan defaults, liquidity disruptions, or declines in asset prices (e.g., market value of loans) that occur more frequently with transactions involving higher-risk populations—those who have with impaired credit histories or face greater income volatility—pose greater costs for prudentially regulated institutions.¹⁶⁸ Consequently, policies that support the CDFI industry's mission may complement policies that promote the stability of financial institutions, particularly if the latter policies, which preclude taking above-normal risks, discourage greater accommodation of higher-risk customers.¹⁶⁹ Alternatively, CDFIs may still be considered weak financial institutions that may face insolvency in the absence of subsidies, which distort the true costs of the default risks associated with serving unprofitable borrowers. Hence, subsidies deployed to counterbalance residual effects that stem from various prudential policies may still result in a less productive use of funds.

Another factor for consideration is the willingness of the private sector to support financial inclusion efforts. As a type of public-private partnership, CDFIs are required to raise funds from the private sector to mitigate the risk of a CDFI shifting additional costs and higher financial default risks to the public sector as well as to supplement the unevenness or decline in available public funding. The sustainability of the CDFI industry's public-private partnership approach, therefore, may signal the extent to which private lenders are willing to put their funds at risk to support financial inclusion.¹⁷⁰

Various metrics related to the overall performance and effectiveness of CDFIs may demonstrate the progress they have made toward financial inclusion—but data challenges exist. For example, large amounts of servicing and loss mitigation adds ambiguity to some CDFI performance metrics. Data collection gaps impede the ability to measure CDFI industry effectiveness. Furthermore, the scarcity of comparable data concerning the lending of other small lenders on these populations and areas is scarce, making it difficult to demonstrate that CDFIs have an impact beyond those provided by other small lenders that do not receive these subsidies. Even if better data were available, CDFI customers face greater income volatility, which can still undermine any benefits provided by CDFIs.