Mainstreaming Minority-Owned Small Businesses: A Look at Capital Access
September 23, 2014
By Krishnan Sethumadhavan, SAS ’17
A study recently published in the Journal of Consumer Research showed that minority business owners were more likely to be asked to provide financial statements, tax returns, and bank account information than their white counterparts – implying that loan officers trusted minority business owners less and were less likely to approve a loan from them. Even when minority-owned businesses are provided loans by banks, they were for smaller dollar amounts and at 32% higher interest rates, on average.
The major obstacle in this quest for capital quest for capital to either initiate or expand minority-owned small business is the trust gap that exists between lenders and borrowers. Lenders tend to view minority owned small businesses as being miniscule, irrelevant, and only marginally profitable when nothing could be further from the truth. Minority owned small businesses have annual receipts of over $1 trillion and employ nearly 6 million employees around the country. They work in all fields from construction to food preparation to finance and tend to grow faster than non-minority owned small businesses – even during the Great Recession. Importantly, these minority owned small businesses are often located in areas with high concentrations of minorities and reinvest in these communities, which can often help to arrest the cycle of poverty wracking urban areas in the United States.
Diminishing credit access and higher borrowing costs disproportionately impact the creation and growth of minority businesses across America. Because minority firms in the United States employ predominately minority people, this capital disparity hurts minority communities by reducing employment and reinvestment in these communities – which can increase negative societal outcomes like crime and drug usage. In turn, these negative outcomes reduce capital availability to minority entrepreneurs, creating a “cycle of impossibility” which hurts businesses and communities.
This is a serious issue, especially in Queens – the borough in which Representative Grace Meng’s district is located, which is one of the most ethnically diverse places in the country and is home to more than 500 certified minority-owned small businesses. Until 1985, the Small Business Administration (SBA) provided direct business loans to qualified small businesses and set aside a number of these loans to businesses certified under the minority small business capital ownership development program. However, it no longer does so and instead only guarantees loans given to small businesses. The size of these loans has steadily increased over the past decade, making it less likely that they would be given to minority-owned small businesses, which are seen as a bigger risk. Currently, the SBA is taking steps to increase capital access to minority-owned businesses, but is only doing so indirectly. These steps include waiving fees for smaller loans and streamlining the application process for underwritten loans of $350,000 or less – which helps reduce the costs of application to minority owned small businesses, which often take out loans for smaller dollar amounts than non-minority owned small businesses.
Examples of how to increase capital availability can be found both in the federal government and in state and local governments. The Department of Transportation (DoT) offers a line of credit of up to $750,000 to largely minority owned businesses pursuing contracting opportunities in DoT funded projects. This means that although the government may not pay the companies quickly, they are still able to access credit to work on projects. Unbundling large contracts and ensuring prompt payment for completed work can also make a substantial difference for minority-owned small businesses with minimal cost to taxpayers. Another example of a program that could be implemented is one modelled after Ohio’s Minority Business Direct Loan Program, which provides low-interest rate loans to certified minority-owned businesses that are purchasing or improving fixed assets and creating or retaining jobs.
These solutions however, do not address the ultimate trust gap that exists between lenders and minority-owned small businesses and cannot be implemented considering the political realities. In our office, we discussed a policy solution that we felt addressed this gap and would be able to pass a divided Congress. Essentially, it calls for the establishment of a public-private partnership that would construct a secondary market for loans to minority-owned small businesses through the usage of Consolidated Loan Obligations (CLOs).
The Current System:
The Proposed System:
The overall structure of this secondary market would be that loan providers like banks, credit unions, municipalities, and other financial institutions would sell their loans to minority-owned small businesses to the overall loan pool, where a government agency (preferably the SBA, but other organizations could work) would package these loans into notes with various levels of risk. Then initially, impact investors from religious foundations, social entrepreneurship firms, and foundations would purchase these packaged loans with the understanding that their money would go towards supporting minority-owned small businesses but that they would receive below-market returns as the initial investors. Soon thereafter, regular investors, such as investment banks, pension funds, insurance companies, and corporations would begin purchasing these packaged loans after seeing the success of impact investors and a cycle would begin where funds would reach minority-owned small businesses. To ensure that the market does not collapse if a loan is defaulted upon, a credit reserve pool would be capitalized that would serve as insurance for investors on these loans. The government would work in a few different capacities in this model: (1) it would provide marketing support for the model, attracting lenders and impact investors; (2) it, along with private charities, would capitalize the credit reserve pool; (3) it will underwrite the initial transaction costs involved in entering the market; (4) to provide information on minority-owned small businesses and ensure transparency in the marketplace in general.
The advantages of this approach are manifold in that the secondary market that has been built is self-sustaining because of the fact that the increased yields appeal to investors’ sense of self-interest and therefore does not require extensive, continuous government expenditure. The vast majority of costs will be initial in nature and as the marketplace grows, transaction fees will help to pay for the startup costs. This policy would address the root causes of the capital shortage for minority owned small businesses – trust – by taking it out of the picture in large part. The marketplace can be implemented and administered through an existing government agency, meaning that there will be no huge increase in red tape and most importantly, the plan represents a public-private partnership which could have bipartisan appeal in a divided Congress.
Additional Blog Posts
Student Blog Disclaimer
The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.