Profitwise News and Views

September, 2003 Issue

Seeds of Growth Conference Summary

Seeds of Growth Sustainable Community Development: What Works, What Doesn't, and Why

Session Six - International and Cultural Dimensions
The paper by Maude Toussaint-Comeau and Robin Newberger of the Federal Reserve Bank of Chicago and Art Rolnick, Jason Schmidt, and Ron Feldman of the Federal Reserve Bank of Minneapolis, Credit Availability in the Minneapolis-St. Paul Hmong Community, seeks to develop a better understanding of immigrant/refugee small business financing. The Hmong are immigrants from Laos and other Southeast Asian countries who settled in the United States in the late 1970s as political refugees following the Vietnam War. There are approximately 170,000 Hmong living in the United States today. The largest concentration lives in Minnesota, part of the Ninth Federal Reserve District covered by the Federal Reserve Bank of Minneapolis, and Wisconsin, which encompasses part of the Seventh District covered by the Federal Reserve Bank of Chicago, and part of the eastern portion of the Ninth District.

Rolnick provided the introduction to the presentation of this paper. He mentioned the congressional mandate set forth in the CRA for the Federal Reserve System to ensure that commercial banks meet the credit needs of their communities. An economist would question the term "credit needs," and would probably instead ask whether credit markets are working, or whether there is market failure. If there is a market failure, the economist would like to understand it and try to develop corrective policies. Possible reasons for credit market failures include asymmetric information, where borrowers and lenders have unequal information. This is a major issue among small businesses. Discrimination (racial/ethnic, age, etc.) is another major issue that can lead to credit market failure. The motivation for the study was to obtain a better understanding of credit markets, within a community at higher risk for market failure and associated effects.

The authors chose to study the Hmong for two primary reasons. First, being a relatively recent refugee group, the Hmong are more likely to suffer from both cultural and economic disadvantages. Cultural disadvantages include a formerly rustic lifestyle and little familiarity with formal borrowing and lending. Rolnick stated that the Hmong "don't even have words for bank or loan." The Hmong also clearly come with economic disadvantages, arriving in the country as refugees - not as immigrants seeking out the economic advantages of living in the United States. The Hmong are an emerging and growing small business sector in the Twin Cities that have not been studied previously. The authors sought to understand credit markets and how they might work in low-income, distressed areas. As a recent immigrant refugee group making economic progress, evidenced by their growing business sector, the Hmong offered a promising case study.

The methodology for the paper was based on a more elaborate survey instrument developed by the University of Chicago and the Federal Reserve Bank of Chicago for their data collection in Hispanic and Black neighborhoods in Chicago.¹ Aside from the current paper by Toussaint-Comeau et al., Paul Huck, Sherrie Rhine, Robert Townsend, and Philip Bond used the data gathered with this instrument in a previous study, A Comparison of Small Business Finance in Two Chicago Minority Neighborhoods, to measure credit access from both formal and informal sources.

For the Hmong study, the original survey tool was translated into Hmong. A Hmong advisory group that provided insights on potential cultural and language problems reviewed the survey. Several issues were identified and worked out through this process. Rolnick stated that "it was very important to work with the community; this was a lesson that came out of the Chicago experience."

The surveyors (the Wilder Institute) compiled a list of all the Hmong businesses they could find, locating 170 establishments, and obtained 121 responses, for a response rate of 71 percent. Rolnick attributed the very high response rate to working closely with Hmong community leaders and promoting the survey on Hmong cable television stations. A comparison group was also established that identified 220 non-Hmong businesses within the same geographic area, namely the central cities of Minneapolis and St. Paul. The latter group provided 131 responses for a 61 percent response rate. Ninety percent of the respondents in the comparison group were White-owned businesses. Therefore, the researchers controlled for geography and race in considering differences regarding the availability of financial resources, especially credit. After obtaining the survey results, the researchers followed up with Hmong community members and local bankers to verify their accuracy. Post-survey focus groups were presented with the results to determine what important aspects, such as experiences and insights, might not have been captured by the survey.

Rolnick stated that the major finding of the study was that "Hmong entrepreneurs in the Twin Cities appear to have well-developed access to the banking sector." He added that the finding was a bit of a surprise, because of all of the factors that the Hmong appeared to have going against them.

Toussaint-Comeau, the lead investigator of the joint Minneapolis/Chicago project, provided more details regarding the paper's analysis. First, she noted the reasons for the focus on access to credit by start-up businesses.

Toussaint-Comeau explained that in the paper, they measure access to credit both in terms of the relative propensity of the Hmong to make use of start-up financing from various sources, in particular from banks, and in terms of the relative size of the loan that they were able to obtain from a bank. The paper also seeks to establish what may have worked to explain the relative success of the Hmong in the Minneapolis/St. Paul market.

According to the survey results, the businesses were concentrated in retail and personal service industries, for both groups. The Hmong, however, were less likely to have capital-intensive businesses, such as construction. Also, Hmong businesses had fewer years in operation. The survey revealed that, on average, Hmong businesses were in operation less than four years, as compared to more than 11 years for the White businesses. She noted that the paper's comparison of Hmong- and (more established, predominantly) White-owned businesses if anything should have biased the results toward finding more disparity in credit access. That no systematic disparity was found in the Hmong use of credit confirms (the paper's assertion of) the Hmong's success in accessing credit at start-up.

The Hmong in the survey were younger and somewhat more educated than the surveyed Whites, and proficient in English. Toussaint-Comeau added that results from national census surveys, as well as results from a local corresponding Hmong household survey that was also conducted in Minneapolis/St. Paul, do not show similarly high levels of educational attainment and English proficiency for the Hmong as a population overall. For example, the corresponding Hmong household survey showed that close to 30 percent of the Hmong had not attended school anywhere. Toussaint-Comeau explained that this finding underscores the fact that the group of Hmong entrepreneurs in Minneapolis/St. Paul may in fact be a very special group of immigrants. In terms of access to credit, the English language skills of the Hmong, she noted, may have made it easier to bridge cultural barriers to formal business credit relationships. Also, the high educational attainment of the Hmong entrepreneurs could have sent positive signals to the credit market as to the potential performance of their firms.

The paper looked to the sources of financing and discussed the initial financial capital structure of the businesses. As expected, the majority of business owners made use of their personal savings. However, the Hmong were more likely to use personal savings and used a higher proportion of their savings. The paper also found that the use of informal, external sources of financing, such as loans and gifts from relatives and friends, were fairly common among both Hmong and White businesses; 46 percent of owners in both groups used informal sources. The focus of the paper was the use of formal bank loans. The authors find that about a quarter of the businesses obtained a formal bank loan. The paper considers the empirical relationship between bank funding and ethnicity, controlling for industry type, human capital, and demographic characteristics, and did not find a significant statistical difference between Hmong and White businesses. Also, both Hmong and Whites had similar self-reported perceptions of reasons for credit denial. In other words, the Hmong were not any more likely than Whites to report perceived discrimination as the reason for having been denied credit.

From a community development perspective, based on the focus group discussion, the authors learned that a proactive approach by banks to serve the Hmong community may also have played a crucial role. For example, feedback from focus groups underscored the importance of banking practices that exhibited cultural sensitivity. All the banks that participated in the focus groups and had a presence in the Hmong community employed a Hmong lending officer. The issue of underwriting flexibility was unanimously viewed as being very important to facilitating a lending process that helped serve the Hmong market. For example, banks modified their traditional underwriting criteria when calculating loan-to-income ratios by considering the income of the entire family, since many of the Hmong businesses are family-owned and managed. The banks also provided counseling to promote understanding of the lending process.

Overall, understanding how other ethnic groups are assimilating financially is an important subject for future research. The authors caution that their study is time and place specific. For example, they don't know the experience of firms that did not survive. Similarly, the authors outline additional questions regarding the experiences of businesses after the start-up phase for consideration in future studies. However, as Toussaint-Comeau stated, the goal of the research was to develop a better understanding of immigrant small businesses. This research provided insights about some of the factors that may help immigrant ethnic businesses access the credit market.

In Human Capital and the Development of Financial Institutions: Evidence from Thailand, Anna Paulson of the Federal Reserve Bank of Chicago discusses some of the challenges and opportunities that confront community development initiatives in developing countries. Paulson's paper focuses on how human capital impacts the development of financial institutions. Education and financial development have both been identified as key engines of economic growth and progress; however, very little is known about how they interact with one another. Paulson has attempted to shed light on this interaction and asserts that principles identified and lessons learned from abroad can have utility and application to community development in the United States.

The paper seeks to answer two questions. First, how does education influence locally run financial institutions in a developing country? And second, what are the implications of the findings for sustainable community development? Paulson addresses these questions by looking at how policies of 161 village banks in Thailand are shaped by the education of the local villagers and the people who run the banks.

Data for the paper was obtained from a survey conducted in Thailand in May 1997, a few months before the Thai financial crisis of July 1997. Data was gathered from 2,880 households in 192 villages. The villages were evenly divided between the poorest part of Thailand in the northeast and the more developed central region, providing the opportunity to explore the impact of village banks in more versus less developed areas. Data was also gathered from all the financial institutions operating in the village. There were 161 financial institutions, and interviews were conducted with the management committee of all of them. Paulson pointed out that these are not always "bricks and mortar" banks, but are organizations centered on people. "They don't necessarily have a physical presence," explained Paulson. "Instead, the people running the bank get together on a monthly basis to conduct business, such as gathering savings deposits, making loans, and sometimes investing in other activities." These are grassroots indigenous organizations run by and for the villagers. Most are not promoted by a particular aid or other nongovernment organization. They are developed by and for the villagers.

Household characteristics indicate that villages with a bank tend to have slightly more educated residents than those without a bank. However, median annual income in the villages without a bank is higher ($2,153) than villages with a bank ($1,784), and similarly median household wealth is higher in villages without a bank ($23,585) than villages with a bank ($19,154). As these are agricultural villages, most wealth is held as land. While it may seem counterintuitive that villages with banks would have lower incomes and wealth than villages without them, village banks are community development tools and would logically be established in relatively poor villages. Characteristics of village banks indicated that 42 percent offered savings accounts and 73 percent make loans. The person who manages the bank tends to be more educated than the typical villager and is usually male (65 percent of bank managers).

The village banks tend to have peculiar policies that make them somewhat inflexible and formulaic. For example, in many banks, all loans originated throughout the year must be repaid on December 31, and the same amount of interest must be repaid â€“ regardless of when the loan was made. For instance, a loan of 1,000 baht (or about $40) that is made on January 1 will require a repayment of 1,200 baht, as will a loan of 1,000 baht that was made on July 1. Clearly, the person who borrows on July 1 pays a higher interest rate. Additionally, village banks and other financial institutions often have very simple contracts that seem to rule out some transactions on an ad hoc basis. In one Thai village bank, for example, all loans must be in multiples of 1,000 baht. Likewise, savings transactions often have similarly stringent features, requiring savings amounts, for example, to be a multiple of 100 baht. Further, about 57 percent of banks require their members to save and 33 percent dictate a minimum monthly savings level. Another 45 percent allow for some flexibility in savings levels, however, the savings amount must be evenly divisible by 50. Seventy-seven percent of banks require a single lump-sum repayment of both principal and interest, eschewing any borrower installment payments.

Despite rigid policies, these village banks are associated with some very good outcomes. Other researchers using the same data have found that participation in a village bank increases asset accumulation, reduces credit constraints in agriculture, and reduces the villagers' reliance on money lenders as a source of credit (village banks are a lower cost alternative to money lenders).² However, these rigidities still limit the effectiveness of village banks, particularly given the agricultural environment in which they exist. Incomes fluctuate with the vicissitudes of the weather â€“ if the rains come, there is a bountiful rice harvest and lots of money; however, lack of rain will dry up the crops and the income. Accordingly, a mandated monthly savings rate as a condition to bank participation presents a potential challenge to those with a fluctuating income.

The study indicates that the rigid policies are largely unaffected by the education level of the money manager. Therefore, these findings argue against technical assistance and training targeted to money mangers as a way to increase the efficiency of village banks. The study indicates that policies are less rigid when villagers have very low or very high levels of education, and policies are more rigid at intermediate levels of education. It is important to realize that these village banks are self-governed and self-policed. The village money manager is in a position of great trust, having access to the accumulated savings of the village, in an environment lacking any governmental oversight, regulation, or insurance. Herein lies a great challenge to the villagers â€“ how do they police the money manager? Paulson argues that the villagers' answer to this challenge is what underlies the rigid policies. In essence, it is much easier for them to determine if the deposit records are accurate when there are only 25 savers and they each must save 100 baht. These unbending policies are the pragmatic response of less educated villagers to the necessity of policing a better educated money manager, in an environment devoid of government oversight.

Another alternative would be to offer governmental legal and regulatory oversight, but for such small banks operating in disbursed villages throughout the country, the infrastructure would be very expensive and impractical. There are some analogies to issues surrounding predatory lending in the United States. Due to deposit insurance and regulatory oversight, there is no concern that U.S. banks will take deposits; however, with predatory lending, legal and regulatory oversight are sometimes unclear. "It's hard to define predatory lending and difficult to find the culprits," explained Paulson referring to predatory lenders, "so the lesson from this study is that financial education for everyone may be the way to control predatory lending practices."

The final point is that sustainable community development, whether in Thailand or the United States, depends on a careful match of program design with the available educational, organizational, and legal infrastructure. In this case, the Thai village banks offer a nice example of organizations that may look strange at the beginning, but these small banks have confronted their difficult environment and constructed policies to deal with the realities of limited education and limited legal infrastructure.

In her work-in-progress, Policies Promoting Micro-enterprises: What Works? What Does Not Work? And Why?, Cecilia Giusti outlines successes and difficulties of some of the programs currently available to promote microenterprises in the Texas/Mexico border region. The paper concentrates on isolated unincorporated areas called colonias in the Laredo area, and will be one of the products of an ongoing research/outreach colonias program developed by the Center for Housing and Urban Development from Texas A&M University. The paper will present the programs designed for disadvantaged minorities and women-owned microbusinesses, and attempt to identify what is and isn't working, and why. Guisti also expects to provide suggestions regarding best practices.

Marty Levine of Shorebank Advisory Services was the discussant. Levine sought out common themes from the papers presented in this session to draw broader inferences about increasing community investment in the United States. Levine stated that he was struck by the degree to which he did find common themes among the papers. He then drew a parallel between the diverse international communities and the domestic themes he hears from practitioners in different local communities, asserting that domestic communities present a distinct, but not so different, set of cultural diversities. The papers illustrate a convergence between research findings and the everyday experience of community investment practitioners.

Levine commented on these common themes. First, he stated that among the challenges in reaching underserved communities is convincing the people that they can take advantage of banking services. Levine was struck in particular by the statistic that 23 percent of all the Hmong small business owners in Minneapolis/St. Paul hadn't even tried to apply for a loan or addressed the issue of a banking relationship because they expected to be turned down.³ Levine observed that clearly "[T]here is still an enormous amount of self-selection out of the process."

Another common theme was the lack, among people who do not have prior banking relationships, of knowledge and understanding needed to foment a successful banking relationship. Levine cited Giusti's paper on colonias, which noted that many potential entrepreneurs didn't understand that a business plan was a basic part of beginning a lending relationship.

A third general theme was that lenders' policies do matter, meaning there are ways to reach out to underserved communities and bring unbanked people into banking relationships. For instance, the successful outreach into the Hmong community stood in stark contrast to the very limited outreach in the colonias, a portrait of a community that had not yet found its way or, alternatively, to which few financial institutions had found their way.

Levine observed in the Thailand example that it seemed as though the banks had moved to potential clients - but in reality, the banks grew from within communities. However, despite being local members of the community, the banks' managers were operating under a set of practices that, in some cases, discouraged potential customers.

Levine closed with his thoughts on how lenders might develop practices to promote sustainable community development. First a community lending program must be designed with a mandate of profitability. "Any institution that enters a business expecting to lose money will no doubt succeed [in losing money]," cautioned Levine, "so there needs to be an expectation of profitability and a commitment to stick with that goal, just as would be expected upon entering any other sort of business." Second, management should be realistic about front-end investments that are necessary to reach under-served communities and at the same time diligent in managing those exceptional costs. A third principle is the critical nature of tailoring a product to the borrower. The small business loan terms needed to serve the colonias might not work in the Hmong community (and certainly would not in Thailand). Likewise, small business lending looks much different from other community lending, and vastly different from micro-lending - where the delivery system, the underwriting, and the monitoring need careful planning.

With outreach is the need for borrower education. Whether it is information about available products, underwriting standards, product suitability, or simply how to become qualified over time, Levine sees education as the key to success. Levine cited the benefits that the movement toward borrower education has brought the housing industry over the past decade and the positive impact that it has had on homeownership in the United States.

Levine's final point was that getting senior management of financial institutions on board is critical. Entry into a new market is a significant undertaking and must be both consistent with the institution's overall business strategy and supported by management.

Notes
¹ These surveys were conducted during the mid-1990s under the direction of Richard Taub, Marta Tienda, and Robert Townsend through the Center for the Study of Urban Inequality, University of Chicago, and were cosponsored by the Federal Reserve Bank of Chicago (Bond and Townsend, 1996; and Huck et al. 1999).

² Joseph P. Kaboski and Robert M. Townsend, 2000, "An Evaluation of Village-level Microfinance Institutions," University of Chicago, mimeo.

³Maude Toussaint-Comeau and Robin Newberger, 2003, "Credit Availability in the Minneapolis-St. Paul Hmong Community," paper presented at Seeds of Growth, Sustainable Community Development: What Works, What Doesn't, and Why, Federal Reserve Bank of Chicago conference, p. 17.