Agents of Their Own Success: Channeling Private Capital to Promote Financial Inclusion

There are 45 million Americans who do not have access to credit and are disenfranchised from today’s financial economy. Those excluded are more likely to come from historically marginalized groups – Black, Hispanic, Native American and low-income households – and reside in communities that are financial deserts not served by traditional financial institutions.

Since these households are likely to be invisible to the national credit rating agencies, lenders are much less willing to extend credit, keeping these households on the periphery of the traditional financial economy. These households find themselves blocked from established paths of wealth-building as they find it difficult, if not impossible, to finance some of life’s biggest goals – education, car purchases, starting a business, buying a home.

Access to credit begets other financial benefits, such as lower borrowing rates, that help households weather difficult times. For example, in 2020, the financial fragility of disenfranchised households was starkly exposed when unemployment due to illness or pandemic-related policies left many households without their main source of income. Many households, particularly those with variable monthly incomes, reported that they would not be able to cover expenses for more than two weeks.

This state of fragility is compounded by time. The longer a household remains in the financial periphery, the more difficult it will be to enter and be included in the traditional financial economy, perpetuating the disenfranchisement of historically disadvantaged communities.

How can we break the cycle?

By leaning into the securitization market’s ability to raise sizable private capital and channeling that capital through community development financial institutions (CDFIs), for instance, institutions can increase lending and expand their primary mission of providing capital and credit to low-income communities, and underserved minority and women-led households and businesses. CDFIs are locally controlled, private-sector financial intermediaries founded on the idea that lenders at the local level are in better positions to understand the nuances of their underserved communities, and therefore make better lending decisions. In 2019, 84% of CDFI customers were low-income, 60% were people of color, 50% were women and 28% lived in rural areas, according to the Opportunity Finance Network’s 2019 annual member survey. This is where securitization has a role to play in financial inclusion.

Securitization is a financing tool that has made credit more available and affordable. Originally conceived to expand homeownership by making mortgages more accessible, securitization has become an important financing technique used by lenders of consumer and commercial loans. In 2020 alone, securitization funded $3.7 trillion worth of loans to individuals, families, small businesses and large corporations. Approximately $15 trillion of existing consumer and commercial loans have been funded using securitization. When a lender uses the funding from a securitization to make more loans, securitization’s multiplier effect can significantly expand a community’s access to critical financial services.

Moreover, recent developments in credit scoring have the potential to facilitate the securitization process. A credit score has traditionally been derived from a person’s credit report and has been predictive of the likelihood that a person will default on a loan. The score considers a person’s payment history on credit card, auto or mortgage loans, as well as incidence of bankruptcies and foreclosures. The score also looks at how long a person has managed credit and types of credit used, among other factors. Unfortunately, a person who has not been able to participate in the traditional credit economy cannot be scored in this way. Fortunately, this is changing. Rapidly evolving data technology has made it possible to compute credit scores using a range of alternative data.

Alternative data looks beyond traditional sources that are only obtainable with some sort of credit history and instead looks at non-traditional sources such as utility payments, home rental payment patterns, and savings and checking account activity, to name a few. A credit score with one of the national credit rating agencies is the key to unlocking access to credit and financial services for millions of Americans. A credit score derived using non-traditional sources would allow credit-worthy individuals to take the first step toward financial stability and wealth-building.

Since a credit score allows a borrower’s risk of default to be quantified, a score facilitates a lender’s underwriting process and allows lenders to scale up their socially responsible lending decisions. Quantifiable default risk also allows capital market investors to incorporate objective data into their investment analysis to make responsible investment decisions while supporting the lending efforts of community focused institutions.

Securitizations backed partially or fully by CDFI loans also provide investors with investment opportunities that make a societal impact – an important investment component for structured finance investors and their underlying pension plans, savings plans, family offices and bank clients. Socially responsible investing has seen a meteoric rise creating a strong demand in the market for investments with both financial and non-financial impacts.

Securitization and expansion of credit scoring can help CDFIs strengthen a community from within, by opening access to the tools that are needed to build wealth and financial stability. Combined with complementary policy solutions, the private capital invested with CDFIs can create a stable, long-standing source of financing for underserved communities and promote a financially inclusive economy.

Elen Callahan is Managing Director, Head of Research of the Structured Finance Association in Washington, D.C.