Lending Risk Considerations For CDFI-Certified Financial Institutions

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While many financial institutions actively promote their commitment to financial inclusion and financial wellness, some have taken that a step further by obtaining Community Development Financial Institution (CDFI) certification. For those who may be unfamiliar, the U.S. Department of the Treasury Community Development Financial Institutions Fund defines a CDFI as one that will “promote access to capital and local economic growth in urban and rural low-income communities across the nation through monetary awards and the allocation of tax credits.” In short, the federal government sees CDFIs as the catalyst for meeting the needs of underserved consumers and providing a pathway for them to actively engage in the U.S. banking system.

For decades, predatory lenders in the form of payday loan agencies, title loan companies and so called “event lenders” have been the only option for many consumers, either because they fall outside of the traditional credit scoring system (as thin-file consumers or “credit invisibles”) or because they happen to live in a geographic area where there simply are not traditional bank and/or credit union branch locations.

Even before the pandemic, the Consumer Financial Protection Bureau (CFPB) was encouraging community financial institutions to fulfill this market need. Add in additional factors such as supply chain issues, the Ukraine war, rising inflation, and a host of economic indicators that we may already be in a recession, and the economic situation for many Americans is trending downward.

Given this, FIs should be asking how they are preparing to better serve existing (and potential new) customers and members in a financial crisis? Are their current credit decision methods working? The pandemic uncovered many of the shortcomings of traditional credit scoring and loan processes and exposed how those approaches are no longer equipped to serve an increasingly larger pool of borrowers, but now there are new ways of reaching and serving this market.

The Paycheck-To-Paycheck Dilemma

Recent data indicates that a majority of American consumers are now living paycheck-to-paycheck, and perhaps most surprisingly, this extends across all income bands as well. In April 2022, it was estimated that 61% of U.S. consumers were living paycheck to paycheck, including those earning a salary of over $100,000. Hard as it may be to believe, a 1/3 of Americans earning $250,000 or more live paycheck-to-paycheck. While that information is surprising, it is the consumers on the lower end of the economic spectrum who are feeling the most pressure, and it is them that the CDFI program is designed to help.

All of this has applicability for institutions that are committed to supporting financial equity and inclusion in their communities. For example, data clearly indicates that Black and Hispanic Americans are more unbanked than White Americans, with respective figures of 16%, 14%, and 3%. It is past time for this to change, and community financial institutions are well positioned to play a key role in helping to close these societal gaps.

CDFIs supply the tools enabling economically disadvantaged individuals to become self-sufficient stakeholders in their own future. These tools include providing financial services, loans, and investments; offering training and technical assistance services; and promoting development efforts that enable individuals and communities to effectively use credit and capital.” The challenge for banks and credit unions who are committed to serving low income and unbanked consumers is how to cost effectively provide access to credit without taking on additional, unacceptable levels of risk.

Automated Use of Alternative Data Holds The Key

With the use of new technologies paired with alternative data sets (such as utility payments, rent rolls, bank statements and mobile phone payments, among others), CDFIs can responsibly provide credit to a wider range of people.

With access to an expanded set of data and the ability to leverage automated decisioning workflows, CDFI-certified institutions can meet their financial inclusion commitments and grow their customer bases in a way that makes sense from a business standpoint. This starts by leveraging solutions that do not require significant internal resources to implement, focusing on the provision of specific types of loans, and creating decision pathways to guide applicants through the required next steps to qualify for those loans. At its core, what alternative data does is help FIs better see patterns that uncover ways to provide solutions to a larger group.

Initially, the opportunity for CDFIs lies in growing customer and member bases by providing more consumers with access to small dollar loans (typically $1,000 or less) and auto finance loans. In doing so, financial institutions stand to benefit from Community Reinvestment Act (CRA) credits and even potential cash rewards under the CDFI Fund’s Bank Enterprise Award Program. More importantly, however, is that these initiatives create a future market for mainstream financial products and services.

Why is the commitment to providing an auto loan to a thin file consumer so important? Because that person gains access to an automobile, which provides reliable transportation to and from a job, which can create a path to a career, allowing them to begin to save money responsibly and perhaps leads to a mortgage loan, and so on…all foundational steps in creating generational wealth over time. The promising news is that today, the convergence of alternative data, analytics and innovative technology is making it possible for CDFIs to truly fulfill the mission of increasing financial inclusion in a responsible way that protects the interests of the institution as well.

About Author:
Steve Bireley is Chief Technology Officer at Lokyata, a company focused on delivering AI-powered digital credit solutions that scale. With over 30 years of large enterprise & B2B SaaS product engineering leadership experience, Steve is an expert in delivering data communications, security, integration, and financial services products from concept to market. To learn more information about Lokyata, visit
https://www.lokyata.com/.