Banking on better neighborhoods.

Building a network of development banks may be the way to funnel badly needed credit into America's inner cities. Candidate Clinton talked about development banks as the backbone for financing urban renewal. Now he's president and it may be an idea whose time has come.

ON FEBRUARY 17, PRESIDENT Clinton announced in his State of the Union address a plan to establish a nationwide network of community development banks. Fulfilling a campaign pledge, the development banking initiative is a key component in the Clinton administration's anti-poverty program.

The Clinton fiscal year 1994 budget appropriates $60 million to fund the administration's community development banking initiative. These development banks will have as their primary function the task of investing in distressed neighborhoods through small business development and specialized lending programs.

In promoting his development banking initiative, President Clinton has cited the operations of a few existing development banks around the country as models. For example, during the presidential campaign Clinton praised the work of two institutions: the South Shore Bank of Chicago and the Southern Development Bancorporation in Arkadelphia, Arkansas. Hillary Rodham Clinton has served on the board of Southern Development Bancorporation.

This article examines three development banks, South Shore Bank, Southern Development Bancorporation, and Community Capital Bank of Brooklyn, in an effort to understand the impact and potential future implications that development banking could have on the financial industry.

The business of development banking

In testimony before the House Subcommittee on Consumer Credit and Insurance of the Committee on Banking, Finance and Urban Affairs, Robert M. Weissbourd, vice president of Shorebank Corporation, the bank holding company of South Shore Bank, defined a community development bank "as a bank holding company with a specialized structure and business plan intended to transform the market dynamics of a geographical target area."

A community development bank is designed to be a comprehensive community development institution, which, in addition to a bank, usually includes other development subsidiaries and affiliates that complement the investment strategies of the bank. These subsidiaries and affiliates help development banks manage what would otherwise be higher-risk investments by identifying and evaluating opportunities before initiating development activities. Through these non-bank affiliates, development banks can invest equity capital in businesses owned by others, rehabilitate commercial and residential real estate, operate social development programs and establish links between residents, financial resources and government programs to revitalize distressed communities.

Development banks combine the qualities of community-based, market-driven, private institutions with the commitment and initiative of community-based, non-profit organizations. For example, development banks make use of foundation investments and grants, state and federal loan guarantees, low-income housing tax credits and other programs to accomplish their revitalization goals, while maintaining the bank's safety, soundness and profitability interests.

Finally, development banks are flexible, even more so than conventional banks, because they are so closely tied to the local economy and must quickly adapt to changing economic circumstances in their delineated community.

Regulatory structure

The establishment of a network of community development banks during the next four years can be achieved if legislation is enacted that provides federal funding for equity investments in development banks. Such legislation would have to win approval first by the appropriations committees in both the Senate and House. The equity investments funded by the federal government should be matched by equity investments from the private sector demonstrating the commitment of the community at large. In return for the equity investment, the federal government should demand a long-term financial return on its investment. The Clinton budget is silent on the topic of the structure and the ratio of government to private sector funding for the proposed development banks.

A federal agency, such as a National Trust for Community Development Financial Institutions, is likely to be created to oversee these institutions. This agency should be independent of existing regulatory authorities in its oversight function because of the specialized investment strategies of development banks.

A careful selection process will have to be established by the agency that selects development bank candidates to isolate institutions with comprehensive business plans, appropriate operating structures and demonstrated capacity for community development. At the same time, the agency must be permitted great discretion in its investment decisions because of the assortment of institutional structures that would be appropriate in certain situations, such as partnerships with existing community development corporations or financial institutions.

In my view, based on my research and analysis of the three existing development banks, the regulatory restrictions currently in place for depository institutions should also govern future development banks. These institutions should not be exempt from existing regulations nor receive special charters or advantages that would alleviate their regulatory responsibilities. Adherence to banking regulations will provide development banks with the same level of discipline and credibility experienced by conventional commercial institutions.

Therefore, it is my view that the agency in charge of the new development bank initiative should establish demanding standards for selecting organizations for investing government equity funds. For example, in order for an organization to qualify for investment funds, the development banking agency should determine that the organization has access to federal investment funds as well as private financing.

Additionally, the organization should have experience in managing a regulated depository institution and have a comprehensive community development plan ready to implement. Finally, the agency should have a control mechanism that allows it to monitor the condition and progress of the development bank. For example, the agency could develop an investment agreement with the bank that would set out the bank's specific development goals. Investment agreements would allow the agency to replace the management of the bank if the development goals were not being met.

Institutional implications

Questions have been raised by banking officials concerning the establishment of 100 community development banks and whether or not the initiative will interfere with the community development lending activities of conventional banks. Conventional banks and existing community development banks do not primarily compete. Community development banks operate in a market niche that does not generally lend itself to the standard underwriting criteria found at conventional institutions. For example, South Shore Bank in Chicago has as its primary lending market the inner-city neighborhood of South Shore, while more conventional Chicago institutions do not have a banking presence there. Development banks, in effect, expand the market opportunities for conventional banks through partnership and shared-risk opportunities.

The demand for a network of development banks should also not be affected by an increase in community lending by conventional banks, but rather development banks should facilitate and complement such an expansion. For example, large banks often find that the most productive way to invest in low- and moderate-income communities is indirectly: through partnerships and participation agreements that include investments in community development corporations and community development financial institutions.

Therefore, the development banking initiative should result in enhancing the relationship between conventional institutions and development banks, thereby positively affecting the quality of life in disadvantaged communities across the country.

Shorebank Corporation

The history of Shorebank Corporation and its delineated South Shore community reflect what occurred in many city neighborhoods across the country in the late 1960s and early 1970s. During this time, the community of South Shore located in the South Side of Chicago underwent a racial transition (in 1960, it was 100 percent white; by 1970, it was 70 percent Black, according to a Harvard Business Review article, May/June 1991. The neighborhood's racial transformation resulted in a significant decline in the amount of credit allocated to the community, and consequently, the last remaining bank--the South Shore Bank of Chicago--sought regulatory permission to move downtown.

At the same time, a group of young bankers working at Chicago's Hyde Park Bank wanted to help revitalize Chicago's inner-city neighborhoods. Inspired by John F. Kennedy's idealism, these young bankers worked at the Hyde Park Bank during the day and volunteered in distressed communities at night.

When the Bank Holding Company Act (BHCA) was enacted in 1970, these young bankers saw their opportunity. The BHCA and subsequent Federal Reserve Board regulations specifically gave bank holding companies for the first time the authorization to invest in community development corporations, provided that the primary purpose was community development for the benefit of low- and moderate-income people. As a result, the group of bankers considered establishing a specially structured bank holding company designed to reach Chicago's disinvested neighborhoods.

When the previous owners attempted to move South Shore Bank to downtown Chicago and the move was rejected by the Office of the Comptroller of the Currency (OCC) because of neighborhood protests, the idealistic young bankers seized the opportunity. Through negotiations with the OCC they were able to reduce by half the asking price for the bank. Supported by patient investors, who shared their idealism and community development commitment, they formed Shorebank Corporation in 1973. It was a one-bank holding company regulated by the Federal Reserve Board, and the owners of the new holding company then purchased the South Shore Bank, a commercial bank chartered by the state of Illinois and regulated by the Federal Deposit Insurance Corporation.

At the outset, the new management team found operating a bank in the South Shore community difficult. The miracle of South Shore Bank was not instantaneous. The problem was, a perception existed in the South Shore community, as evidenced by their protest against the relocation of the South Shore Bank, that Chicago area financial institutions were not serving their credit needs.

It was not until 1978 that Shorebank Corporation was able to raise additional capital and expand the operations of the corporation. With the additional capital, Shorebank created three new subsidiary corporations. They were: City Lands Corporation (CLC): a for-profit real estate development corporation involved in multifamily housing and commercial real estate development; The Neighborhood Fund (TNF): a for-profit venture capital company licensed by the U.S. Small Business Administration; and The Neighborhood Institute (TNI): a 501(c)(3) non-profit community development corporation involved in providing technical assistance and training in affordable housing and other activities.

These non-bank affiliates continue to work together to affect the local South Shore market and thereby reinforce the viability of the bank. For example, City Lands Corporation traditionally has purchased and refurbished run-down buildings in South Shore neighborhoods. Once these buildings are rehabilitated and occupied, Shorebank's Neighborhood Institute steps in and teaches tenants how to form associations, establish crime watches and other activities that protect their leasehold interests. Another example occurred in 1990, when City Lands Corporation built a shopping mall right in its own South Shore neighborhood and Neighborhood Institute provided job screening and placement for tenants who filled the shops in the mall.

These examples illustrate how these non-bank subsidiaries and affiliates have established a reciprocating investment relationship that reinforces each other's viability as well as the viability of South Shore Bank.

In the last five years, Shorebank has created three additional subsidiaries and affiliates to advance its expansion strategy: Shorebank Advisory Services, a for-profit consulting firm providing advisory services on community economic development issues; North Coast BIDCO, a Michigan-regulated, for-profit, small business investment corporation; and NEICorp., a 501 (c)(3) nonprofit corporation that specializes in providing support for small business development in Upper Peninsula Michigan.

As of December 31, 1992, Shorebank Corporation, through its subsidiaries and affiliates, had made $351 million in development investments in its targeted Chicago neighborhoods, according to testimony given before the House Subcommittee on Consumer Credit and Insurance, by Weissbourd of Shorebank Corporation. Testimony further revealed that through the end of 1991, Shorebank had financed or leveraged the renovation of 7,716 residential units in South Shore, almost 30 percent of all the units renovated in that community.

From a financial standpoint, Shorebank has also been successful. According to congressional testimony, as of December 31, 1992, Shorebank had assets of $244 million, stockholders' equity of $17 million. South Shore Bank had assets of $229.1 million and equity of $14.2 million. Bank net income for 1992 was $2.2 million, comprising a 15.3 percent return on equity and a 1 percent return on assets. These numbers signify that the Shorebank Corporation and its banking arm, South Shore Bank, have performed at levels comparable to their peers.

Cited as a model community development bank by President Clinton, Shorebank Corporation clearly has a bright future. Currently, Shorebank continues to provide leadership through its subsidiary Shorebank Advisory Services, where it is consulting with a number of organizations that are in varying stages of establishing development banks. As the future unfolds, Shorebank can expect requests to duplicate its success in Chicago in other cities and towns across this country.

Southern Development Bancorporation

Southern Development Bancorporation (Southern) was incorporated in August 1987 and began operations in May 1988. Looking for a way to stimulate the state's sluggish agricultural economy, then-Governor Bill Clinton invited the development bankers responsible for stabilizing Chicago's South Shore community to apply some of their ideas to the Mississippi Delta problems. As a result, Southern is patterned in large part on Shorebank Corporation, and indeed, Ronald Grzywinski serves as chairman of both Southern and Shorebank.

The state of Arkansas, like Shorebank's South Shore community, went through its own economic upheaval in the mid-to-late 1980s, which led to the intervention of Shorebank and the establishment of Southern. In the 1960s, the state of Arkansas made an aggressive move to attract businesses by offering low labor costs. While the feature brought jobs to the state, Arkansas continued to suffer from its lack of a truly indigenous economy. Thus, when companies discovered cheaper labor costs offshore in the late 1980s, they left Arkansas as quickly as they came, taking with them jobs.

Especially hurt during the economic change was southern rural Arkansas. For example, Arkadelphia, the headquarters of Southern and its banking arm, Elk Horn Bank & Trust Company, is a town of 10,000 people, and at least four major employers moved away in the mid-to-late 1980s taking with them more than 1,000 jobs.

The conditions were ripe for the creation of Southern. Specifically, Southern was created for the purpose of accelerating economic activity among low- and moderate-income residents of rural Arkansas. Towns like Arkadelphia, Pine Bluff and Hughes, Arkansas, needed an economic stimulus, and the establishment of Southern in 1987 served to fill the void. The Winthrop Rockefeller Foundation, the John D. and Catherine T. MacArthur Foundation and the Ford Foundation provided much of the financial support needed to establish Southern and its affiliates.

Southern is a bank holding company regulated by the Federal Reserve. Owned by a group of 26 shareholders, including philanthropically motivated individuals, charitable foundations and business corporations, Southern's primary target market is a 32-county area of southwestern Arkansas.

Southern's structure includes a bank and a group of subsidiary institutions acquired or created by Southern. For example, in 1988 Southern created the Opportunity Land Corporation, a community development company focusing on industrial and commercial properties and residential housing for low- and moderate-income residents. Also in 1988, Southern created the Arkansas Enterprise Group, a non-profit affiliate that owns and operates three distinct businesses: Southern Ventures Inc., a for-profit, Small Business Administration-licensed investment corporation; Good Faith Fund, which makes short-term micro-loans, (some as small as $250) to rural residents; and the Arkansas Manufacturing Services, which provides financing, marketing and accounting services to small businesses.

Southern's banking arm, Elk Horn Bank & Trust Company, was purchased in 1988 by Southern. Elk Horn is a full-service commercial bank regulated by the Federal Deposit Insurance Corporation, which originates development credit through commercial and residential loans. Elk Horn is an active participant in small business lending and agricultural credit.

In the four years between May 1988 and the end of June 1992, Southern invested more than $14.1 million in 278 development projects in rural Arkansas, according to George Surgeon, president and CEO of Southern and Elk Horn Bank & Trust Company, in testimony he gave before the House Subcommittee on Policy Research and Insurance--a subcommittee of the House Committee on Banking, Finance and Urban Affairs. Almost $13 million of these funds have been equity investments or commercial loans to small businesses and family farms.

Southern has accomplished these development objectives within the framework of a regulated bank holding company, while sustaining modest investment losses and relatively low delinquency rates. According to Surgeon's congressional testimony, Southern had lost less than $450,000, or 3.1 percent, of the $14.1 million in development investments as of June 30, 1992.

Southern's profit base continues to derive from its banking subsidiary, Elk Horn Bank & Trust Company of Arkadelphia. With assets of $87.2 million as of June 30, 1992, Elk Horn remains the largest bank in Clark County. Elk Horn also generated record earnings of $730,353 in 1991 and was on schedule for another record-breaking year in 1992, with earnings standing at $430,029 at the halfway point.

The bank's record profits and development initiatives have been achieved while simultaneously retaining a solid loan portfolio. Elk Horn has lost less than 1 percent on the development loans it has originated to date. Loan losses for the entire banking industry during the past four years according to Sheshunoff Information Services, Inc., have increased from 0.99 percent of average loans outstanding in 1988 to 1.58 percent in 1991. Elk Horn continues to have an extraordinarily low delinquency rate on development loans of 0.25 percent, while conventional loan delinquency rates at other banks hit 3.7 percent, according to Sheshunoff.

Most importantly, Elk Horn is profitable. With the exception of 1988, Elk Horn has earned at, or in excess of, the industry benchmark 1.00 percent return on average assets.

With Bill Clinton now in the White House, Southern Development Bancorporation's star is clearly on the rise. Shorebank may be the model, but Southern will be the instrument of change. Southern's unique position will stimulate efforts to create and expand small, locally owned businesses, which in time will create more jobs and make those businesses less likely to leave Arkansas. Southern will be busy in the months and years ahead, and Arkansas, especially rural Arkansas, will be the better for it.

Community Capital Bank

Community Capital Bank (CCB) is located in downtown Brooklyn, New York, but its genesis can be traced to San Francisco. Lyndon Comstock, CCB's founder and current chairman, began his banking career in San Francisco with Wells Fargo Bank. But it was only after transferring to New York City and working with First Chicago as a credit officer that Comstock experienced how low- and moderate-income neighborhoods in the city were being underserved.

Comstock saw a whole market of business opportunities not being served by the city's large money center banks and thus began exploring how best to fill the vacuum. In 1986, Comstock stopped thinking about opening up a community development bank and made his move. He quit his job, sold his apartment in the city at the height of the real estate boom and lived in modest fashion off the proceeds from the sale. He began working full time on setting up the bank. It wound up taking five years to meet all the regulatory requirements, put together a team of people, develop a business plan, and most time consuming of all, raise $6 million in equity capital.

But the time was well spent because it allowed Comstock to review all the plans, programs and community development efforts of other institutions, such as Shorebank Corporation and Southern Development Bancorporation, and to use the best they had to offer. So when Comstock was ready to open the doors of CCB in January of 1991, he had given a great deal of thought to the bank's establishment and operating structure.

Community Capital Bank is a New York state--chartered, FDIC-insured commercial bank. It is a de novo institution. It is distinct from both South Shore Bank of Chicago and Elk Horn Bank & Trust Company in three important areas: CCB does not have the umbrella of a bank holding company like the other two institutions; CCB is the only independent commercial bank ever organized in the United States specially as a community development bank--the other two were purchased and then converted into development banks; and CCB does only community development lending--the other two banks are full-service institutions.

These differences affect the structure of CCB. For example, the fact that CCB is not a subsidiary of a bank holding company hurts its financial flexibility. CCB only has a $450,000 legal lending limit for its first three years, a relatively small amount when it comes to funding multifamily housing projects. As a result, CCB's margin of error involving credit decisions is significantly smaller than what applies for the two other existing development banks.

The fact that CCB is a de novo bank has its advantages and disadvantages. The biggest advantage afforded a de novo institution is that it starts with a clean slate. CCB was able to choose its location, market, operating strategy and management team. When a bank is already in existence, like South Shore and Elk Horn were, then the ability to move in a certain direction can be frustrated by the bank's own past (i.e., uncooperative lending officers, which happened with South Shore, or a bank's image in given communities).

The major disadvantage of a de novo bank is the cost involved in getting started. The problem of raising equity capital is the most important reason there are so few community development banks today. For example, CCB was initially capitalized at $6 million, which was raised from socially concerned institutional investors (i.e., religious organizations, banks, corporations, foundations and individuals representing 40 states). With all the cooperation, national attention and goodwill associated with starting a development bank, it still took five years. Comstock described the effort in February this year in a statement to the Senate Committee on Banking, Housing and Urban Affairs: "It took about one-person-year of professional staff time per million dollars raised."

If President Clinton's plan to create 100 such institutions is to work, the time involved in establishing a development bank clearly must be reduced.

Finally, CCB learned a valuable lesson from South Shore and Elk Horn: do not become a retail bank. CCB's mission is to improve capital access for low- and moderate-income communities through specialized lending efforts. CCB does not make car loans, does not issue bank credit cards or undertake any activity traditionally associated with a retail bank. "What differentiates us from the typical commercial bank is that 60 percent of our loan portfolio will be dedicated to affordable housings," explains Stephen S. Laine, president and CEO of CCB. "Forty percent of our portfolio will be in small business lending, which ends up creating jobs."

Laine believes if South Shore or Elk Horn had the ability to do it over again, they would follow CCB's exclusive community development focus.

Based on the statement Comstock gave to the Senate committee, CCB is successfully filling its market niche. CCB has made or committed more than $7 million in loans and letters of credit so far, all of which are community development-related. To date, CCB does not have a single non-performing loan. Roughly $3 million of the total committed by CCB involves multifamily affordable housing; the other $4 million supports small business and non-profit organizations in the low- and moderate-income neighborhoods of New York City.

For example, CCB is associated with LEAP, Inc., a 501(c)(3) non-profit corporation providing technical assistance. LEAP was started out of a recognition that CCB, as a commercial bank cannot perform certain activities needed in CCB's Brooklyn community (i.e., risk capital or technical assistance to start-up businesses). LEAP fulfills these needs. LEAP is legally independent of CCB, but Comstock serves as its chairman and LEAP is located within the office of CCB in downtown Brooklyn.

Comstock continues to promote the idea of development banking as a way to improve capital access for low- and moderate-income communities. Two years ago, Comstock traveled to the Mississippi Delta region at the invitation of then-Representative Mike Espy, (D-MS), now secretary of the Department of Agriculture, to determine the viability of establishing a development bank there. As the Clinton administration moves forward with its development banking plans, CCB, along with the other development banks, will no doubt gain national exposure and new business opportunities.

As Ross Perot says, the devil is in the details. The concept of establishing community development banks for the purpose of reviving depressed inner-city areas could become the cornerstone of Clinton's economic counterrevolution. But in order for conception to meet reality, his plan, as it is currently portrayed, needs modification. In my view, there are two areas of primary concern: cost and implementation.

The Clinton administration still, even with the budget, has not released information on how it plans on paying for the initiative. Federal assistance in several forms has been reported on in the press. For example, an article in The New York Times (January 18, 1993) mentioned government grants, where each dollar invested by the government would be matched by $2 raised by the bank. This form of federal assistance may require the banks to pay back the government once they reach a certain level of profitability. Another form of federal assistance under consideration combines the resources of the federal government with other financial institutions. Under this payment plan, banks that fund development banks would receive compliance credit under the Community Reinvestment Act (CRA).

In the final analysis, it is my opinion that the federal government will pay a significant share of the cost involved in creating development banks. But for the Clinton plan to succeed, private investors, such as existing banks, must contribute. Therefore, an incentive system where banks receive CRA credit for funds contributed to development banks in my view, needs to be part of the plan. Forcing institutions to contribute through legislation will not create the proper climate for development banks to flourish.

Secondly, there is a great deal of concern over how Clinton's development banking initiative will be implemented. For example, banking industry critics of President Clinton's plan claim that it will favor new institutions over existing ones. Again without specifics, it is difficult to predict, but the strategy of creating 100 development banks in the next four years will be difficult to accomplish. As the Community Capital Bank case study illustrates, the amount of time and money required is exhaustive.

If the decision is to create 100 banks like Community Capital Bank, then the current regulatory system for chartering banks must be modified. If the decision is to use existing institutions and convert them to development banks, like South Shore Bank and Elk Horn Bank & Trust Company, then the selection process must be clarified.

The optimal solution, in my view, is a combination of newly established development banks plus converted institutions. Only the proposed institutions with a comprehensive business plan, appropriate operating structures and demonstrated capacity for community development should be selected as start-ups. When converting institutions to community development banks, special care must be exercised to ensure that existing institutions devoted to community lending not be excluded. Federal funds should be available to existing banks and credit unions, as well as for start-up banks.

The three case studies spotlighted in this article clearly demonstrate that development banking, when done properly, can be both effective and profitable.

Kevin T. Kane is president of CRA Consultants Inc., Boston.

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