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Bank holding company investments for community development.

Kenneth P Fain and Sandra F Braunstein, of the Board's Division of Consumer and Community Affairs, prepared this article.

Since 1971, the Federal Reserve has permitted bank holding companies to invest, under certain guidelines and limitations, in projects primarily benefiting economically disadvantaged communities. Through subsidiaries, limited partnerships, and other business ventures, bank holding companies have used this limited authority to help provide housing and job opportunities for low- and moderate-income persons, assist in the development of small and minority businesses, and provide essential services to otherwise deprived communities.

These activities have been approved by the Federal Reserve, under its Regulation Y, with certain constraints needed to protect the safety and soundness of the holding companies and ensure that required public benefits result. This article explores the concept of community development and examines the mechanisms used by bank holding companies to undertake community development investment activities under Regulation Y. It suggests that bank holding companies making limited but focused use of equity investments for community welfare purposes can stimulate the economic revitalization of neighborhoods and communities.


Through their traditional, conventional functions, financial institutions have always played a role in the economic growth of the communities they serve. Conventional mortgages, home improvement loans, and financing for businesses and public facilities all create development opportunities for others and in turn help fuel housing development, job creation, and economic growth in general.

Over the past two decades, financial institutions also have been asked to help address the special financing needs of lower-income families and economically distressed neighborhoods and communities. Hence, many banks and other holding company subsidiaries now originate loans guaranteed or subsidized by government for housing and business. Financial institutions also purchase community development loans from other lenders, provide technical and loan-packaging assistance to nonprofit groups, and participate in state and local government programs aimed at housing, business development, and economic revitalization in distressed urban and rural communities. In recent years, an increasing number of financial institutions have established specialized lending units that focus on community development finance.

Although these activities are specialized, they are still well within the traditional, primary function of financial institutions: the allocation of capital in the form of debt financing. In performing this function, institutions must wait for their customers to initiate projects and commit equity capital before loans can be made.

The Federal Reserve has recognized that traditional bank and holding company activities may be insufficient to support the revitalization of some economically distressed communities. Lack of interest by conventional investors has severely limited the capacity of financial institutions to originate loans on a safe and sound basis in lower-income areas. The shortage of equity capital is often the critical factor in the continued economic stagnation or decline of certain urban neighborhoods and rural areas.

Beginning in the 1960s, local nonprofit groups created a new type of institution, the community development corporation, or CDC, to generate investment in economically weak neighborhoods. The CDCs had a dual character as community-based organizations dedicated to the advancement of local economic activity and as corporate entities able to invest successfully in housing and other business ventures. This dual character made the CDCs especially effective in helping focus government, private, and local resources on grass-roots solutions to neighborhood problems. CDCs became important catalysts for community revitalization.


In viewing the problems of low-income communities and the contribution of the CDCs of the 1960s, the Board of Governors of the Federal Reserve System determined that equity investments by bank holding companies could be a useful community-development tool that could directly benefit low- and moderate-income persons and areas. The 1970 amendments to the Bank Holding Company Act gave the Board the flexibility it needed to include community development in Regulation Y, which specifies the nonbanking activities considered proper and permissible (subject to individual applications) for bank holding companies. The 1971 change in Regulation Y, now contained in section 225.25 (b)(6), defines the term community development as follows:

Making equity and debt investments in corporations or projects designed primarily to promote community welfare, such as the economic rehabilitation and development of low-income areas by providing housing, services or jobs for residents. In the remainder of this article, the use of the term equity investment will be used to refer to equity investments for community development in the sense just defined.

The Federal Reserve Board views equity investments in CDCs or other qualifying ventures as important, flexible tools that bank holding companies can use to stimulate and supplement but not replace) their nonequity programs to finance community development.1 Through such investments, bank holding companies can play a direct role in public-private partnerships for community revitalization and job creation. And by leveraging other public and private funds, these investments can help community-based organizations undertake key projects as well as provide the capital and expertise to support other, more traditional forms of bank financing.


The Federal Reserve allows bank holding companies some latitude to tailor their investments to meet the disparate needs of disadvantaged communities. However, the Federal Reserve does examine all community development proposals to determine whether the planned investment meets the "community welfare test" whether the size of the investment is appropriate to its purpose and prudent for the institution, and whether there is community involvement in the project or organization supported by the investment.

Community Welfare Test

The definition of community development in Regulation Y refers to investments . . . designed primarily to promote community welfare." Board decisions have generally held that an investment that directly and primarily benefits economically disadvantaged persons and communities meets the community welfare test. Usually, such benefits are in the form of new or rehabilitated housing, jobs created through a variety of commercial and industrial developments, or health and educational services, all targeted on low- and moderate-income persons and areas.

The Board has made clear, however, that investments to build or rehabilitate upper-income housing or to develop any facilities not explicitly designed to create improved job opportunities for lower-income persons are presumed not to benefit the public welfare under Regulation Y even if they may entail some such benefit. For example, investments to develop upscale housing in an economically distressed community might indirectly benefit some low- and moderate-income persons through resulting construction jobs or through an increased tax-base that could help finance enhanced local services to low-income groups. But without strong evidence to the contrary, such benefits would be insufficient to merit Federal Reserve approval of a community development activity under the community welfare standard of Regulation Y.

Nevertheless, recognizing that the size, population mix, community needs, and economic condition of communities vary, the Federal Reserve has demonstrated flexibility in applying the standards of Regulation Y to holding company applications for community development activities. In particular, it has given holding companies some latitude regarding profit goals and geographic scope when planning their community development investments.

Profits and Dividends. A bank holding company may invest in CDCs, projects, and other business ventures meeting the community welfare test on either a for-profit or nonprofit basis. The Federal Reserve sets no explicit limits on the amount or rate of profit that may be generated, although significant profits are generally not to be expected. Moreover, profits or dividends from a CDC or venture may be provided to the holding company at any time. This flexibility is often necessary to attract capital from other nonbank investors.

The majority of holding company CDCs and other equity investments have been for-profit ventures. Although the capacity to obtain immediate returns on investments may be important in principle to holding companies and participating nonbank investors, in practice most holding companies choose to reinvest profits in the CDC or in additional projects that benefit the community welfare.

Geographic Scope. The Federal Reserve does not limit the geographic scope of community development investments. Thus, bank holding companies can and do make their investments in the market areas served by their subsidiary banks, whether those areas are in one community or several states.

Some holding companies, anticipating expansion across state lines, obtain approval for a nationwide scope of community development investments so that they can assist newly acquired subsidiaries wherever they may be located. So long as the activities in new locations meet the community welfare test and are consistent with the approval received, this approach allows a holding company or its CDC to make community development investments in new areas served by subsidiary banks without having to seek additional approvals.

Capital Investment

The size of community development investments by a bank holding company will vary substantially according to the community needs to be addressed and the holding company's objectives, financial capacity, and geographic scope of operations. Many bank holding companies have chosen to capitalize CDC subsidiaries with small initial investments, adding needed capital as projects reach the development stage. In other cases, such as investments in limited partnerships that develop or own lower-income housing, the partnership agreements often have required phased payments of capital by bank holding companies and other investors over a period of years.

In light of the diversity of community development activities, the Federal Reserve takes a flexible approach in its evaluation of equity commitments. Although the Board sets no minimum or maximum levels for capital investment by holding companies, it does expect that the financial commitment will be appropriate to the nature and scope of anticipated investment activities and prudent with respect to the size, financial condition, and capitalization of the holding company.

The extent to which public sector funds are available for community revitalization will have a bearing on the magnitude of a financial institution's equity investment. Where public funds are present, financial institutions can focus on providing supplementary equity capital to fill financial gaps in projects. If public sector funding is inconsistent or uncertain, bank holding company CDCs may have to invest additional equity capital and significantly greater planning and managerial resources in projects. They also may have to rely more on additional private sector sources of subsidized capital, such as foundation grants, corporate and individual donations, and voluntary "sweat equity" contributions.

Community Involvement

Community development is a process that, almost by definition, involves the participation of a variety of public and private organizations. Efforts to revitalize economically disadvantaged areas and meet the housing and employment needs of low- and moderate-income persons can rarely occur or be truly successful without effective community involvement in the planning and financing processes. The Federal Reserve does not require or specify any particular approach to ensuring public involvement in the community development investments of bank holding companies. Nonetheless, bank holding companies contemplating community development investments are encouraged to seek and consider the views of the affected parties-neighborhood development organizations, community advocacy groups, local government officials and agencies, small businesses, merchant associations, and other business organizations, depending on the nature and location of a project. Such consultations help investors identify worthwhile projects; establish cooperative working relationships with public agencies, development groups, and potential investors; and facilitate the marketing of completed projects to those most in need. Many holding company CDCs have community representatives on their boards of directors. Others have established community advisory committees in each community where projects are considered, or they use outreach mechanisms already established by their subsidiary banks.


Bank holding companies may invest in both nonprofit and for-profit ventures, and they may structure their investments in a variety of ways. The most commonly used structures are subsidiary CDCs, partnership in a CDC or investment pool, investments in a limited partnership, and investments in a single project or business. Each approach has advantages and disadvantages, depending on the holding company's size and objectives and the nature of the local community.

Subsidiary Community Development Corporations

Generally, any holding company that regularly receives requests from affiliate banks, government agencies, and community groups to help finance community development projects, or that wishes to engage in community development activities on a long-term basis, might find it advantageous for several reasons to create a wholly owned CDC subsidiary.

First, the revitalization of declining communities almost always requires a long-term commitment of resources on several fronts. In that context, a bank holding company that creates a subsidiary CDC makes an institutional commitment that enables both the company and its affiliate banks to take extended action on many different types of community development projects with the maximum flexibility. The subsidiary CDC may develop its own projects, form or invest in joint ventures and limited partnerships, invest in small businesses, or provide gap equity and financing for single-purpose community development projects developed by others. Moreover, holding company CDCs may specialize solely in housing or small business investment, or they may invest in a wider range of community development projects.

Second, community development finance in general and equity investment in particular are unique activities requiring knowledge that may not be present in traditional banking organizations. A subsidiary CDC, like a specialized bank lending unit, can be a corporate focal point that enables the holding company to centralize community development expertise.

Third, with a CDC, a holding company can leverage its capital for investment in disadvantaged communities while limiting its exposure to the associated risks. As a corporate entity, a CDC can leverage its capital with loans and reinvest its income in additional projects without requiring additional financial resources from its parent. The CDC corporate structure can help shield the parent institution from exposure to potential liabilities associated with real estate development or business ventures.

Finally, a CDC subsidiary is often useful in helping bank affiliates pursue their own community development programs by providing, for example, technical assistance, advisory services, equity investments, or debt financing. In this way, the CDC can enhance the performance and image of affiliate banks in their respective communities.

The activities of bank holding company CDCs have been as varied as the needs of their communities. Although most CDCs have focused on lower-income housing or on business development that creates jobs for lower-income persons, CDC projects also have included, in one case, the creation of a test farm to support experimentation on crops that would help diversify a local rural farm economy and, in another instance, rehabilitation of a medical clinic in a small community seeking to attract doctors. In each case, benefits for low- and moderate-income persons were clearly demonstrated.

CDCs have proved to be useful mechanisms for both small and large holding companies. For example, the CDC of one small bank holding company makes debt and equity investments through limited partnerships in low-income housing projects, primarily in smaller communities. The CDC also has served as a general partner in a limited partnership to develop 166 units of low- and moderate-income housing. Another small holding company formed a CDC to promote industrial development and job creation for lower-income residents in a small rural county.

The CDC of a larger, regional bank holding company has made development investments in several states. With a capitalization of almost $10 million, the CDC has provided equity and debt financing for housing rehabilitation and new construction of rental housing projects for low- and moderate-income families. In addition, this CDC is an investor in a statewide equity fund that provides capital for the acquisition and renovation of housing for low- and moderate-income areas. Consortium CDCs and Equity Pools Using another major approach to community development, a bank holding company may join with several other financial institutions or with nonbank investors to create a CDC or an equity pool. Such ventures, commonly called consortium CDCs, allow institutions to share community development resources as well as risks and are especially well suited for a holding company that lacks the capital or expertise to address multiple community needs or larger, more complex projects on its own.

Most consortium CDCs have been organized to provide housing for low- and moderate-income persons or to address the needs of small and minority businesses. Their geographic scope has ranged from the neighborhood to the nation. Other investors in consortium CDCs have included national banks, state banks (where authorized by state law and permitted by their primary regulator), thrift institutions, utilities, insurance companies, and other local corporations, businesses, and individuals. Where statutes allow, state and local government redevelopment agencies and quasi-public development corporations may invest in consortium CDCs.

An important advantage to a consortium CDC is its ability to tap the expertise and resources of its investor organizations to help manage CDC operations. Executives with a variety of skills and professional backgrounds can serve on the CDC board and investment and loan review committees or help manage the CDC's day-to-day operations. And, if necessary, a consortium CDC can raise the funds needed to hire full-time management and staff with expertise in community development finance without undue burden on any one investor.

For some holding companies, consortium CDCs may present drawbacks. First, the CDC's investment decisions may not always match the holding company's priorities or preferences. Second, the consortium approach may limit the ability of a multibank holding company to assist its affiliate banks, often located in different communities and states. For example, if a consortium CDC's projects are not located in the community delineated for purposes of evaluating a bank's CRA performance, the CDC projects may not be counted in that bank's CRA evaluation. For that reason, some holding companies may wish to help capitalize consortium CDCs in the communities of their affiliate banks.

Third, investment returns must be shared with other investors, as must public recognition for the support given to the CDC's revitalization activities. And finally, depending on how it is structured, the consortium may prevent a holding company from receiving any of the tax advantages flowing to the CDC from its project investments. Profit Considerations of the CDC Form Bank holding companies should carefully consider their option to invest in CDCs and consortium CDCs on a for-profit or nonprofit basis. Each approach has advantages and disadvantages.

The Nonprofit Form. An advantage of nonprofit organizations is their eligibility to receive grant money directly from many foundations and government agencies. In the case of rental or for-sale housing, such grants help reduce the cost of debt service, thereby allowing rents or sale prices to be set at levels affordable to low-income persons. Also, because a nonprofit community development venture must reinvest its earnings in other development projects, its nonprofit status emphasizes community benefit, not direct financial gain, as its primary purpose. By conveying this message, a financial institution's community development activity may achieve increased community support and credibility.

A drawback is that community-based nonprofit groups could perceive a nonprofit CDC that is controlled by a financial institution as an advantaged competitor for scarce, hard-to-obtain government and foundation grants. A nonprofit CDC also may have difficulty attracting funds from those who would prefer to earn a return on their investment. This problem is especially significant in the case of consortium CDCs or partnerships, which may need to attract significant capital from a variety of corporate and individual investors so that they may undertake larger revitalization projects.

The For-Profit Form. The for-profit approach often is more acceptable to the management and boards of directors of would-be investors because it places community development in a business context that conveys seriousness of purpose and organizational discipline. In addition, the potential for investment returns (including in some cases, tax benefits) attracts investments from others in a community who share an interest in community revitalization. Successful for-profit CDCs and ventures help demonstrate to other developers and businesses that community development work can be profitable and rewarding.

For some bank holding companies, the for-profit approach may have some disadvantages. Community and neighborhood groups may perceive a for-profit CDC as more risk-averse and less willing to pursue difficult projects in low-income areas even though these may be most needed. Also, some community organizations may prefer to see potential net earnings from any community development project used to reduce project costs, rents, or sale prices rather than passed back as profits to the financial institution sponsors. Thus, a for-profit CDC or investment may not be viewed by the community as providing the maximum benefits to low- and moderate-income persons.

Most bank holding companies choose the for-profit form for their CDC investments, finding that many of the advantages of nonprofit operations can be obtained through partnerships with existing nonprofit community organizations.

Limited Partnerships

The advent of a federal tax credit for business investment in low-income housing has made this type of investment more attractive to businesses and corporations. As a result, a growing number of limited partnerships invest exclusively in qualified low-income housing projects. The limited partnerships are formed by a general partner-usually a private developer, nonprofit organization, or government-sponsored housing finance corporation-which in turn sells shares to the limited-partners.

Limited partners are essentially passive investors and risk losing their limited liability status if they participate in managing or directing the partnership's investment activity. Consequently, the financial strength, experience, and character of the general or managing partner is of utmost importance and must be assessed carefully by any holding company considering the purchase of shares as a limited partner. For this reason and because limited partnership arrangements often involve complex legal and accounting issues, investors often must incur significant costs for "due diligence" investigations before making any investment decision.

Generally, limited partnerships for low-income housing come in two varieties: operating limited partnerships and master limited partnerships. Both types can provide direct investment returns and tax benefits to the limited partners while limiting their exposure to many of the liabilities associated with direct real estate development.

For example, one bank holding company has committed equity investments of almost $5 million to limited partnerships that developed 12 housing projects with a total of more than 500 housing units for lower-income families and the elderly. One was a master limited partnership that developed 340 housing units in 8 projects located in smaller, rural communities.

Operating Partnerships. Operating partnerships usually are created for a particular housing project, although some partnerships invest in several. The equity investments generated by an operating partnership reduce significantly the amount of debt needed to finance the project. Hence, the debt service that the rents must support is also lower, allowing for reduced rents that are affordable even to families with very low incomes.

A bank holding company may be the sole limited partner or be one of many. The partnership owns the housing project, and the limited partners benefit from any net income and tax credits generated by the project in proportion to their ownership interest.

Master Limited Partnerships. Master limited partnerships are formed to purchase shares in operating limited partnerships, particularly for low-income housing. They are usually created by national or statewide groups such as housing finance agencies and nonprofit or quasi-public corporations, but some are based locally. Equity funds or equity pools for low-income housing are often organized as master limited partnerships; others may employ the corporate form and operate as consortium CDCs.

Direct Investments

Instead of forming or joining a CDC or investing in limited partnerships, a bank holding company may invest directly in community development projects. For example, it may provide additional equity for a neighborhood housing project or commercial redevelopment venture, making it possible for the sponsor to qualify for debt financing and move forward. Bank holding companies using the direct investment approach usually have preferred to enter into a joint venture with a local developer or nonprofit development corporation that initiates and manages the project.

A direct project investment may be useful in helping the holding company respond to a specific and immediate community need - the investment can be made without incurring the delays and costs associated with incorporation of a CDC or formation of a limited partnership. On the other hand, a single-purpose investment may spark requests for participation in many other projects located throughout the institution's trade area. And a CDC could accommodate an expansion of the institution's territory.

Management Considerations

The complexities of the community development process demand that investment organizations exercise careful management and oversight. The level of commitrnent of management resources may vary considerably, however, depending on the type of investments. For example, CDCs that focus on venture capital investments in small and minority business will require a relatively large commitment of staff to monitor the progress of the businesses assisted.

The level of management resources committed may also vary according to the investment mechanism being used. For example, a subsidiary CDC involved in several projects and regularly adding more may require a full-time chief executive officer and other staff members to conduct community outreach, review project proposals, manage the investment approval process, and monitor investments once made. On the other hand, a CDC that makes only occasional project investments as needs or opportunities arise can be managed effectively by its board of directors with part-time support from the staff of the holding company or affiliate bank. Most CDCs also form an investment committee of bank or holding company officers and other real estate development experts.

Limited partnership investments require far less management than a CDC. Indeed, as limited partners, holding companies that engage in activities that might constitute management" of the partnership risk exposure to potential liabilities as a general partner. Nonetheless, limited partnership investments may be extremely labor intensive during the period when the holding company is considering purchase of partnership shares and reviewing partnership documents. Having invested, holding companies will need to review the project and the activities of the general partner to ensure that their interests are protected and that any tax benefits promised the limited partners are in fact provided.


When making equity investments, financial institutions have usually focused on housing and on the commercial revitalization of neighborhoods, both for the benefit of low- and moderate-income families, and on the development of small and minority businesses in distressed areas. Such investments can benefit the institutions in a variety of ways, including a return on the investment, the development of new market opportunities, a gain in leadership stature and competitive advantage in the community, the protection or enhancement of the value of the institutions' assets that already exist in the community, and support of the subsidiary banks' performance under the Community Reinvestment Act.

Development of New Market Opportunities

In both new and existing markets, active participation in community development helps an institution create new business opportunities. Equity investments can help generate additional deposits and increased demand for bank loans or other services in markets previously perceived as weak. Construction or rehabilitation of low- and moderate-income housing, for example, can reestablish neighborhoods and help create local demand for shopping and other business services. Similarly, projects for commercial revitalization or industrial redevelopment that provide jobs for unemployed and underemployed persons can lead directly to new or expanded banking relationships.

Community Leadership and Competitive Advantage

Rather than wait for other private investors to commit capital, a holding company itself can make the commitment, an action that can increase community confidence and help attract the interest of other private investors. In thus becoming a catalyst for additional investment, the institution also becomes a leader in the overall revitalization process.

In a financial services marketplace that is highly competitive, such leadership demonstrates an institution's commitment to the economic well-being of its community and local markets and helps the institution distinguish itself from its bank and nonbank competitors. Such leadership also helps cement business relationships with decisionmakers in government and business and with consumers who view community support as an important factor when they select a financial institution.

Investment Return

When properly conceived and structured, equity investments in projects designed to benefit lower-income persons and areas may yield direct capital gains or after-tax profits. Although the profitability of community development investments will vary with the type of project, the capacity to earn a return could make holding-company participation as an equity investor in community-welfare projects more attractive than charitable contributions and grants for essentially the same purposes.

Enhancing CRA Performance

A bank holding company's equity investments for community development do not relieve its affiliate banks from their responsibilities under the Community Reinvestment Act (CRA). But a holding company's strategic use of such investments can help strengthen its banks' CRA performance. For example, the investments, made directly by the holding company or through its CDC, may help community projects qualify for development loans from the holding company's subsidiary banks. Or a holding company's CDC may provide technical assistance that will help subsidiary banks identify appropriate projects and package safe and sound community development loans.


Community development investments may not be suitable for every bank holding company. The option has, however, generated interest among banks and holding companies seeking new ways to support the revitalization of distressed communities.

The extent to which a bank holding company is willing to approach community development through equity investments depends on many corporate and community factors, each of which may vary over time. The nature and required extent of the investment activity and the availability of holding company capital and other resources for community development purposes are some key considerations. Also important is the extent to which a holding company and its subsidiary banks have effective, ongoing community relationships; these relationships can aid the institution in identifying projects that both need equity capital and meet the needs of lower-income persons and areas.

The holding companies that have made community development investments, whether through CDCs, limited partnerships or other ventures, have found them to be valuable supplements to those products and services that are more traditionally employed to help meet community reinvestment needs.

1. Bank holding companies may prefer to initiate and manage equity investments for community development through one or more bank subsidiaries rather than through the holding company itself. In such cases, each bank should seek authorization for such investments from its primary supervisory agency.
COPYRIGHT 1991 Board of Governors of the Federal Reserve System
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Braunstein, Sandra F.
Publication:Federal Reserve Bulletin
Date:Jun 1, 1991
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