Statement by Griffith L. Garwood, Director, Division of Consumer and Community Affairs, Board of Governors of the Federal Reserve Board System, before the Subcommittee on Financial Institutions Supervision, Regulation and Deposit Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, February 3. 1993.
I want to call the subcommittee's attention to two publications we have provided with our written statement.(1) The first is Community Development Investments, which describes in some detail the Federal Reserve's policies and guidelines for bank holding company CDCs and community development project investments and also outlines key issues that holding companies should address when considering such investments. Although I will touch briefly on some of these guidelines and issues today, those who are interested in additional detail should consult the publication. The second publication is Directory: Bank Holding Company Community Development Investment, which includes profiles that describe the CDCs and other community development projects in which bank holding companies have invested.
In my remarks today I begin by discussing CDCs in the context of banking's overall role in financing community development. Second, I will provide the subcommittee with some background on the Federal Reserve's policies and guidelines for bank holding company CDCs and community development investments. Finally, I will share with you some observations about key ways in which the equity investment option is being used around the country and some of the more common misperceptions about bank-related CDCs.
As you know, interest in banking's overall role in financing community development is increasing in banks and their communities. Those seeking funds for low-income housing projects, small and minority revitalization efforts have increasingly looked to banks as the primary source of financing. Because of their expertise in finance, their local presence, and their community reinvestment obligations, financial institutions are viewed as natural partners in the community development process by housing groups, community organizations, small business, neighborhood development groups, and city and county governments, as well as private developers.
Over the past five years, in particular, we have observed significant growth of bank financing for community development in both large and small communities throughout the country. Some of that growth has been reflected in the increasing use of community development corporations and investments by banks and bank holding companies.
The Role of Banks in Community
I want to make clear at the outset, however, that although CDCs and community development investments remain important tools for banks and bank holding companies, they are, in fact, only one part of a much larger picture. Despite the significant growth in the number of bank-related CDCs and the expanding scope of their activities, the primary way in which financial institutions support community development programs and projects continues to be in the more traditional form of loans. These loans may include direct loans or loan participations, involvement in special housing or small business lending consortium organizations, the offering of credit lines to other community development lenders, or the purchase of loans and other common forms of debt securities to help meet the credit needs of a bank's community. Often these loans are provided through collaborative public-private partnerships. Financing packages may include public funds used as loan guarantees, interest rate subsidies, second and third position loans, contingency reserves, or project grants. But, at its core, the financing of community development by banks is still primarily through lending.
To illustrate this point, I have included with my written testimony a list of more than ninety examples of activities of banks in community development. These examples were recently compiled by the Community Affairs Officers of the Federal Reserve Banks. Although this compilation includes a very small sample of projects, based on information that was readily available, we do believe that it reflects the wide variety of community development and reinvestment activities being undertaken around the country by banks. With few exceptions, these projects include a combination of public and bank financing.
Special Role For CDCs
In the context of banking's overall role in community development, I want to draw a simple distinction between CDCs, project investments, and other forms of community development finance in which the banking community engages. Typical bank lending for community development requires others who own property or businesses to commit capital before lending can occur. On the other hand, authority granted to banks and bank holding companies for investment in special community development enables them to take a position of ownership by investing equity capital through CDCs and other means.
The practical result is that these institutions can expand the roles they can play in the community development process. Rather than waiting for others to initiate projects, institutions using this special authority can also buy, rehabilitate, and sell properties or provide supplemental equity or special debt investments that help make projects or business ventures feasible. In effect, the CDC option provides an additional dimension that allows financial institutions to become catalyst for the revitalization of economically distressed areas.
Commonly, this option enables financial institutions to fill gaps in equity capital projects, making the participation of other lenders and investors possible. The capacity to provide additional equity to a project is especially important in areas that are poor in capital or with nonprofit community-based development corporations that typically have little working capital to support neighborhood revitalization projects or to help them obtain loans.
Legal and Regulatory issues
The Federal Reserve's formal involvement with bank holding company CDCs began shortly after the 1970 amendments to the Bank Holding Company Act, which provided some flexibility to the Federal Reserve Board concerning permissible bank holding company activities. In 1971 the Board revised its Regulation Y to authorized bank holding companies to invest in community development equity activities. Section 225.25(b)(6) defines the term "community development" as "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."
Let me emphasize that equity investments in corporations or development projects are not part of the traditional role played by financial institutions. Such investments constitute exceptions to laws that restrick bank and bank holding company ownership of real estate or nonbanking business ventures and thus require special legal and regulatory authority. They also necessitate a cautious approach by supervisory agencies to ensure that bank holding companies are using this authority only for legitimate community development purposes and in a manner that does not pose undue risk to the tank holding company or its insured financial institution subsidiaries.
Nevertheless, several Federal Reserve decisions have provided bank holding companies with considerable flexibility in tailoring their investments to meet the needs of their disparate communities. Generally, the Federal Reserve has held that holding company investments in CDC ventures or community development projects generally meet the "community welfare" test if they primarily benefit low- and moderate-income persons and economically disadvantaged neighborhoods and communities.
More than seventy bank holding companies have been authorized by the Federal Reserve to invest in CDCs and projects. These investments have had a variety of purposes, including construction or rehabilitation of rental housing for low- and moderate-income families; purchase, rehabilitation, and sale of affordable homes; industrial development and the development or expansion of small and minority business enterprises in economically distressed areas; and development of community facilities that provide health, educational, and other essential services for low- and moderate-income persons.
Over the years, the Federal Reserve has made clear that investments for corporations or projects that are organized to build or rehabilitate high-income housing or commercial, office, and industrial facilities that are not designed explicitly to create long-term job opportunities for low-and moderate-income persons - even though such investments might provide some indirect benefits to low- and moderate-income persons - would be presumed not to meet the community welfare test. That distinction is important. The Federal Reserve does not want CDC authority used to enable bank holding companies to engage in large-scale real estate development or non-banking business ventures as a conventional business activity.
Nonetheless, the Federal Reserve recognizes that neighborhoods and communities in both urban and rural settings vary greatly in size, population mix, and economic condition, and it has remained flexible in applying the standards of Regulation Y for approval of community development activities. For example, approved community development activities have included, in one case, the creation of a rural test farm for crop experimentation that could help diversify a rural farm economy, and in another case, the rehabilitation of a medical services clinic to help attract doctors to a small rural community.
Characteristics of CDCs
Under Federal Reserve guidelines, community development investments by bank holding companies may be made on either a for-profit or a nonprofit basis, although most holding company CDCs and investments have been for-profit ventures. Although the Federal Reserve does not discourage profit seeking from community development investments by holding companies, significant profits are, as a practical matter, generally not expected.
The Federal Reserve also takes a flexible approach concerning the amount of capital that bank holding companies commit for community development investments. Although the Federal Reserve sets no minimum or maximum levels for capital investment by bank holding companies in CDCs or community development projects, it does expect that use of holding company equity for such purposes will be appropriate for anticipated investment activities, and certainly prudent with respect to the size, financial condition, and capitalization of the holding company. The Federal Reserve will not allow community development equity investments in amounts that might pose undue risk to the safety and soundness of the holding company. Recent legislation related to bank investments sets certain limits for banks themselves.
For practical reasons related to the functions of bank holding companies, the Federal Reserve also does not limit the geographic scope of a holding company's community development investments. Bank holding companies typically conduct their CDC and project investment activities in economically disadvantaged neighborhoods and communities in the market areas served by their subsidiary banks. As a result, although some holding companies focus their community development investment activities in one community or one state, others with banks in several states have established CDCs that have been approved to make investments on an interstate or even national basis.
Despite this flexibility, we do expect that bank holding companies will seek and consider the views of the affected neighborhoods or communities when making an investment decision, although the Board does not specify any particular approach for ensuring community involvement. Some holding company CDCs have established community advisory committees in each community where projects are considered, while others use community outreach vehicles already established by their affiliate banks. Although community representation on the board of directors of a bank holding company's CDC may be helpful in certain situations, it is not required.
Types of Community Development
Let me now turn to the various approaches used by bank holding companies when making community development investments. There are four primary ways in which bank holding companies utilize their authority for community development equity investment, and these methods are not like those used by national banks. First, the bank holding company can establish a wholly owned, de novo CDC as a stand-alone subsidiary. Usually, the holding company capitalizes the CDC with an initial equity contribution and may provide loans or lines of credit to fund the CDC's investments and lending. The CDC then becomes the vehicle that makes debt and equity investments in community development projects. An advantage in having a subsidiary CDC is that it can be used by the holding company to support a variety of projects over time.
Currently there are about forty CDCs operating as wholly owned subsidiaries of bank holding companies. One example is Banc One's CDC, which provides equity investments for projects identified and supported by the holding company's subsidiary banks that are located in many states. The CDC has participated in several neighborhood housing renovation projects in Cleveland, Columbus, and Dayton, Ohio, and in Milwaukee, Wisconsin. It also has invested in the Ohio Equity Fund, the Wisconsin Equity Fund, and the National Equity Fund, all of which help finance acquisition and renovation of lower-income housing projects in several communities. Other large holding companies, such as Citicorp, Chase Manhattan Corporation, and J.P. Morgan and Company in New York, have formed wholly owned CDCs, but many smaller holding companies that serve smaller communities or neighborhoods have also used this approach. For example, Moxham Bank Corporation of Johnstown, Pennsylvania, formed a CDC that became a limited partner in a fifty-eight-unit apartment complex for lower-income senior citizens.
A second approach, one that is increasingly popular, is participation in a multi-investor consortium CDC that, in turn, invests in one or more community development projects and business ventures. Sometimes called multibank or non-bank CDCs, these CDCs are intermediaries that pool the investments of several financial institutions or other investors. Participation in a multi-investor CDC enables a bank holding company to share community development expertise, resources, and risks with others; such participation is an especially valuable tool for smaller institutions that do not have sufficient capital by themselves to make larger investments, which can have the most significant impact on community development needs. In rural Illinois, for example, the Tri-County Community Development Corporation was created by two bank holding companies - FirstBank of Illinois Company, in Springfield, and Farmers Holding Company, in Jacksonville - along with several smaller banks, all located in three adjacent counties in western Illinois. A local utility, a power cooperative, and a local chamber of commerce are also investors. The CDC's purpose is to promote economic development and to help new and existing small businesses to expand, thereby creating jobs in the three-county area. The CDC provided financing that helped attract a music company distribution center to the area, and it is also participating in a state program that assists companies in retooling and modernizing their facilities.
A third approach used by bank holding companies is investment in limited partnerships that are formed to invest in one or more community development projects. The availability of federal low-income housing tax credits has made investments in limited partnerships that finance low-income housing projects increasingly attractive. An increasing number of large and small bank holding companies have invested in such partnerships. Holding companies can be the sole limited partner, or they can be one of many partners.
For example, BB & T Financial Corporation, a parent of Branch Banking and Trust Company, has invested as the sole limited partner in three separate low-income housing limited partnerships that developed a total of 118 rental units in three North Carolina communities. In another case, First Bank System, headquartered in Minnesota, formed a CDC that in turn has become an investor in several limited partnerships in the Minneapolis-St. Paul area that support fifteen separate low-income housing projects; it has also invested in limited partnerships and projects in other states that are served by First Bank System subsidiaries.
Finally, bank holding companies may make direct investments in single-purpose community development projects or business ventures alone or jointly with others. This investment can be made without forming a CDC or participating in a limited partnership. For example, Perry Bancshares, Inc., in Perry, Oklahoma, purchased an industrial site in its community and is working with the local chamber of commerce to market the site to potential industrial users while exploring other potential uses that will benefit the community.
As these examples illustrate, the option to make equity investments for community development purposes produces several benefits for financial institutions and their communities. Through its Community Affairs programs at each of the Federal Reserve Banks, the Federal Reserve System provides information and technical assistance to banks and holding companies about about community development investment options.
Issues Related To CDCs
Although fully supporting the CDC concept, the Federal Reserve believes that use of community development corporations and investments has limitations and that these mechanisms should not be oversold. In that regard, there are several issues that both financial institutions and policy-makers should address.
First, bank-related CDCs should not be viewed as a panacea for the ills of our urban neighborhoods and rural communities nor as the main vehicle for bank activity. As I noted earlier, the option for community development equity investment is an important and useful tool, one that we believe can effectively supplement ongoing bank lending programs and community efforts to revitalize economically disadvantaged areas. Although though we continue to expect increased CDC activity by state member banks and bank holding companies, we believe that community development lending by financial institutions and other intermediaries will continue to be the primary nongovernmental source of funding for community development.
Second, as interest develops in CDCs, there is a growing need to reiterate how bank CDCs relate to the Community Reinvestment Act (CRA). Under current provisions of the CRA, CDCs and project investments can provide positive contributions to an institution's CRA performance, but they are not considered to be a substitute for the institution's CRA program. By making loans and equity investments in low- and moderate-income areas, CDCs help fulfill CRA's aims. But any expectation a bank may have that forming a CDC or making a few low-income housing investments will automatically result in a satisfactory or better CRA performance rating is unrealistic under current law. In the absence of any other CRA-related activities, a CDC, unless it is extremely active in community outreach and lending, would not make up for an otherwise deficient CRA record of performance.
Third, it is clear that no one model is appropriate for every financial institution or every community it serves. As even the few examples discussed here illustrate, there are many options. Banks and holding companies must continue to have flexibility to look at community needs and create the community development response that best fits their circumstances.
Fourth, several other issues can impact the effectiveness of bank CDCs and community development investments. For example, there are practical limitations on the amount of bank and bank holding company capital that can be devoted to community development purposes. expectations concerning widespread use of bank capital for community development purposes may be too optimistic. Although we believe that the trend will continue to be very positive over the longer term, for many institutions there are limits to the speed with which they can commit large amounts of capital to CDCs and related community development investments.
In addition, financial institutions must consider community resources. CDCs are rarely successful unless there are effective partners with which to work. These might include other nonprofit CDCs, the local business community, local and state government agencies and program resources, or federal program funds that help provide the subsidies that make community development projects feasible and affordable for lower-income people. While some communities have many effective partners and can communities have many effective partners and can assemble appropriate resources for projects, others do not.
Finally, I think financial institutions and policymakers need to consider the human resources aspect pf CDCs. Community development investment requires special knowledge of real estate development and business ownerships, and a somewhat different approach to finance issues. Although community development finance as a specialty in banks continues to grow, we believe that development of effective specialists and managers to meet the demand and current expectations of community groups, local governments, and financial institution management will take time.
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|Title Annotation:||Statements to Congress|
|Publication:||Federal Reserve Bulletin|
|Date:||Apr 1, 1993|
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