Starting a

by Peggy Delinois Hamilton • Yale Law School

10 Spring 2006 Community Development Bank

A New Haven Story

starting a community Fund, which led to today’s 750-plus com- and grow the business. In addition, every development bank to munity development financial institu- bank must meet the safety and soundness meet the needs of low- tions (CDFIs), 50 of them banks and requirements of one to four regulatory In 3 and moderate-income residents, First thrifts. authorities before they open. The rules City Fund Corporation is charting new Communities start community regulate not only the nature of the busi- territory in New Haven. The corporation development banks hoping to address ness and the qualifications for managers, is one of a select few nationwide showing local needs for capital, credit, savings, but also how much capital must be raised that it is possible for nonprofits to estab- investment, and transaction services. The and maintained. lish strong banks. banks are an attractive alternative to check cashers in low- and moderate- First Things First Banking on Communities income communities (who may deduct 2 From my experience, raising the cap- Since the 1994 Riegle Community percent) and payday lenders (who may ital to establish a de novo community Development and Regulatory charge as much as 400 percent).4 To the development bank is the most difficult Improvement Act (commonly called the extent that they provide for savings and step. In 1993, I was retained to help start Community Development Banking Act), City First Bank of D.C., a bank designed community development banking has to serve low- and moderate-income become a cottage industry.1 State or fed- It is possible for neighborhoods in the District of erally chartered and insured by the nonprofits to Columbia. Federal Deposit Insurance Corporation, From that odyssey, I learned that the banks have a primary mission of com- establish strong starting a community development bank munity development—typically, activi- has at least 10 discreet steps: (1) identify- ties benefiting low- and moderate- banks. ing the market need; (2) determining the income individuals or geographic areas.2 type of financial institution that will best Before 1994, there were two self-pro- investment, the new banks help create meet that need; (3) writing the business claimed community development banks: wealth and alleviate poverty. plan and submitting the charter applica- ShoreBank in and Elk Horn Starting a bank, however, is no easy tion; (4) determining the need for other Bank & Trust in Arkadelphia, . task. Like any business, banks must have regulatory memberships (such as the The law established the Community sound management, feasible business Federal Deposit Insurance Corporation, Development Financial Institutions plans, and sufficient capital to sustain Federal Reserve Board, or the Federal

Communities &Banking 11 and the competition from both unregu- lated lenders and traditional banks.

Motivating Socially Responsible Investors Community development banks seek innovative ways to motivate poten- tial investors. For example, they may participate in the New Market Tax Credit program, the Bank Enterprise Award program, and the CDFI Fund Financial Assistance Award program (all administered by the CDFI Fund) to obtain sources of capital.6 Such pro- grams often reassure private sectors and can help generate stronger financial returns. Community development banks also promote their “double bot- tom line.” Because financial returns may be lower than for their peers, the banks reach out to investors motivated to help build affordable homes, create jobs, or launch small businesses. Nonprofit organizations also are helpful in attracting capital to commu- nity development banks. The Internal Revenue Service recognizes nonprofits as federally tax-exempt because their purposes are charitable or promote social welfare. It also recognizes that sometimes those purposes intersect with community banking.

Supporting Social Welfare Consider the nonprofit City First Enterprises, Inc., the bank-holding company of City First Bank of D.C. City First Enterprises is tax exempt under section 501(c)(4) of the Internal Home Loan Bank); (5) determining the 1933. Regulation D permits the sale of Revenue Code, which gives exemption need for affiliates (such as a bank hold- securities without Securities and to organizations that exclusively pro- ing company, a financial holding com- Exchange Commission registration—so mote social welfare. The IRS saw the pany, or an operating subsidiary); (6) long as the offer is not made to the pub- group’s support for a community bank raising capital (at least $2 million net of lic and does not involve a general solic- as part of its mission. With a successful preopening expenses); (7) securing the itation. Such private offerings are made application to the U.S. Department of location; (8) hiring management; (9) primarily to accredited investors, usual- Housing and Urban and Development providing a service and assessing ly institutional investors or high-net- and the Department of Housing and impact; and (10) attaining and sustain- worth individuals. Community Development, City First ing profitability. Of the five years it Raising the minimum capital nec- Enterprises was able to contribute $4.5 took to open that bank, raising the ini- essary to meet the bank’s business needs million in initial capital to City First tial $9 million capital took nearly and the regulatory requirements is diffi- Bank. Having provided nearly half of three.5 cult given the investment’s illiquidity, the start-up money, City First De novo community development the lack of operating history, the high Enterprises became the bank’s control- banks often raise capital under operating losses expected initially, the ling owner. Regulation D of the Securities Act of focus on lower-income populations,

12 Spring 2006 Working with Government do well to consider this new way of income taxes for making qualified equity invest- In New Haven, First City Fund making more financial services available ments in designated community development entities. Substantially all of the qualified equity Corporation—like City First Enterprises to low- and moderate-income commu- investment must in turn be used to provide in —is establishing and nities. investments in low-income communities. The becoming controlling owner of a com- credit provided to the investor totals 39 percent of munity development bank. However, the cost of the investment and is claimed over a seven-year credit-allowance period. Investors may First City Fund’s tax exemption is under Peggy Delinois Hamilton is the Selma not redeem their investments prior to the conclu- section 501(c)(3), so it can fulfill its char- sion of the seven-year period. For the CDFI Fund itable purpose by promoting community Levine Lecturer in Clinical Law at the New Markets Tax Credit Program see and economic development in New Yale Law School in New Haven. http://www.cdfifund.gov/programs/programs.asp ?programID=5. Through the Bank Enterprise Haven and adjoining towns, where it can Endnotes Award Program, the CDFI Fund backs financial help with capital, credit, savings, invest- institutions dedicated to supporting community 1Community Development Banking Act, P.L. and economic development. The program com- ment, and transaction services to organi- No. 103-324,108 Stat. 2160 (Sept.23, 1994). plements the community development activities zations and individuals in lower-income 2 See 12 CFR 25.12(g). of FDIC-insured depository institutions by pro- neighborhoods. It will work with city iii Certified CDFIs as of January 1, 2006, may viding financial incentives to expand investments government in (1) spurring affordable be found at www.cdfifund.gov. in CDFIs and to increase lending, investment, housing and small business growth, (2) 4 Michael S. Barr, “Banking the Poor,” Yale and service activities within economically dis- providing relief to the poor and under- Journal on Regulation 21, no. 1 (winter 2004): tressed communities. For the CDFI Fund Bank 121-237. Enterprise Award Program, see http://www.cdfi- 5 FDIC Statement of Policy on Applications for fund.gov/programs/programs.asp?programID=1. Deposit Insurance, February 28, 2003, at p. 5349 Through the Financial Assistance awards, the Raising the capital (available at http://www.fdic.gov/regulations/laws CDFI Fund invests in CDFIs that demonstrate /rules/5000-3000.html). Normally, the initial cap- the following: they have the financial and mana- to establish a de ital of a proposed depository institution should be gerial capacity to provide affordable and appropri- sufficient to provide a Tier 1 capital-to-assets lever- ate financial products and services that positively novo community age ratio (as defined in the appropriate capital reg- impact their communities; they are viable finan- ulation of the institution’s primary federal regula- cial institutions; and they use and leverage CDFI development bank is tor) of not less than 8.0 percent throughout the Fund dollars effectively. Such awards are made in first three years of operation. In addition, the the form of equity investments, loans, deposits, or the most depository institution must maintain an adequate grants and must be matched by the applicant with allowance for loan and lease losses. funds of the same type from nonfederal sources. For CDFI Fund Financial Assistance Program, see difficult step. 6 The New Markets Tax Credit Program per- http://www.cdfifund.gov/programs/programs.asp mits taxpayers to receive a credit against federal ?programID=7. privileged, (3) combating community deterioration, and (4) lessening govern- ment burdens. First City Fund Corporation plans to raise $25 million to help create the bank. It is not new for nonprofit organi- zations formed “to relieve poverty, elim- inate prejudice, reduce neighborhood tensions and combat community deteri- oration” to support loans and business enterprises in economically depressed areas. What is a new development is nonprofits taking a leadership role in providing financial services. First City Fund Corporation in New Haven and City First Enterprises in Washington demonstrate that non- profits can actually start a bank. Given their ability to attract socially conscious investors and provide a tax deduction for donations, nonprofits could be increasingly important in community development banking. Neighborhood groups and existing foundations would

Communities &Banking 13

This article was first published in the Federal Reserve Bank of Boston's Communities & Banking magazine.The views expressed are not necessarily those of the Federal Reserve Bank of Boston or the Federal Reserve System. Information about organizations and upcoming events does not constitute an endorsement. To subscribe, e-mail [email protected].