Small Business Finance in Two Chicago Minority Neighborhoods
Total Page:16
File Type:pdf, Size:1020Kb
Small business finance in two Chicago minority neighborhoods Paul Huck, Sherrie L. W. Rhine, Philip Bond, and Robert Townsend Introduction and summary ultimate success depends, in part, on how successful Chicago is enlivened by the presence of many ethnic they are in obtaining adequate capital and credit. neighborhoods, which are reflected in the citys small Loan guarantees and other programs offered by business sector. This makes Chicago an excellent loca- the U.S. Small Business Administration are examples tion for studying small business finance in ethnic of government policies aimed at increasing access to communities. The topic is important because the credit for small businesses. Considering access to availability of capital may depend, in part, on ethnic capital and credit across neighborhoods and across differences in factors such as the use of informal ethnic and racial groups raises other policy issues. financing (loans or gifts from family, friends, or busi- Owning a successful business builds personal wealth, ness associates) as opposed to formal financing from and self-employment historically has been an impor- banks and other financial institutions. We still have tant means for raising the economic status of some much to learn about business access to capital in an ethnic groups. Promoting the success of small busi- ethnic context. To shed some light on these matters, ness is an important part of community economic the Federal Reserve Bank of Chicago and researchers development strategies, particularly for minority from the University of Chicago conducted surveys in neighborhoods that have suffered from a lack of two Chicago neighborhoods, Little Village, a predomi- investment in the past. The purpose of the Community nantly Hispanic community, and Chatham, a predomi- Reinvestment Act is to encourage depository institu- nantly Black community. These communities were tions to help meet the credit needs of the communities chosen because they are distinct and well-recognized in which they operate, consistent with sound bank- ethnic neighborhoods with viable small business sec- ing practices. While racial discrimination in residential tors. Although most of the business owners inter- mortgage markets has been the subject of a number viewed are either Black or Hispanic, other ethnic of empirical studies, the effect of racial discrimination groups are represented. One of the important features on access to capital for minority business owners of the surveys is that they shed light on informal and and neighborhoods has received little attention to 3 formal sources of financing for both households and date from researchers. businesses. Small business access to capital is an important Paul Huck and Sherrie L. W. Rhine are economists at policy issue because business owners may face the Federal Reserve Bank of Chicago. Philip Bond is a funding limits, known to economists as liquidity con- visiting lecturer at the London School of Economics. straints. Although many observers might take funding Robert Townsend is a professor of economics at the University of Chicago and a consultant to the Federal limits as self evident, studies have shown that liquid- Reserve Bank of Chicago. This project was originally ity constraints affect entrepreneurs both upon start-up funded by the Center for the Study of Urban Inequality and after the business is underway.1 These constraints of the University of Chicago, with Richard Taub, Marta Tienda, and Robert Townsend as principal investigators, deter entry into self-employment and force would-be and is cosponsored by the University of Chicago and owners to save for longer periods before launching a the Federal Reserve Bank of Chicago. Robert Townsend business. The effects of start-up constraints extend also receives financial support from the National Science Foundation. The authors would like to thank to ongoing businesses, because starting with more Dan Aaronson, David Marshall, and Alicia Williams for capital increases an owners prospects of developing helpful comments on an earlier draft. a viable, growing business.2 Thus, entrepreneurs 46 Economic Perspectives In practice, owners meet the challenge of obtain- than the formal sector. However, an important advan- ing capital to start and run their businesses by using tage of formal credit institutions is their ability to effi- informal sources, as well as personal assets and loans ciently mobilize large amounts of capital. Recognition from formal sources. Thus, informal financing via net- of the strengths of both informal and formal sources works can substitute for borrowing in the formal sector, of financing should be a part of programs and policies either because formal credit is not offered or because aimed at encouraging the flow of capital to small informal financing is preferred. Credit offered by a businesses. supplier, or trade credit, is another alternative to bor- In the next section, we briefly discuss some of rowing from financial institutions. Businesses form the theoretical issues involved in understanding the networks with their suppliers, and there may be an eth- use of formal and informal sources of capital and nic dimension to these networks, in that the ethnicity credit. We hope that data from the Little Village and of the supplier may matter for some transactions. Chatham studies may better inform the process of The main contribution of this article is to provide building more useful theoretical models of financial information about the use of formal and informal intermediation. Measurement of the use and nature of sources of financing. We confirm the importance of informal networks is particularly important because, personal savings and informal sources of credit in as discussed below, the theoretical treatment of infor- meeting the entrepreneurs need for start-up funding. mal financing is still in its infancy. There are pronounced ethnic differences in the amount of start-up funding used by businesses in Theoretical overview the sample. In particular, we find that Black owners Why do individuals borrow or save to start their businesses with significantly less capital go into business? than Hispanic owners. This difference persists after In a world with perfect information, completely controlling for industry types and various measures specifiable and enforceable contracts, and no trans- of human capital (such as the skills, abilities, and action costs, borrowing, lending, and insurance con- training of business owners in the sample). The Black tracts essentially allow a separation of household Hispanic gap in total start-up funding is due to differ- consumption and saving decisions from occupational ent levels of nonpersonal sources of funding rather choice and investment decisions. That is, a potential than different amounts of personal savings put up business entrant would evaluate present and future by the owner. profitability, buy options against future contingencies, Turning to the use of trade credit, our most strik- and convert income streams into a single present ing finding is that Black owners are much less likely value number. That number, when compared with to owe their suppliers than owners in other ethnic alternatives, will determine for the individual which groups. This is partly because Black owners are less occupation, technology, or type of enterprise to take likely to be offered credit by their suppliers, and be- up, if any. That number plus existing wealth will deter- cause they are less likely to use trade credit if it is mine, in turn, household consumption and saving offered. Trade credit can be a relatively expensive decisions. These two types of decisions are separate source of ongoing credit, and it is not clear whether from one another. In practice, however, household using less trade credit indicates a constraint or a lack consumption/saving decisions and occupation and of need. However, being offered credit by a supplier, business investment decisions appear to be related, whether or not it is used, is clearly desirable. We find very much so in the present study. that comparing the ethnicity of owners and their sup- One branch of existing theory argues that credit pliers does not explain ethnic differences in the use contracts for business start-ups and ongoing financ- of trade credit. ing are very much limited. Some researchers, for exam- If these results hold beyond the Little Village and ple, Bernhardt and Lloyd-Ellis (1993), assume that Chatham neighborhoods, the findings have important there are no credit possibilities at all, in which case implications for understanding ethnic differences in start-ups and operations are limited to accumulated business survival and growth, the decision to become saving and past profitability and to the entrepreneurs self-employed, and income and wealth accumulation. own educational investments and experience. In other The importance of informal sources of funding sug- cases, such as Evans and Jovanovic (1989), Hart and gests that this type of funding has features that meet Moore (1997), and Banarjee and Neumann (1993), the needs of small businesses in these communities. acquisition of some credit is possible, but it is limited, Informal funding may be more flexible and better suited for example, to some multiple of accumulated wealth to providing relatively modest amounts of capital or available collateral, as in the use of personal collat- eral or trade credit backed by the goods supplied. Federal Reserve Bank of Chicago 47 More recent studies