Banks and other financial institutions use outdated and inequitable practices to determine who receives loans and who is worthy of an investment. These practices are based on out-dated notions of “risk,” going back to the antebellum South in which former slaves were not seen as safe investments, leading to practices in the US such as redlining that limited investments in communities of color.
Today, 98% of assets under management are controlled by white men, which limits the amount of capital going to entrepreneurs of color. Because people tend to consider those with similar characteristics — such as race, education, or upbringing, as riskier investments — the high concentration of white men making investment decisions puts women and people of color at a disadvantage. Barriers to capital for small businesses owned by people of color remain high, preventing them from growing and scaling their businesses. These barriers limit overall investments in communities of color, continuing a cycle of divestment and wealth extraction in those communities.
To create an equitable financial sector, we need to implement equitable underwriting practices. Underwriting is the process to determine if someone is creditworthy or not, examining, for example, a potential lender’s credit score, collateral, or previous business history. Revisiting our common assumptions about underwriting can help us examine a process that, on the surface, seems fair, but actually places a higher burden on people of color and gives a leg-up to white people in accessing capital.
The equitable underwriting community of action
Path to 15|55, a collaborative initiative that includes experts across all sectors, designed to grow Black businesses and their communities, convened a “Community of Action” to explore and set equitable underwriting practices. Path to 15|55 worked with Underwriting for Racial Justice and the Beneficial State Foundation to bring together financial lending organizations and institutions that touch nearly every region of the United States, including: CommunityWorks; Growth Partners Arizona & Kiva; ICA; Impact Ventures & Inclusive Capital; Partner Community Capital; Self-Help Ventures Fund; and Trufund. The goal of the cohort was to jump start an ecosystem for greater adoption of equitable underwriting among community development financial institutions (CDFIs) as well as large financial institutions.
Because lending institutions are very risk averse, they interpret anything new as having the potential for downside, rather than considering the up-side benefit.
Through a six-month process of meetings and convening, including connecting directly with potential small business borrowers, the cohort was able to identify a few key insights and lessons learned. One of the major barriers to adopting equitable underwriting was the threat, or perceived threat, of regulation. Many banks and CDFIs (incorrectly) assume that regulations prevent equitable underwriting practices. Because lending institutions are very risk averse, they interpret anything new as having the potential for downside, rather than considering the up-side benefit. Additionally, the threat of disciplinary action keeps institutions from experimenting with different approaches.
To overcome this barrier, the cohort identified three paths forward:
- The first is to establish standards around equitable underwriting and banking to help all players get on the same page about what is and is not possible. This work has been largely completed by our partner, Beneficial State Foundation, which published equitable banking standards. These standards, while broad and generally focused on equity, rather than equitable underwriting, offer a starting point for banks and other financial institutions to understand the value of equity in loans and other financial products.
- The second is to continue experimentation with different approaches to underwriting. Many of the cohort members shifted their underwriting processes during the COVID lockdowns out of necessity. Some of these changes included shifts in how credit scores were used, as well as reliance on collateral. Many of these changes are similar changes required by an equitable underwriting process. Now that we are a few years out from these shifts, we can look at the effects of these shifts in practices and help inform future equitable underwriting practices. The results can help make the case for equitable underwriting being a safe and secure way to approach loan distributions.
- Third and perhaps most importantly, we recognized that more work needs to be done to spread the message around equitable underwriting. CDFIs and collaborative groups like Path to 15|55 should not be the only entities pushing equitable underwriting practices. Regulators and large financial institutions should also be supporting these efforts as a signal that equitable underwriting is possible, needed, and meets fiduciary responsibilities of lending institutions. To that end, Path to 15|55 is exploring a partnership with the Federal Reserve to consider ways to embed equitable underwriting into their processes.
More work needs to be done to spread the message around equitable underwriting.
The seven members of the equitable underwriting Community of Action will not be able to make the financial industry more equitable on their own. Path to 15|55 is lucky to have partners in this work like Underwriting for Racial Justice, the Beneficial State Foundation, and many other banks and CDFIs seeking out ways to implement equitable underwriting. We hope the lessons from the cohort will be the spark that creates a broader change throughout the industry.
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