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• Community Development Financial Institutions as a Means to Overcome Market Failures
• Housing Externalities

Transcript

Sablik: My guests today are Surekha Carpenter and Borys Grochulski. Surekha is a senior research analyst and Borys is a senior economist, both at the Federal Reserve Bank of Richmond. Thank you both for joining me!

Carpenter: Thanks for having us, Tim. We're excited to be here.

Grochulski: Glad to be here.

Sablik: We're going to be talking about a recent Economic Brief article that you wrote together which examines the case for community development financial institutions, or CDFIs. Regular listeners will perhaps remember that we've talked about CDFIs on the show before. These are financial firms with a mission to serve low- and moderate-income Americans living in underserved communities that lack adequate access to credit, capital, or mainstream banking services.

The CDFI designation was created by Congress in 1994 to address unmet needs through a sort of public-private partnership. Surekha, you've been studying CDFIs for some time and are involved in the Federal Reserve's CDFI Survey. Could you explain a bit more about the legislation that gave rise to CDFIs and how they're funded?

Carpenter: Absolutely. The legal foundation for the CDFI Fund is the Riegle Community Development and Regulatory Improvement Act of 1994. Around that time, Congress recognized that there were ongoing inequities in economic opportunity and this legislation was meant to improve that. They acknowledged three things: that some communities lack adequate access to credit and financial services; that traditional private-sector institutions don't fully serve those communities, even when residents there are creditworthy; and that those communities or areas suffer economic distress as a result.

Part of the remedy, through this legislation, was to create the CDFI Fund. Housed within the Treasury Department, the CDFI Fund provides financial and technical assistance to certified depositories, or lenders, so they can expand financial access in underserved markets. The idea was to leverage public capital to attract additional private money to these communities to help them expand opportunity.

The CDFI Fund has the ability to certify financial institutions that meet certain requirements. To be a CDFI, a firm has to serve a defined distressed target market — often, these are low-income areas like you mentioned, Tim — pair its lending with development or technical support and have community development as its primary mission in its charter.

Today, there are just under 1,400 certified CDFIs across the nation. Those are mostly comprised of mission-driven loan funds, credit unions, and community development banks.

The CDFI Fund gets its money through annual congressional appropriations and passes it on as grants, tax credits, and bond guarantees to individual CDFIs. For context, in 2022, the Treasury estimated that the target population for CDFIs is roughly 134 million people. That's about 42 percent of the country. In fiscal year 2025, around $348 million was appropriated for the Fund. Spread across that 134 million people, that's about $2.60 per person per year.

Of course, as intended, CDFI [Fund] appropriations are not the only funding that CDFIs draw from. Many CDFIs also take deposits. They earn revenue on loans and other services. They attract philanthropic or private funding. CDFIs also participate in other federal or state programs that can help bolster their assets. But that federal $2.60 per-person figure is worth keeping in mind as we get into the economics of these institutions.

Sablik: Yeah, we'll definitely be coming back to that figure.

Thinking about them through an economics lens, CDFIs were created by Congress to address a perceived failure by the private market to meet the needs of low- and moderate-income households. Borys, why might private lenders fail to adequately address those needs?

Grochulski: This is where the economics is really interesting. The standard story isn't that private lenders are doing anything wrong. They can be behaving perfectly rationally and you can still get an outcome that's bad for society. That's what economists mean by a market failure — individually optimal choices don't result in an efficient allocation of resources. The culprit is an externality — some effect that the market simply can't put a price on.

In a 2006 speech, Ben Bernanke pointed to two externalities that matter a lot in community development and we organized our EB article around them. The first is neighborhood externalities. The value of your property depends partly on your neighbors' properties. So, if a block has suffered from underinvestment or deferred maintenance, that drags down the value of the homes around it, which makes it less attractive for anyone nearby to invest, which drags values further down.

The key point is that when I fix up my property, some of the benefit spills over to my neighbors, but I don't capture that. The social return on my investment is higher than the private return I can capture, but I'm only willing to pay for the latter. In equilibrium, that gap means too little investment gets made.

The second one is information externalities. In a lot of underserved neighborhoods, mainstream lenders just don't have good information about borrowers' creditworthiness or about how risky local projects really are. Gathering that information is expensive. If I spend money to learn that a neighborhood is a better credit risk than it looks, my competitors benefit from that knowledge, too. So, no single lender finds it worth doing. Instead, lenders lean on automated underwriting and compete for borrowers with thick, verifiable credit files. People with thin credit histories get left out.

That creates a vicious circle of its own because without lending, there's no repayment record. Without a repayment record, the area keeps looking riskier than it actually might be. So, you get persistent underinvestment relative to the true underlying potential.

Sablik: What are some ways that CDFIs could help to overcome these market failures?

Grochulski: Oh, the lever is public subsidy. A well-placed subsidy — a below-market loan or a loan guarantee — can take a project whose private return is just a bit too low and make it pencil out. That way, a project with real positive spillovers actually gets built, stabilizing a block or anchoring a local business district.

On the information side, a subsidized loan to a borrower with a thin credit file can generate the repayment track record that was missing, which then lets private lenders step in and price that risk properly down the road. We call that financial deepening and it's the long-run objective — public money priming the pump so private capital eventually flows in on its own.

CDFIs are well-positioned to deliver that subsidy because of their mission and their proximity to the communities. They can underwrite loans that would be too costly for a big mainstream institution to evaluate. They can counsel borrowers who'd otherwise be invisible to the mainstream.

I'd add one caveat, though. The whole case rests on the social return and that's genuinely hard to observe because it includes diffuse benefits to lots of community members. So, the real danger in picking projects is not so much getting the private return wrong. It's overestimating the social return and subsidizing something that didn't actually deserve it.

Critics also point out you can waste subsidies on projects that would have been funded anyway or just relocate investment from one place to another. Those are fair concerns. But even a privately viable project isn't guaranteed funding when private capital for these communities is scarce, so a subsidy can act as a useful selection device. And if positive spillovers are stronger inside the target areas than outside them, even simply relocating investment into those areas can raise overall welfare.

Sablik: With that in mind, what sort of projects or locations can benefit the most from CDFI investment?

Carpenter: From the institutional side, the design already points the money toward the right places — the distressed, low-income tracts — and the evidence does show CDFIs concentrate their lending there. So, the targeting, in terms of where, is working. But which projects deliver the biggest bang is what we discuss in the Economic Brief.

Grochulski: It comes down to where those neighborhood externalities are strongest and the evidence here is quite striking.

The most-cited estimate comes from a 2010 JPE [Journal of Political Economy] paper by Richmond-Fed-affiliated researchers Esteban Rossi-Hansberg, Pierre Sarte, and Ray Owens. They looked at a program in Richmond, Va., that put about $14 million into housing across four neighborhoods between 1999 and 2004. Esteban, Pierre and Ray estimated that every dollar invested raised the values of surrounding, untreated parcels by somewhere between $2 and $6. That's a social return of at least 200 percent.

Those spillovers are intensely local, declining by 50 percent roughly every thousand feet, and — this is the crucial part — they only show up if you clear a certain intensity threshold. Urban studies scholars like George Galster call it a "critical mass" or a "minimum effective dose" of investment. Spread the same money thinly across lots of neighborhoods — what they call "sprinkling" — and you get no positive spillovers. You never generate enough improvement to kick off self-sustaining private activity. You have to concentrate it.

Another caveat is location. Research finds that new low-income housing placed in a low-income neighborhood can raise surrounding home values by about 6.5 percent. But the same investment placed in a high-income neighborhood can lower surrounding home values by about 2.5 percent.

So, the recipe for impact is concentrated investment above the critical mass threshold, placed in genuinely low-income areas. The Richmond program studied by Esteban, Pierre, and Ray met both these criteria.

It's worth noting the investment intensity number: $14 million across neighborhoods with about 7,600 residents works out to roughly $367 per resident per year, every year for five years, which is around $603 in today's money. That intensity of investment was high. Keep that figure in mind.

Sablik: Surekha, when you were both putting together this EB, did you find any evidence from economic studies about how well CDFIs have done in achieving their goals?

Carpenter: The literature asks two different questions. One, do CDFIs lend in the right places? Two, does that lending actually generate the neighborhood spillovers and financial deepening that would mean the market failure is being overcome?

On the first question. the answer is a clear yes. The most comprehensive evaluation studies use loan-level CDFI data merged with mortgage, small-business and census data, and find CDFIs lend overwhelmingly in underserved markets to low-income and minority borrowers in distressed tracts, at roughly twice the all-lender rate. So, the targeting is real.

The second question is where things get difficult. The tract-level studies did not find a significant effect of concentrated, sustained CDFI lending on the revitalization metrics you'd hope to see move — the mortgage application acceptance rate being a central one in that literature.

To be fair, there are other studies — and we review several in our appendix — that do find positive effects of CDFI lending. But those tend to look directly at aid recipients at the micro level and they're generally documenting correlation in selected examples rather than well-identified causal effects across all the places CDFIs operate. So, a positive result for the people directly helped is entirely consistent with no detectable change at the level of the whole census tract.

Sablik: Yeah, I was thinking to ask, how do you reconcile some of these positive effects that these other studies have found and what you found?

Grochulski: This goes back to that critical mass idea. In the comprehensive CDFI impact studies that Surekha mentioned, when you look at census tracts with the most concentrated, sustained CDFI exposure, CDFI investment there amounted to about $100,000 per tract per year for five years. With roughly 4,000 residents per tract, that's about $25 per resident per year or, adjusting for inflation, about $36 in today's money. Compare that to the $603 per resident per year that was spent in Richmond. Even the most intensively served CDFI tracts in the entire country received investment on the order of one-sixteenth of what the successful Richmond program delivered.

So, it isn't that CDFIs do nothing. It's that the dollar amounts are simply too small to clear the threshold that activates the positive externalities that people hope to see. You can help individual borrowers a great deal and still be spreading the money far too thin to transform a whole neighborhood.

Sablik: Surekha, I mentioned you work on the Fed's CDFI Survey. Can the survey shed any light on how well CDFIs are meeting their individual missions?

Carpenter: Our survey comes at the question from a different angle, which is the industry's own perspective.

First, on CDFI demand: we have been fielding this survey nationally since 2019 and the data tells a pretty consistent story throughout. In 2019, about three-quarters of our respondents said demand for their products and services had recently increased. In 2025, even with higher interest rates compared to 2019, 71 percent still reported seeing rising demand. The need of accessible banking and credit services clearly has not gone away.

Second, on whether these institutions are distinctive in the banking and credit landscape — are they offering things that mainstream financial institutions are not, for example — we asked CDFIs about their own comparative advantage amid the industry. Thirty eight percent pointed to their underwriting practices or to their ability to offer better loan terms than customers could get elsewhere. As we've been talking about, CDFIs are designed to blend public and private funds to achieve a more favorable rate for their customers. So, these arguments for comparative advantage line up very nicely with the information externality story — the ability to lend where automated underwriting won't.

And, related, the last thing that we heard from the survey was the importance of that public money to this industry. About three quarters of 2025 survey respondents said that federal programs specifically help them deliver products or services their customers could not get otherwise. So, what we've heard through the survey reinforces that CDFIs are reaching underserved customers and that public subsidy does matter to their model.

Sablik: Surekha and Borys, thank you both so much for joining me today.