Community Development Financial Institutions as a Means to Overcome Market Failures

Community development financial institutions (CDFIs) are financial firms whose primary mission is to provide financial products and services to low- and moderate-income Americans living in underserved communities that lack adequate access to credit, capital or mainstream banking services. CDFIs include both depository institutions — that is, banks, thrifts and credit unions — and nondepository finance providers such as loan funds and venture capital funds.

In this article, we ask what economic role CDFIs fulfill that mainstream financial institutions do not, and why. Our answers are grounded in the economic theory of externalities and market failure. We argue that CDFIs can be thought of as a means to overcome neighborhood and information externalities. We review research showing that these externalities are strong and can lead to underinvestment in low-income communities by private-market entities. This market failure can be overcome by government intervention: By spurring positive externalities, public subsidies to investment in underserved communities can realize social gains that exceed the social cost of funds. And CDFIs can play a productive role in implementing these welfare-enhancing subsidies.

However, research suggests that investments in underserved communities can spur positive externalities only if they clear a critical mass threshold: Small, thinly spread investments have no positive external impact. Sufficiently intense consolidated investment can generate up to $6 of value per $1 invested in the community.

Studies evaluating the impact of CDFI activities suggest that their investments broadly fail to clear this critical mass threshold. Census tracts most exposed to CDFI lending received investments approximately 16 times smaller than the investments made under one well-documented example in Richmond, Va., of a successful revitalization program. This suggests that CDFIs should aim to concentrate their investments carefully to generate meaningful impact in their target markets.

This article is organized as follows. We start with a short introduction to CDFIs. We then define economic externalities and the corresponding market failures, and we discuss the CDFIs' role in overcoming them. After reviewing research showing that social returns in community development projects can be high, we review studies that evaluate the CDFI sector's performance to date. Finally, we review the findings of the Federal Reserve's 2025 CDFI Survey and offer a short conclusion.

Legal Basis and Implementation

The CDFI designation was formally established by Congress in the Riegle Community Development and Regulatory Improvement Act of 1994. In this act, Congress stated that:

• Some communities lack adequate access to credit, investment capital and financial services.
• Traditional private-sector financial institutions and markets do not fully serve these communities in lending or deposit-taking, even when residents are creditworthy.
• As a result, these underserved areas suffer from economic distress, underinvestment and limited opportunities.

Specifically, the Riegle Act defines target investment areas and populations, respectively, as areas with high poverty rates, low median incomes or other indicators of economic distress, and groups of individuals who are low-income or lack adequate access to capital and financial services, regardless of where they live.

Congress's intended remedy, as provided in the Riegle Act, was to:

• Create the CDFI Fund within the Treasury Department
• Provide financial and technical assistance to certified CDFIs so they could expand credit, savings and investment in underserved markets and could deliver development services — such as financial literacy education, business training and credit counseling — alongside lending
• Leverage public capital to strengthen mission-driven intermediaries so they could attract additional private investment
• Encourage partnerships between CDFIs, mainstream financial institutions and public agencies

With this legal basis, the Treasury Department issued regulations making the CDFI designation operational. The CDFI target population is primarily defined as all low-income individuals, meaning people with incomes below 80 percent of the area median income. CDFI target investment areas are those that are in economic distress, defined as meeting one or more of the following conditions:¹

• An absolute poverty rate above 20 percent of residents
• A median family income lower than 80 percent of the metropolitan area median family income
• An unemployment rate higher than 1.5 times the national average
• A 10 percent population loss (5 percent for areas not inside a metropolitan statistical area) between the two most recent census periods

It is worth noting that the CDFI target population is substantial under these definitions. As of 2022, there were 134 million low-income individuals living in the U.S., comprising about 42 percent of the whole U.S. population.²

To obtain CDFI certification, financial firms must provide loans or equity investments in conjunction with financial education, counseling, development services or similar support activities. They must serve target markets or populations, and they must have community development as the primary mission explicitly stated in their charter or bylaws. 

As of February 2025, there were 1,426 certified CDFIs in the U.S. and Puerto Rico.³ About 25 percent were banks, thrifts or bank holding companies, 35 percent were credit unions, and 40 percent were nondepository loan or venture capital funds.

CDFI Funding and Sector Total Size

The CDFI Fund is funded by Congress in the annual appropriations process. The fund then passes on the resources to eligible CDFIs in the form of grants, awards, tax credits and bond guarantees. In fiscal year 2025, the fund projected it would distribute around $348 million through its core programs:⁴

• $155 million for the CDFI Financial and Technical Assistance Program
• $25.2 million for the Native American CDFI Assistance Program
• $23.8 million for Persistent Poverty County Financial Assistance

With a target population of approximately 134 million, the CDFI Fund's core programs amount to approximately $2.60 per member of the target population per year. Even if one were to narrow down the target population to just the people living in absolute poverty, the amount per person would still be relatively small. Per the U.S. Census, there were about 36 million people in that category in 2024, which would mean the CDFI Fund's outlays would be approximately $9.67 per person in absolute poverty per year.

In addition to Congressional outlays, many CDFIs use deposits, retained earnings, private-sector grants, donations and/or philanthropic funds to support their activities. As of 2024, total assets held by CDFIs amounted to $436 billion.⁵ CDFI banks and thrifts held approximately $113 billion in assets (26 percent of the total), CDFI credit unions held $282 billion (65 percent), and CDFI loan and venture capital funds held $40 billion (9 percent).

Overcoming Market Failures: the Economic Role of CDFIs

Economic analysis suggests a role for CDFIs based on the well-known concept of market failure. Market failures occur when optimal actions of economic agents do not result in an efficient allocation of resources. Economists typically associate market failures with so-called externalities, which are economic effects that the market mechanism is unable to price, resulting in inefficiency.

In a 2006 speech, Federal Reserve Chair Ben Bernanke specifically discussed two externalities that can lead to capital market failures in the context of community development: neighborhood externalities and information externalities.⁶

Neighborhood Externalities

Neighborhood externalities occur across physical space via property and investment valuation mechanisms, where the market value of a property is indirectly affected by valuations of its neighboring properties. Past underinvestment or insufficient maintenance in a block of properties depresses the value of properties in their close proximity. This leads to further underinvestment, as property owners and their lenders face insufficient private returns.

Fully counted social gains from investment in these neighborhoods internalize the impact of an improvement on neighboring properties. Private returns, however, do not count the impact on the neighbors, as these gains do not accrue to the investor funding the investment. Social gains, thus, exceed the gains that can be privately realized, leading to underinvestment in capital market equilibrium.

Information Externalities

In many underserved neighborhoods, mainstream financial institutions lack good information about the creditworthiness of individuals and small businesses as well as the risk of investment projects. Because reliable data are thin, private lenders perceive higher risk. As a consequence, they either charge high rates or avoid lending altogether. This is an example of an information externality: Information about economic opportunities in an area could benefit many lenders but is costly to gather, so no single lender finds investing in obtaining the data profitable.

Specifically, faced with strong competition in lending to borrowers with established, verifiable credit histories, lenders strive to economize on the underwriting cost and instead rely heavily on automated underwriting systems. In this business model, borrowers with incomplete or thin credit histories remain unserved.

This mechanism creates another vicious cycle and market failure: The lack of lending means no repayment track record is built. Without data on repayment, underserved neighborhoods and populations continue to appear riskier than they really are. Private-market lenders, therefore, underinvest relative to the true underlying investment potential.

CDFIs' Role in Overcoming Market Failures

Public subsidies can potentially correct these market failures by getting socially productive projects funded. A subsidized loan or a loan guarantee may make an otherwise marginal project attractive to a private developer or lender. The subsidy ensures that projects with positive spillover effects — such as improving the housing stock, stabilizing a neighborhood or creating a local business anchor — go forward even when the private financial return is too low to get these projects funded in the absence of subsidy. Similarly, a loan funded by a public grant to a borrower with thin credit history can produce a track record of performance, allowing private lenders to subsequently better assess borrower risk.

CDFIs are particularly well positioned to channel these subsidies effectively because of their mission-driven business models and close connections to the communities they serve. In some cases, CDFIs can underwrite projects that would be too costly for mainstream institutions to evaluate. They can also counsel and support borrowers who are invisible to (or perceived as too risky by) mainstream institutions. These actions can mitigate neighborhood and information externalities and increase the odds that the subsidy leads to lasting impact and an eventual financial deepening, where private lenders step in and serve the community in the long run.

Social Returns and Selection of Projects for Government Subsidy

A major challenge in choosing which projects or community development activities should receive public funding is that the true social return — one that counts all gains and costs, including the indirect ones that do not accrue to the project's owner — is not directly observable. To compute this return, one must include the benefits that accrue to a dispersed group of community members, which is a difficult task. For this reason, the true social return often remains uncertain, but it is precisely this return that should decide which community development projects receive government support.

In the appendix, we present a simple conceptual framework for optimal selection of projects deserving government support. In that framework, we compare a project's private and social return to the private and public cost of raising funds. Our analysis emphasizes two main findings:

• Cases exist such that both private investors and the government may optimally choose not to fund a given project if they make their investment decisions separately, but the project becomes economically viable and is socially beneficial if private and public funding is combined.
• The optimal criterion for selecting projects for government support is highly sensitive to the level of social return to investment, much more so than it is to the level of private return.

With the exact level of social return to a project being hard to measure, the main danger in selecting projects for public investment subsidies is that privately nonviable projects may receive funding because of an incorrect perception of a high social return, whereas in reality that return is much lower than perceived.

Critics of CDFIs have pointed out two additional circumstances in which errors are made in selecting projects for government support:⁷

• When privately viable projects receive grant funding
• When grants simply cause a relocation of investment into CDFI focus areas from other areas

While acknowledging these valid concerns, we should note two things. First, although a privately viable project may get funded without public support, there is no guarantee it will be funded, especially under conditions of limited private resources available for investment in low- and moderate-income communities. With multiple projects competing for private-market funding, a public subsidy may serve as a selection tool, incentivizing private capital to fund projects with a particularly high social return. Second, to the extent that positive spillover effects from new investment are stronger in CDFI target areas than they are outside of them, a mere relocation of investment into a CDFI target area, incentivized by a government subsidy, may be welfare-enhancing.

In sum, our analysis in the appendix highlights that the strength of the external effects generated by new investment is of primary importance for the effectiveness and efficiency of public subsidies to community development projects. Next, we discuss the literature on the strength of neighborhood externalities. This literature finds evidence that the desirable external effects can be strong, although not without important caveats.

How Strong Are Neighborhood Externalities?

One of the most widely cited studies estimating the strength of residential neighborhood externalities was authored by researchers affiliated with the Richmond Fed. In their 2010 paper, Esteban Rossi-Hansberg, Pierre-Daniel Sarte and Raymond Owens study the effects of a coordinated urban revitalization program in Richmond that invested $14 million in housing across four city neighborhoods between 1999 and 2004.⁸ Activities funded included demolition, rehabilitation and new construction of housing in the treated neighborhoods. The researchers took a detailed account of exact investment locations in the treated neighborhoods and compared these neighborhoods against a control neighborhood that was similar but was not included in the revitalization effort. They estimated parcel-level land prices before and after the revitalization program and recovered a measure of neighborhood externalities acting through land prices.

The externalities they find are strong but highly localized. The total increase in land values of nontreated parcels caused by the revitalization effort stood at between $2 and $6 per revitalization dollar spent. The estimate of 200 percent should therefore be considered a lower bound on the total social return, excluding the valuation gains of the treated parcels themselves. Spatially, this impact on neighboring land prices is highly local: It gets halved with every 1,000 feet of distance from a treated parcel.

These estimates suggest that public subsidies to community development investment may indeed be justified by strong neighborhood externalities. Such strong local spillover effects have also been documented in numerous other studies that use events such as the removal of rent controls, local placement of new low-income housing, local spillovers of foreclosures triggered by differential exposure to interest rate shocks, and rehabilitation of foreclosed REO properties.⁹

However, two important caveats have been identified by this literature:

• Scale effects in positive external impacts
• The possibility of negative external impacts

First, on the scale effects, extensive research by George Galster and co-authors argues that a "critical mass" (or "minimum effective dose") of investment is essential for triggering effective community change.¹⁰ Spreading resources thinly across numerous neighborhoods through a "sprinkling" approach is shown to be ineffective, as it does not generate enough positive spillovers or amenity improvements to stimulate self-sustaining private-market activity. Above the minimum effective dose threshold, the returns to community development investment exhibit the usual pattern of diminishing marginal returns.

Second, a 2019 paper shows that the impact of a new low-income housing development on neighboring residential property values depends on the neighborhood's initial income level.¹¹ While such investments in low-income neighborhoods increase local home prices by an estimated 6.5 percent, the same investments placed in higher-income neighborhoods decrease local home prices by 2.5 percent.

We should note here that the revitalization program from Richmond studied by Rossi-Hansberg, Sarte and Owens appears to have successfully avoided these two caveats. According to the authors, Richmond's revitalization program was implemented in neighborhoods inhabited by 7,619 individuals. With $14 million spent over five years, the average amount spent was $367 per resident per year for five consecutive years. Adjusting for inflation, that amount is $603 per resident per year in 2025 dollars. The four neighborhoods targeted in Richmond were also low income, with home prices lower and poverty rates higher than in the city of Richmond as a whole.

Evidence on CDFIs' Performance

CDFIs have attracted a fair amount of attention and research interest in the literature on financial intermediation. Studies in this literature have focused on two main questions:

• Do CDFIs concentrate their lending in the target communities and populations as defined in the Riegle Act?
• Does CDFI activity demonstrably create positive neighborhood spillovers and financial-deepening effects over longer time horizons, consistent with overcoming market failures?

This second question is particularly hard to estimate: If CDFIs are lending in underserved areas, then areas with CDFI presence are likely to look worse on measures of access to financial intermediation.

In this literature, an early and comprehensive study evaluating CDFIs' activities and impacts at the census tract level was done by Eric Hangen, Jack Northrup and Michael Swack in 2014.¹² The authors analyze loan-level data from grant-recipient CDFIs reported to and subsequently released by the CDFI Fund for fiscal years 2003 through 2012. These data are then merged with data from several sources: Community Reinvestment Act small-business lending data, Home Mortgage Disclosure Act mortgage loan application data, and Census demographic and business data from the American Community Survey and County Business Patterns releases. The authors' analysis combines descriptive statistics, difference-in-difference and propensity scoring specifications.

On the first main question, they find that CDFIs do lend primarily in underserved markets, including to low-income and minority borrowers in distressed areas. On the second main question, however, they do not find significant effects of concentrated and sustained CDFI investments on a number of neighborhood revitalization metrics, with the mortgage application acceptance rate being a key one: Census tracts that receive CDFI investments do not show a subsequent increase in mortgage application acceptance rates relative to similar census tracts with no CDFI activity.

Could scale effects and the mixed externalities that we discussed earlier be behind this nondetection result? First, the authors identify 15 census tracts with the most concentrated and sustained exposure to CDFI lending. The level of exposure in these tracts was on the order of $100,000 (in 2011 dollars) per tract per year for five years. With a tract population average of 4,000 residents, this exposure amounts to $25 per resident per year, or $36 in 2025 dollars, adjusting for inflation. Thus, even the most exposed census tracts received CDFI investments approximately one-sixteenth the size of the investments made in Richmond under the successful revitalization program studied by Rossi-Hansberg, Sarte and Owens.

Second, the authors find that CDFI lending activity is heavily skewed toward low-income, high-poverty census tracts. When normalized by tract-level CRA-reported small-business loans or by tract-level HMDA-reported mortgage lending by all lenders, CDFI exposure to low-income tracts is about twice as high as the all-lender average.

In our appendix, we review several recent studies evaluating the impact of CDFI lending. These studies tend to be more narrowly focused and generally document correlation rather than well-identified causal impacts. They provide examples of CDFI lending having a positive impact. However, because they focus on selected examples, they do not speak to the question of the systematic impact of CDFI activity on all treated locations and populations. Generalizing these findings from selected examples to comprehensive measures of transformation of target populations and investment areas, as well as establishing well-identified causal relationships, remains an opportunity for future research.

In sum, the partial detection of impact among selected observables and the comprehensive nondetection result in Hangen, Northrup and Swack's paper may simply have been due to CDFIs' failure to achieve a scale of lending sufficient to activate the positive neighborhood externalities that trigger self-sustaining private-market follow-up activity. Richmond's successful community development program provided local stimulus about 16 times stronger than what CDFIs have been able to provide even in the tracts with the most concentrated and sustained CDFI lending exposure.¹³

Evidence From the Fed's CDFI Survey

The Richmond Fed conducts a survey of CDFIs that can help to further the research on the CDFIs' role in overcoming market failures in underserved communities. The CDFI Survey is conducted biennially as part of the Fed's public service mission to provide financial stability and promote a healthy economy and full employment. The survey data help inform researchers and policymakers of the condition and reach of the CDFI industry.

The 2025 Key Findings Report reflects several aspects of CDFIs consistent with their mission. Through the survey, CDFIs reported consistent and growing demand, acknowledged their unique contribution to the finance industry focused on expanding access to underserved individuals, and reported that public subsidies are very important to their ability to meet increasing demand and offering value that other institutions cannot.

The CDFI Survey began asking about changes in demand for CDFIs across the nation in 2019. That year, about three-quarters of respondents said that demand for their products and services had increased. In 2025, despite higher interest rate levels relative to 2019, 71 percent of respondents reported that they saw increased demand.

Conclusion

The economic theory of market failure provides a rationale for public subsidies for lending and the provision of banking services to underserved communities and populations. Supply of credit and financial services by for-profit entities can be suboptimally low, as private markets generally fail to price spatial and informational externalities. Research suggests that these externalities can be strong. Consequently, overcoming these market failures through public subsidies holds significant potential for realizing large social gains.

CDFIs aim to take an active role in correcting this market failure. Empirical evidence suggests that CDFIs channel public and philanthropic funding into projects with social gains likely exceeding private gains. Studies have shown positive correlation between CDFI activities and positive community development outcomes along a few selected dimensions. Additional research is needed to validate this conclusion by generalizing these results to comprehensive (rather than selected) measures of community development and by pinpointing causal impacts (rather than just correlation) of CDFI activity. Comprehensive studies have thus far been unable to demonstrate systematic impact of CDFI activities on community development outcomes.

Importantly, it appears that CDFI investments typically fail to clear the threshold of critical mass needed to spur self-sustaining growth in the community. CDFIs — and their investors — should consider the concentration of their investments. Public investment that is spread too thinly fails to stimulate follow-up activity. Consolidated investment can unlock value gains that dispersed community development efforts cannot realize.

Surekha Carpenter is a senior research analyst, and Borys Grochulski is a senior economist, both in the Research Department at the Federal Reserve Bank of Richmond. They would like to thank, without implicating, Anna Kovner and Huberto Ennis for comments and conversations on the topics of this article.

To cite this Economic Brief, please use the following format: Carpenter, Surekha; and Grochulski, Borys. (May 2026) "Community Development Financial Institutions as a Means to Overcome Market Failures." Federal Reserve Bank of Richmond Economic Brief, No. 26-14.

This article may be photocopied or reprinted in its entirety. Please credit the authors, source, and the Federal Reserve Bank of Richmond and include the italicized statement below.

Views expressed in this article are those of the authors and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.