Strategic options for bankers in rural development

Federal Reserve Bank of Kansas City ◆ F I N A N C I A L I N D U S T R Y P E R S P E C T I V E S 2 0 0 0 33

INTRODUCTION

While the United States has enjoyed an unprece-dented economic expansion during the last decade,the picture for rural counties, especially thoselocated in the “great plains” region, has been morevaried. Metropolitan areas, counties near cities, andcounties close to scenic amenities continue to growwhile other counties — particularly those moredependent upon agriculture — often experiencepopulation loss (see Figure 1). This population losshas clouded the future for many rural communities.

The Great Plains — that huge tier of countiesextending from Texas to Montana and North Dakota— continues its decades-long decline in population.Changes in agriculture together with a lack of eco-nomic alternatives and many amenities that driverural population growth today are responsible. As aresult, community services become more expensive toprovide, the region’s population ages, and futureprosperity becomes even more difficult to achieve.2

With recent strains in agriculture and with thepotential for greater job and population loss loom-ing, it is not surprising that many bankers haveheightened concerns for their communities and aninterest in initiatives they can undertake to promotelocal growth and development.3

In this paper, we address this banker interest inlearning more about the role their bank organiza-tions can play in the economic development of theircommunities. We begin by defining communitydevelopment lending. We then identify a process,with specific steps, that can help bankers achievesuccess in their community development initiatives.Within the context of this process, we report on sev-eral banker-driven development initiatives, examin-

Larry Meeker andForest MyersLarry Meeker is a vice president and ForestMyers is an economist in the Division ofSupervision and Risk Management. The viewsexpressed are those of the authors and donot necessarily reflect those of the FederalReserve Bank of Kansas City or the FederalReserve System.

Strategic Options for Bankersin Rural Development1

ing the management decisions behind them and les-sons gleaned from their implementation.

COMMUNITY DEVELOPMENTLENDING DEFINED

Banks often can and do participate in commu-nity development through their everyday lending.For example, they make conventional mortgagesand small business and commercial loans. They alsopurchase community development loans made byother lenders and participate in state and local gov-ernment financing programs designed to meet thehousing and business development needs of low-income individuals, small businesses and agricul-tural borrowers.

Often, it is when a deal or project falls outsidethese normal or conventional channels that banksseek other ways to get it completed. This frequentlyinvolves tapping different government programs forfinancial support and working with local commu-nity leaders to muster community and political sup-port for projects that could not be done otherwise.

Today, much of the community developmentlending that involves using government programs— small business lending or lending to low- tomoderate-income homebuyers — has become rou-tine. For example, many institutions use SmallBusiness Administration (SBA) loan guarantees andFederal Housing Administration (FHA) guaranteesto help address the special needs of small businessesand lower-income homebuyers. While the necessityof government involvement makes these transac-tions fit the definition of community developmentlending — deals that cannot be done without out-side assistance — the volume and routine nature ofthese activities result in their being normal businesslines for many lenders.

However, many banks want to extend theirinvolvement beyond the routine. For example, ruralcommunities often have problems with aging infra-structure, a lack of technical skills to support entre-preneurial activity, a scarcity of affordable housingfor lower income working families, and a need forjobs. Meeting these needs requires tailoring uniqueresponses to the community’s special circumstances

and an investment of time and resources thatextend beyond the routine. Some communitydevelopment initiatives, such as multifamily afford-able housing lending, involve unique complexitiesand transaction costs that are unlikely to becomeroutine, especially in rural communities. In addi-tion, sometimes the need is simply for equity capitalinvestment, something that banks can’t provide inthe normal course of business.

Community development lending opportunitiescome in many forms. A typical example is afford-able housing, where the goal is to provide housingfor people who cannot afford market rate housing,such as housing for the homeless, low- to moderate-income families, or the elderly.4 In each instance,the project’s financial challenge is straightforward:the cost of creating the housing exceeds the clientpopulation’s ability to pay for it. Hence, there is animportant need for government or other third partyresource support. Similarly, many small businessdevelopment initiatives require outside supportbefore a loan can be made. For example, new busi-nesses, or smaller businesses strapped for workingcapital, may find it difficult to obtain bank creditwithout a government loan guarantee or a secondmortgage from a government agency.

The common thread in each of these commu-nity development lending examples is the need foroutside support to make a potential loan bankableor to make a deal attractive to an investor. It is thesenon-routine projects that receive attention in thispaper. These projects usually involve a longer-termcommitment of financial and managerial resources,and they are usually part of an overall strategy toachieve broad community goals.

STEPS FOR SUCCESS

Although there may be many complexities asso-ciated with community development projects, expe-rience shows that it is important for bankingorganizations to treat these projects like any otherbusiness. By thoughtfully considering communityneeds, available resources, regulatory requirements,and appropriate development role and organiza-tional structure, banking institutions may be able to

34 Federal Reserve Bank of Kansas City ◆ F I N A N C I A L I N D U S T R Y P E R S P E C T I V E S 2 0 0 0


avoid costly missteps that limit their success incommunity development. These points are high-lighted by results of an Office of the Comptrollerof the Currency (OCC) survey of banks that partic-ipated in a study of effective community develop-ment practices. The OCC found two guidingprinciples in successful community developmentfinancing:

First, banks that are successful in community devel-opment financing actively investigate their communi-ties for CD [community development] opportunitiesappropriate for [their] markets and take a strategicapproach to partnerships with CD organizations andgovernment agencies. Second, banks learn as much asthey can from the best in the business, replicate appro-priate strategies in local markets, and go back to thedrawing board to develop new approaches when pre-vious methods don’t work.5

Table 1 identifies issues to consider before engag-ing in community development activities toimprove chances of success.6 The first two stepsfocus on the community’s needs and the resourcesavailable to address those needs. The third, deter-mining potential roles for a bank or bank holdingcompany, identifies ways a bank’s or company’sresources can help meet community needs. The lasttwo address internal considerations for the bankingorganization: how to structure an activity and howto address related regulatory issues.

COMMUNITY DEVELOPMENTEXPERIENCES

Not every bank or bank holding company willexplicitly follow the steps outlined in Table 1, norwill they give the steps the same amount of atten-tion.7 However, most institutions will give someconsideration to these issues once they decide to getinvolved in community development projects. Tobetter understand the motivation and issues to beconsidered in devising and implementing commu-nity development activities, we interviewed by tele-phone the management of seven banks and sevenbank holding companies in the Tenth FederalReserve District8 that are currently engaged in ruralcommunity development.9 These 14 institutionsconstituted most of the rural-based organizations

identified in previous surveys as having communitydevelopment activity in Tenth District states.

All of the institutions interviewed were small,ranging in size from total assets of $12.4 million to$712 million as of December 1999. They showedwide diversity in their approaches to communitydevelopment. Some had made multiple communitydevelopment investments, with one holding invest-ments at both the bank and bank holding companylevels. Several institutions held investments in acommunity development financial institution(CDFI), and one had an ownership stake in amultibank community development corporation.10

Affordable housing was the principal communitydevelopment project for one bank and six bank hold-ing companies. One institution owned a test farm,and two others worked on projects to entice newbusinesses to their communities. Another participatedin an office expansion for the community’s majoremployer. One played a role in a regional hospitalexpansion and a variety of other development projectsto improve the community. One held an equityinvestment in a rural television cable company.

With the exception of those having an investmentin CDFIs, none of the activities of those interviewedwere conducted in more than one community. Inevery case, the community development activities of

Figure 1County Population Change: 1990-1997

Source: USDA

Tenth District

Great Plains Region

High growth

Low growth

MSAs


the banking organizations interviewed were a rela-tively small part of their total business activities.

Our interview questions focused on each of theactivities listed in Table 1. The comments made bybankers about their experiences with these activitiesand the implementation of their accompanyingaction steps are included in the sections below.

Conduct Community Needs AssessmentPerforming a community needs assessment is an

important first step in determining an institution’spotential role and participation in communitydevelopment services.11 Information for this assess-ment can come from a variety of sources in a com-munity. Neighborhood organizations are often wellpositioned to see unmet or inadequately met hous-ing needs. Local government officials are on thefront lines in knowing community infrastructureneeds and opportunities. Bankers themselves arewell positioned to be aware of community develop-ment needs as they review loan requests and declinethose that don’t meet the bank’s credit standards.Though marginally unbankable, many of thedeclined requests may present development oppor-tunities for the community.

All the institutions we interviewed did someform of needs assessments before implementingtheir development projects. They held discussionswith local merchants, performed or reviewed stud-ies, worked with consultants, or used their personalexperiences from living in the community to iden-tify development projects.

In most instances, these analyses were right ontarget, and development projects performed asexpected, leading two of those interviewed to say“they couldn’t have been more pleased” with theirproject’s outcome. Two others, however, were not assatisfied and noted that, if they had done a morecomplete analysis, they might not have made theircommunity development investment.

Identify Available ResourcesOnce development needs are identified and a

project is proposed, the next step is to determine theresources required to complete that project. Thishelps identify gaps to be filled and aids in the search

for partners and programs that can help make proj-ects compatible with lender or investor requirements.

Partnership arrangements invariably are madewith those who have financial resources to con-tribute: private investors, other financial institutions,government agencies, charitable organizations, orventure capital funds. In addition, they include part-ners with special knowledge, skills, credibility, andcontacts, such as community development organiza-tions and community and civic groups who can helpreduce the transaction costs associated with trans-forming an undoable deal into one that meets mar-ketplace risk-return requirements.12

Government agencies are resource partners inmany community development projects, simplybecause their programs have been created to miti-gate higher risk or to compensate for below-marketreturns that are common to many economic devel-opment projects. These programs come in a varietyof forms, including special tax incentives to attractnew businesses and train their workers, governmentloan guarantees to lessen credit risk on small busi-ness loans, grants that make home ownershipaffordable for first-time or low-income homebuyers,and tax credits that provide builders or developerswith incentives to construct affordable housing.

Some of those we interviewed partnered withothers, while others went it alone. Those who part-nered often did so with other banks and bank hold-ing companies and with private investors. Theorganized community groups that are many timesfound in metropolitan areas did not enter the part-nership picture for the simple reason that they oftendon’t exist in many small rural communities.

Many of the banking partners and investors werelocated in the same town or county. Few that weinterviewed could recall the exact circumstancesthat brought them together with their partners.Those who did mentioned referrals by a consultantor common participation on a city or county eco-nomic development council. Most said they couldaccomplish more, work on bigger projects, and havemore of an impact on the community if theyworked together. Partnership arrangements there-fore became a way to leverage bank or bank holdingcompany development resources.


In addition to part-nership arrangements,institutions can lever-age their own resourcesby combining themwith those availablethrough federal, state,and local developmentprograms. There are amultitude of programsto assist communitydevelopment, but find-ing appropriate pro-grams to meet specificdevelopment needs canbe time consuming.Computerizeddatabases, suchas 1st Source(http\\:www.1stsource.kc.frb.org), establishedby the Federal ReserveBank of Kansas City,can help simplify thistask by matching pro-grams with needs forspecific projects.13

Another useful aidis the CommunityDevelopment ResourceGuide which providesinformation on avail-able resources from 60community develop-ment, banking, andgovernmental organiza-tions. It may be pur-chased from the OCCor downloaded fromthe OCC’s Internet siteat http://www.occ.treas.gov/cdd/resource.pdf.

For those we interviewed, low-income housingtax credits were the most frequently used enhance-ment.14 To receive these credits, banks and bankholding companies invested in limited liability cor-

porations that developed and managed low-incomehousing units.

Resources used by those interviewed alsoincluded other business and housing programs.One bank took advantage of tax increment financ-

Table 1Checklist of Issues to Consider Before Engaging in Community Development

Activity Action Steps

Conduct Community Needs AssessmentWhat does the community needto grow/remain viable and whatobstacles are keeping the communityfrom fulfilling these needs?

Identify community development needsAffordable housing, job creation,gap financing/venture capital forexisting businesses or start-ups,attracting/assisting applicable newbusinesses to move to community,technical assistance

Identify resources needsPrograms — technical assistance,financial assistance

Partners — major employers,community groups, financialinstitutions, governmentagencies/programs,community leaders

Identify potential financial and mana-gerial resources to commit relative tothe gap to be filled

Evaluate consistency with theorganization’s strategic goals

Determine scale of activityExtent — one or multiple projects/one or more locations, relative size,short-term/long-term commitment

Consider who benefitsLow-to-moderate income individualsor areas

Decide tax statusNonprofit or for-profit

Identify entity to conduct activityLimited partnerships, CDC, SBIC, etc.

Consider safety and soundness issuesand comply with applicable regulations

Identify Available ResourcesWhat financial and managerialresources are available to removeobstacles to the community’seconomic growth?

Determine Potential Role forBank/Bank Holding Company

What gaps can our organizationfill in overcoming obstacles to thecommunity’s economic development?

Consider Structure OptionsWhat is the best way to structureour organization to fill the gapsand overcome obstacles to thecommunity’s economic development?

Identify Regulatory RequirementsIs an application or notice required?Will loans be made to affiliates?


ing offered by the city in which it was located tohelp finance an office expansion for a majoremployer. Another took advantage of the Depart-ment of Housing and Urban Development (HUD)Section 8 rent supplement program.15 Still another,whose projects were in the planning stages, plannedto apply for Department of Commerce grants tobring new employers to town.

Determine Potential Rolefor Bank/Bank Holding Company

Matching community needs with availableresources helps define potential roles for a financialinstitution in local development initiatives. Narrow-ing these options requires review of an institution’sstrengths, resources, and strategic objectives. Thisprocess helps set the course for the institution andclarifies what it seeks to accomplish. For example, abank operating in a rural community might have astrategic objective to diversify its loan portfolio inorder to lessen its reliance on agricultural borrowers.Its development objective therefore may be toattract nonagricultural businesses to the commu-nity. Consistent with this objective, the bank mightmake equity investments in new building construc-tion to attract and house new companies or itmight participate with a development team thatactively pursues new businesses by offering taxabatements and attractive financing packages. Theobjective broadly defines the development role to beplayed by the bank or company, the degree of thatinvolvement, and the time horizon for it (see theaccompanying box summarizing the communitydevelopment objectives, activities, and organiza-tional structure of Southern Development Bancor-poration as an example).

The role played by those interviewed varied,with some being passive investors and others play-ing an active part or taking a leadership role incommunity development. For those who played amore passive role, their financial investment permit-ted them to support community development whilelimiting demands on their managerial and person-nel resources, leaving identification, implementa-tion, and management of development projects toothers. Examples of this approach were those who

invested in the CDFI and those who had becomelimited partners in affordable housing projects inorder to receive tax credits.

Others took a more active role. In one case, abank holding company purchased a test farm anddesigned experiments to improve management andproduction on area farms. In another, the bankingorganization did the accounting work for theaffordable housing project in which it had invested.Besides helping track the project’s financial progress,this also provided a way to watch over the bank’sinvestment.

In still another case, two investing bank organi-zations actively participated with others in the com-munity in the management of a communitydevelopment corporation. They kept majority own-ership in the organization in order to control andprevent the possible misuse of the corporation’sfinancial resources.

Consider Structure OptionsThere are many ways an institution can imple-

ment its community development strategy. Thestructure adopted depends upon a large number offactors, and ultimately there may be more than onesuitable organizational structure. Figure 2 shows fourbasic organizational models used by banks and bankholding companies to conduct their communitydevelopment activities. These activities can be con-ducted directly by a bank (Panel A) or a bank hold-ing company (Panel C), or indirectly by a banksubsidiary (Panel B) or a bank or financial holdingcompany subsidiary (Panel D). More than one orga-nizational structure can also be employed if thedevelopment activities of the banking organizationwarrant. Furthermore, these structures can be usedby a single banking organization or a group oforganizations acting together to assist in meeting thedevelopment needs of one or more communities.

To pare down the best choice of an organizationalstructure that fits the development role to be played,it is helpful to answer the following questions:

• Will the institution’s involvement be con-fined to a single project or will the bank orcompany engage in multiple projects?

• Will the institution’s development projects


be isolated to a single location or will theybe geographically dispersed and take placewherever the institution has a banking officeor other physical presence?

• Is the institution’s commitment to commu-nity development of limited duration or willit be long-term?

• Will a significant amount of the institution’scapital (5 percent or more of the bank or bankholding company’s capital and surplus) bedevoted to community development activities?

• Does the institution have the managerialresources and staff expertise to successfullycarry out the development role it has chosen?

• Is the activity expected to provide competi-tive returns to the institution and are thesereturns to be made available as dividends toits shareholders?

Answers to these questions further define thescale and time horizon for the banking organiza-tion’s community development activities, the bene-ficiaries of its activities, and the organization’s ownneeds — shareholder return and community servicerecognition — and help define the most effectivestructure to adopt.

ScaleThe number, size, duration, and locations of

the development projects in which an institutionbecomes involved are important issues in organiza-tional structure. If a single, small (relative to the sizeof the banking organization) project or only a fewsmall projects of short duration, limited to a fewlocations, are envisioned, then conducting develop-ment activities directly from the bank or bank hold-ing company may be a low-cost and quick way toimplement these activities. On the other hand, iflarger development projects are going to be under-taken over long periods of time and at many loca-tions, then housing the development activities in aseparate subsidiary may be more appropriate.

From a shareholder and regulatory perspective,corporate separateness helps shield the insureddepository institution from any added risk exposurethat larger scale community development projectsmay pose. From a business perspective, a separate

Figure 2Alternative Organizational Structuresfor Community Development Activities

Direct Activities Indirect Activities

Notes:

The federal banking agencies’ list of pre-approvedcommunity development activities include:

• building or refinancing the construction of low- tomoderate-income residential housing;

• financing or participating in the rehabilitation andredevelopment of commercial property located in low- to moderate-income neighborhoods or other areas needingrevitalization;

• investing in or providing financing for small businessesin economically depressed areas;

• job training and placement for low- to moderate-incomepersons;

• investment in entities which will provide long-termemployment opportunities for low- to moderate-incomepersons;

• credit counseling, and research and development servicesto low- to moderate-income individuals and other firmsengaged in community development activities; and

• other activities approved by state and federal banksupervisory agencies.

Bank

BHC/FHC

D

BHC/FHC

C

Bank

B

BankCommunity Development

Activities

Community DevelopmentActivities

CommunityDevelopment

Activities

Community DevelopmentActivities

A


subsidiary may also allow concentrating the bank-ing organization’s community developmentresources and permit taking advantage of any avail-able scale economies in conducting these activities.In this regard, it takes time and money to searchout partners and resources to help get a projectfrom the drawing board to completion. Oncefound, it takes additional resources to manage themany aspects of the project as it is implemented.All of these efforts increase transaction costs.

Vesting community development knowledge in asingle unit or group of individuals may help reducetransaction costs. Depending upon geographic dis-tribution and volume of development activity, abanking organization may be able to hire peoplewho concentrate their attention on communitydevelopment activities.16 These people may have abackground in real estate and small business lendingand have practical knowledge of local, state, andfederal government programs that can be used toleverage the organization’s resources. Furthermore,they may be familiar with the community develop-ment organizations and intermediaries in local com-munities and be aware of how partnerships withthese organizations can help a bank or bank holdingcompany meet community needs.

A similar argument can be made for bankingorganizations joining with one another to engage incommunity development activities. For example, 18

BoxSouthern Development Bancorporation:A Comprehensive Approach to Community Development1

Most bank-initiated community development activitiesare incidental to a bank’s broader business activities. In afew cases, however, just the opposite is true. SouthernDevelopment Bancorporation is such an organization. Withcharitable foundations as principal shareholders and a missionof “…transforming rural economies in Arkansas by creatingnew trends of investment in people, jobs, businesses and realproperty,” its primary objective is to provide returns to thecommunity, rather than profits to its shareholders.

While most banking organizations may not subordinateshareholder return to engage in community developmentactivities to the extent Southern Development Bancorporationdoes, the organization’s structure and activities are illustrativeof the breadth of opportunities in which rural communitybanks can become involved to better their communities.The accompanying abbreviated organizational chart depictsthe various pieces of Southern Development Bancorporationand their relationship to one another.

The banks in Southern Development Bancorporation arerun like most banks, with a focus on serving financially strongcustomers and employing good underwriting criteria. Unlikemany banks, however, these banks are willing to accommodateborrowers who are slightly more risky than traditional bankborrowers. Accommodating such borrowers frequentlyrequires using various government programs to help mitigatethat risk. They are willing to expend the time and resourcesit takes to utilize these programs to reach a broader customerbase, even though it may mean lower profit expectations.One of the banks, Elk Horn Bank and Trust Company, also hasa mortgage company subsidiary to facilitate mortgage lending,including lending to lower-income borrowers.

Opportunity Lands Corporation and Southern CommunityDevelopment Corporation are, respectively, for-profit andnot-for-profit real estate development subsidiaries. Workingindividually or together, they are able to develop bothcommercial and residential real estate, depending upon acommunity’s needs. Many of their projects involve affordablehousing for low-income residents. Thus, the non-profit entity,Southern Community Development Corporation, is often usedto access government and other money to help subsidizethese projects.

The Arkansas Enterprise Group’s (AEG) focus is on assistingsmaller businesses without the operating and credit historiesnecessary to access bank funding. Its subsidiaries provide

Abbreviated Organization Chartfor Southern Development Bancorporation*

SouthernDevelopment

Bancorporation

OpportunityLands

Corporation

SouthernCommunity

DevelopmentCorporation

ArkansasEnterprise

Group (AEG)Banks

*The abbreviated organization chart shown is based on a more detailed chart taken fromSouthern Development Bancorporation’s 1999 Annual Report.


banks, a bankers’ bank, and a government agencyinvested in Oklahoma Metafund CommunityDevelopment Corporation (Metafund). The pur-pose of this fund is to “finance and invest in com-munity economic development and workforcedevelopment to promote job creation and self-employment opportunities, housing, and propertydevelopment/rehabilitation, and maintenance pri-marily for low and moderate income individuals inunder served populations in Oklahoma.”17 Withthis in mind, it is the goal of the Metafund to workwith existing partners in communities, includingbanks, and to fill whatever gaps other partners arenot able to fill. Hence, in one community Meta-fund might buy a run-down house to be rehabili-tated by others to rent to a low-income resident,while in another, it may extend a second mortgageto a local, expanding business.

Interviews with several bank investors indicated avariety of reasons for joining this statewide venture.Among these were the ability to promote economicdevelopment in individual communities and the stateof Oklahoma; to receive an acceptable return oninvestment; to work around the inability to join withother local banks on community development proj-ects; to obtain benefits such as capturing scaleeconomies and sharing risks and expenses in commu-nity development projects; and to obtain Commu-nity Reinvestment Act (CRA) investment credit.18

BeneficiariesIt is important to identify beneficiaries of com-

munity development projects because banks andbank holding companies have been given addedflexibility to make investments in projects that pri-marily benefit low- to moderate-income individualsand areas. These include affordable housing, com-munity services, small business and farm finance,and neighborhood revitalization and stabilizationactivities. In such cases, banking organizations,which are subject to safe and sound operationrequirements and the regulatory limitations dis-cussed below, can make investments and conductactivities that might otherwise be prohibited.

All of those interviewed were located in low- tomoderate-income areas or their development proj-

Box (continued)“non-traditional financial services, technical support, andhuman resource development.” A lending officer representingAEG sits on the loan committee of the banks to determine ifcredits that are unacceptable to the banks might be workablefor AEG. Technical assistance is made available for AEGcustomers both to improve business operations and to helpmanage AEG’s credit risk. This support is provided via a thirdparty so as to avoid lender liability risks to AEG. Finally,another AEG subsidiary provides job training to improve theskills of local residents, thereby helping them obtain meaningfulemployment. Many of these clients are exiting welfare rolls.

Throughout the years, Southern DevelopmentBancorporation has adjusted its operations and operatingphilosophy to better serve its communities. Some operations,such as Southern Ventures, a venture capital company providingequity funding, have been de-emphasized, because they lostmoney and didn’t accomplish their purpose or a better waywas found to accomplish the same purpose. Others, such asthe company’s job training programs, received greaterattention because of their success. For example, Careers inHealth Care, which provides certified nurses training andcareer development opportunities, has graduated 142 certifiednursing assistants since its inception in 1997 and is being lookedat as a model for similar programs offered by others.

Additionally, Southern Development Bancorporation hasmoved from a philanthropic to a business-like operatingphilosophy to help maximize resources flowing to itscommunity development activities. Although profits are stillnot the primary motivating force behind the company’scommunity development activities, it does attempt to provideits development services at no less than a breakeven level.Without such fiscal responsibility, the company’s ability toprovide continuing, long-term financial support for its activitieswould disappear.

For more information about Southern DevelopmentBancorporation and its operation and the lessons learned fromthose operations, contact Mr. Phillip Baldwin, Executive VicePresident and Chief Financial Officer, at (870) 246-3945. Hise-mail address is [email protected].

1 Southern Development Bancorporation is headquartered in Arkadelphia, Arkansas.


ects primarily benefited low- to moderate-incomeindividuals. Without provisions in banking lawsand regulations designed to benefit low- to moder-ate-income individuals and communities, many oftheir activities may not have been allowed or wouldhave been reduced in magnitude.

Needs of the bankor bank holding company

The needs of the bank or bank holding companyshould be balanced with community economicdevelopment needs. Banks and bank holding com-panies have the option of organizing their develop-ment activities in for-profit or non-profit entities,making the need for earnings an important consid-eration in structuring their activities.

Private foundations and government agenciesoften have grant money or other funding that canbe used by non-profit organizations for communitydevelopment. As a consequence, banks and bankholding companies hoping to take advantage ofthose funds often elect non-profit status under theFederal Internal Revenue Code for their commu-nity development activities.

Typically, this is done under Section 501(c)(3) ofthe code — the exemption from federal income taxfor “corporations … organized and operated exclu-sively for … charitable … purposes ….”19 The trade-off in making this election is that “no part of the netearnings [can] inure to the benefit of any privateshareholder or individual.”20 Because of this stipula-tion in the Internal Revenue Code, an investment ina 501(c)(3) corporation is a non-earning asset. There-fore, if some form of shareholder return is expected,placing housing development activities in a for-profitentity may be a more appropriate structure.

However, investing in a 501(c)(3) corporationdoesn’t necessarily preclude receiving investmentreturns. For example, investments in Metafund, a501(c)(3) corporation, are structured to meet thedefinition of an equity investment used by theDepartment of Treasury’s CDFI fund but not thatof the Internal Revenue Code.21 Thus, Metafundshareholders can receive a return on their invest-ment without violating tax law. Another way forobtaining a return on an investment in a 501(c)(3)

corporation is through lending to it. The rate onthe loans can include an investor return plus anyamount parties to the loans agree is an appropriateinterest rate.

Four banking organizations interviewed madecommunity development investments through501(c)(3) corporations. Three of the non-profitinvestments were in Metafund, and the fourthplaced its community development activities in a501(c)(3) corporation because it planned to applyfor grant money.

Alternative organizational structuresAfter addressing the above issues and questions,

alternative organizational structures can readily beidentified. The most frequently used structure bythose interviewed was the for-profit, limited liabilitycorporation. Limited liability corporations are sepa-rate legal entities that can be viewed as a crossbetween a general corporation and a partnership.Like general corporations, limited liability corpora-tions offer their owners the advantage of limited lia-bility.22 Like partnerships, these corporations permitpass-through taxation, which means the earnings oflimited liability corporations are treated like thoseof sole proprietorships, partnerships, and S corpora-tions,23 thereby avoiding double taxation. For thoseinterviewed, this advantage translated into pass-through of low-income housing tax credits.

Bank-owned community development corpora-tions (CDCs) were another structural option chosenby two of those interviewed. CDCs are separatelyincorporated entities whose primary corporate pur-pose is to make equity and debt investments in proj-ects designed to promote community welfare,development, and revitalization (see note to Figure2). One CDC was organized as a for-profit corpora-tion. The other was organized as a non-profit corpo-ration to take advantage of possible grant money.One was owned by a bank, the other by a bank anda bank holding company. No reason was given forthe difference in ownership structure adopted exceptindividual preference for the federal banking super-visor with whom the organizations worked.

Forming a Small Business Investment Company(SBIC) was an option chosen by one of the banks


interviewed, making it somewhat unusual amongthose surveyed. SBICs are for-profit corporations orlimited partnerships licensed by the Small BusinessAdministration under the Small Business InvestmentAct of 1958 to provide venture capital to small,independent businesses. They can buy equity securi-ties and convertible debt securities issued by smallbusinesses and also make loans to them. Banks andbank holding companies are restricted from beinggeneral partners in a small unincorporated businessand from becoming liable for its general obligations.SBICs owned by banks and bank holding compa-nies often serve as venture capital units.

As far as banking involvement is concerned,SBICs are typically owned by larger banks andcompanies, because a minimum of $5 million capi-tal is required to start one. It is this relatively largecapital commitment that makes the small ruralbank interviewed unusual.24

Although not yet used by Tenth District organi-zations, new regulations regarding merchant bank-ing activities of financial holding companies mayplay a role in community economic development inthe future.25 Merchant banking activities arebroadly defined as “investments in any amount ofthe shares, assets, or ownership interest of any typeof non-financial company.” Subject to limitationson the investment holding period, capital exposure,and management control, merchant banking mayprovide smaller banks another tool for communitydevelopment.

Identify Potential Regulatory Issues Banks and bank holding companies operate

under a host of laws and regulations to promote safeand sound operations and to ensure fair dealingswith consumers. Among other things, these lawsand regulations place restrictions on the products,services, and investments of banks and are importantconsiderations in structuring community develop-ment activities. Of particular relevance for commu-nity development activities are investment andlending restrictions placed on banking organizationsand matters pertaining to safe and sound operations.

Investment restrictionsSubject to provisions of state law, state chartered

banks face the same limitations and conditions ontheir equity investments as nationally charteredbanks. Bank holding companies do not face restric-tions on their stock ownership as severe as those ofbanks, but their ownership is limited to entities thatengage in financial activities, nonbank financialactivities that complement financial activities, oractivities that are closely related to owning and con-trolling banks.

National banks cannot own shares of stock in acorporation, except as specifically permitted by law(for example ownership in a bankers’ bank).26 How-ever, they are authorized to make investmentsdesigned to promote public welfare, including thewelfare of low- to moderate-income areas or indi-viduals, such as providing housing, services, orjobs.27 By federal regulation, state chartered bankscan also make these types of investments as long asthey are permissible under state law. Bank holdingcompanies can do so as well, as long as they abideby the restrictions of the Federal Reserve Board ofGovernors’ Regulation Y.28

Although banks and bank holding companieshave greater ownership latitude when making com-munity development and public welfare invest-ments, there are limits and conditions on thisownership. In no case can the aggregate of welfareand development investments exceed 10 percent ofa bank’s or company’s capital and surplus. Further-more, in the case of banks, the investments theymake cannot expose them to unlimited liability.These limitations and conditions help explain whythe investments made by those interviewed wererelatively small in relation to their capital, and whythese investments were in corporations and limitedpartnerships.29

The passage of the Gramm-Leach-Bliley Act of1999 (GLB), which created financial holding com-panies, provides a new means to promote publicwelfare by permitting equity investments above thepreviously described limitations. Financial holdingcompanies can commit as much as $6 billion or 30percent of their capital in equity investments as part


of an authorized merchant banking activity. Theseexpanded limits could permit greater commitmentof a banking organization’s resources to communitydevelopment activities, provided the investments areconsistent with the restrictions for merchant bank-ing activities.30

In some instances, these restrictions may limitthe use of merchant banking activities in promotingpublic welfare. For example, they put limits on theholding period for merchant banking investments,specify capital support, and restrict taking part inmanaging companies in which equity investmentsare held. While each of these restrictions could limitthe use of merchant banking activities as a commu-nity development tool, the restrictions on controlmay be of particular concern. Some of the institu-tions interviewed wanted to exercise control overthe organizations in which they invested. Their rea-sons ranged from having a voice in how funds wereused to making sure funds were fully accounted for.Thus, for these banking organizations, existingcommunity development tools may still representtheir best option.

Lending restrictionsBesides investments, banking organizations can

make loans to finance community developmentprojects. In some situations, they may be faced withmaking loans to corporations in which they have aninvestment. This was the case for two of those inter-viewed. Another interviewee said that it was likelythey would extend a line of credit in the future.

In cases such as these, care must be taken toensure compliance with Sections 23 A & B of theFederal Reserve Act. Sections 23 A & B place limitsand collateral requirements on loans and certainother transactions with affiliates and require termson these transactions to be similar to those withnonaffiliated entities. The purpose of these sectionsof law is to prevent banks from sacrificing their ownprofitability to favor their affiliates.

An affiliate is defined as any company that con-trols a bank and any other company that is undercommon control with a bank. “Control” includesinstances where one company, directly or indirectly,owns, controls, or has power to vote 25 percent or

more of any class of voting securities of anothercompany. It also includes cases in which a companycan elect the majority of directors of another orwhere a company has a majority of its owners/direc-tors in common with another company.

When a company is an affiliate of a bank, thenlimitations and conditions apply to transactionscovered by Sections 23 A & B. Covered transac-tions include, among other things, loans or exten-sions of credit by a bank to an affiliate, and a bank’spurchase of or investment in securities issued by anaffiliate. In the case of a single affiliate, the com-bined amount of covered transactions with thebank cannot exceed 10 percent of the bank’s capitalstock and surplus.31 For all affiliates in aggregate,covered transactions with the bank cannot exceed20 percent of capital stock and surplus. The effecttherefore is to limit the total commitment of abank’s resources to affiliates to 20 percent of its cap-ital and surplus. This commitment can be in theform of loans, equity investments, or any combina-tion of loans and investments.

Issues pertaining tosafe and sound operations

Banks and bank holding companies have limitedresources, and it is important to treat developmentactivities as other business is treated. Resourcesdevoted to development activities need to be usedeffectively, efficiently, and with due regard for safeand sound operations. This means establishing poli-cies and internal controls commensurate with thesize and complexity of these activities and having amanagement team and staff with the capabilities tolessen the operational, liquidity, market, and creditrisks they may pose. Where community develop-ment activities consist of a single project, little moremay be required than a written statement that setsout the objectives to be accomplished, an assessmentof the project’s appropriateness for the organization,plans to supervise the project, board guidance andapproval of the project, and time frames for periodicreporting to the board on progress.

On the other hand, if large or multiple projectsare planned, then more detailed policies and inter-nal controls may be needed to guide the organiza-


tion’s staff in seeking out community developmentprojects, making decisions about them, and com-mitting the organization’s resources. Formal budgetand profit objectives may be needed to assess thefinancial implications of the project. In addition,since many development projects tend to be long-term, consideration needs to be given to issues ofliquidity and market risk. Also, if lending is to bedone as part of the development activities, thenappropriate additions must be made to loan policiesto mitigate the additional credit risk these activitiesmay pose and to ensure compliance with Sections23 A & B.32

All of those interviewed had briefed their boardsof directors on proposed community developmentinvestments and received approval for those invest-ments. None of those interviewed had written poli-cies pertaining to their community developmentactivities. Many had a single investment and didn’thave immediate plans to make others, lesseningtheir need for written policies regarding theseinvestments.

SUMMARY AND CONCLUSION

Many rural Midwest communities have experi-enced prolonged job loss and population declineassociated with technological and structural changesin agriculture. A small number of Tenth Districtbanks and bank holding companies have takenadvantage of special provisions in banking law tomake loans and investments to promote the welfareof and arrest adverse trends in their communities.For the most part, they joined with privateinvestors, other banks, and government agenciesand took advantage of government programs toleverage financial and managerial resources devotedto community development.

Their development projects often focused onfunding construction of better quality housing forlow-income individuals, enticing new business, andhelping existing businesses in their communitiesexpand. With only two exceptions, they viewedtheir community development projects as success-ful. Their activities have provided good housing forlow-income elderly residents, changed farm produc-

tion techniques, and provided increased job oppor-tunities for workers. The lesson learned from thosewho were less satisfied with their community devel-opment projects’ outcome was the importance ofperforming a good needs analysis at the outset.

Although promoting community good was a pri-mary motivation for investments made by those inter-viewed, altruism was not the only motivation. Mostdevelopment activities were organized as for-profitcorporations, and many interviewees received somereturn, if not a market return, on their investment.

Banking organizations have many options avail-able to them in structuring their community devel-opment investment activities and the structurechosen depends heavily upon the organization’s andthe community’s needs. Recent passage of GLB pro-vides an additional option for banking organiza-tions to promote economic development throughmerchant banking activities. However, existingdevelopment tools appear to offer banking organi-zations more flexibility and control over theirinvestments in low- to moderate-income areas.

In conclusion, all those interviewed thoughttheir investments, regardless of outcome or return,helped improve their communities. Some, in fact,took special pride that their investments helpedmove their communities from stagnation anddecline to renewed growth.


ENDNOTES1 This paper is based on an economic development presenta-

tion given by the authors earlier this year.

2 USDA Economic Research Service, Rural Development Per-spectives, Great Plains Issue, vol. 13, no.1, June 1998, p. 2.

3 Bankers attending the Federal Reserve Bank of Kansas City’s1999 Regulatory Update Seminar expressed interest in learn-ing more about community development banking andrequested this topic be covered in the 2000 Seminar.

4 Low- to moderate- income means individual or familyincome less than 80 percent of area median income ormedian family income.

5 Office of the Comptroller of the Currency, Effective Strate-gies for Community Development Finance, Washington,D.C., p. 4. This publication can be purchased from theOCC or downloaded from the agency’s Internet site(http://www.occ.treas.gov/strategy.pdf)

6 The information presented in Table 1 includes a synthesis ofinformation taken from Community Development Invest-ments: A Guide for State Member Banks and Bank HoldingCompanies, Board of Governors of the Federal Reserve Sys-tem Washington, D.C., pp. 11-31.

7 References to bank holding companies include financialholding companies that were created by the Gramm-Leach-Bliley Act of 1999.

8 The Tenth Federal Reserve District encompasses all or partsof Colorado, Kansas, Missouri, Nebraska, New Mexico,Oklahoma, and Wyoming.

9 We interviewed only bank and bank holding companieswhose home offices were located outside of MetropolitanStatistical Areas.

10 CDFIs were created as part of the Riegle Community Devel-opment and Regulatory Improvement Act of 1994 in aneffort to promote community revitalization and communitydevelopment in areas under served by financial institutions.

11 Sandra L. Jacobsen, Federal Home Loan Bank Des MoinesCICA Research Project, April-May 1999, (Jacobsen Associ-ates, Inc. 1999), pp 43-45, 49.

12 Transaction costs refer to expenses incurred by a lender orinvestor to evaluate a project for its suitability, to search outdevelopment partners and enter into agreements with them,and to find appropriate development programs and complywith their requirements.

13 1st Source is an interactive, Internet database through whichthe inquirer, by checking boxes that describe a project,receives a tailored list of potentially applicable programs withsummary descriptions. Additionally, 1st Source provides weblinks to more detailed program information from the spon-soring agencies.

14 Under this program, investors in eligible housing projects aregranted credit against taxes they would have otherwise paid.These credits, administered by state government, can be usedfor up to 10 years. To avoid recapture of these credits, eligiblehousing projects must be set aside for a minimum of 15 years.

15 Section 8 — Rental Certificate and Rental Voucher Programand Contract Renewals — is one of the largest HUD pro-grams. It provides funding to state and local public housingagencies so they may provide rental certificates or rentalvouchers to qualified low-income households.

16 When functions are specialized, capturing scale economiesmay be elusive. For example, there is evidence to suggest thata separate department making single family residential mort-gage loans that are eligible for CRA credit may incur higherorigination costs than if this lending were kept with otherloan activities. See Larry Meeker and Forest Myers, Finan-cial Industry Perspectives, “Community Reinvestment Actlending: Is it Profitable,” December 1996, pp. 30-31.

17 Metafund is a CDFI.

18 An institution may receive investment credit under the CRAregulations if it invests in a fund whose purpose is commu-nity development, “provided the investment benefits one ormore of the institution’s assessment area(s) or a broaderstatewide or regional area(s) that includes one or more of theinstitution’s assessment area(s).” Examiners take these invest-ments into account in assessing a bank’s performance underthe CRA.

19 26 USC § 501(c)(3)

20 Ibid.

21 The investment is structured as an equity note, a form of debtcapital, that qualifies as “equity-like investments” under thedefinition used by the Department of Treasury’s CDFI fund.

22 Unlike limited partnerships that limit the liability of their lim-ited partners but not their general partners, limited liabilitycorporations limit the liability of all their owners. Also, unlikelimited partners, limited liability corporation owners can fullyparticipate in governing and managing the corporation.

23 S corporations are corporations that have elected under the Fed-eral Internal Revenue Code to pass their income through totheir shareholders, thus avoiding federal corporate income taxes.

24 For more information on venture capital investments in ruralmarkets see Equity for Rural America: Community Develop-ment Venture Capital, Community Reinvestment, Fall 1999,Federal Reserve Bank of Kansas City.

25 Financial holding companies are bank holding companiesthat have certified they are eligible to be treated as financialholding companies as authorized by the Gramm-Leach-Bliley Act of 1999.

26 12 USC 24(Seventh)

27 12 USC 24(Eleventh)


28 12 CFR 225.127

29 Banks may self-certify or provide post notice of a commu-nity development or welfare investment if the aggregate of allthese investments remains below 5 percent of their capitaland surplus and meets other tests set out by their primaryfederal banking supervisor. This allows banks to respondquickly to community development opportunities, and thecertification/notification process is relatively inexpensive andhassle-free, providing extra incentive to keep aggregate com-munity development investments at 5 percent or below.

30 12 CFR 225.171

31 Capital and surplus is defined as the sum of Tier 1 and Tier2 capital under the federal banking agencies’ risk-based capi-tal guideline plus the balance of allowance for loan and leaselosses not included in Tier 2 capital under these guidelines.See 12 CFR 240.242.

32 Office of the Comptroller of the Currency, Effective Strate-gies for Community Development Finance, p 18.

Strategic options for bankers in rural development

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