Philip Bond - Visiting Lecturer, London School of Economics
Paul Huck - Economist, Federal Reserve Bank of Chicago
Sherrie L.W. Rhine - Economist, Federal Reserve Bank of Chicago
Robert Townsend - Economics Professor, University of Chicago
Published September 1, 1999 | September 1999 issue
The Federal Reserve System and other supervisory agencies are responsible, under the Community Reinvestment Act of 1977 (CRA), for encouraging financial institutions to help meet the credit needs of the communities in which they operate, consistent with sound banking practices. Small business lending, particularly in low- and moderate-income communities, is within the scope of CRA. The Equal Credit Opportunity Act of 1974 prohibits discrimination in credit transactions based on race, color, religion, national origin, sex or marital status. Taken together, these laws reflect policies aimed at enhancing credit and community development opportunities wherever possible. Availability of capital to small business owners may depend, in part, on ethnic differences in factors such as the use of informal financing and access to ethnic networks. Despite the importance of these issues, we still have much to learn about business access to capital in an ethnic setting.
In order to shed light on these matters, the Federal Reserve Bank of Chicago and researchers from the University of Chicago recently cooperated in conducting surveys in two Chicago ethnic neighborhoods: Little Village, a predominantly Hispanic community, and Chatham, which is predominantly Black. These communities were chosen because they are distinct and well-recognized ethnic neighborhoods with viable small business sectors. Most of the owners interviewed were either Black or Hispanic, although other ethnic groups are represented. Findings that pertain to Black and Hispanic owners are emphasized in the discussion that follows. One of the important features of the surveys is that they were designed to shed light on informal sources of financing, such as loans or gifts from family and friends and business associates, as well as formal sources of funds, such as loans from financial institutions, for both households and businesses.
In summary, the surveys revealed that Black owners start their businesses with significantly less capital than Hispanic owners, even after controlling for industry type and various measures of the owner's human capital. The Black-Hispanic gap in total start-up funding is due to differences in the use of nonpersonal sources of funding rather than disparities in the amount of personal savings put up by the owner. Black owners are also much less likely to owe their suppliers than owners in the other ethnic groups.
One reason small business access to capital is an important policy issue is because business owners may face funding limits, known to economists as liquidity constraints. Although many observers might take funding limits as self-evident, studies have provided evidence that liquidity constraints affect entrepreneurs both upon start-up and after the business is under way. These constraints deter entry into self-employment and force would-be owners to save for longer periods before launching a business. The effects of start-up constraints extend to ongoing businesses, as starting with more capital increases an owner's prospects for survival and growth. Thus, the ultimate success of an entrepreneur will depend, in part, on how successful he/she is in solving the problem of obtaining adequate capital and credit.
The provision of loan guarantees and other programs by the U.S. Small Business Administration are examples of government policies aimed at increasing access to credit for small businesses. Considering access to capital and credit across neighborhoods and across ethnic and racial groups raises other policy issues. Owning a successful business builds personal wealth, and self-employment historically has been an important means for raising the economic status of some ethnic groups. Promoting the success of small business is an important part of community economic development strategies, particularly for minority neighborhoods that have suffered from disinvestment.
In practice, owners meet the challenge of obtaining capital to start and run their businesses by using informal sources of capital as well as personal assets and loans from formal sources. Informal financing via networks can thus substitute for borrowing in the formal sector, either because formal credit is not offered or because informal financing is preferred. Credit offered by a supplier, which is known as trade credit, is another source of financing. Businesses also form networks with their suppliers, and there may be an informal dimension to these networks, in that the supplier relationship, including ethnic ties, may be important for some transactions. Thus, trade credit may share some of the features of informal financing, and we group it with clearly informal sources of capital in our discussion of start-up funding.
The survey results confirm the importance of personal savings and informal sources of credit in meeting the need for start-up funding. We illustrate the relative importance of the various funding sources with the average proportion of total funding provided by each source. Personal savings is the most important source of funding, as it provides, on average, 66 percent of total funding for Hispanic owners and 69.6 percent for Black owners. Highlighting the importance of personal resources, 50.9 percent of Hispanic owners and 55.3 percent of Black owners in the sample started their businesses using personal savings as their only source of funding. Informal and miscellaneous other sources, which includes trade credit, provide 25.4 percent of total funding for Hispanic owners and 17.4 percent for Black owners. By comparison, formal sources provide only 10.5 percent of total funding for Hispanic owners and 12.1 percent for Black owners.
There are pronounced ethnic differences in the amount of start-up funding used by businesses in the sample. In particular, after controlling for industry type and various measures of human capital, we find that Black owners start their businesses with significantly less capital than Hispanic owners. We first compare start-up funding without controlling for these factors. In light of the fact that a few businesses started with large amounts of funding, which means that a comparison of averages would put a great deal of weight on a small number of businesses involving large dollar amounts, we compare median amounts of start-up funding rather than average amounts. The results show that median start-up funding for our sample ($15,650) is fairly modest and that Black owners ($12,653) and Hispanic owners ($12,629) began their businesses with quite similar levels of funding.
These results are incomplete, in that other factors beyond ethnicity may affect the level of start-up funding. For example, a grocery store with a requirement for an extensive stock of inventory on the shelves may require more start-up funding than a business that provides a service largely based on the skills of the owner. The next step is a regression analysis to control for some differences in business type, demographics and human capital (such as education or prior experience running a business) to see what ethnic differences emerge. In order to illustrate the ethnic differences implied by the regression analysis, we calculate estimated levels of start-up funding for Hispanic and Black owners using the same set of baseline characteristics.2 The results of this analysis indicate that a Black owner with the baseline characteristics starts his/her business with about one-half the amount of estimated start-up funding as a comparable Hispanic owner.
The Black-Hispanic gap in total start-up funding is due to differences in the use of nonpersonal sources of funding rather than disparities in the amount of personal savings put up by the owner. We get this result by analyzing the amount of funding provided by personal savings in a similar fashion to the analysis of total start-up costs discussed above. That is, ethnicity, industry type, and various demographic and human capital variables are included in a regression analysis. The results show that the difference between personal funding provided by comparable Black and Hispanic owners is small and statistically insignificant. This finding suggests that we must look elsewhere to explain the gap in start-up funding.
The remaining sources of funding beyond personal savings are informal, formal and other sources. Unfortunately, the sample size and the relative infrequence with which these sources of funding are used do not allow us to establish conclusively how each source contributes to the Black-Hispanic funding gap. However, the average proportions of start-up costs provided by each source of funding suggest some patterns. Recall that, on average, Black owners used a higher proportion of formal financing and a lower proportion of informal and other sources of funding compared to Hispanic owners. This evidence suggests that less use of funding from informal and other sources may play a role in accounting for lower levels of start-up funding for Black-owned businesses relative to Hispanic-owned businesses.
Once in operation after the start-up stage, a business may need ongoing financing to meet working capital needs or to expand the business. Trade credit is an important source of ongoing credit, and it is widely used by businesses in Little Village and Chatham, as 38.2 percent of them owe one or more suppliers. There are substantial ethnic differences in the use of trade credit. The proportion of Black owners who owe a supplier (20.1 percent) is much lower than that of Hispanic owners (44.4 percent).
Whether or not a business uses trade credit depends on the supplier as well as the business owner because the supplier must be willing to extend credit to a given business. Hispanic owners (57.6 percent) are more likely to be offered credit by a supplier than Black owners (44.8 percent). Business owners must decide whether or not to take up a supplier's offer of trade credit. Compared to Hispanic-owned businesses (75.3 percent), Black-owned businesses (44.9 percent) are less likely to owe a supplier given that credit is offered.
Thus, Black owners are much less likely to owe their suppliers than Hispanic owners, in part because they are somewhat less likely to be offered credit by their suppliers, and also because they are much less likely to use trade credit if it is offered. Trade credit can be a relatively expensive source of ongoing credit, and it is not clear whether using less trade credit indicates a constraint or lack of need. However, being offered credit by a supplier, whether or not it is used, is clearly desirable as a potential source of funds.
One possible explanation for these patterns is that the various ethnic groups may differ in their access to ethnic networks formed by businesses and their suppliers. This explanation can be tested by looking at the use of trade credit in light of the ethnic relation between businesses and their suppliers. In general, suppliers of the same ethnicity as the business owner are not substantially more likely to offer trade credit. In addition, minority business owners are not substantially more likely to take up trade credit if it is offered by a supplier of the same ethnicity compared to a supplier of a different ethnicity. Thus, the differences across ethnic groups in the use of trade credit are not easily explained by the simple fact of how the ethnicity of a supplier matches with that of the business owner. If these results prove to hold beyond these neighborhoods, the findings would have wide implications for our understanding of ethnic differences in business survival and growth, the decision to enter self-employment, and income and wealth accumulation. The importance of informal sources of funding suggests that this type of funding has some features that meet the needs of small businesses in these communities. Informal funding may be more flexible and better suited to providing relatively modest amounts of capital compared to the formal sector. However, an important advantage of formal credit institutions is their ability to efficiently mobilize large amounts of capital. Recognition of the strengths of both informal and formal sources of financing should be a part of programs and policies aimed at encouraging the flow of capital to small businesses.
1 These authors are in the Consumer Issues Research unit of the Consumer and Community Affairs Division of the Federal Reserve Bank of Chicago. The opinions expressed in this study are the authors' and do not necessarily represent the opinions of the Federal Reserve Bank of Chicago or the Federal Reserve System.
This article is a summary of the authors' paper, "Small Business Finance in Two Chicago Minority Neighborhoods," published in Economic Perspective, Second Quarter 1999. [PDF Format]
2 We chose the following baseline characteristics: eating/drinking place, high school education, proficient in English, no previous experience as an owner, aged 37 years, male, business started 12 years ago.
This study is one of several under way by researchers in Consumer and Community Affairs at the Federal Reserve Bank of Chicago that focus on issues related to access to credit among minority small business owners and households. See, for example, a summary of the article, "The Use of Formal and Informal Financial Markets Among Black Households," published in the Consumer Interests Annual, Volume 45, 1999, available on the Consumer and Economic Development Research and Information Center (CEDRIC) Web site.
CEDRIC was established under the auspices of the Federal Reserve Conference of Presidents Subcommittee on Community Affairs to foster research related to consumer and community development issues. Uniquely, the Center has a repository that includes abstracts and full text of articles, reports, working papers and other studies generated by Federal Reserve researchers as well as academicians, government agencies and nonprofit organizations. CEDRIC provides a listing of data resources available on the Web, with convenient links to these Web sites. Announcements about upcoming consumer and community development events also are included on CEDRIC.