The role of banking debt in community development
An excerpt from a speech Federal Reserve Bank of Minneapolis President Gary H. Stern delivered at the 1997 Nation Building Conference in Missoula, Mont.
Published April 1, 1998 | April 1998 issue
Editor's note: This article is excerpted from a speech given by Gary H. Stern, president of the Federal Reserve Bank of Minneapolis, at last year's Nation Building Conference: Building Tribal Infrastructure for Economic Prosperity. The conference, held April 1316 in Missoula, Mont., was cohosted by the Montana-Wyoming Tribal Leaders Council, the University of Montana Law School and the Federal Reserve Banks of Minneapolis and Kansas City. Among the conference's other highlights were discussions by nationally recognized speakers, interactive workshops on understanding tribal and bank cultures and presentations on the effective use of sovereignty.
I am pleased to have the opportunity to discuss economic and community development issues on tribal lands. Usually, I am asked to comment on monetary policy, so it is refreshing to be talking about a somewhat different topic. However, I say only a somewhat different topic because Federal Reserve monetary policy and opportunities for economic prosperity on reservations are more closely related than they might at first appear. The Fed is well known for the strategies it uses to promote a low-inflation environment, particularly those of the Federal Open Market Committee, which makes decisions that affect interest rates. However, the use of these tools to keep inflation in check should not overshadow the larger goal of the Federal Reserve, which is to improve standards of living nationwide.
While I believe a low-inflation environment provides the best climate for improving living standards, it is clear that some areas have been left behind in this time of sustained economic expansion. Isolated rural areas, core central cities and many tribal lands have not shared in the benefits of economic growth, and therefore may well require extra attention to ensure that they too benefit as the overall economy progresses. One of the important limitations in these communities has been access to capitalaccess that is critical to starting and growing businesses.
Equity capital: A scarce resource for new businesses
First, I'd like to discuss what capital is, where it can be obtained and why it is important. As most of you know, there are two types of capital: equity and debt. Equity capital is the money put in the business by the owners and not financed through a lender. The more equity capital invested in a business, the less money the owners need to borrow, other things equal. This results in lower payments for a new business that often operates on slim margins.
While some amount of equity almost always comes from the savings of the business owner, outside investors can also provide it in exchange for an ownership interest in the business. Outside equity capital can be difficult to attract, especially in rural areas where the investor is located at a distance and cannot keep an eye on the business. Also, many new businesses do not survive. Because of this, outside equity investors want a relatively high rate of return to compensate for the risk of losing their investment if the business fails. Equity capital can, and often does, come from friends or family members who are not as concerned about a high rate of return. However, family money is likely to be much less available on reservations, where many people have not been able to accumulate savings. If resources from friends and family are not available, there are few other sources of equity capital for most new businesses.
Debt capital: The engine of business development
It seems clear that outside equity capital cannot by itself be the driving force behind significant and sustained economic development. Therefore, most new businesses will need access to debt capital. Debt capital is expensive in the sense that the business owner will need cash every month to make loan payments, but it is also much more widely available than equity. Debt financing also allows the borrower to retain full ownership of the business and to use his or her cash to invest in facilities and equipment to get the business started.
Although it may not seem clear at first, debt financing is one of the primary ways to build savings to be used as equity. For example, consider a rancher who wants to expand her herd, but is not making enough money to buy more cattle outright. Using her existing assets of the current herd as collateral, she can get a loan for more cattle that will allow her to earn more profit. The profits from the larger herd are used to pay off her loan, and she now has greater assets and profit potential. This process of using debt to enable an entrepreneur to expand a business with a relatively small amount of business equity is called leverage. The debt is used as a lever to increase the size of the business.
This may be a good time to make a distinction between using debt financing as a lever to build assets and simply "being in debt," which frequently has a negative connotation. In the example I just used, the rancher is making a rational decision about taking on debt based on her belief that the returns from a larger herd will be greater than the costs of paying for the loan. Taking out a business loan is often a logical financial choice, and should not be viewed as a sign of poor financial management, but rather as making use of an effective business growth tool.
There is another benefit from the use of debt capital that should not be overlooked. The loan to the rancher resulted in a profit for the lender, who can now loan out more money to other businesses in the community to continue the cycle of lending and reinvestment.
Local banks: Providing services and capital to borrowers
Bank loans are the primary source of debt capital for small businesses. Banks traditionally have made money by making loans to businesses and consumers, so they have both the resources and expertise to finance business creation and expansion. Bringing bankers into the economic development partnership adds another level of expertise and imposes another level of discipline to the business plan or project. Bankers review and evaluate loan requests, and weigh the risks and prospects for success. In other words, they review whether the business will likely stay in operation and whether the borrower will likely make the loan payments.
This risk evaluation can be viewed as technical assistance from the banker to the potential borrower. It prevents an entrepreneur with a good idea but a not-so-great business plan from receiving a loan that could possibly result in personal financial hardship if the business fails. Lenders are protecting their assets when they say no to some loans, and they are also providing valuable advice to the potential borrower about the weaknesses of his or her business proposal. Many bankers also offer advice to potential borrowers about other sources of funding or assistance, for example education about business planning that may be tied to a revolving loan fund. In summary, a local banker can be a valuable resource to an entrepreneur, even if the loan request is not granted immediately.
Other business financing resources: Important but limited
Banks are the most significantbut not the onlyproviders of debt capital financing to businesses. Another source of debt capital is revolving loan funds, which are most often operated by nonprofit organizations. Access to these funds is frequently contingent on completing a business planning and education process with the nonprofit organization. Such resources provide access to capital for entrepreneurs who are not able to qualify for bank financing. Although this is an important resource, especially for the first-time business owner, it is not a permanent solution. Resources tend to be limited, and the number of businesses that can receive loans is quite small. The goal of most of these organizations is to "graduate" their borrowers to conventional bank financing when they have had some success with their businesses. Revolving loan funds are an important tool, but they lack the resources to sustain long-term, significant economic development.
Another source of business financing comes through enhancements, which are resources or services that improve the financial soundness of the project. These resources offer an opportunity to make a project stronger by filling gaps in finances or management experience in a proposed business plan. One example of an enhancement is a guaranteed loan program available through a government agency for lending on tribal lands. Many banks offer these programs to their customers since they promote access to capital and result in significantly reduced risk for lenders. Other enhancements, such as grants or loan subsidies from outside sources, can improve the cash flow of new businesses to make the loan more attractive to conventional lenders. Enhancements will not make every deal work, but they can be an important tool for strong business prospects that need some assistance to get started. However, resources for enhancements are usually quite limited and are often used to complement bank financing.
Building banking relationships: The key to accessing capital
I have been discussing why access to debt capital is important to economic development. The next step is identifying how tribal members can access debt capital so business and economic development can begin. First, tribal members must build banking relationships. Building relationships with lenders offers tribal members two important benefits. One benefit is access to basic banking services, such as checking and savings accounts and the ability to apply for loans. These services are valuable because they make doing everyday business easier: for example, paying a bill with a check instead of a more costly money order. Car and home loans allow people to obtain reliable transportation and improve their living conditions without having to save enough money to cover the entire expense at the time of purchase.
The second important benefit is for those tribal members who are interested in starting a business. For these people, banking relationships offer a way to begin developing the credit history that is vital to accessing debt financing. Creditworthiness is first established by obtaining consumer loans, such as for cars or homes. When borrowers prove they are good risks for consumer loans, banks are more likely to provide them with business loans.
There are a number of reasons why many tribal members currently do not have banking relationships, and it is probably fair to say that both lenders and tribal members can do more to make these relationships work. There are several ways bankers and tribal members can work together to develop such relationships. As just one example, bankers could offer basic banking education in partnership with tribes or tribal colleges. This is beneficial to all parties since bankers can reach new markets and potential customers are better prepared to use available banking services. Two challenges must be addressed to improve access to capital: getting more bankers to lend to tribal borrowers and preparing more tribal borrowers for good banking relationships.
Taking the next step: Promoting entrepreneurship
Let's assume that tribal members and bankers work together to build relationships and that in the future, increased numbers of tribal members will have access to banking services and to at least some business debt financing. An equally important step on the path to economic development is getting people interested in and prepared for starting a new business. Entrepreneurs, who are the people who develop the creative ideas and take the chance on starting new businesses, are vital to a healthy and innovative economic climate. Unfortunately, entrepreneurship on tribal lands has been limited by a lack of role models and limited access to capital. This problem is not unique to reservations. It exists in many communities, especially in low-income and rural areas.
Promoting an entrepreneurial mindset is an important challenge on reservations that must be addressed through creative education and training programs. It is important because simply making bank financing more accessible has little value if no one wants to borrow the money. Developing a climate that fosters and encourages entrepreneurship takes time, but it can happen and is critical to building a diverse economic base.
Understanding different motives: Working together for mutual success
I'd like to suggest to you the value of all of you pulling together to make economic development happen on reservations. This can be challenging since each of you may operate under a different constraint and may have a different goal. My earlier example of a lender who seeks to protect the assets of the bank but also offers valuable assistance to the potential borrower suggests that participants in economic development often have multiple and sometimes competing motives.
The intentions and motives of others may also be more complex than they initially appear. For example, banks must operate within certain regulatory rules to protect the assets of all bank customers. This means that they are sometimes unable to make loans which they think may be good for their communities, but which simply aren't sufficiently strong financially to uphold the standards of safe and sound banking.
Although the motives of business owners, tribes and bankers may be different, they are legitimate for their business. The key is for each party to respect the motives and constraints of the others and to work within those boundaries to make the business or project as strong as possible.
We all share the common goal of making economic development on reservations a reality. The key is to use each others' strengths to work together and form a partnership for this shared goal.
Tribes have human and natural resources and the ability to create a positive climate for economic development.
Lawyers bring the skills to assist in the creation of a legal structure that promotes business development and respects the values of the tribe.
Entrepreneurs and business owners bring new ideas, job opportunities, needed services and the "spark" for change.
Bankers provide the capital that is essential to the long-term growth of most businesses. They lend the money that entrepreneurs can use to create jobs and new opportunities and to build wealth in the community.
Finally, organizations such as government, foundations and nonprofit organizations provide critical resources that can often make a project happen.
Economic development will not happen consistently without all partners working together. I don't want to minimize the challenges of this kind of partnership; however, the opportunities and rewards can also be substantial. Economic vitality on tribal lands can and should be beneficial for all. I encourage you to think and act creatively to make economic opportunity on reservations a reality.
As president of the Federal Reserve Bank of Minneapolis, Gary Stern is a member of the Federal Open Market Committee, the Federal Reserve System's principal body for establishing national money and credit policies. Stern serves on the board of trustees of the National Council on Economic Education and the boards of directors of the Minneapolis College of Art and Design, the Northwest Area Foundation and the Carlson School of Management at the University of Minnesota. He is a Wisconsin native.