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CDFIs as an Alternative to Payday Lenders

CDFIs as an Alternative to Payday Lenders

Community Development Financial Institutions (CDFIs) have in recent years gained prominence as a source of credit to the financially excluded (i.e. people not able to access credit from mainstream banks). In addition to credit, they also provide financial advice to individuals and enterprises in impoverished and underinvested communities with no or limited access to high street banks. CDFIs have become an established third sector since 2000 in the UK, filling the gap created by market failure, they provide credit to individuals seen as high risk by banks. In recent years CDFIs’ funding has grown and sources of funding become diversified. There is also increased public awareness of CDFIs. While latest legislations on capping payday lenders has led to the withdrawal of some of the smaller lenders just before introduction of the cap in January 2015, and some of the big ones such as Wonga and Money Shop have reduced their operations. This has created a gap and opportunity for CDFIs but to fully rise to the challenge they must overcome obstacles in terms of professionalising and automating their internal processes such as their Loan Management System and Customer Relationship Management (CRM) systems, so as to become more efficient and cope with growth.  

Background

CDFIs’ main purpose of operation is not profit maximisation. Instead the funds they receive are given out in loans and once repaid they are reinvested into other loans. This creates a cycle where finance is reinvested into the community continuously. CDFIs establish close relationship with their customers by guiding them in the initial stages of their loan application and also in the process of repayment. They provide loans to individuals and to for-profit or social enterprises usually in geographically disadvantaged areas. Particularly in developing countries, CDFIs have had a positive effect on poor communities. A notable example is Mohammad Yunus’ microfinance Grameen Bank in Bangladesh. Established in 1983, it has been lending small amounts of money to individuals and groups of women to help them start or run their businesses as a first step to alleviating people from poverty.

Appearing first in the USA in the 1970s, CDFIs’ original aim was adapted from prior initiatives to alleviate poverty and racial discrimination but also to fill a gap created by banks not providing loans to individuals and small enterprises from disadvantaged backgrounds that might have a bad credit history. This gap can be traced back to another phenomenon which is market failure. Market failures occur when there is inefficient allocation of resources in a given market so that some form of impediment means that a demand is not satisfied by it. In the case of CDFIs, they satisfy the demand for credit by people who cannot access it from mainstream banks. For example, people with bad credit history or no history at all, viewed as high risk, get rejected by banks who believe the chance of loan repayment is low meaning they could lose money. Nevertheless it is worth noting CDFIs are not the only alternative to fill in the gap but there is also payday lenders operating on short-term and high interest rates basis and often with significant charges.

However, CDFIs can handle risky borrowers because they develop a closer relationship with their customers. They try to gather as much information as possible on their finances and provide them with advice throughout the process of approving the loan. As they guide their clients, some CDFIs also manage the process in a way that will help their borrowers gain a positive credit background. Other CDFIs lending to small businesses might offer training courses, in management for example, and might spend a considerable amount of time at the company to ensure everything is running as it should. Therefore the steps that CDFIs take mean that, unlike mainstream bank, they can cater to high risk borrowers while decreasing the chances of losing money. This is in contrary to payday lenders lending money to individuals without proper financial background checks and based on limited details they enter online.  In turn borrowing between £50 and £3000 could run up rates up to 6,000 per cent a year.

CDFIs can be important for both the national economy and communities as they can create jobs, and support businesses and individuals. On a wider scale, CDFIs are crucial in addressing the remaining imbalance in supply and demand in the UK’s financial sector. The imbalance was particularly apparent in the 2009 report by New Economics Forum (NEF)[1] which highlighted that 9 million people in the UK did not have access to mainstream credit which resulted in them seeking loans from alternative ‘rip-off lenders’ in the form of payday lenders. Having large numbers of people stuck in a cycle of debt with payday lenders, operating on the basis of high-cost short-term credit, creates problems at personal, community and national levels.

Growth & Recent Trends

As non-deposit taking institutions CDFIs obtain funds from some other sources to be able to lend. While with the start of the financial crisis funding declined, from 2010 onward it appears funding has seen differing patterns of growth as sources of funding have diversified. CDFIs standard funders over the years have consisted mainly of institutional investors’ grants, government support and individual investors.[2] However, funding has opened up for other possibilities such as crowd-funders, trusts and foundations, loans from mainstream banks[3] as well as housing associations and local partnership. This diversification of funding constitutes as one of the recent trends of CDFIs and has enabled them to become more self-sufficient and cover their operating costs.

Another recent trend is recognition and rising awareness of the sector. On one level this has come from the public, especially the individuals and communities that would benefit from CDFIs. As recently as 2009 the sector was struggling for recognition as a viable alternative in the midst of the financial crisis.[4] The sector was further overshadowed with the rapid growth of payday lenders from 2010 onwards, but it has become apparent that more people using payday lenders have switched to CDFIs for financial support. A CDFA 2014 report shows 41% of those who received a CDFI personal loan had used a high-cost credit provider such as a payday lender or a loan shark in the previous year. This shift could also be attributed to the regulations being imposed by the government on the payday lending industry since 2014; consequently their gradual withdrawal has been significant in contributing to the CDFI sector.

Moreover there is an opportunity for CDFIs to further grow after the imposed cap on payday lenders since 2nd January 2015. The new regulations have had critical impact on the industry and supressed the opportunities to generate large profits. Before the cap was introduced some of the smaller lenders ceased operations and since the cap has been applied the bigger lenders have reduced operations as the sector has become less profitable hence cutting hundreds of jobs. This indeed is an opportunity for CDFIs to attract the customers who are leaving the payday lenders, for example c.400,000 left Wonga following the introduction of the cap. Additionally, unlike payday lenders CDFIs conduct proper checks to assess if people could afford to repay their loans and guide them through the process contrasting to Wonga where they wrote off 330, 000 customers’ debt worth £220million after acknowledging that they had lend to people who were unable to repay them. Essentially CDFIs try to understand their customers better than payday lenders and their focus is more on the community than short-term profit making.

Current Obstacles

Despite positive trends for CDFIs, there remain obstacles that could prevent CDFIs from realising their full potential. A problem of success and growth is the need to improve, standardise and professionalise CDFIs’ internal processes.

A major obstacle are the internal systems and structure of individual CDFI institutions as there is currently no ‘CDFI Management System’. CDFIs use a mixture of old and modified systems to standardise their processes, for example their Loan Management System (LMS) as well as their Customer Relationship Management (CRM) system. From our experience of working with CDFIs and in-depth research into the sector, it appears these internal problems are experienced by the majority of CDFIs, and even those with an IT system in place will report difficulties. This has also been highlighted in CDFA’s latest annual report which states that though there is positive progression toward self-sufficiency, CDFIs have “experienced a tension in providing affordable finance and high quality support services.” Indeed this tension can adversely affect the efficiency of CDFIs in their attempt to attract more finance while reaching more customers in need.

A crucial aspect of a CRM system for any business or organisation is managing their customer relationships. Understanding customers helps in improving business processes and ultimately growth. This aspect is particularly significant for CDFIs as they take more interest in their customers than most banks because they are high risk.  This requires a lot of customer data and continuing customer contact and monitoring by the CDFI staff.  This drives CDFI’s need for CRM.  Thus this aspect of customer management worsens as the CDFIs grow and have to share customer information across more staff and locations.

Additionally, based on our experience, finding the right software and system can be difficult, particularly as there are no CDFI specific systems available. Furthermore, customisation of current systems is available in the market but can be costly. Even then, selecting the right software with limited expertise within the organisation can be a difficult task for CDFIs. Regardless, having a CRM system in place can improve business efficiency significantly as having the right information means generating the right product.

A CRM Cycle (shown below) consists of different activities. Another problem for CDFIs with CRM is knowing which activity to focus on with their limited resources. An organisation with clear priorities means a more targeted CRM project can be generated which can result in a better outcome. An organisation is required to identify the processes that most support the organisation’s strategy and work on that particular activity of the CRM cycle.

CRM Cycle

 CRM Cycle (Source: Rigby & Ledingham 2004)[5]

 

Prospects for the Future

There is a lot of room for growth. Even though the state of funding has undoubtedly improved, there is still more to be done and certainly the financial gap left by mainstream banks remains to be filled. A CDFA report[6] published in 2013 puts the unmet demand by individuals and organisations, who do not qualify for mainstream bank funding at £6 billion. If CDFIs had half that funding they would be able to contribute to the creation of around 68,000 jobs and 39,000 businesses. Therefore there still remains the major issue of capital constraints but, provided government’s public policy and further diversification continue this would lead to the strengthening of CDFIs and closing down of the funding gap.

In addition, with the withdrawal of payday lenders there is now more opportunity for CDFIs to play a central role as an alternative finance provider. However, CDFIs need to streamline their processes and increase efficiency within their institutions to take advantage of the opportunity and attract the customers leaving payday lenders. Ensuring they have the right LMS and CRM systems will allow CDFIs to stay competitive with other providers of alternative credit. Also, CDFIs need to build stronger connections with their communities and client base ensuring they continue to raise awareness of their sector. The CDFA has also highlighted this issue, reiterating that public awareness and understanding of community finance is low and therefore not all those in need of credit and refused by mainstream banks know other sustainable alternatives.

 

[1] Theil, Veronika, 2009, “Doorstep Robbery: Why the UK Needs a Fair Lending Law”, NEF (New Economics Foundation),  http://b.3cdn.net/nefoundation/ba4652645aa9335c7e_o8m6ibdcn.pdf [15 November 2015].

[2] How investors can make money when investing in a not for profit organisation in general can be attributed to its potential social impact and philanthropic intentions than high returns. Thus there is the socially motivated capital that people invest in CDFIs as they share the goals of a particular CDFI while organisations provide grants and loans to make socially responsible investments.  Regardless investing in CDFIs is an investment and not a contribution unless it is specified as a grant. Therefore there is a rate of return but it is lower than the market rate, however, this is known to the investor and hence they accept such rate.

[3] There is also the recognition of CDFIs by the banks; their funding to CDFIs has been increasing, showing more trust in the sector despite its high risk reputation and majority of its loans being unsecure. But they are interested in getting involved not only because they are confident in CDFIs’ abilities but because they deal with borrowers that the banks themselves would not lend. Therefore CDFIs by substitute are fulfilling the banks’ role, in turn preventing potential government introduced policies to pressure mainstream banks to deal with high risk borrowers.

[4] Morgan, Bernie, 2009, “Hidden Lenders to the Rescue”, The Guardian, http://www.theguardian.com/commentisfree/2009/mar/10/banks-lending-finance [10 November 2015].

[5] Rigby, D and Ledingham, D (2004), “CRM Done Right”, Harvard Business Review, 82, 118-22.

[6] Henry, Nick and Craig, Philip, 2013, “Mind the Finance Gap”, CDFA (Community Development Finance Association), http://responsiblefinance.org.uk/policy/publications/mindthefinancegap/ [30 October 2015].

 

NOTE:

CDFIs, Community Development Financial Institutions, were rebranded to Responsible Finance Providers in November 2015 by the trade association representing the sector Community Development Financial Association (CDFA) which in turn also changed its trading name to Responsible Finance. However, for the purpose of this article the former names have been used as they are still most commonly known by.