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Formal and Informal Financing in a Chicago Ethnic Neighborhood

The Community Reinvestment Act (CRA), the Equal Credit Opportunity Act, and the Fair Housing Act all assign a key role to the formal banking sector, based on the view that it is vital for poor and ethnic minority sections of society to have access to banks and other mainstream financial institutions. The usual regulatory view rarely considers alternatives to the formal banking sector, contributing to the impression that rejected bank loan applicants and nonapplicants are left to fend for themselves, perhaps vulnerable to loan sharks and pawn merchants of dubious repute. It is beginning to be noticed, both theoretically and empirically, that such an extreme view cannot be supported. In this context, we seek to document not only the actual use of banks, but also the widespread use of alternative financing mechanisms, using data from a survey of households and businesses in a Hispanic neighborhood of Chicago.(1) Our purpose is to present the salient facts, together with what we view to be reasonable interpretations, and to clearly delineate the boundary of our existing knowledge. In broad terms, this article adds to the existing literature concerning the actual and potential role of banks in disadvantaged communities. In recent years, there has been a surge of interest in the issue of whether banks and other formal financial institutions are effectively serving poor and ethnic minority sections of U.S. society. The associated empirical literature has tended to focus on the volume of bank lending in certain neighborhoods or to certain groups. While this approach has value, it suffers, to some extent, from a failure to address the reasons why an individual would actually desire a bank loan. Given that informal alternatives to banks do exist, the volume of total bank lending may not be the best indicator of the availability of credit within communities. Starting with a theoretical examination of underlying motives for borrowing, we reconsider the issue of credit provision in a context that admits the existence of informal community-based alternatives. To achieve this, we make use of the extensive data set from the 1994-95 Little Village Surveys of households and businesses, conducted in South Lawndale (popularly known as the Little Village), a principally Hispanic community on the southwest side of Chicago. Modern economic theory has done much to clarify why individuals borrow and save. Ideally, people would like to insure themselves against all fluctuations in income, paying out money when times are good and receiving money when times are bad. If insurance is unavailable (and clearly complete insurance against all fluctuations is not available), people can insulate themselves partially from income changes by borrowing and saving, effectively transferring resources from periods of high income to periods of low income. This also implies that individuals will generally prefer loan contracts that offer at least some provision for default, effectively giving limited insurance against bad times. Similar reasoning applies to a consideration of optimal loan contracts to finance one-time capital investments, such as those entailed in house purchase or business financing. Related theories have shown the importance of information in actually implementing loan or insurance contracts in the face of moral hazard incentive problems. One branch of research has suggested that financial intermediaries essentially owe their existence to their role as "information machines" that effectively minimize the costs of information creation. However, this research has yet to produce compelling reasons why intermediaries should take the form of formal institutions. The role of credit in helping individuals to insulate themselves against periods of low income or high expenditure requirements makes effective access to credit an issue of considerable importance. Similarly, the potential for self-employment to provide a route out of poverty has led to fresh interest in the problems of small business financing. …