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What’s Character-based Lending?

Our standard lending system is broken. Here’s a primer on what we’re trying instead.

Authors: Cristina Diaz-Borda, Editorial Manager

So you have a big idea—you start your business and you want to take this fledgling product to the next level. Typically, you’d go through a standard funding journey. First, you’d turn to your closest allies for the friends-and-family round where they can support you before you’re able to prove yourself to creditors or funders. After that, you either turn to the traditional financial system for a loan, or to venture capital firms for backing.

Except here’s the problem: when it comes to funding your big idea, chances are that unless you are a white man, the cards are stacked against you. Theoretically, it’s as simple as going to a bank and demonstrating one’s creditworthiness, but creditworthiness depends on credit scores which are reliant on racially skewed data like home ownership — an area we know BIPOC folks have been historically shut out from, and completely disregard the unbanked, which includes includes about 17 million adults, of which 21.7% are Black, 19.3% are Latino and 15.5% are Native American.

Venture capital isn’t a solution either, and frankly not applicable to many businesses — particularly those whose models won’t scale. Think about the local family-owned restaurant down your street, which will be passed down to children and grandchildren, without ever intending to be scaled or sold. What’s more, only 1% of all venture-backed startup founders are black. According to a 2019 report by RateMyInvestor and the Diversity VC, startups funded by the top Venture Capital Firms were nearly 90% male and 72% of founders were white. As soon as we peel back the layers of the financial onion, it’s easy to see that the system leaves a vast swathe of our community, especially those from traditionally underserved groups, in the financial dark.

Enter one of our potential solutions: Character-Based Lending (CBL). CBL is far from a new idea. In fact, it’s as old as lending itself — and it exists, but with a heavy reliance on those racist credit scores. But in the days before credit scores even existed, loans were given out based on the relationship that an individual had with the lender, and the strength of that relationship acted as an indication of a person’s ability to repay back that loan — provided that you were a white male of course. Modern CBL is basically the same concept: a model that considers the applicant’s character as a safeguard for the likelihood that they will repay the loan. And here’s the thing, “data has shown that better relationships between lenders and borrowers equal better credit performance.” Community lenders and nonprofits have explored and done CBL before, but with the lending industry the way it is today, more inculcation and adoption are clearly needed. So we decided to experiment and partner with expert network leaders and organizations to build on past CBL work and push the envelope more on ceding power to community experts.

After a month or two of desk research and conversations with other progressive lenders, we felt we had a solid understanding of what type of character-based loan capital was available to organizations in the Common Future network. Given the promising results from other lenders, we thought we could push harder to lower borrowing costs and incorporate community voice and power into both the term setting and the referral process.

We reached out to a few ESOs in our network with strong community roots and an ambition to provide financial capital to their businesses: MORTAR, Native Women Lead, ConnectUP! Institute. Each of these organizations was well situated in their communities to know what their local BIPOC businesses needed, thanks to the years of close relationships and care they’ve cultivated with them. With the support of Common Future and Community Credit Lab, these leaders drove the process of how terms would be set for loans and who would eventually be referred (loans will not require collateral or credit checks; will be, on average, $30,000; range from 0–3% interest; and be repaid within 3–6 years).

We didn’t have a predetermined set of terms for loans or fundraising total that we felt we needed to hit. We knew we would put in the first capital and then help raise the rest, but we landed at $800,000 for the pilot because we asked the partners “How much do you want/can deploy through this program?” We asked, they told us, and we acted.

We were also hyper-intentional about the capital we raised: Simply put, intermediaries (like Common Future, in CBL’s case) typically have to charge a higher interest rate to borrowers if investors into the intermediary require a higher rate of return, which can lead to extractive rates offered to the people we’re supposed to be supporting. We wanted BIPOC entrepreneurs to capture the upside, or at least not be subject to the downside—higher than helpful interest rates—not the relatively more privileged investors. To do this, we intentionally set out to raise cheaper money, so that we could lend to borrowers at the lowest possible rates.

Will it work? We don’t know yet. We’ve set out a rubric defining success that we’ll share down the road, but it was incredibly important for us to reimagine what we would define as success. Many of the recipients of these loans would have been completely excluded from the traditional lending system, so even in the worst case (100% default rate), we will have at the very least provided capital to those who likely would never have had access to it. We’re far more interested in saying that we provided affordable, impactful loans to Black, Brown, and Indigenous-owned small businesses, and asked what it could look like in banking could start to truly serve them. We’re incredibly excited to see how this experiment will pan out, and what recipients will be able to achieve.

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