There is considerable development finance activity at the state and local level; however, financing of minority business via these activities remains marginal in amount and method.

Despite the spotty record, there is indicated interest to do better and there are promising models and important lessons applicable to federal, as well as state and local minority business finance efforts.

Among the lessons and opportunities are the following:

The Limits of Debt: Asset-based financing, though most available and easiest to collateralize is not likely to be most helpful to minority firms. We must not make the mistake of a generation ago where minority entrepreneurs incurred enormous debt burdens when what they needed was equity. This resulted in the loss of a generation of black entrepreneurs. There is not substitute for equity.

The Limits of Retailing Finance: We cannot afford to launch_programs, at least at the state level, that can only finance a few firms if our aim is to meet the growth opportunities afforded by thousands of firms. Political structures do not lend themselves to objective economic decision making. Therefore, private management serving public objectives is preferred. Retail lending by public authorities is expensive, slow, small and inherently weak.

Life Cycle Finance: For maximum impact and minimal substitution of public for private capital, focus should be on the critical inflection points of the business life-cycle, notably pre-seed, seed, risk, working, expansion and restructuring capital. Early, equity capital is especially important.

The Promise of Wholesaling: State finance institutions have been able to achieve greater scale by focusing on changing private sector financing patterns or by creating whole new classes of financial institutions. In this way, public authorities can leverage private management expertise for public purposes.

The Rise of Microenterprise Finance: Microenterprise programs seem to offer a better way of melding social and economic objectives than concessionary lending programs. Their record so far in the U.S., though short, suggests they reach minority firms and more disadvantaged individuals in a way that seems to generate moderate and sustainable losses.

Expand the Staff Capacity to Increase Investment: Virtually every institution we interviewed suggested that they could develop and finance more and better deals with more skilled staff. The harder to find the deals, the less the tradition of entrepreneurship in the community, the greater the staff intensity required-and the greater the pay-off.

Convertible Loans: Future returns are often discounted, and MBE finance programs are often regarded as losing charities. The notion of convertible loans piloted in Michigan offer to relate public investment to public returns, an increase in accountability that we think can increase willingness to invest. It should be tested further.

Federal, state, and local interest in developing effective minority business investment vehicles is high. A major obstacle has always been a lack of knowledge of how to be more effective; however, much has been learned recently to increase the knowledge base. The time is ripe for a new generation of federal, state, and local

initiatives for minority business financing. Given both the tightness and the variability in state fiscal condition, even a small, federal investment designed in accordance with lessons learned, is likely to leverage significant state activity.

1.1.3 Recommendations

During recent years, there has been no voice of leadership calling for minority enterprise development in this country, or demanding capital for this purpose. This has been true despite the fact that minorities are becoming an increasing portion of our population and that by the year 2000 will represent well over 40 percent of new entries into the country's work force. This failure of leadership has continued even while America's place in the global economy has been threatened by new development abroad.

It is clear that any successful effort to increase access to capital for minority business development must attract private sources of funds. Government can and should serve as a catalyst and underwriter for such attempts, but the private sector, where the money and the expertise lies, must play the major role.

As will be indicated later in this report, the rise of state and local government in development finance has been called "the quiet revolution." Over the past fifteen years, an increasing number of states have become involved in helping provide seed, venture, product development, as well as long-term debt and medium risk funds. However, the problem has been that with a few exceptions-Maryland, Michigan, Florida, California for example-most of these efforts, have not significantly affected minority enterprise development. Similarly, many of these state and local funding efforts have had only minimal connection with federal or national minority funding operations.

There are many successful minority enterprise_development efforts, that could be reinforced and strengthened greatly with a small amount of government participation. Most of these efforts are small and underfunded. The government can provide incentives that would produce significant private investment and lead to more jobs, increased minority business ownership, and more taxes, rather than welfare for both the Federal Government and its states and cities.

Finally, through the creation of a far more viable minority business community, new role models for minority youth would come into being and help offset crime and drugs in the inner-city commu

nities.

Therefore, the OFC Project Team recommends that the President and the Secretary of Commerce, under the management of MBDA, take the following steps.

1. Establish a National Minority Enterprise Finance Corporation (NMEFC).

The NMEFC, a non-profit private/public partnership, will carry out the following functions:

A. Raise private capital and establish windows to provide loans and secondary market operations to enhance minority business development.

Capital assistance would be provided to financial intermediaries and programs serving minority business including:

Minority Business and Industry Development Corporation (MBIDCOs) and minority-owned banks and savings and loans

• Bank Loan Purchase Program

• Direct Purchase of Larger Loans made by MESBICS and MBIDCOS

B. Establish and manage a Performance-Based Loan Program, in which federal and other loans would be converted to grants based on performance.

Investments would be made in MBIDCOs, minority banks and thrifts, a minority-owned surety bonding company, multi-bankssponsored CDCs, and other programs at the state and local levels. This would involve a capacity for the Government and others to loan money to licensed and regulated minority-owned and managed financial institutions. The loan could be converted to a grant, based on performance in achieving non-financial goals-i.e., loans that create jobs, minority business ownership, investment in targeted communities or enterprise zones, etc. All participating financial institutions would be minority owned and managed, and all institutions would have some private equity underlying the Government grant.

The Corporation would have a board, primarily comprised of members of the private sector, appointed by the Government. The quasi-private Corporation would receive loss-reserve funds from the Government and would have the capacity to provide guarantees for leveraged, borrowed funds.

2. Recommend and implement tax and other incentives for informal individual investment.

Seed capital comes overwhelmingly from an informal system of investmentof personal savings, and savings of friends, families and associates This system, which works so well on the whole, works very poorly in most disadvantaged, minority communities. To extend the supply of seed capital to minority entrepreneurs, we recommend:

As part of capital gains reform, allow investors in qualifying businesses in distressed communities (defined geographically or ethnically) to write off investments up to $50,000 per investor as though it were an immediate loss. This narrowing of capital gains tax reduction is likely to be less expensive, more productive and more equitable than the broader reduction. It is already contained in the Administration proposal for enterprise zones. We believe it can energize minority and non-minority investment in minority businesses.12

The Federal Government should exempt from taxation contributions of up to $2,000 per year to an Individual Development Account (IDA), and use a sliding scale to match such contributions for the benefit of the poor. The accounts could be used for college education, training, business capitalization, or purchase of a first home. We have had long standing and demonstrably successful policies such as the home mortgage deduction pension exclusions, preferential capital gains designed to promote asset acquisition among middle and upper income Americans. However, because

they rely on tax liability, these programs have been of no help to the one-third of Americans who have no investable assets. It is precisely the lack of such investable assets that limits the ability of most minority groups in America to generate seed capital. The establishment of IDAS, funded by reallocating a portion of the $100.0 billion we spend annually on asset policy, could help remove this impediment without requiring net increases in expenditures.13

Several states have begun to invest in capitalizing community microenterprise seed capital funds. For example, Texas appropriated $5.0 million for this purpose in 1990. The availability of Federal matching grants could accelerate this development and leverage matching investments from state and local governments and the private sector. To obviate the need for budget increases, a small percentage-perhaps 1 percent of funds currently allocated for business investment, could simply be earmarked for this purpose. 3. Utilize Community Reinvestment Act (CRA) and Other Incentives for Bank Financing and Investment Programs

A. Multi-Bank Sponsored Community Development Corporations (CDCs).

Under the new CRA guidelines, business loans as well as realestate loans are included as means through which national banks can meet their commitments to more fully serve the credit needs of disadvantaged neighborhoods. Increasingly, banks are looking toward the organization of multi-bank sponsored CDCs to accomplish this. The OFC Project Team has recommended pilot matching grants to five to six cities to help them organize such CDCs. We recommend that this technique be promoted wherever possible by MBDA, the Office of the Comptroller (OCC), and other government agencies responsible for bank adherence to CRA and the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA).

B. Recapitalization of Minority Financial Institutions.

Under FIRREA regulations governing capital requirements for banks and savings and loans, minority banks and thrifts already short on capital, are being squeezed out by higher capital requirements. The OFC Project Team r commends that OCC permit majority banks, as part of their CRA commitments, to invest in minority banks and thrifts, as banks are now permitted to do with banksponsored CDCs.

C. Capital Access Program.

One of the programs implemented in Michigan is not specifically a minority enterprise program, but is available for all small businesses, which have included some minority businesses. The program is effective, efficient, non-bureaucratic, and so well received by the Michigan banks that we recommend it as a way to provide banks with the capacity to make more aggressive loans to small minority businesses.

The Capital Access Program (CAP) allows banks and other financial institutions that are making a number of loans to small and medium-sized businesses to consider making loans that would be slightly more aggressive than usual. The Government would contribute partially to a reserve fund to cover losses under the portfolio of loans that they develop under the program.

The program is different from the Small Business Administration Loan Guarantee Program in that there is no loan-by-loan guarantee. Instead, the bank registers each loan made under this program with a Government agency, for example SBA, that has enrolled the bank in the program. An account is opened in the bank's name. At the time the loan is registered, the bank indicates the amount of reserve it has contributed to the loss reserve fund. That reserve usually is provided one-half by the business receiving the loan in the form of points or fees and one-half by the bank itself. That combined reserve, which can range from 3 percent of the loan to 7 percent of the loan, will then automatically be matched by the Government agency when the program is registered, generating a total loss reserve Contribution of 6 percent to 14 percent. In the Michigan case, and as was anticipated, the average cost to the Government to contribute to the reserve fund is slightly over 5 percent against loans made to a portfolio of small businesses.

While the reserve contribution is on a loan-by-loan basis, collections in the case of a failure allow the bank to call on the full amount of the reserve that the bank has generated from all its loans in the program. Therefore, the program is especially attractive to medium-to-larger banks that will make a number of financings under the program, and will be able to develop effectively their own insured loss-reserve fund. For example, if the average contribution by the bank and the business is 5 percent and the Government's contribution is 5 percent, the average reserve contribution by the business, the bank and the Government would be 10 percent of the portfolio of loans made. The bank then would be able to collect up to 100 percent of any losses under the program, if they were able to keep the aggregate losses under 10 percent If the losses go over 10 percent, the bark will be responsible for that additional loss. If the losses continue to remain very low, which in a sense would reflect that the bank is still being too conservative in its small business lending practices, the reserve fund belongs to the Government, not to the bank. So the bank's only way of taking advantage of the buildup in that reserve is to aggressively pursue small business lending.

The beauty of the program is the built-in incentive for the banks to keep loss rates a little higher than normal, but not to let them get out of hand. The program in Michigan operates with virtually no Government involvement. In fact, the loans are registered with the Michigan Strategic Fund within ten days after they are made. The program was specifically designed that way for two reasons: • to provide the bank with sufficient flexibility in timing, structure, and design of the loan.

⚫ to make it clear that they alone are responsible for the credit decision, (the state would not attempt to oversee loan and investment decisions).

The program operates on the basis that each participating bank signs a contract with the administering agency. That contract lays out the rules of the program. For example, there are prohibitions on self-dealing. Other than that, there is considerable flexibility on terms and conditions, and timing, including personal signature re