Small community development banks, whose primary purpose is to promote and support development in economically disadvantaged neighborhoods, can feel proud of the economic revitalization they have helped spur in areas traditionally neglected by mainstream lenders.

However, in light of changes in the community development finance business, we believe these specialized entities must address certain strategic issues if they are to continue their good work.

The community development landscape has shifted over the past few years as a result of regulatory and legislative changes, as well as increased competition for loans and funding.

Federal funding for community development has been decreasing steadily over the past several years, and there is considerable ambiguity about the future of some key programs. For instance, the CDFI Fund could face a cut of as much as $14.5 million this year, and the New Markets Tax Credit program, which has benefited community development financial institutions and increased private investment in low-income communities, is scheduled to expire this year. Efforts to extend the program are under way, but its future is uncertain.

Large banks, whose CRA-related investments in community development banks have been a significant source of funding, are seeking higher financial and social returns on their investments. Also, private foundations increasingly are requesting specific measures of the social benefit their grants generate. Some large banks are requiring "branding" agreements that can restrict community development banks from seeking funds from other financial institutions in their market.

A number of new players in community development lending have increased competition for loans as well as funding. Many traditional community banks and thrifts now compete for credits that heretofore were the sole province of community development banks. Additionally, political considerations may further expand the community development lending of the government-sponsored enterprises, as they seek to burnish their images in the wake of accounting and governance scandals.

Several large banks have initiated or are developing programs aimed at the unbanked and underbanked. These programs tend to focus on retail banking services, but many of the immigrants who make up a large percentage of the target market are the same individuals whom community development lenders target for small-business loans.

In light of these developments, which have increased competition for community development loans, put pressure on margins, and expanded the pool of institutions vying for scarce funding, organizations need more consistent financial management, bigger scale, and disciplined business practices to remain viable.

Here's what community development banks need to succeed in this challenging environment.

An area of focus. A "generalist" approach will become more difficult to maintain as loan competition increases. Banks must develop an area of focus - a geographic region, a segment of the population, or a loan type - to compete effectively and deliver more substantial value to the customer.

Part and parcel of this strategy is a well-conceived business plan specifying how the bank will serve its target niche. This plan is critical not only for guiding the bank and managing its resources, but also for attracting investments. Plans must be bolstered with financial metrics to measure progress against goals.

Proactive balance sheet management. Community development entities must optimize their balance sheets to maximize revenue and community impact while minimizing cost and risk.

To spur development while generating interest revenue, banks may increase the percentage of earning assets in loans through activities such as loan participations. To improve capital and risk management, banks may take loans off the balance sheet through securitizations or other capital markets activities.

Nontraditional intermediation. Programs such as the New Markets Tax Credit face an uncertain future. Community development banks must identify nontraditional programs and revenue opportunities that would appeal to funders and could have a significant impact on community development.

Robust reporting for risk management, sales management, and control. Potential funders need to feel confident they are making a safe investment that will generate the expected level of return. Community development banks need sound, efficient, and well-documented processes for underwriting and credit administration.

Faced with a number of challenges, such as decreased funding availability and increased competition, small community development banks must be proactive about managing their business.

These challenges notwithstanding, we are confident banks that develop these operating capabilities will be well positioned to meet the economic and community development needs that remain.

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