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Supporting Small Businesses Through Financial Innovation

Across the United States, small businesses are vital contributors to job creation, innovation, and the economic strength of local communities. However, many entrepreneurs—especially those from low-income backgrounds and communities of color—continue to face significant hurdles in accessing affordable funding. A less obvious but equally important problem is that many community lenders, who play a critical role in supporting these small businesses, often struggle with obtaining stable and inexpensive capital. This constraint limits their capacity to meet the growing demand from small enterprises that are eager to expand and thrive.

The Capital Bottleneck Facing Community Lenders

Minority Depository Institutions (MDIs) and Community Development Financial Institutions (CDFIs) are often at the forefront of efforts to support small businesses that find themselves excluded from traditional credit markets. These institutions leverage strong community ties, intimate knowledge of local markets, and flexible underwriting practices to reach entrepreneurs who are frequently overlooked by larger financial entities. According to research from the Federal Reserve Bank of New York, CDFIs are characterized as "financial first responders," capable of transforming "missing markets" into investable opportunities by channeling funds to where they are desperately needed.

Despite their invaluable role, many community lenders encounter serious structural constraints regarding their capital. They often have limited access to low-cost deposits, rely on expensive short-term funding, and lack adequate balance-sheet capacity, all of which stymie their ability to scale their lending efforts effectively. A report from the Congressional Research Service highlights that while CDFIs are designed specifically to broaden access to affordable financial services, a lack of capital depth impedes their ability to quickly respond to rising demand for loans or to finance larger, growth-focused investments.

This situation creates a perplexing paradox: small businesses are often credit-ready, community lenders are mission-driven and prepared to help, yet the available capital is neither sufficiently affordable nor scalable to effectively bridge the gap between demand and supply.

Why Capital Structure Matters for Small-Business Access

The economics of lending can be particularly harsh. When community lenders encounter higher funding costs or uncertain capital sources, various financial repercussions arise, including compressed net interest margins, increased liquidity risks, and diminished lending flexibility. Data from the Federal Deposit Insurance Corporation indicates that during funding crises, banks typically shift their focus to liquidity management, prioritizing balance-sheet stability over the origination of new loans.

For small businesses, this translates to fewer loans being issued, lower loan amounts, shorter loan terms, and often higher interest rates. Studies conducted by the Federal Reserve System consistently emphasize that community and local banks are crucial players in small-business lending, particularly in underserved areas. Without a steady and reasonably priced source of capital, even the most mission-oriented institutions are forced to ration credit, which deepens the financial divide.

To make matters worse, the uncertainty surrounding federal funding streams—especially those designed to support CDFIs—highlights the inherent fragility of the current capital ecosystem. An analysis conducted by the Milken Institute shows that reliance on sporadic or politically unstable funding sources crowd out the long-term sustainability necessary for community development finance.

Building a Capitalization Strategy for Community Lenders

Addressing these challenges requires a profound shift in perspective: the capitalization of community lenders must be treated as a form of infrastructure investment essential to the economy, rather than merely a niche policy initiative. Several complementary strategies appear promising:

1. Stable, Low-Cost Deposits as Lending Fuel

Increasing access to stable deposits—particularly from institutional and corporate partners—can greatly enhance the balance sheets of community lenders. Deposits serve as the most flexible and cost-effective source of lending capital, empowering community lenders to expand their loan portfolios without exposing themselves to excessive risk or financial burden.

2. Patient, Mission-Aligned Capital Instruments

Innovative financing solutions, such as blended-finance structures and economic mobility bonds, can offer long-term, affordable capital that aligns well with community lending missions. These financial instruments minimize reliance on short-term funding and enable lenders to facilitate business expansion, readiness for procurement, and investments that create jobs.

3. Capacity Building Beyond Capital: The Role of Ecosystems

Capital alone is insufficient to support community lenders effectively. Research consistently reveals that capital deployment yields the best results when paired with a supportive ecosystem that includes technical assistance, borrower readiness programs, and initiatives focused on enhancing institutional capacity.

This is where the AI legalese decoder can play a transformative role. By simplifying complex legal jargon and clarifying funding agreements, this AI tool can help community lenders better understand their capital options and the implications of various funding sources. Through enhanced comprehension of the legal frameworks surrounding their operations, community lenders can navigate the financing landscape with greater confidence and precision.

The Milken Institute Initiative on Inclusive Entrepreneurship (IIE) works at the intersection of finance, policy, and entrepreneurship to fortify the systems that foster inclusive business growth. Through research, convenings, and collaborations with lenders, policymakers, and ecosystem builders, IIE seeks to:

• Build institutional capacity among community lenders.
• Align capital providers with local lending systems.
• Strengthen technical assistance and borrower preparedness.
• Minimize risk through improved coordination among public, private, and philanthropic stakeholders.

For instance, an IIE implementation partner, Mission Driven Finance (MDF), recently announced a $9 million investment to help fund Cairnspring Mills’ new Blue Mountain mill on the Umatilla Indian Reservation in Oregon. Working alongside eight Native CDFIs and other stakeholders, MDF’s expertise in capital structuring enabled innovation in financing to support Indigenous economic development.

By investing in the supportive infrastructure surrounding community lenders—not just in individual transactions— IIe ensures that the influx of new capital translates into sustainable lending capacity and lasting benefits for small businesses.

A Broader Lesson for Inclusive Economic Growth

As insights from the Milken Institute on disaster recovery and community development illustrate, resilient economic systems rely on diverse capital sources and collaborative efforts across sectors. This is equally true for small-business finance. Widening access to affordable capital necessitates a synchronized approach that combines deposits, long-term investment strategies, and a robust ecosystem capacity rather than depending on a single funding source.

Community lenders are integral to this approach. When adequately capitalized and supported, they become powerful links between capital markets and local entrepreneurs, facilitating investments that lead to job creation, wealth generation, and community stability.

From Capital Constraints to Capital Access

Enhancing small businesses’ access to affordable capital begins by fortifying the financial infrastructure of the institutions that supply it. By integrating innovative capitalization strategies with broader capacity-building efforts—such as those promoted by the Milken Institute’s Initiative on Inclusive Entrepreneurship—we can move well beyond fragmented solutions to cultivate a scalable, resilient model for inclusive economic growth.

In doing so, we empower community lenders to fulfill their essential missions and open new avenues for the small businesses and communities that depend on their support.

To explore innovative methods for bolstering community lenders, consider joining the Milken Institute at the IIE national webinar on Wednesday, February 18, at 12:30 p.m. ET. Register to participate in the discussion on capitalizing community lenders to broaden access for small businesses.

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