The Inner City Boom Goes Bust

If investment banks and venture capitalists were to invest in America’s inner city businesses, how would they be rewarded: with an unstable money pit or a treasure trove of untapped profit?

In a 2010 paper, Wayne State University economics professor Timothy Bates contends that while our inner cities are not the next frontier of high finance, if lenders pay careful attention to scale, diversification, and creditworthiness, they can both turn a profit and provide a much needed boost to struggling urban economies.

Bates analyzes two widely debated papers  from 1995 and  1997, in which Michael Porter of Harvard Business School argued that government and private investment could make low-income urban communities into the hidden gem of the American economy. Bates examines three of Porter’s key arguments: inner city consumers are currently underserved by businesses, the clustering of businesses in inner cities lowers costs, and the inner-city workforce is motivated and well-suited for new jobs.

Bates finds little evidence of the financial windfall that Porter projects. Bates argues that inner city neighborhoods have the same number of businesses per $1 million of purchasing power as other areas, most inner city companies employ commuters rather than minority residents, and any “agglomeration advantage” of clustered businesses is outweighed by the disadvantages of being based in the inner city.

However, Bates does corroborate Porter’s central point: there is a crippling dearth of capital available to inner city, minority-owned businesses. Even when controlling for credit and other risk factors, Bates finds that businesses in minority neighborhoods are less likely to receive loans, are approved for lower amounts, and many are forced to use commercial credit cards to finance their businesses.

Government strategies to address this problem are usually too small or tend to back unsuccessful businesses. Private venture capital strategies, including one created by Porter himself, have achieved 30% returns by investing in companies that predominantly employ minorities, yet they only achieve significant returns on investments outside the inner city. Bates also finds that many inner city microfinance organizations and community banks fail because they do not reach the scale of $20 million or so in assets necessary to overcome operating costs.

Bates highlights two lenders, Medallion in New York City and Shorebank in Chicago, that achieved the necessary scale, and profited from inner city finance, even if temporarily. (Shorebank failed after Bates completed his paper and has since been reorganized as Urban Partnership Bank.)

Both lenders have built a diverse portfolio of roughly 200 yearly business investments and employ an experienced staff capable of determining the creditworthiness of borrowing companies. Additionally, both companies have high standards for collateral or insurance on their investments, so that even if the business fails the loans are repaid.

While Bates finds that the inner city is not the boomtown Porter predicted, his research shows that there is a financially viable niche that needs to be filled by private action and government support.