Academic journal article
By Huck, Paul; Rhine, Sherrie L. W.; Bond, Philip; Townsend, Robert
Economic Perspectives , Vol. 23, No. 2
Introduction and summary
Chicago is enlivened by the presence of many ethnic neighborhoods, which are reflected in the city's small business sector. This makes Chicago an excellent location for studying small business finance in ethnic communities. The topic is important because the availability of capital may depend, in part, on ethnic differences in factors such as the use of informal financing (loans or gifts from family, friends, or business associates) as opposed to formal financing from banks and other financial institutions. We still have much to learn about business access to capital in an ethnic context. To shed some light on these matters, the Federal Reserve Bank of Chicago and researchers from the University of Chicago conducted surveys in two Chicago neighborhoods, Little Village, a predominantly Hispanic community, and Chatham, a predominantly Black community. These communities were chosen because they are distinct and well-recognized ethnic neighborhoods with viable small business sectors. Although most of the business owners interviewed are either Black or Hispanic, other ethnic groups are represented. One of the important features of the surveys is that they shed light on informal and formal sources of financing for both households and businesses.
Small business access to capital is an important policy issue because business owners may face funding limits, known to economists as liquidity constraints. Although many observers might take funding limits as self evident, studies have shown that liquidity constraints affect entrepreneurs both upon start-up and after the business is underway.(1) These constraints deter entry into self-employment and force would-be owners to save for longer periods before launching a business. The effects of start-up constraints extend to ongoing businesses, because starting with more capital increases an owner's prospects of developing a viable, growing business.(2) Thus, entrepreneurs' ultimate success depends, in part, on how successful they are in obtaining adequate capital and credit.
Loan guarantees and other programs offered by the U.S. Small Business Administration are examples of government policies aimed at increasing access to credit for small businesses. Considering access to capital and credit across neighborhoods and across ethnic and racial groups raises other policy issues. Owning a successful business builds personal wealth, and self-employment historically has been an important means for raising the economic status of some ethnic groups. Promoting the success of small business is an important part of community economic development strategies, particularly for minority neighborhoods that have suffered from a lack of investment in the past. The purpose of the Community Reinvestment Act is to encourage depository institutions to help meet the credit needs of the communities in which they operate, consistent with sound banking practices. While racial discrimination in residential mortgage markets has been the subject of a number of empirical studies, the effect of racial discrimination on access to capital for minority business owners and neighborhoods has received little attention to date from researchers.(3)
In practice, owners meet the challenge of obtaining capital to start and run their businesses by using informal sources, as well as personal assets and loans from formal sources. Thus, informal financing via networks can substitute for borrowing in the formal sector, either because formal credit is not offered or because informal financing is preferred. Credit offered by a supplier, or trade credit, is another alternative to borrowing from financial institutions Businesses form networks with their suppliers, and there may be an ethnic dimension to these networks, in that the ethnicity of the supplier may matter for some transactions.
The main contribution of this article is to provide information about the use of formal and informal sources of financing. …