Private Banks Hold Lien on a Better Life

Now that the Los Angeles Community Development Bank has gone belly up, we can say, we told you so. “The most obvious problem,� we wrote in a 1994 article, “is that it is unlikely that officials of community development banks will have incentives or be able to identify the most productive investments.�

We argued that private entrepreneurs are better at picking productive, job-creating opportunities than are public officials or their representatives. We also suggested that the lack of diversification in lending would cause the downfall of community development banks in a recession.

The community development bank -- funded primarily by government -- is just one of a list of misguided public programs ostensibly aimed at improving conditions in low-income communities. Others include the Community Reinvestment Act and enterprise and empowerment zones.

Government programs such as these, which take tax dollars and attempt to direct urban investment and growth, waste valuable resources.

The private sector already has a means by which to identify productive opportunities and to promote them. It is called the banking industry. Banks specialize in identifying those individuals and projects most likely to succeed. The accompanying job creation isn’t the goal of the bankers, but it improves opportunities for millions of workers. Acting in their own self-interest, bankers identify the best use of investment funds. Only those banks prosper that are able to harness the talents of individuals to make the difficult investment decisions that turn out to be so valuable to society as a whole.

Making loans is a risky business. Banks sometimes make bad loans, but if they do, bank capital owned by private individuals will be lost. Community development banks loan taxpayer money. They are more subject to political influence and are more likely to make questionable loans. Studies across countries show that the greater government involvement in lending, either directing loans or through government ownership of banks, the worse the performance of the overall economy. Government intervention means that loans do not get channeled to the most important projects.

Diversification is a sound principle of banking. In order for banks to operate in good times and in bad, they need to lend to a variety of industries and locations. When one location is doing well, another may be floundering.

Community development banks defy this principle. They concentrate their loans in small, high-risk businesses that private banks, with their knowledge about risk, have rejected. While well-intended, that is not how to create jobs -- that is how to flush money down the drain.

Government programs directed at cities should not try to guide investment and employment, but facilitate private market efforts toward this end. For example, instead of trying to lure businesses to crime-ridden, poor neighborhoods with low-interest loans and short-term wage and tax subsidies, reducing crime and improving schools would make firms eager to move there on their own.

More important, if all the money that is spent on economic development were used to reduce crime, pave streets and improve schools, it would have a much bigger impact on the lives of low-income families.

Los Angeles city and county governments have been covering the administrative and operating expenses of the Community Development Bank. Instead, why not install streetlights in poor neighborhoods to have a lasting effect on community safety and quality of life?

Politicians who think that the problem was just this community development bank -- and if they had just done something differently, it would have worked -- need to rethink the concept of government involvement in banking. Any government effort to direct such funds is likely to fail. Government should not take on things that private companies do better.

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Robert Krol is a professor of economics and Shirley Svorny is chairwoman of the Department of Economics at Cal State Northridge.