Racial Inequality Is a Business Risk

Unfortunately, the pandemic has been reversing this trend and exacerbating others. Black-owned small businesses are closing at nearly twice the rate of small businesses overall. New York Fed researchers Claire Kramer Mills and Jessica Battisto have linked this disparate impact to geographic location and lower rates of coverage from the Paycheck Protection Program, as well as weaker cash positions, weaker bank relationships, and preexisting funding gaps that left little cushion coming into the crisis. According to the US Bureau of Labor Statistics, the Black-white unemployment gap has expanded significantly during the pandemic. As of December 2019, the Black unemployment rate was 3.2 percentage points higher than the white unemployment rate. By December 2020, that gap had expanded to 4 percentage points. This reflects long-standing empirical trends showing that Black individuals are often last to be hired during periods of economic growth and first to be fired during recessions, suggests research by University of Connecticut’s Kenneth A. Couch and University of California at Santa Cruz’s Robert Fairlie.

Economic inequality: A key business risk—and opportunity

Bolstered by the events of 2020, there is increasing momentum in the investor community to emphasize the management of diversity-related risks and opportunities as a business imperative. Investors, as well as corporate leaders, need to understand that the risks presented by the racial wealth gap affect companies in both systemic and acute ways.

A 2020 study by Citigroup researchers suggests that the US economy lost $16 trillion over the past 20 years because of discriminatory policies surrounding Black wages, education, housing, and investment. Addressing these issues, the researchers note, could yield an additional $5 trillion in GDP over the next five years. World Bank lead economist Daniel Lederman and Australian National University’s Markus Brueckner have also linked higher income inequality to reduced GDP. Research also demonstrates that rising inequality has damaging effects on social and political cohesion, causing social unrest and retrenchment from globalization, according to the economist Dambisa Moyo.

As investors monitor macroeconomic trends across their portfolios, these signals should give them pause. There is strong reason for concern about forgone growth and the destabilizing effects of racial injustice and economic inequity.

In addition to these macroeconomic and societal risks, not addressing economic inequality and not embedding diversity in a company's culture can pose acute risks at the company level. Companies and investors should not view these issues purely as threats, though. Proactively and thoughtfully addressing these issues can lead to sustainable advantages for companies in five ways:

• Improving financial performance: The Sustainable Accounting Standards Board identifies 10 industries where issues of employee engagement, diversity, and inclusion are likely to have a material impact on a company's financial condition or operating performance. This view of materiality may be too narrow. On the basis of our analysis of portfolio companies and engagement with corporate boards, we believe that these issues have a material impact across all industries.
• Strengthening governance: Diverse perspectives are a key element of strong governance and oversight. Companies with more women on their boards are less likely to be subject to costly public governance controversies such as bribery, fraud, or shareholder battles, according to a 2015 MSCI study.
• Attracting talent: Diverse and inclusive cultures can help companies attract and retain top talent. Deloitte's Millennial Survey 2018 of millennials and Gen Z individuals finds that they have greater rates of employer loyalty to diverse companies.
• Engendering confidence and trust: Opting out of the diversity discussion, or participating in a superficial way, also presents a risk to a company's social license to operate. Customers and other stakeholders take note when a company makes a public commitment to diversity but fails to follow through in its day-to-day operations. (For more, read “In Corporate Responses to Black Lives Matter, Commitment Speaks Volumes” from August 2020.) Investors increasingly are attuned to this as well.
• Building resilient business models: Just as companies are taking steps to prepare for the transition to a low-carbon economy, they should be incorporating diversity into their strategic planning, since it has the potential to affect long-term financial performance.
• Enhancing innovation and problem-solving: Homogeneity and groupthink undermine creativity and critical thinking. Bringing varied perspectives to the table enhances a group's ability to make difficult decisions. University of Michigan's Scott E. Page found in 2008 that diverse backgrounds and perspectives help teams to identify better solutions to complex problems.

How companies can address the risk—and be part of the solution

Companies across industries are making commitments to address racial equity and justice. Often, these commitments involve making financial contributions to organizations committed to serving communities of color, as well as backing employees' efforts to support these types of organizations.

While we applaud these efforts, addressing these systemic issues requires embedding change within the systems that define companies' strategies, operations, and cultures. But with so many initiatives put into action this year, how should companies refine their efforts to deepen diversity strategies, and mitigate the acute and systemic risks presented by the racial wealth gap?

To guide these efforts, we propose using a simple framework developed by the Black Corporate Directors Conference: people, purchasing, and philanthropy.

People

Organizations should tie executive pay to diversity metrics, set clear hiring goals, measure workforce diversity data at all levels and set targets, break out diversity metrics by racial and ethnic groups, require that more than one diverse candidate be interviewed for open senior positions and/or board seats, and measure employee participation in 401(k) plans and address racial disparities.

Measuring and reporting on employee and leadership diversity needs to become more nuanced and granular—and corporate leaders must be held accountable for progress toward these goals. 

Many companies report information about employee diversity by grouping all women and ethnic/racial minority employees into one multicultural minority group. This reporting often puts all levels of employees—from entry-level workers to senior executives—into one pool. As a result, these data paint a two-dimensional picture of the company’s commitment to diversity, making it difficult for investors to make informed assessments.

By disaggregating the data, companies can identify gaps and create targeted recruitment and retention strategies while also providing more useful information for investors. A disaggregated approach reveals when diverse representation is concentrated in lower-wage, entry-level, or administrative roles versus mid-level or management-track positions. This type of reporting is increasingly common at the board level, but we recommend that companies extend it to the C-suite, senior management, and all other levels of the organization.

Creating a pipeline of diverse talent is essential to improving minority representation at the highest levels of corporations. Indra Nooyi, who served as PepsiCo’s CFO before becoming the company’s CEO, and Ken Frazier, who served as Merck & Co.’s general counsel before eventually becoming CEO, are just two examples of minority executives who gradually rose to lead big companies.

But what practical steps can companies take to build a strong pipeline? Setting granular and measurable targets—such as specific, public goals and time frames for female, Black, and Latinx representation at senior executive levels—is a great starting point.

Since 2003, the National Football League has required the inclusion and interview of at least one minority candidate for any head-coaching opening. The so-called Rooney Rule has since expanded to include general manager positions. While the Rooney Rule presents a partial solution to the challenge, companies should expand it to include more than one minority candidate. Research demonstrates that including only one minority in a slate of candidates elicits implicit bias. Having more than one minority in a candidate pool is the best way to guarantee all individuals a fair opportunity.

Purchasing

Organizations should think beyond “supplier diversity” to complete “business diversity” across all their operations, measure the diversity of executives among their vendors and professional-services partners and require them to make measurable progress, and recognize that minority-owned businesses need access to customers in addition to access to capital.

Partnering with minority businesses across services is a powerful way for companies to access different sources of expertise while bolstering businesses that can fuel growth in minority communities.

While most Fortune 500 companies set supplier diversity goals, very few of these extend to professional services, financial services, and technology. In fact, many supplier diversity program “success stories” focus on lower-margin areas such as construction, catering, or janitorial services. When vendor diversity efforts exclude the high-margin, high-growth parts of the economy, this reinforces implicit bias that minority-owned professional companies cannot provide certain services at a high level.

Building vendor or business diversity programs, particularly in professional services industries, is a powerful opportunity for companies to embed diversity more deeply into their business practices. As one chief diversity officer recently told us: “We have to stop thinking about diversity and inclusion as an HR silo. . . . Embedding equity, access, and opportunity into all aspects of our business, including purchasing, is a no-brainer.”

Company purchasing programs can also encourage diversity when partnering with nonminority-owned professional-services firms by pushing for diverse partners and teams. For example, Intel implemented a rule in 2021 stating it will only hire US law firms with above-average diversity, meaning their US equity partnerships are composed of at least 21 percent women and 10 percent underrepresented minorities. These policies put pressure on law firms, consulting firms, money managers, and others to recruit, retain, and promote diverse talent to the leadership ranks of a company.

Philanthropy

Organizations should measure corporate philanthropy to ensure it benefits civil-rights groups and others serving communities of color, commit to using corporate philanthropy to build long-standing, multiyear relationships, and encourage executives to push for diversity on the civic and nonprofit boards on which they serve.

Donations to civil-rights organizations and other groups that target minority communities ultimately serve to uplift the corporation’s employee and customer bases.

In the wake of George Floyd’s murder, many companies made significant contributions to civil-rights groups and organizations committed to fighting racism. These contributions bolster companies’ relationships with their communities and provide much-needed support for these groups’ missions.

Such donations are just a first step in addressing the risks associated with inequality and the racial wealth gap. When a company makes a philanthropic contribution, we suggest a multiyear commitment. This ensures that those organizations in receipt of critical funds can build long-term budgets and focus on implementing sustainable actions for addressing some of society’s most intractable challenges.

Turning influence into impact

The pandemic has brought into focus the long-standing and critically important disparities between Black and white communities in the US. The wealth gap has grown, and health outcomes have worsened. All members of society should examine whether they contribute to the problem or are part of the solution.

These issues are unquestionably complex, and the solutions are not always easy to conceive or execute. But that does not lessen the responsibility and urgency for action. Corporations can use their positions as employers, customers, and philanthropists to address the material risk that the racial wealth gap poses to the US economy. It is time for investors and corporations to turn their influence into impact.

John T. Oxtoby and Leah Yablonka teach a seminar on ESG and impact investing at the University of Chicago Harris School of Public Policy. They are ESG investment professionals at Ariel Investments.