Access to credit is critical to the success and job-creating ability of America’s small businesses. But small business credit was hit hard during the recent recession and has been slow to recover. Beginning in early 2009, the federal government acted quickly to unfreeze credit markets with programs ranging from loan guarantees to capital infusions and regulatory changes. A number of these were extremely effective and also efficient in their use of taxpayer dollars, but most were not meant to be permanent.
Currently, as described in the HBS working paper The State of Small Business Lending, gaps persist in certain areas of the small-business market, and regulatory overhang continues to create pressures on small business credit.
Government steps to loosen credit
Three landmark pieces of legislation passed between 2009 and 2012 were aimed at, first, responding to the immediate impact of the financial crisis on small business and, second, driving economic recovery in the years following. Together, the three-the American Recovery and Reinvestment Act of 2009 (Recovery Act), the Small Business Jobs Act of 2010, and the Jumpstart Our Business Startups Act of 2012 (JOBS Act)-leveraged effective federal programs that already existed, while also taking action in some new areas.
With the Recovery Act, the federal government significantly expanded its role as a guarantor of small business capital, particularly through the Small Business Administration (SBA), which runs a $100 billion loan guarantee program that operates as a public-private partnership with about 3,000 banks nationwide. In early 2009, loan volume, including SBA loans, had dropped dramatically as banks were reluctant to act even with SBA’s existing 75% guarantee. The Recovery Act eliminated most SBA lender and borrower fees and temporarily raised the guarantee on its largest loan program to 90%. The response was immediate. From February 2009 to September 2010, weekly SBA loan dollar volumes rose more than 90% compared to the weeks preceding the Recovery Act’s passage.
The second piece of legislation, the Small Business Jobs Act (SBJA), temporarily continued the increased guarantees and fee waivers, and permanently increased SBA loan size limits from $2 million up to $5 million; the maximum microloan grew from $35,000 to $50,000. These steps were coupled with efforts to streamline loan paperwork and reduce turnaround times, particularly in small dollar loans. Together, these actions resulted in three record years in SBA lending. In 2012 alone, 3,786 financial institutions made an SBA-guaranteed loan, up 41% from February 2009.
Guarantees have proven to be a very cost-efficient government tool when it comes to small business credit, even during strong economic times, since they do not require an outlay of cash unless the business defaults. Lenders rely on the full amount of the guarantee as a reduction in their risk. For example, a loan guarantee program of $100 million with a proven default rate of 5% will be “costed” at $5 million, but will deploy $100 million of new capital into the marketplace.
A second important piece of SBJA was the effort to infuse capital into smaller banks and incent them to lend into the small business market. The Small Business Lending Fund (SBLF) invested over $4 billion in 332 institutions, with more than 68% increasing their small business lending by 10% or more.
The federal government also partnered with state governments through the State Small Business Credit Initiative (SSBCI), which was funded with $1.5 billion from SBJA to support state and local programs that provide lending to small businesses and small manufacturers. To date the SSBCI has funded more than 150 programs, including collateral support programs, Capital Access Programs (CAPs), loan participation programs, loan guarantee programs, and state-sponsored venture capital programs.
Additionally, in 2011 the SBA leveraged its partnership with larger banks, resulting in 13 of America’s top lenders committing to increase their small business lending by more than $20 billion over the next three years, a goal that they have exceeded to date.
More help required
The 2012 JOBS Act reduced the regulatory burden for small businesses looking to raise equity in the public markets. It provided an “on-ramp” of up to five years for new IPOs to phase in certain costly Securities and Exchange Commission (SEC) requirements, and expanded the Regulation A “mini-public offering” cap from $5 million to $50 million.
On the debt side, over the past few years programs at the SBA and other loan guarantee agencies, including the US Department of Agriculture, have been streamlined and coordinated. This has greatly increased the participation of smaller banks in federally guaranteed loan programs, and provided borrowers with improved processes and reduced paperwork requirements.
Banks, however, have faced a less transparent scrutiny from a complex group of regulators, which has had a dampening effect on small business lending. During the 2009 financial crisis, banks were required to make a number of changes to their capital structure, including holding more Tier 1 capital and submitting to stress tests. Some regulatory guidance was also issued on what constitutes “bad” loans. Unfortunately, banks often report that regulators and bank examiners are inconsistent, which leads to confusion and an aversion to taking on more risk from bankers.
During the most difficult part of the crisis, the Federal Deposit Insurance Corporation (FDIC) issued guidance to improve the consistency of loan examination among regional examiners. This had a positive impact at the time, but today regulators should continue to look at ways to simplify their lending guidance with an eye to clarity and transparency. This is a low-cost effort that could go a long way to getting smaller banks back to small business lending.
In a paper released in May 2013, economists from the Federal Reserve Bank of Minneapolis quantified the costs of increased regulation on community banks, modeling the impact of new regulatory costs as the hiring of additional staff, resulting in higher total compensation and lower profitability. The analysis found that a bank’s return on assets is reduced from the addition of new regulatory officers, falling about 4 basis points for banks with $500 million to $1 billion in assets, but falling almost 30 basis points for banks with less than $50 million in assets.
Additionally, a 2012 study by Federal Reserve economists found an elevated level of supervisory stringency during the most recent recession, based on an analysis of bank supervisory ratings. This research concluded that an increase in the level of stringency can have a statistically significant impact on total loans and loan capacity for several years—approximately 20 quarters—after the onset of the tighter supervisory standards.
Could Government Do More?
Government clearly played a critical role in responding to the recent credit crisis, stepping in when markets failed and credit froze. However, the ongoing role of the SBA indicates that there is a market failure in the clearing of the small business loan market. This is evidenced by a large portfolio of creditworthy loans, disproportionately from underserved segments, that banks would not have made without credit support.
In the future there is opportunity to use government guarantees and other proven tools at the state and federal levels to get capital into the hands of small businesses and entrepreneurs, where market gaps exist. One example would be to meet the capital scale-up needs of new advanced manufacturing firms for pilot plants and other operations.
The likely key to success is for government to diversify its risk by partnering with a number of experienced private-sector investors and lenders, and allowing them to pick the winners and losers. These new public-private partnerships and the use of well-costed government guarantee programs have the potential to significantly enhance economic growth and job creation at the local, regional, and national levels.
In the next post in our series, Mills will look at the emerging industry of online lenders that are leveraging technology and big data in ways that could significantly change the small business credit markets.
About the author: Karen Mills is a senior fellow at the Harvard Business School and Harvard Kennedy School focused on competitiveness, entrepreneurship, and innovation. She was a member of President Obama’s cabinet, serving as administrator of the US Small Business Administration from 2009 to 2013.