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By Ben R. Craig, William E. Jackson, III, and James B. Thomson


Does Government Intervention
in the Small-Firm Credit Market
Help Economic Performance?




Does Government Intervention in the
Small-Firm Credit Market Help
Economic Performance?
By Ben R. Craig, William E. Jackson III, and James B. Thomson
The guaranteed lending programs of the Small Business Administration (SBA) are large
and growing rapidly. The SBA’s fiscal year 2008 performance budget calls for
$25 billion in guaranteed loans for small businesses—a new record for the agency. Some
critics of SBA programs suggest they do not help small businesses or overall economic
performance. Other critics suggest that these programs unfairly benefit the financial
institutions that participate in SBA’s guaranteed lending programs. While very little serious
empirical evidence exists on whether the net economic impact of the SBA’s guaranteed
lending programs is positive or negative, a few recent studies provide some insight into
the question. In general, they suggest a small positive impact of the SBA’s programs on
economic performance. However, the results are very tentative and further research is
needed to declare a more definitive position. We provide a general overview of the SBA’s
guaranteed lending programs and summarize the results of these studies.

Ben R. Craig is an economic
advsor at the Federal Reserve
Bank of Cleveland. William
E. Jackson III is professor
of finance and management
and the Smith Foundation
Endowed Chair of Business
Integrity in the Culverhouse
College of Commerce at the
University of Alabama. He
is also a visiting research
scholar at the Federal Reserve
Bank of Atlanta. James B.
Thomson is a vice president
and economist at the Federal
Reserve Bank of Cleveland.
The authors thank Gerald
Dwyer, Scott Frame, and
Larry Wall for many valuable

Materials may be reprinted,
provided that the source
is credited. Please send
copies of reprinted
materials to the editor.


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ISSN 1528-4344


Federal loan guarantees provided by the U.S. Small Business Administration (SBA) have
grown markedly in recent years. During fiscal year 2006, the SBA guaranteed a record $18
billion in loans for small businesses—a 43 percent increase over the $12.6 billion guaranteed for fiscal year 2003 (SBA 2007). Even more striking, the SBA expects to guarantee
$25 billion for the fiscal year 2008, representing a two-year growth rate of about 30 percent (SBA 2007).1
SBA loan guarantees are aimed at a segment of small business borrowers that presumably
would not otherwise have access to credit. But the increase in SBA guaranteed lending
has occurred at a time when the benefits of SBA guarantees should be declining.Advances in computer and communications technology have substantially reduced information
costs to the economy, and technological innovation has improved the informational efficiency of credit markets—especially small business credit markets.

1. The $25 billion projected loan
guarantees by the SBA in
2007—while large from the
standpoint of SBA activities—historically represents a
small share of the small
business lending market, less
than 10 percent of estimated
small business loan originations
by banks, thrifts, and other

The recent growth of SBA loan guarantee programs, as well as their overall magnitude, raises questions as to whether there are demonstrable benefits to SBA activities and
whether the benefits of the programs exceed their costs. Furthermore, because these
programs represent society’s decision to subsidize credit to promote small business in
the United States, we should ask whether government loan guarantees are the best way to
do this from a social welfare standpoint.To answer that question, we must know whether
the subsidies are delivering their social benefits at the lowest social cost.
De Rugy (2007) argues that SBA guaranteed lending programs do not help small businesses or improve economic performance in the areas that receive these loans. She claims
that SBA programs merely provide large subsidies for the financial institutions that participate in SBA’s guaranteed lending programs.
It should be possible to empirically test for any signs of differential economic performance across local geographic markets based on the amount of SBA guaranteed loans
flowing into those markets. SBA loan guarantee programs have been in existence for a
substantial period of time, and they vary significantly in the amount of lending they channel into different geographic areas.
There are a few recent studies that do just that. They test for the impact of SBA
guaranteed lending on economic performance, and they generally find a positive one.
However, they also observe that their findings do not provide conclusive evidence that
SBA guaranteed lending increases economic welfare. After all, SBA guaranteed lending
programs provide subsidies either to lenders or borrowers or both, and we know that
subsidies are not free. Someone must explicitly pay for them, and there may also be an
implicit welfare cost.
We review these studies here and discuss their implications for public policy.We begin
by sketching the economics of small business credit markets and the underlying eco1



nomic mechanisms that might allow a directed subsidy such as SBA guaranteed lending
to result in better observed economic performance before turning to the net welfare effect of SBA-administered subsidies.

Small Business Credit Markets
Lenders may fail to allocate loans efficiently because of information problems in the market for small business loans. For example, lenders may not be able to obtain reliable information concerning a potential borrower’s ability to repay a loan. Information problems
may be so severe that they lead to credit rationing and constitute a credit market failure.
In Stiglitz and Weiss’s (1981) classic analysis of credit market equilibrium in the presence
of information frictions, banks consider both the interest rate they will receive on a loan
and its riskiness when deciding to lend. However, in the presence of imperfect information, banks face two information effects that may cause the riskiness of the bank’s loan
portfolio to be affected by the bank’s choice of a lending rate; this in turn, makes it unlikely that a rate will emerge that suits both the available buyers and sellers (that is, no
interest rate will “clear the market”). One information effect, adverse selection, impedes
the ability of markets to allocate credit using just the lending rate because it increases
the proportion of high-risk borrowers in the pool of prospective borrowers. The other
information effect, moral hazard, reduces the ability of rates alone to clear lending markets because once loan is extended the actions of borrowers is not independent of the
lending rate.
Adverse selection is a consequence of an environment in which lenders can only
observe the risk characteristics of a pool of borrowers but not those of any individual
borrower. The inability of lenders to determine the risk characteristics of an individual
borrower would not be a problem if loan applicants were drawn randomly from the
borrower pool. In such a case, banks could post a loan rate that the reflected the risk of
the average potential borrower. The bank could make a large number of small loans to
borrowers in the pool, and the bank’s loan portfolio would have the same risk and return
characteristics as the pool of borrowers. Unfortunately, the willingness of a borrower to
pay any posted lending rate is not independent of his risk. Borrowers who are willing to
pay a higher interest rate are likely to be, on average, worse risks, since they are likely willing to borrow at a higher interest rate because they perceive their probability of repaying
the loan to be lower. So, as the interest rate rises, the average “riskiness” of those who are
willing to borrow increases—the adverse selection effect—and this may actually result in
lowering the bank’s expected profits from lending.
Moral hazard arises because the price a firm pays for credit can affect its investment
decisions. Higher interest rates may induce firms to undertake riskier projects—projects
with lower probabilities of success but higher payoffs when successful. Leveraged borrowers have more incentives to undertake risky projects than unleveraged ones. Simply


raising the lending rate to account for lending-induced changes in firm risk-taking can
be counterproductive, because a higher lending rate decreases the payoffs of successful
projects to the firm.
As a result of adverse selection and moral hazard, a bank’s expected return may increase less than proportionately with an additional increase in the interest rate, and beyond a certain point, may actually decrease as the interest rate increases. Clearly, it is
conceivable that the demand for credit may exceed its supply in equilibrium. Although
traditional analysis would argue that in the presence of an excess demand for credit, unsatisfied borrowers would offer to pay a higher interest rate to the bank, bidding up the
interest rate until demand equals supply, it does not happen if market imperfections lead
to adverse selection and moral hazard.This is because the bank will not lend to someone
who offers to pay the higher interest rate, as this borrower is likely to be a worse risk
than the average current borrower. The expected return on a loan to a borrower at the
higher interest rate may be actually lower than the expected return on loans the bank is
currently making. In such an environment, there are no market forces leading supply to
equal demand, and credit is rationed.

Lending Relationships as a Partial Antidote to Credit Rationing
Lending relationships have been recognized by economists as an important market mechanism for reducing credit rationing.2 Lending is based on limited information on the quality of borrowers in the market, but a close and continued interaction between a firm and
a bank may provide a lender with sufficient information about, and a voice in, the firm’s

2. See, for example, Kane and
Malkiel (1965), Petersen and
Rajan (1994), Berger and
Udell (1995), and Stein (2002).

affairs so as to lower the cost and increase the availability of credit. Conditional on its
positive past experience with the borrower, the bank may expect future loans to be less
risky, which should reduce its average cost of lending and increase its willingness to provide funds.
The relationship-lending literature suggests that in addition to being formed over time,
relationships can be built through interaction over multiple products. That is, borrowers may obtain more than just loans from a bank. Borrowers may purchase a variety of
financial services such as checking and savings accounts. These added dimensions of a
relationship can affect the firm’s borrowing cost in two ways. First, they increase the precision of the lender’s information about the borrower. For example, the lender can learn
about the firm’s sales by monitoring the cash flowing through its checking account or by
factoring in the firm’s accounts receivable. Second, the lender can spread any fixed costs
of monitoring the firm over multiple products.
Overall, the available evidence indicates that the strength and duration of lending relationships are significantly correlated with both the terms (lower loan rates and fewer
loan covenants) and the availability of credit. From the perspective of the banks, the




stronger the relationship, the more likely the borrower is to select the bank for future
credit needs and other banking services.

The Potential Role for SBA Loan Guarantees
Ensuring access to credit has been an important pillar of public support for small business in the United States for more than half a century.3 Concerns that small firms may
face problems in getting access to funding may be valid, as a large share of small firms
are relatively young and have little or no credit history. Lenders may be reluctant to fund
small firms, especially those with new and innovative products, which are likely difficult
to evaluate. If small businesses face severe credit rationing, they may become credit constrained and miss out on projects that have a positive net present value because they cannot raise the external capital necessary to fund them.This possibility suggests that to the
extent credit rationing significantly affects small business credit markets, a rationale exists for supporting small enterprises through government programs aimed at improving
their access to credit.

How Can SBA Loan Guarantees Reduce Credit Rationing?
Loan guarantees are one mechanism that can be used to mitigate credit rationing by providing a mechanism for pricing loans that is independent of borrower behavior. By reducing the expected loss if the borrower defaults on the loan, the guarantee increases
the lender’s expected return—without increasing the lending rate.With the guarantee in
place, lenders could profitably extend credit at loan rates below what would be dictated
by the risk of the average borrower. Hence, loan guarantees lessen the adverse selection
problem, as the lower interest rate increases the share of loan applications from lowerrisk borrowers, increasing the likelihood that the risk characteristics of the bank’s loan
portfolio increasingly approximate that of the borrowing pool. Moreover, the guarantee
increases the profitability of the loan by reducing the losses to the bank in those instances when the borrower defaults.
To the extent that the loan guarantees reduce the rate of interest at which banks are
willing to lend, external loan guarantees will also help mitigate the moral hazard problem. This is because the lower lending rates afforded by external guarantees reduce the
bankruptcy threshold and thereby increase the expected return of safe projects vis-à-vis
riskier ones.
Thus, in theory, SBA loan guarantees should reduce the probability that a viable small
business is credit rationed. And because the program reduces the risk to the lender of
establishing a relationship with informationally opaque small business borrowers, it may
also increase the prospect of relationship-based loans in the future. Finally, the SBA loan
guarantee programs may improve the intermediation process by lowering the risk to the


3. Public support for small enterprise appears to be based on
the widely held perception that
the small business sector is an
incubator of economic growth—a
place where innovation takes
place and new ideas become
economically viable business
enterprises. In addition, policymakers routinely point to small
businesses as important sources
of employment growth. Possibly
as a result, there is widespread
political support for government
programs, tax breaks, and other
subsidies aimed at encouraging
the growth and development
of small business in the United
States, and increasingly, around
the world (Bergström, 2000).


lender of extending longer-term loans, ones that more closely meet the needs of small
businesses for capital investment.
It is interesting to note that small-firm credit markets are becoming better at addressing some of the problems SBA guarantees are intended to address. For example, credit-scoring technology may help alleviate some credit rationing. As discussed in Berger
and Frame (2006), small-business credit scoring is a lending technology used by many
financial institutions over the last decade to evaluate applicants for “micro credits,” those
under $250,000.The credit-scoring technology analyzes consumer data about the owner
of the firm and combines it with relatively limited data about the firm itself using statistical methods to predict future credit performance. As these markets develop and more
financial institutions engage in these lending technologies, the degree to which small
businesses face credit rationing may decline, which suggests that the value of SBA guaranteed lending may decline as well; at least to the extent that small-business credit scoring
reduces frictions in the small-firm credit market.4
One should not jump to the conclusion that the presence of a market imperfection, in
this case a credit market friction, means that government intervention to correct it is desirable.The SBA’s loan guarantee programs, for example, selectively influence credit allo-

4. For more on credit scoring as a
lending technology see: Berger
and Frame (2006); Berger,
Frame, and Miller (2005); Frame
and Woolsey (2001); Frame,
Padhi, and Woolsey (2004).

cation by guaranteeing the loans of a certain class of small enterprises. From Kane (1977)
and Craig and Thomson (2003), we know that selective credit allocation is likely to be
an inefficient and possibly counterproductive policy tool. In the case of financial institutions, the provision of subsidies tied to small-enterprise lending is likely to have costly
unintended effects. The welfare costs of these unintended consequences may include
deadweight losses associated with resource misallocation, wealth redistribution, and the
possible reduced stability of the banking system. In the case of small businesses, the
provision of subsidies tied to borrowing is likely to increase the amount of debt capital
held by small firms and produce any resultant welfare costs associated with this differing
capital structure. The subsidy associated with SBA guaranteed lending may have redistributional effects that are inconsistent with conventional notions of social welfare. For
example, it is likely that most of the wealth transfer will go to established small business
owners or to the shareholders of the lending institutions, neither of which represents the
poorest or most disadvantaged groups in our society.5
Nonetheless, the net value of subsidizing small businesses will be positive if the ben-

5. See Craig and Thomson (2003) for
more on this point.

efits are greater than the costs. One of these benefits may be an increase in local market
employment rates. This employment increase may have significant social benefits, especially in areas with chronic levels of low employment.

SBA Loan Guarantee Programs and Local Economic Performance
The Small Business Administration was born on July 30, 1953. The SBA received most of
its powers from two agencies that were dissolved at its birth. These agencies were the



Reconstruction Finance Corporation (RFC) and the Small Defense Plants Agency (SDPA).
The SBA received the authority to make direct loans and guarantee bank loans to small
businesses from the RFC. It was also assigned the RFC’s role of making loans to victims of
natural disasters. From the SDPA, the SBA received the authority to help small businesses
procure government contracts and to help small business owners by providing managerial, technical, and businesses training assistance.
Recognizing that private financial institutions are typically better than government
agencies at deciding on which small business loans to underwrite, the SBA began moving
away from making direct loans and toward guaranteeing private loans in the mid-1980s.
Currently, the SBA makes direct loans only under very special circumstances. Guaranteed
lending through the SBA’s 7(a) guaranteed loan program and the 504 loan program are
the main form of SBA activity in lending markets.
The more basic and more significant of these two programs is the 7(a) loan program.
The program’s name refers to Section 7(a) of the Small Business Act, which authorizes
the agency to provide business loans to small businesses. All 7(a) loans are provided by
commercial lenders. A very large percentage of American commercial banks participate
in the 7(a) program, as do a number of finance companies, credit card banks, and other
nonbank lenders.
It is important to note that 7(a) loans are made available only on a guarantee basis.
This means that they are provided by lenders who choose to structure their own loans in
accordance with SBA’s underwriting requirements and then apply for and receive a guarantee from the SBA on a portion of the loan.The SBA does not guarantee the full amount
of a 7(a) loan but rather usually about 50 to 85 percent of it. The maximum 7(a) loan is
$2,000,000 and the maximum guarantee on that loan is $1,500,000 (SBA 2007). Because
the SBA guarantees only part of the full amount of these loans, the lender and the SBA
share the risk that a borrower will not repay them in full.
The 504 loan program is a long-term financing tool for economic development within
a community.The 504 program provides growing businesses with long-term, fixed-rate financing for major fixed assets, such as land or buildings, through a certified development
company (CDC).A CDC is a nonprofit corporation set up to contribute to the economic
development of its community. CDCs work with the SBA and private-sector lenders to
provide financing to small businesses.There are about 270 CDCs nationwide. Each CDC
covers a specific geographic area (SBA 2007).
Typically, a 504 project includes a loan from a private-sector lender, which covers up
to 50 percent of the project cost, a loan from the CDC (backed by a 100 percent SBAguaranteed debenture) covering up to 40 percent of the cost, and a contribution of at
least 10 percent equity from the small business being helped.The SBA-backed loan from
the CDC is usually subordinate to the private loan, which has the effect of insulating the



private lender from loss in the event of default. (For more on the 504 or 7(a) programs
see SBA, 2007.)
If SBA loan guarantees reduce credit rationing in the markets for small business loans,
there should be a relationship between measures of SBA guaranteed lending activities and
economic performance.We are thinking here primarily in terms of credit market frictions
in the form of costly information acquisition and project verification, which can lead to
lower levels of credit allocation that negatively impact economic performance in the local market.6 To the extent that SBA’s guaranteed lending program mitigates such credit

6. An implicit assumption here is that
labor and capital are least for small firms.

market frictions, there should be a positive relationship between the amount of SBA guaranteed lending and economic performance, especially across local markets where credit
market frictions are likely to be a significant


Recent Empirical Literature
Does more SBA guaranteed lending lead to higher levels of local market economic performance? A search of the economic literature since 1990 on this question found only
three papers—two of those by the authors of this article—that attempt to address it. We
review those papers here.
The results from Craig, Jackson, and Thomson (2007b) suggest that the answer to our
question is yes; SBA guaranteed lending does lead to higher levels of local market economic performance. In that paper we empirically test whether SBA guaranteed lending
has a greater impact on economic performance in low-income markets. This hypothesis

7. This empirical relationship is
also supported by the economics
literature that documents a
significant positive correlation
between economic growth and
financial market development.
This literature dates at least
to the controversial studies of
Schumpeter (1911) and Robinson
(1952). More recent important
studies that provide evidence that
relatively higher levels of financial
market development tend to
lead to higher levels of economic
performance include King and
Levine (1993a, 1993b), Jayaratne
and Strahan (1996), Rajan and
Zingales (1998), and Guiso,
Sapienza, and Zingales (2004).

is predicated on priors related to four overlapping assumptions.These four assumptions
are: (1) income levels proxy for relative development of the local financial markets, (2)
less developed financial markets are more likely to have more severe information asymmetry problems, and thus are more likely to be impeded by credit rationing problems (Stiglitz and Weiss, 1981), (3) SBA guaranteed lending is likely to reduce these credit rationing
problems—thus, improving the level of development of that local financial market, and
(4) increased financial development helps to lubricate the wheels of economic performance (Rajan and Zingales, 1998).
Using local labor market employment rates as our measure of economic performance,
we find evidence consistent with this proposition. In particular, we find a positive and
significant correlation between the average annual level of employment in a local market
and the level of SBA guaranteed lending in that local market. And the intensity of this
correlation is relatively larger in low-income markets. Indeed, one interpretation of our
results is that this correlation is positive and significant only in low-income markets.
In Craig, Jackson, and Thomson (2007a) we report regression results that are consistent with the hypothesis that SBA guaranteed lending produces positive, albeit small, net
social benefits. Specifically, we report consistent evidence that the level of SBA-guaranteed lending activity (per $1000 of deposits) is positively related to the growth of per



capita income at the local market level—for both urban and rural markets.The impact of
SBA-guaranteed lending on growth appears to be small. However, this small measurable
economic impact of SBA loan guarantees on local economic growth would be expected
given the limited role they play in the overall (small and large firm) credit intermediation
In Craig, Jackson, and Thomson (2007a), our sample consists of local economic markets for which we have complete SBA guaranteed lending data over the sample estimation period (1992 through 2001). Our sample contained more than 360,000 SBA loans
aggregated to the local market level for each year in our sample.We estimated our models
separately for urban and rural markets (that is, MSA and non-MSA counties, respectively).
We used the instrumental variables (with the instruments from prior periods) and meantransformed data in our estimation procedures.
The results from both Craig, Jackson, and Thomson (2007a) and Craig, Jackson, and
Thomson (2007b) should be interpreted with caution, however, for at least two reasons.
First, we are unable to control for small-business lending at the local market level, so
we do not know whether SBA 7(a) loan guarantees are contributing to economic performance by helping to complete the market for small firm credit or whether they are
simply proxying for small business lending in the market. Second, we are not able to test
whether SBA loan guarantees materially increase the volume of small business lending
in a market—a question that is related to who captures the subsidy associated with SBA
loan guarantees. In other words, simply finding a positive correlation between measures
of SBA guarantees and local economic performance is only the first step towards establishing the desirability of these programs. More evidence is needed to establish that SBA
guaranteed lending programs are welfare enhancing.
Rappaport and Wyatt (1990) investigate the effects of bank characteristics and market
demographics on bank participation in SBA lending.They find that banks that participate
more intensively in SBA lending concentrate more on business lending, are more likely
to be members of a holding company, and may substitute SBA loans for consumer loans
secured by personal assets in markets with populations of 50,000 or less.They also find
that in local markets with a population of 50,000 or less, greater SBA lending is associated
with lower per capita income levels. They surmise that this correlation may be because
the SBA has achieved its economic development policy objective, which is to focus more
on low-income rural market areas.

The Performance of SBA-Guaranteed Loans
Glennon and Nigro (2005) examine the loan performance of small firms receiving SBAguaranteed loans. They place the performance history of SBA loans into perspective by
comparing their default experience to that of rated corporate bonds. They find that the



historical cumulative default rates of SBA-guaranteed loans fall between the Ba/BB and B
rated corporate-bond grades as reported by Moody’s and S&P. Although as a group, SBA
loans are below investment grade, this historical behavior places them in the upper end
of the speculative grade category and of similar credit quality as a large percentage of
loans held by large commercial banks.
Unlike previous research, Glennon and Nigro find that the hazard of default for SBA
loans is conditional on several key borrower, lender, and loan characteristics. More specifically, they find that loans to new businesses have a greater hazard of default than established firms. They also find, surprisingly, that larger SBA-qualified firms (measured by the
number of employees at time of loan origination) experience a greater hazard of default
than smaller ones.
As might be expected, they find that SBA-specialized lender programs (i.e., certified
lender program and preferred lenders program) have lower hazard rates than the SBA’s
regular lender programs.They also find that loans with higher guarantee percentages are
associated with a greater hazard of default. This result is consistent with agency theory,
which would explain that lenders with less at stake on a loan have less incentive to monitor that loan.The SBA has been addressing this issue by lowering the maximum guarantee
percentage over the past decade.
Finally, Glennon and Nigro also identify an important link between both regional and
industry economic conditions and the likelihood of loan default. Similar to previous research on other loan types, they find that the success and failure of small-business loans
are closely tied to the regional and industry-specific economic conditions in which the
borrower operates.

The SBA’s guaranteed lending programs are large and growing rapidly. Some suggest these
programs are useless for helping small businesses or improving economic performance
in the areas that receive these loans. Others insist the programs are needed to provide
support to small businesses, which often face difficulties finding sufficient borrowing opportunities.
However, very little serious empirical evidence exists on whether the net economic
impact of SBA’s guaranteed lending programs is positive or negative.A few recent studies
provide some insight for considering this question. In general, they provide evidence consistent with a likely small positive impact of SBA’s guaranteed lending programs on economic performance. However, these results are very tentative and much more research
is needed to declare a more definitive position. Nonetheless, it appears that the preponderance of the evidence from the current economics literature neither provides a strong
case against nor a strong case for continuing the SBA’s guaranteed lending programs.




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