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Ma\ 15.

Federal Reserve Bank of Cleveland

Does Small Business
Need a Financial Fix?
bv Katherine A. Samolvk and Rebecca Wetmore Humes

-tVlthough by most conventional
economic standards the recent recession is two years past, the health of the
economy remains a concern to policymakers. The slow pace of the recovery
and the attendant lack of employment
growth have led to the perception that a
shortage of credit, especially bank lending, is part of the problem. As the story
goes, the small business sector, considered
a major source of job creation in our
economy, is stagnating, largely because
of a credit crunch. Shortages of bank
credit tend to hit small businesses particularly hard because banks have traditionally been the major source of funding for
this sector.
The focus on small business borrowing
leads in several directions. On one
hand, many debate whether these firms
are in any sense constrained in their
ability to get credit, or are simply
choosing to finance their activities
from sources other than conventional
lenders. On the other hand, even
among policymakers who espouse the
credit crunch explanation, there is a
lack of consensus as to whether the
dearth of small business borrowing
reflects an inefficiency inherent in private credit markets or the impact of
government policy—be it federal borrowing or financial market regulation.
Finally, some argue that sluggish

ISSN 0428-1276

growth mirrors a lack of demand for
funds rather than factors related to the
supply of credit.
Without attempting to resolve these
issues, policymakers have prescribed
a number of remedies for the anemic
growth in small business credit in the
form of political initiatives. This Economic Commentary examines several of
these proposed financial fixes. Some
aim to spur credit to this sector by promoting activity in the secondary market
for small business loans. Others attempt
to encourage direct lending by reducing
the costs of originating and holding
these claims. The initiatives differ not
only in the types of financing proposed
to increase business credit, but also in
the government's role in achieving this
end. Some call for direct government
intervention, while others recommend
a change in regulations to affect the
market's allocation of credit. Here.
we argue in favor of a deregulatory
approach—indeed, an approach that
has already been initiated.
• Funding Small Business
Small businesses are frequently credited with fueling job creation as well as
new technology. For example, in 1975
a young entrepreneur. Bill Gates, founded Microsoft Corporation with a boyhood friend. Today this enterprise has

In response to concerns that a credit
crunch is impeding growth of the
small business sector, policymakers
have brought forward several proposals aimed at fueling additional lending. Some advocate direct government intervention, while others aim
to change existing regulations to promote the market's allocation of credit
In assessing these proposals, the authors
contend that market-oriented initiatives, such as a recent Securities and
Exchange Commission ruling, represent the right approach to improving
the access of small businesses to
credit markets.

grown to be the largest and most influential company in the software industry—
a S2.8 billion behemoth. A 1988 survey
by the National Federation of Independent Business (NFIB) states that prior
to the recent recession, nearly half of
the nation's output was produced by
small firms.' The importance of the
small entrepreneur as a player in the
economy underscores current concerns
about the ability of this sector to obtain
needed funds.

Examining the market for small business finance is not a simple task. The
only available data on the balance
sheets of smaller firms are found in the
Quarterly Financial Report for Manufacturing Corporations." As the title
indicates, this information covers only
the manufacturing sector, which accounts
for less than 20 percent of our economy's
national income. For small firms in the
increasingly important service sector,
balance sheet data are unfortunately
not readily available.
Small businesses have identified commercial banks as their main suppliers
of financial services, which include
funding for working capital." These
institutions are the primary source of
unsecured lines of credit as well as
other types of lending that are often
tailored to the particular needs of each
enterprise. To the extent that these borrowers are small and specialized, their
liabilities are relatively illiquid and
hence unmarketable, because it is hard
to identify and communicate the associated credit quality to potential investors.
Given that banks are a special conduit
of funds to small firms, their capacity to
lend translates into the ability of these
firms to obtain external funds. Thus, it is
not surprising that in the wake of major
restructuring in the banking industry,
some consider the dearth of small
business credit to be symptomatic of
a credit crunch.
However, in tandem with problems in
the banking sector during the past decade, there has been a proliferation of
small business credit from nonbank
sources, such as finance companies.
To some degree, the surge in credit supplied through these lenders reflects
improvements in information technology
that have increased their cost effectiveness in supplying credit to smaller
firms. In fact, bank holding companies

are joining the trend toward providing
business credit by selling asset-backed
securities through nonbank subsidiaries
in a process known as securitization.
This trend is commonly viewed as a
response to the regulatory costs associated with the provision of the federal
safety net, as well as to greater nonbank
competition.4 To the extent that the
loans financing autos, inventories, and
the like are being securitized, a de facto
secondary market for business credit
has emerged. Although it is impossible
to tell the degree to which small firms
use this source of finance, the documented growth in these credit vehicles
suggests that the drop in business lending on banks' balance sheets may, at
least in part, reflect increased use of
alternative credit sources.
Another problem in examining the
funding of small business is that people
frequently confuse venture capital, which
is generally defined as the resources used
to start up new businesses, with working
capital, which refers to the financing
used by existing firms as they conduct
their current operations and expand the
scale of their activities over time.
Though the data on sources of venture
capital for small business are sparse,
another survey by the NFIB finds that
the number of new business owners
who used either institutionalized venture capital or government programs
was negligible.5 In fact, while financial
institutions do provide some funding for
firms' start-ups, most new business owners generally rely on their own resources
to set their enterprises in motion.
Nevertheless, the concern with credit
availability as a prerequisite for the job
growth associated with small businesses
underlies the sentiment for government
policies to promote lending to this sector. Examining several of these proposed policies will illustrate the issues
involved: 1) the viability of making

business loans marketable: 2) the extent
to which banks can be encouraged to
lend more; and 3) the degree to which
regulations constrain small business
access to direct credit markets.
• The Secondary Market Approach
Currently, at least two pieces of congressional legislation seek to promote a
secondary market for small business
loans. This would allow loan originators—such as banks—to package business loans and sell them to other investors rather than fund them with their
own debt (for example, deposits). The
underlying motive is to increase the
marketability of this type of credit and
hence the flow of funds to smaller
firms, just as home buyers' access to
mortgage financing has been enhanced
by a strong secondary market for residential mortgage loans.
A plan introduced by Sen. John Kerry
(D-MA) and Rep. John LaFalce (DNY) proposes that government play a
role as a financial intermediary for
small business loans similar to that of
other government-sponsored credit agencies, such as the Federal National Mortgage Association (Fannie Mae). The
Small Business Credit Act would create a government-sponsored enterprise
(GSE) called the Venture Enhancement
and Loan Development Administration
for Smaller Undercapitalized Enterprises (Velda Sue). This enterprise
would buy and package loans made to
businesses with net worth less than SI8
million and net income less than $6
million, then issue securities backed
by these pools.
The loans pooled by the proposed GSE
would be secured by senior mortgages.
Velda Sue would purchase only 80 percent of the loan, leaving the remainder
with the originator. Finally, the U.S.
Treasury would have a proposed obligation to purchase up to SI.5 billion of


Small Business Credit Act

Would create a government-sponsored enterprise to buy and securitize small

(Velda Sue)

business loans.

Small Business Loan Securitization

Would reduce regulation, making it easier for the private market to securitize

and Secondary Market

small business credit.

Enhancement Act

Small Business Capital

Would create a government-subsidized loan loss reserve fund for small

Enhancement Act

business loans.

Joint Interagency Policy
Statement on Credit Availability

Reduces the regulatory burden on depository institutions provided all statutory
requirements are met.

Small Business Incentive Act

Would change regulations to make it less costly for small businesses to issue
securities and make it easier for different types of investment pools and business
development companies to invest in the securities of small businesses.

S O U R C E S : Congressional

Record. U.S. Senate. February 17, March 2. and March 4. 1993: and Daily Report for Business Executives.

Velda Sue securities. Thus, while the
asset-backed securities are not government guaranteed, the Treasury's role is
likely to cause market participants to
treat them as if they were.
An alternative to direct government
sponsorship of business credit securitization is to change the regulations
limiting investments in private intermediaries that conduct these activities in
order to alter market incentives for the
pooling and funding of small business
loans. A measure sponsored by Sen.

approach. The Small Business Loan
Securitization and Secondary Market
Enhancement Act would make it simpler for private institutions to expand
secondary markets on their own.
Under this law, financial institutions
that manage pension funds would be
allowed to participate in the pooling
and packaging of small business loans.
Some restrictions in the margin and
delivery rules under federal securities
laws would be removed, allowing issu-

March 11 and March 3 1 . 1993.

ers more time to pool small business
loans and sell them as securities. The
legislation would also reduce costs
by permitting issuers to file a single
registration statement with the federal
government instead of filing in every
state, as is currently the case. Banks
would not be required to hold "prohibitively excessive" amounts of capital
against small business loans that had
been sold. In addition, the proposed
amendments to federal banking laws
and state investment laws would increase

the number of potential investors by allowing depository institutions, insurance companies, and pension funds to
hold these securities. Finally, the Secretary of the Treasury would be directed to clarify the tax rules relating to
these securities to facilitate their sale.
Encouraging small business loan securitization by deregulation will perhaps
increase the volume of secondary market activity already in existence. Some
business loans may be difficult to standardize, thus not lending themselves well
to sale in a secondary market. Still, if
depository institutions can free up
some of their on-balance-sheet lending
capacity, there may be a corresponding increase in the less marketable forms
of small business lending.
• Encouraging Direct Lending
An alternative to the secondary market
approach is a policy that would promote direct lending to small business
by reducing the cost to lenders. Again,
there are two possible paths to achieve
this end: direct government intervention
and deregulation. A bill introduced by
Sen. Donald Riegle (D-MI) is one
example of government subsidization of
direct lending to small businesses. The
Small Business Capital Enhancement Act
would establish a stale-administered program in which the borrower, lender, and
state and federal governments would pay
premiums into a loan loss reserve fund
that would compensate the lender in the
event of borrower default.' Participating
lenders would include banks, savings
and loans, and credit unions with
proven lending experience and financial and managerial capacity. Supporters believe that this bill will increase
lending to small businesses by lowering
the risk to banks and other lenders.
In the event of default, the lender could
recover losses up to the total of the premiums associated with that loan. If a

loss exceeded this amount, the lender
could still draw on contributions associated with any other loans it had made
under the program. Each lender's claim
on this fund would be limited to the
premiums associated with its loans, so
that it would be required to absorb any
additional losses. Thus, while the program is not an outright government
loan guarantee program (the stated liability is limited to the fund contribution),
the government's ante in the fund is
clearly a subsidy.
Notwithstanding concerns about the
federal budget deficit, the issue of subsidizing small business loans should be
addressed. If the private sector is unwilling to make these loans without government support (because they are
unprofitable or too risky), perhaps they
should not be made. Alternatively, if this
credit is not being extended because of
the costs associated with government
policies, a more fruitful approach may
be to address regulatory burdens. Several proposals specifically target bank
costs of lending.
The new administration and the four
financial regulatory agencies recently
released a policy initiative aimed at
reducing regulatory burdens without
any legislation. The Joint Interagency
Policy Statement on Credit Availability
represents a collaborative effort between
the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve Board, and
the Office of Thrift Supervision. The
plan was still broad in focus when it
was released on March 10. but the specifics of any change will be announced
as they are finalized. Here, we concentrate on two parts of the plan that target
small business lending.
One area would eliminate barriers to
loans for small and medium-sized businesses by reducing documentation and

encouraging the use of lenders" judgment and borrowers" reputations. On
March 30. it was announced that strong,
adequately capitalized banks will be
allowed to make and carry a basket of
loans with few documentation requirements. The maximum amount of each
loan qualifying for this program is
S900.000. or 3 percent of the lending
institution's portfolio, and the total of
such loans is limited to an amount
equal to 20 percent of the institution's
capital. Banks and thrifts will be encouraged to make these loans "based on
their own best judgment as to the creditworthiness of the loans and the necessary documentation." thus allowing for
so-called character loans. The loans
will be evaluated on the basis of performance and are exempt from examiner criticism of banks' documentation.
The implications of this policy for
small business credit availability hinge
on two factors. The first is whether the
documentation of credit quality represents a relatively large share of the cost
associated with lending to smaller
firms. In addition, banks must be willing to reduce documentation. They
may not be prepared to do so. as documentation costs seem to be viewed as
necessary in evaluating credit risk.
Although the specifics have not yet
been announced, another area of the
policy initiative that could encourage
small business borrowing is one that
would reduce the appraisal burdens
associated with real estate. Property is
often used as collateral by small businesses that have few other tangible
assets. However, the high costs of
appraisals may make these loans
unprofitable. The new policy would
change requirements so that these
appraisals would not need to be conducted by licensed or certified appraisers when real estate is offered as additional collateral. The agencies also seek

to limit the frequency of required appraisals to only those needed for safety
and soundness. In addition, the agencies
hope to prevent loans from being foreclosed on when the collateral value has
dropped even though the borrower has
proven to be capable of servicing the
debt. Easing foreclosure rules on real
estate lending would benefit small businesses by making their main source of
collateral more attractive. Nonetheless,
all of these changes come with the stipulation that all statutory requirements
must be met. So. the strict requirements
for appraisals outlined in the Financial
Institutions Reform. Recovery, and
Enforcement Act of 1989 (FIRREA)
and the Federal Deposit Insurance
Corporation Improvement Act of
1991 (FDIC1A) may blunt the impact
of this new policy initiative.
• Access to Debt and
Equity Markets
The policy prescriptions outlined above
aim to encourage lending to small business by financial intermediaries. Alternatively, in an attempt to increase the
access of small business to financing in
direct credit markets. Sen. Christopher
Dodd (D-CT) has introduced a bill, the
Small Business Incentive Act. that would
amend the Securities Act of 1933 and the
Investment Company Act of 1940. Public offerings of securities up to S10 million could be exempted by the Securities
and Exchange Commission (SEC) from
registration and disclosure provisions.
The current exemptive authority is only
55 million. By lowering the costs of issuing small amounts of securities, more
small firms would have access to the
market. This bill would also make it
easier for different types of investment
pools and business development companies to invest in the securities of small
businesses by amending the Investment
Company Act of 1940. which governs
mutual funds and other entities that
deal in securities of other businesses.

• Does Small Business Need
a Financial Fix?
With all of the aforementioned proposals on the table, it might seem impertinent to question whether small business
truly needs a financial fix of any kind.
The multifaceted pursuit of remedying
the perceived lack of small business
credit may in fact be a case of legislative overkill. Indeed, we recommend a
second opinion in light of recent regulatory changes by the SEC.
In particular. Rule 3a-7 of the Investment Company Act of 1940. which the
SEC passed last fall, targets small business lending by expanding the options
for asset securitization. The provisions
of this rule will allow lenders, including banks, to package a broader range
of assets, including small business
loans. Because banks can earn fee
income for servicing the loans being
sold, acting as a trustee for investors
as well as providing credit enhancements,
they will benefit from the expansion of
the breadth of asset securitization.
Beyond representing a potential profit
opportunity for the banking sector, the
SEC action is intended to promote business credit availability. The means to
this end involve making this class of
loans more marketable to both originators and investors. For example, securities backed by general-purpose loans to
smaller firms can now be sold on public
markets, allowing them to be securitized
in a manner similar to that used for residential mortgages. By increasing both
the liquidity and the profitability of these
loans, this policy encourages bank lending to this sector. This remedy is attractive in that it facilitates small business
lending via asset-backed securities markets that are proliferating because they
are profitable. As noted by SEC Chairman Richard Breeden. "The rules
should have a direct and quite immediate benefit to the capital markets in per-

mitting greater flexibility with instruments that have proven their value to
the financial markets.
At the other extreme, governmentsponsored attempts to promote lending
would represent a move to encourage
lending in an area the market has
deemed unprofitable. Proponents of
direct government intervention (in the
form of Velda Sue or the loan loss
reserve program of the Small Business
Capital Enhancement Act) argue that
such intervention is needed because
the private sector is not in a position
to absorb the risks involved in small
business lending. However, credit markets have become more efficient in
recent years, so if the private sector is
not extending certain types of credit,
it is because these products have not
become profitable enough relative to the
associated risks or regulatory costs.
The merit of current proposals to reduce
regulatory burdens is uncertain. The
Clinton plan seems well-intended, yet
the impact of some of its elements may
be blunted by vagaries of interpretation
as well as statutory regulations. Proposed
legislation aimed at expanding small business access to securities markets would
allow the market to make the ultimate
allocative decisions and may have
merit. Yet. the recent SEC changes have
diminished the urgency of a quick fix.
These policies should thus be evaluated
on their probable long-term effects rather
than on more immediate sentiments
for spurring small business lending.
Perhaps the most prudent action regarding small business credit availability
would consider the effect of the SEC
ruling before prescribing future regulatory changes.

• Footnotes
1. See William J. Dennis. Jr.. William C.
Dunkelberg. and Jeffrey S. Van Hulle. Small
Business and Banks: The United States,
National Federation of Independent Business
Foundation. 1988.
2. This report, published by the U.S. Department of Commerce. Bureau of the Census,
gives daia by asset size categories of less than
S5 million. $5-10 million. SI0-25 million.
$25-50 million. S50-IOO million. S10O-25O
million. $250 million to SI billion, and greater
than SI billion.
3. See Gregory E. Elliehausen and John
D. Wolken. "Banking Markets and the Use
of Financial Services By Small and MediumSized Businesses." FederalResene Bulletin.
vol. 76. no. 10 (October 1990). pp. 801-1 7.
4. See Charles T. Carlstrom and Katherine
A. Samolyk. "Securitization: More than Just
a Regulatory Artifact." Federal Reserve
Bank of Cleveland. Economic Commentary,
May 1. 1992.
5. See Arnold C. Cooper. William C.
Dunkelberg. Carolyn Y. Woo. and William J.
Dennis. Jr.. New Business in America: The
Finns andTheir Owners. National Federation of Independent Business Foundation. 1990.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

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6. While entrepreneurs may draw on an existing source of credit (such as a second mortgage) to stan a business, banks generally do
not lend solely on the basis of the prospective profitability of the new enterprise.
7. The bill authorizes S50 million of federal funds to cover the federal government's
pan in the program. The borrower would pay
a share (from 1.5 to 3.5 percent) of the loan
amount to the loss reserve fund. The lender
would pay the same amount. The lender
could also negotiate with the borrower as to
how much of its contribution would be paid
by the borrower as pan of the loan. The total
borrower-lender contribution would be
matched by the state. The federal government would then reimburse the state for half
of its advance to the loss reserve fund.
8. Banks must earn one of the top two supervisor)' risk ratings and qualify as adequately
capitalized institutions according to guidelines set forth in the Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA). Insider loans and delinquent
loans cannot be included with these loans.

9. Banks are expressly forbidden from
serving as a trustee of these assets if the\
also provide credit enhancement in support
of these instruments.
10. See "SEC Eases Securitization Rules:
Banks Gain Options." American Banker.
November 20. 1*>92. p. 1.

Katherine A. Samolyk is an economist and
Rebecca Wctmore Humes is a senior research
assistant at the Federal Reserve Bank of
Cleveland. The authors thank James B.
Thomson for helpful comments.
The views staleil herein arc those of the
authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve

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