Why Isn’t The SBA Loan Reaching The Most Needy

We ran out of money in just about two weeks after opening the Small Business Administration’s (SBA’s) $350 billion lending facility under the CARES Act. Several small businesses, especially the ones without existing business ties with the banks, could not get any funds under this program.

This happened at a time when there is an unprecedented level of liquidity in our financial system: The U.S. Treasury and the Federal Reserve Bank have committed more than $6 trillion in the last few weeks to help our economy. Their policy interventions are covering practically all critical parts of the financial market: treasury bonds, commercial papers, muni-bonds, mortgage-backed security, and several other credit markets. In an economic system with so much liquidity, why are small businesses struggling to get even a penny? The answer lies in the banker’s incentives to lend. We need a better system that addresses these incentive issues, not barely more funds.

SBA assistance flows to borrowers through the banking sector. Banks, by design, are credit providers, not relief providers. Their lender-mindset was on full display when it became apparent early on that they are prioritizing their existing customers for this assistance. The ease of processing applications can partially justify this focus on existing customers. After all, banks already have a lot of documents and information about these borrowers. But beyond the ease of processing, there is a clear credit-driven incentive to provide SBA loans to their existing customers first. By doing so, banks are effectively lowering the overall risk exposure of their outstanding portfolio: their loans become safer when their borrowers can obtain additional funds during this crisis. Unfortunately, not much attention has been paid to this vital incentive issue in the current debate on the design of the SBA lending. 

Further, banks are likely to prioritize customers to make their relationship even stronger. These gestures are expected to bring more business to the bank when things get back to normal. The same logic suggests that banks will prefer borrowers that are relatively more creditworthy than the ones who are truly marginal. Creditworthy borrowers are going to bring more business to the bank in the future. Again, the fact that banks are lenders, and not relief providers, come to the forefront of this debate. We must address these incentive issues carefully as we go forward with additional rounds of SBA lending to help our small businesses. 

The speed at which small businesses needed help necessitated the help of banks in reaching them. But what can be done to make the design better? How can we overnight change credit-mindset to relief-mindset? The CARES Act has already made an excellent first step in that direction by guaranteeing the entire amount of these loans. Banks are not taking any credit risk on their own books; in fact, they earn handsome fees for processing these loans. But to avoid the incentive issues highlighted above, we must think in terms of alignments the lender’s incentives to lend to truly needy, marginal borrowers. 

One way to achieve this incentive alignment is to link the loan processing fees to the borrower’s relationship status with the bank. Paying higher fees to process loans for new borrowers can go a long way in incentivizing banks to lend to new customers. 

Similarly, higher processing fees for lending to marginal borrowers can be helpful. In the current design, the processing fee is linked to the amount of loan. The current system pays higher processing fees for smaller loans, and that is a reasonable approach. To the extent that marginal borrowers are likely to be smaller, the current design partly achieves this goal, albeit indirectly. We can do better by directly connecting it to the nature of the borrower.

Going back to the issue of the unprecedented amount of liquidity in our financial system, another mechanism to ensure the flow of credit to small businesses is to link the liquidity injection in a bank to how well they do on their SBA lending. In regular times, banks are evaluated on their performance on metrics such as lending to low-income borrowers under the Community Reinvestment Act (CRA). Banks that fare poorly on this dimension face regulatory sanctions. In a similar vein, there should be a clear policy on evaluating a bank’s performance in lending to small businesses, even beyond the money provided under the CARES Act, in the aftermath of COVID-19 crisis. Linking their SBA lending performance to federal assistance should go a long way in incentivizing them to lend to small businesses that are in dire needs.

Secretary Mnuchin and Speaker Pelosi seem close to reaching a deal for allocating more money to small businesses. Perhaps an additional help of $300 billion will be available very soon. Additional funding is a step in the right direction, but we need more than money. We need critical structural changes in the distribution of this money to ensure the liquidity of this system reaches the thirsty first.