On Tuesday, the Subcommittee on Economic Policy of the Committee on Banking, Housing, and Urban Affairs held a hearing on proposals to address barriers to small business lending. Following a similar House hearing late last month, the purpose of the hearing was to further develop an understanding of the problems unique to small business financing and formulate a resolution.
The Subcommittee, chaired by Senator Sherrod Brown (D-OH), heard testimony from the following witnesses:
- Arthur Johnson, Chairman and CEO, United Bank of Michigan, Grand Rapids, MI on behalf of the American Bankers Association
- Eric Gillett, Vice Chairman and CEO, Sutton Bank, Attica, OH on behalf of the Independent Community Bankers Association
- Raj Date, Executive Director, Cambridge Winter Center for Financial Institutions Policy
Small businesses are the “engine of our economy,” commented Senator Jeff Merkley (D-OR) in his opening remarks, but despite long-standing relationships with lenders and paying customers, small businesses are struggling to obtain, or simply maintain, financing. With momentum building, Senator Merkley called on the panelists to provide guidance in formulating an approach to keep our economic engine running.
Senator Merkley shared the results of the most recent Quarterly Banking Profile released by the FDIC: Lending by the banking industry declined by approximately $587 billion, or 7.5%, in 2009. According to Senator Carl Levin (D-MI), by one estimate, overall bank loan volume in his home state of Michigan plummeted by 74% from 2007 to 2009. Senator Stabenow (D-MI) added that the effect of such a decline in lending is compounded by the fact that 64% of jobs in this country are created by small businesses.
At the outset of the second panel, Mr. Johnson disputed the theory that banks just do not want to lend money; after all, “lending is what banks do,” and less lending means less profit. He and the other panelists noted other factors that contributed to these troubling statistics.
First, the demand for financing has declined – the biggest contributor so far, according to Mr. Date. Mr. Gillett referenced a recent survey by the National Federation of Independent Business (NFIB) stating that “weak sales” were the most commonly cited as the biggest problem facing small businesses. Businesses are skittish, but, Mr. Johnson claims, the downward trend has flattened, and businesses are engaging lenders to test the market, even if they are not quite ready to close. Mr. Date added that the recovery will be further bolstered by a “re-localization” of lending away from banks that are “too big to fail,” which will further contribute to a rebound of demand for small bank lending.
Second, just as in the residential mortgage market, the collateral values in the commercial lending market have also deteriorated. Senator Levin explained that businesses with strong credit and paying customers are frequently unable to obtain financing only because the value of their equipment, buildings or inventory has declined. In addition, businesses with existing credit facilities are unable to refinance because of diminished collateral value, according to Mr. Johnson.
Third, although capital may be sufficient to meet current demand, Mr. Johnson fears that banks lack sufficient capital to fund an economic recovery. Also, the virtual disappearance of the market for commercial mortgage backed securities (CMBS) also affected small business lending. Mr. Johnson explained that commercial real estate developments are typically financed by community banks with loans that mature in three to seven years. Once completed, the loans are frequently refinanced with funds from CMBS (“take-out financing”) based on anticipated operating income from the property. Without a market for CMBS, small banks are left without an exit strategy for loans secured by properties with diminished values and peaking vacancy rates.
Small Business Administration
The panel members proposed several forms of legislative action, but all panel members universally agreed that the Small Business Administration (SBA) is in need of legislative attention. The SBA’s loan guarantee program reported a 30% decline in volume from 2007 to 2008 and another 41% decline from 2008 to 2009. All panel members agreed that the SBA loan guarantee, which is set to expire this month, should not only be extended, but should be augmented to authorize a larger maximum loan. However, Mr. Johnson discouraged any direct lending by the SBA. He recalled that the SBA previously engaged in direct business lending and expressed his opinion that it would be a mistake to return to the practice. Instead, he believes it would be more effective to build the SBA's resources and support existing channels of lending. The panel members most actively engaged in hands-on commercial lending, Mr. Johnson and Mr. Gillett, called for the elimination of unnecessary restrictions imposed on SBA lending. For instance, the SBA prohibits refinancing of existing debt by the bank that currently holds the debt. When Mr. Merkley asked about the rationale behind such a prohibition, Mr. Johnson could not articulate any justification for the rule and opined that any limitation whatsoever on the ability to refinance is counter-productive. Mr. Johnson also noted that the SBA staff has been reduced by nearly 1,000 people, or one-third of its employees, and emphasized that additional staff will be required to efficiently administer any new program. Last, Mr. Gillett called for a revival of the “LowDoc” program. He claims the program was primarily used by small banks that lacked a dedicated SBA loan staff.
Mr. Date cautioned against a major revamp of the SBA, because such an investment would be a “massive and complicated undertaking.” He emphasized that there are limits to the government’s capabilities, and despite the initial negative reaction to the original TARP capital infusions, which were administered through bank intermediation, such an approach would more practically meet the urgent needs of small businesses.
Support for Collateral Value Deficits
Senator Levin, supported by several other panel members, proposed federal adoption of a program modeled after currently existing programs in his home state of Michigan. The first such program, the Capital Access Program (CAP), helps support deficits in collateral value. Mr. Johnson explained that the lenders, the borrowers and the Michigan Economic Development Corporation (MEDC) pay a small premium into a reserve fund enabling borrowers to obtain fixed asset and working capital financing. Michigan’s second program, the Michigan Collateral Support Program (MCSP), funds interest-bearing cash collateral accounts with the lenders, which is then pledged as collateral on behalf of the borrower. Both programs have been highly utilized in Michigan, and the first $13 million committed to the CAP fully committed within the first five months.
Senator Stabenow proposed to devote a portion of President Obama’s Small Business Lending Fund, if approved by Congress, to programs modeled after those in Michigan. Mr. Johnson, supported by Mr. Gillett, strongly urged Congress to disassociate any program from the Troubled Asset Relief Program (TARP) because there is a “very real possibility that the TARP stigma will discourage banks from participating.” Stigma aside, any new program must protect participants from subsequent changes to the terms of the financing. Mr. Johnson testified that regulators encouraged small banks with no sub-prime loans to participate in the TARP, even though the funding was not needed, only to be “demonized” by adverse restrictions subsequently imposed.
Mr. Johnson and Mr. Gillett asserted that there is a substantial disconnect between positive messages sent from Washington and more restrained messages from local regulators. Both panel members applauded the joint statement by federal financial regulators promising that small banks would not be criticized for loans prudently made based on a comprehensive review of the borrower’s financial condition, but questioned whether field examiners would adhere to this commitment. Examinations are unreasonably tough, and regulators frequently employ an overly conservative approach, requiring downgrades whenever there is “any doubt” about a loan’s condition. Further, Mr. Gillett claims that regulators are “stereotyping” by requiring downgrades of solid loans only because they are located in a state with a high mortgage foreclosure rate. As summarized by Mr. Gillett, “the regulatory pendulum has swung too far in the direction of overregulation at the expense of lending.”
Fannie Mae and Freddie Mac
Mr. Gillett urged Congress to place a reasonable value on the preferred stock of Fannie Mae and Freddie Mac, both of which continue to report huge losses, and resume payment of dividends. At the encouragement of regulators, community banks invested in such preferred stock, which was included in their Tier 1 capital, and were “severely injured” shortly thereafter when the U.S. Treasury placed Fannie Mae and Freddie Mac into conservatorship. On Monday, Congressmen Issa (R-CA) and Jordan (R-OH) requested a hearing on the administration’s plans for Fannie Mae and Freddie Mac, which may address this issue.