Trust in Small Business (Loans)

Although the recent credit crisis has had limited effect on small businesses, there are some signs that this area may be affected as well. One established company suddenly found its asset-backed revolving credit line slashed in half. While the business had solid fundamentals, it appeared that the bank itself needed to pull back.

At times like these, it’s often worthwhile reviewing what former leaders had to say about the issues. A 1998 conference on small business banking issues sponsored by the US Treasury and the Comptroller of the Currency gives such a picture. (Full document available here.)

Eugene Ludwig, former Comptroller of the Currency (1993-1998) describes how he restored the flow of credit to small businesses:

First, we went over our regulatory rule book with a fine-toothed comb, weeding out or modifying those rules that seemed to complicate unduly fair access to small business credit.

Second, we developed innovative new programs to encourage financial institutions to make those loans.

Third, we conducted research into the systemic problems that interfere with the whole process
of small business lending. Finally — and the one that made all the other possible — we sought to stabilize and strengthen the national banking system, so that banks were once again in a position to lend.

Let me give you some specific examples.

  • We liberalized the rules requiring a small business owner to obtain a real estate appraisal from a licensed appraiser whenever personal real estate was used as collateral for a business loan — a change whose benefits, for those who qualify, can be measured, not only in the savings of dollars, but also in the savings of time — weeks sometimes, critical weeks when loans can be delayed awaiting the completion of an appraisal.
  • We adopted a low documentation loan program to allow highly rated and well-capitalized
    banks to make a portion of their loans to small and medium-sized businesses — loans that examiners would review solely on the basis of performance and not on the basis of the documentation in the file. These are loans made because of character that may not
    necessarily meet standard requirements for collateral or detailed performance plans.

Nowadays, it might sound excessively lax to be providing loans without documentation, and lowering barriers to collateralizing loans… but remember that historically small businesses have had lower default rates than other classes of borrowers. And lack of trust is precisely the problem that could send the economy spiraling downwards even further. The principles behind Ludwig’s approach were first to enable financing (through securitization, etc), and second to increase trust (through simplification and reduced bureaucracy)

At times like these we need to recognize that things may have swung too far in one direction, but a happy medium is much better than moving to the other extreme.

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