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Replace the SBA's Outdated 7(a) Loan Program

Replace the SBA's Outdated 7(a) Loan Program
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The U.S. Small Business Administration’s signature effort to provide small business owners with access to capital – the 7(a) loan program – should be replaced with a new model that better fits the needs of today’s small business owners. Established in 1953, the 7(a) program was designed to overcome the “market failure” that results from the difficulty and cost of gathering information about small companies’ creditworthiness. By offering lenders a federal guarantee of repayment on loans made to small businesses unable to obtain credit under acceptable terms from other sources, the SBA induced bankers to offer loans to businesses that were otherwise denied financing.

While economic theory suggested the value of the 7(a) loan program at the time it was developed, research has shown that the extent of small business credit rationing is much smaller than theoretical economic models predicted. As a result, the need for a government program to ensure that private markets provide capital to small businesses turns out to have been overstated.

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Moreover, advances in technology have reduced the market failure that justifies the program. In the 1950s, lenders did not use credit scoring or computer algorithms to gather and analyze data to predict the probability that small businesses would repay their loans. However, today many financiers use these tools to assess small business credit risk. With more information about business owners’ likelihood of repaying loans, private markets are less likely to fail to provide small businesses with adequate capital than they were when Eisenhower was president.

The 7(a) loan program works through banks – a shrinking source of small business credit. Bank loan-based programs are less effective at meeting small business owners’ capital needs today than they were when term loans from financial institutions were the primary source of small business credit. Over the years, small business owners have diversified their sources of capital, and bank loans currently comprise a minority of small business borrowing.  A 2011 survey of a representative sample of 850 small businesses, conducted on behalf of the National Federation of Independent Business by the Gallup Organization, showed that 88 percent of companies either had credit outstanding or immediate access to credit, but only 29 percent had a bank loan. Federal Deposit Insurance Corporation data show that the small loan (less than $1 million) share of all domestic commercial and industrial loans declined from 33 percent to 21 percent between 1995 and 2014.

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These changes mean that the 7(a) program plays a very small role in ensuring that U.S. small businesses have access to credit. Survey of Business Owners data reveal that only 0.7 percent of businesses used any “government-guaranteed loan to start or acquire a business, and only 0.3 percent used a “government-guaranteed business loan to finance expansion.”  Data from the Federal Reserve show that SBA-guaranteed loans accounted for only 0.4 percent of the commercial and industrial loans made in the United States in 2014. Statistics from the SBA and the Census Bureau reveal that 7(a) loans went to only 0.2 percent of the small businesses in this country.  

If the 7(a) didn’t have a cost, none of this would matter. However, taxpayers must pay up when the SBA fails to price loan guarantees correctly or when economic contractions cause more-than-expected numbers of small businesses to fail.

The SBA could fix these problems by replacing its 1950s-era loan scheme with a 21st Century model. By redesigning its signature loan program to address the problems faced by today’s small business owners (rather than those of their grandparents), the agency would make it possible for more small companies to obtain credit at a lower cost to taxpayers.

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