Over the last 10 years, the Small Business Administration has been responsible for well over $100 billion in small business credit extensions, more than any single private lender. This Commentary explores the motivations for such a large investment of taxpayer dollars.Small Business Administration ; Loans ; Credit

Ben R. Craig

James B. Thomson

William E. Jackson, III

English

Research Papers in Economics

■ The Economics of Credit 
Markets
The economic justification for any 
government-sponsored small business
lending program or loan guarantee pro-
gram must rest on a generally acknowl-
edged failure of the private sector to allo-
cate loans efficiently. Absent such a
clearly identified problem with private-
sector lending to small businesses, the
SBA’s activities would simply seem a
wasteful, politically motivated subsidy
to this sector of the economy.
Many economists, most notably Joseph
Stiglitz and Andrew Weiss, contend that
private lending institutions may indeed
fail to allocate loans efficiently because
of fundamental information problems in
the market for small business loans.
These information problems may be so
severe that they lead to credit rationing,
the allocation of credit by means other
than price. Nonprice rationing is a less
efficient mechanism for allocating credit
than price, and, where it exists, it gener-
ally reduces the credit available to the
market overall. Credit rationing then
constitutes the failure of the credit mar-
ket. Stiglitz and Weiss claim that
rationing is a likely outcome in credit
markets with small business borrowers
because of banks’difficulty in getting
September 15, 2004*
Federal Reserve Bank of Cleveland
Are SBA Loan Guarantees Desirable?
by Ben R. Craig, William E. Jackson, III, and James B. Thomson
ISSN 0428-1276
*printed December 2004
Over the last 10 years, the Small
Business Administration has been
responsible for well over $100 billion
in small business credit extensions,
more than any single private lender.
This Commentary explores the moti-
vations for such a large investment of
taxpayer dollars.
T he promotion of small businesses is a
cornerstone of economic policy for a
large number of industrialized countries.
Public support for small enterprise
appears to be based on the widely held
perception that the small business sector
is an incubator of economic growth, a
place where innovation takes place and
new ideas become economically viable
business enterprises. In addition, policy-
makers routinely point to small busi-
nesses as important sources of employ-
ment growth—even though economic
studies find little evidence to support
this claim. It is not surprising, then, that
there is widespread political support for
government programs, tax breaks, and
other subsidies aimed at encouraging the
growth and development of small busi-
ness in the United States and, increas-
ingly, around the world.
A particular area of concern for policy-
makers is whether small businesses have
access to adequate credit. Growing busi-
nesses have an acute need for credit, but
many small firms may have a hard time
obtaining it because they are young and
have little or no credit history. Lenders
may also be reluctant to fund small firms
with new and innovative products
because of the difficulty associated with
evaluating the risk of such products. If
small businesses lack a sufficient supply
of credit, policymakers should be con-
cerned, for the next Google, Microsoft, or
Starbucks might wither on the vine for
want of funding. To the extent that some
market failure significantly impairs the
access small businesses have to credit, a
rationale exists for supporting these busi-
nesses through government programs
aimed at improving their access. 
One specific government intervention
aimed at improving small firms’
access to credit is the Small Business
Administration (SBA) guaranteed 
lending program. SBA loan guarantees
are well established, and their volume
has grown over the past decade. Nearly
20 million small businesses have
received direct or indirect help from one
or another of the SBA’s programs since
1953. The SBA’s current business loan
portfolio of roughly 219,000 loans is
worth more than $45 billion, making it
the largest single financial backer of
small businesses in the United States.
Over the period 1991 to 2000, the SBA
assisted almost 435,000 small busi-
nesses in obtaining more than $94.6 bil-
lion in loans, more than in the entire 
history of the agency before 1991. No
other lender in this country has been
responsible for as much small business
financing as the SBA has during that
time (SBA, 2004). These lending num-
bers are remarkable when one considers
that SBA loan guarantees are aimed at
that segment of small business borrow-
ers that presumably would not otherwise
have access to credit.
Is there a market failure that justifies
intervention of this magnitude? Many
economists believe that credit markets—
whose efficient operation depends so
heavily on the ease with which lenders
can gather information on borrowers—
are indeed prone to failure when the
nature of the borrowers makes it hard to
obtain this information, as is the case
with small businesses. To know how
well the SBA lending program is
addressing that failure (and doing so
with no adverse side effects), we also
have to be sure we know what the
mechanics of the failure are and ask
whether the program is designed to tar-
get only those areas where the break-
down in natural market forces arises.sufficient information about them. They
argue that when banks are deciding
whether to make a loan, they are con-
cerned about the interest rate they
receive on the loan and the riskiness of
the loan. But the imperfect information
banks have after evaluating loan appli-
cations can cause two things to happen,
both of which allow the interest rate
itself to affect the riskiness of the loan
pool. This is the crux of the problem,
because when the price (here, the 
interest rate) affects the nature of the
transaction, it is unlikely that a price
will emerge that suits either the avail-
able buyers or sellers (no price will
“clear the market”). The first effect,
adverse selection, affects the ability 
of markets to allocate credit on price
because it removes the lower-risk 
borrowers from the set of potential 
borrowers. The second consequence,
moral hazard, reduces the ability of
prices to clear the lending markets by
influencing the actions of borrowers. 
Adverse selection is a consequence of
different borrowers having different
probabilities of repaying their loan. The
expected return to the bank on a loan
obviously depends on the probability of
repayment, so the bank would like to be
able to identify borrowers who are more
likely to repay. Typically, the bank will
use a variety of screening devices to do
this. The interest rate that a borrower is
willing to pay may act as one such
screening device. For example, those
who are willing to pay a higher interest
rate are likely to be, on average, worse
risks. These borrowers are willing to
borrow at a higher interest rate because
they perceive their probability of 
repaying the loan to be lower. So, as the
interest rate rises, the average “riskiness”
of those who borrow increases, and this
may actually result in lowering the
bank’s expected profits from lending. 
Similarly, as the interest rate and other
terms of the contract change, the behav-
ior of the borrower is likely to also
change. For instance, raising the interest
rate decreases the profitability of pro-
jects that succeed. Higher interest rates
may thus induce firms to undertake pro-
jects that are riskier—ones with lower
probabilities of success but higher pay-
offs when successful. In other words, the
price a firm pays for credit can affect its
investment decision. This is the moral
hazard problem.
As a result of these two effects, a bank’s
expected return may increase less rapidly
than the interest rate and, beyond a point,
may actually decrease. Clearly, under
these conditions, it is conceivable that
the demand for credit may exceed the
supply of credit in equilibrium. Although
traditional analysis would argue that in
the presence of an excess demand for
credit, unsatisfied borrowers would offer
to pay a higher interest rate to the bank,
bidding up the interest rate until demand
equals supply, it does not happen in this
case. This is because the bank would not
lend to someone who offered to pay the
higher interest rate, as such a borrower is
likely to be a worse risk than the average
current borrower. The expected return on
a loan to this borrower at the higher
interest rate is actually lower than the
expected return on the loans the bank is
currently making. Hence, there are no
competitive forces leading supply to
equal demand, and credit is rationed.
SBA loan guarantees should improve
credit allocation by providing a mecha-
nism for pricing loans that is indepen-
dent of borrower behavior. By reducing
the expected loss associated with a loan
default, the guarantee increases the
expected return to the lender—without
increasing the lending rate. In the
absence of adverse selection, lenders
could simply offer borrowers loan rates
that reflected the average risk of the
pool of borrowers. Each loan made
would reflect a random draw from the
pool of borrowers, and if the bank made
a large number of small loans to borrow-
ers in the pool, then the bank’s loan
portfolio would have the same risk and
return characteristics of the pool of bor-
rowers. But, as explained, adverse selec-
tion increases the average riskiness of
the pool to the point where banks are not
willing to lend. With the guarantee in
place, the lender could profitably extend
credit at loan rates below what would be
dictated by the risk of the average bor-
rower. The reason for this is that the
guarantee increases the profitability of
the loan by reducing the losses to the
bank in those instances where the bor-
rower defaults. 
To the extent that the loan guarantee
reduces the rate of interest at which
banks are willing to lend, external loan
guarantees should help mitigate adverse
selection. After all, lowering the lending
rate increases the number of low-risk
borrowers applying for credit, which, in
turn, increases the likelihood that the
average risk of firms applying for loans
is representative of the pool of borrow-
ers. Moral hazard behavior is also miti-
gated because the lower lending rates
afforded by external guarantees reduce
the bankruptcy threshold and thereby
increase the expected return of safe pro-
jects vis-à-vis riskier ones. Thus, in the-
ory, SBA loan guarantees should reduce
the probability that a viable small busi-
ness is credit rationed. 
■ Small Business 
Administration Loan 
Guarantee Programs
The legislation that created the Small
Business Administration, the Small
Business Act, was enacted on July 30,
1953. By 1954, the SBA was already
making direct business loans and guar-
anteeing bank loans to small businesses,
as well as making loans to victims of
natural disasters, working to get govern-
ment procurement contracts for small
The essence of the American economic system of private enterprise is free competi-
tion. Only through full and free competition can free markets, free entry into business,
and opportunities for the expression and growth of personal initiative and individual
judgment be assured.  The preservation and expansion of such competition is not only
to the economic well-being but to the security of this Nation. 
Such security and well-being cannot be realized unless the actual and potential capacity
of small business is encouraged and developed.  It is the declared policy of the Congress
that the Government should aid, counsel, assist, and protect insofar as is possible the
interests of small-business concerns in order to preserve free competitive enterprise, to
insure that a fair proportion of the total purchases and contracts for supplies and ser-
vices for the Government be placed with small-business enterprises, and to maintain
and strengthen the overall economy of the Nation. [emphasis added]
—Small Business Act of 1953 (establishing  the Small Business Administration)businesses and helping business owners
with management and technical assis-
tance and business training. Recogniz-
ing that private financial institutions are
typically better than government 
agencies at deciding which small 
business loans to underwrite, the SBA
began moving away from making direct
loans and toward guaranteeing private
loans in the mid-1980s. Currently, the
SBA makes direct loans only under
very special circumstances. Guaranteed
lending through the SBA’s 7(a) guaran-
teed loan program and the 504 loan 
program are the main form of SBA
activity in lending markets.
The 7(a) loan program is the more basic
and more significant of these two pro-
grams. Its name comes from Section
7(a) of the Small Business Act, which
authorizes the agency to provide busi-
ness loans to American small busi-
nesses. All 7(a) loans are provided by
lenders who are called participants
because they participate with the SBA
in the 7(a) program. Not all lenders
choose to participate, but most Ameri-
can banks do, as well as a number of
nonbank lenders. This expands the
availability of lenders making loans
under SBA guidelines.
Loans made through the 7(a) program
are available only on a guarantee basis.
This means that they are provided by
lenders who choose to structure their
own loans according to the SBA’s
requirements and who apply for and
receive a guarantee from the SBA on a
portion of this loan. The SBA does not
fully guarantee 7(a) loans. The SBA
guarantee is usually in the range of 50
percent to 85 percent of the loan
amount, and the maximum guarantee is
$1,000,000. The lender and the SBA
share the risk that a borrower will not
be able to repay the loan in full. The
guarantee is a guarantee against pay-
ment default and does not cover other
contingencies, such as imprudent 
decisions by the lender (such as under-
pricing of the loan, failure to enforce
loan covenants, or failure to perfect a
lien on collateral) or misrepresentation
by the borrower.
The 504 loan program is a long-term
financing tool for economic develop-
ment within a community. The 504 
program provides growing businesses
with long-term, fixed-rate financing for
major fixed assets, such as land or
buildings, through a certified develop-
ment company (CDC). A CDC is a 
nonprofit corporation set up to con-
tribute to the economic development 
of its community. CDCs work with the
SBA and private-sector lenders to 
provide financing to small businesses.
There are about 270 CDCs nationwide.
Each CDC covers a specific geographic
area (SBA, 2004). 
Typically, a 504 project includes a loan
from a private-sector lender, covering
up to 50 percent of the project cost, a
loan from the CDC (backed by a 100
percent SBA-guaranteed debenture),
covering up to 40 percent of the cost,
and a contribution of at least 10 percent
equity from the small business being
helped. The SBA-backed loan from the
CDC is usually subordinate to the pri-
vate loan, which has the effect of insu-
lating the private lender from loss in the
event of default. Generally, a business
must create or retain one job for every
$50,000 provided by the SBA. The
maximum SBA debenture is $1,000,000
for meeting the job creation criteria or a
community development goal and
$1,300,000 for meeting a public policy
goal. Current public policy goals recog-
nized by the SBA are business district
revitalization, expansion of exports,
expansion of minority business develop-
ment, rural development, enhanced eco-
nomic competition, restructuring
because of federally mandated standards
or policies, changes necessitated by fed-
eral budget cutbacks, expansion of small
business concerns owned and controlled
by veterans, and expansion of small
business concerns owned and controlled
by women (SBA, 2004). 
■ Proper Program Design
Ensuring access to credit has been an
important pillar of public support for
small business for more than half a cen-
tury. Over the last 10 years, the SBA has
been responsible for well over $100 bil-
lion in small business credit extensions,
more than any single private lender. Of
course, this is what the SBA was created
to do. The agency’s primary mission as
set forth by Congress is to assist small
businesses in their quest for credit on
reasonable terms. Properly structured
loan guarantee programs that work
through existing credit channels, as is
the case with the majority of the SBA’s
programs, are more likely to produce
results consistent with growth-oriented
public policy objectives than direct
lending programs. 
■ Recommended Reading
Ben R. Craig, William E. Jackson, III,
and James B. Thomson, 2004. “On
SBA Guaranteed Lending and Eco-
nomic Growth,” in Government-
University Partnerships to Enhance
Economic Development Through 
Entrepreneurship, Edward Elgar 
Publishing (forthcoming).
Elisabeth H. Rhymes, 1988. Small
Business, Banks, and SBA Loan Guar-
antees: Subsidizing the Weak or Bridg-
ing a Credit Gap? Quorum Books,
New York, NY.
SBA, 2004. Webpage for Small Busi-
ness Administration, accessed March 8,
2004, <www.sba.gov>.
Joseph E. Stiglitz, and Andrew Weiss,
1981. “Credit Rationing in Markets
with Imperfect Information,” American
Economic Review, 71 (3): 393–410.
Walker F. Todd, 1992. “History of and
Rationales for the Reconstruction
Finance Corporation,” Federal Reserve
Bank of Cleveland, Economic Review
92 (4): 22–35.Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Return Service Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted if the source is
credited. Please send copies of reprinted
material to the editor.
Ben R. Craig is an economic advisor at the
Federal Reserve Bank of Cleveland, William
E. Jackson, III, is an associate professor of
finance at the University of North Carolina’s
Kenan-Flagler Business School, and James
B. Thomson is a vice president at the Federal
Reserve Bank of Cleveland.
The views expressed here are those of the
authors and not necessarily those of the Fed-
eral Reserve Bank of Cleveland, the Board of 
Governors of the Federal Reserve System, or
its staff. 
Economic Commentary is published by the
Research Department of the Federal Reserve
Bank of Cleveland. To receive copies or to be
placed on the mailing list, e-mail your request
to 4d.subscriptions@clev.frb.org or fax it to
216-579-3050. Economic Commentary is also
available at the Cleveland Fed’s site on the
World Wide Web: www.clevelandfed.org/
research.
We invite comments, questions, and sugges-
tions. E-mail us at editor@clev.frb.org.
PRSRT STD
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Are SBA loan guarantees desirable?

http://www.clevelandfed.org/Research/commentary/2004/0915.pdf

Are SBA loan guarantees desirable?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics