Insurance, Incentives, and Efficiency in Small Business Lending

Abstract

Since the inception of the Small Business Administration (SBA) in 1954, more than $16 billion has been received by small businesses under SBA programs. The SBA's business lending efforts are carried out under four basic programs: the Section 7(a) Regular Business Loan Program, the Economic Opportunity Loan Program, the Development Company Loan Program, and the Displaced Business Loan Program. In order to qualify under any of these programs, the small business must be unable to obtain conventional financing. Thus, the loans approved by the SBA are, by nature, risker than conventional bank loans. However, the Agency must have reasonable assurance of repayment before an application will be approved. Under its four basic business loan programs, the SBA engages in three types of lending relationships: direct loans, immediate-participation loans, and guaranteed loans.1 In direct lending, the SBA lends funds directly to the small business. Under an immediateparticipation loan, both the SBA and a commercial bank advance a portion of the loan principal at the time the loan is made. In a guaranteed loan, the SBA acts as an insurer, and guarantees up to 90 percent of the loan principal that a commercial bank extends to a qualifying borrower. In case of default by the borrower, the Agency is liable and has to purchase the loan from the bank. Loan guarantees, by far, constitute the most important type of SBA lending activity. Approximately 89 percent of the dollar amount and 81 percent of the total number of business loans outstanding are of the guaranteed variety [15]. This study examines the incentives of the contracting parties to the SBA guaranteed business loan to exercise care when information asymmetries are present. We also empirically evaluate the efficiency of the default-loss avoidance activities of the parties to the