The Role of Government in Small Business Finance

The federal government plays a large role in the market for small business credit. The Consumer Financial Protection Bureau (CFPB) estimated that, in 2019, the outstanding balance of small business credit supported and extended by the government was around $200 billion. This estimate included programs such as the 7(a) loan guaranty at the Small Business Administration (SBA) and the Farm Credit System. It did not include programs such as the State Small Business Credit Initiative (SSBCI), through which $10 billion is being provided to states to stimulate private sector lending and investment. The CFPB’s estimate also did not include standalone efforts by state and local governments: “the Bureau estimates that there are likely over 100 government small business lending programs” across the country.

Yet the small business credit market is quite large. The CFPB’s total market estimate, in terms of the value of outstanding balances, was $1.2 trillion in 2019. Government programs thus account for about one-sixth of that total. On an annual basis, SBA’s 7(a) program helps originate no more than 10% of new credit provision for small businesses. This explainer looks at the reasons for government involvement in small business lending, trends in the largest programs, and its effects.

Justification for Government Intervention

There has been longstanding concern among policymakers and small business advocates about “credit rationing” because of the challenges in lending to them. Small businesses “don’t have as much publicly available, transparent information for lenders,” leading to a dearth of “standardized, quantitative criteria” for assessing creditworthiness. Small businesses are frequently said to be “informationally opaque.” Even sophisticated lenders “have had difficulty determining the creditworthiness of applicants for small business loans. The heterogeneity across small firms, together with widely varying uses of borrowed funds, has impeded the development of general standards for assessing applications for small business loans and has made evaluating such loans relatively expensive.”

Even when a bank, for example, has insight into a prospective small business borrower’s accounts, there is considerable “fluidity” between business and personal accounts: “Business owner liquid wealth is difficult to characterize, even among businesses with single owners. They may hold cash in both their personal and business deposit accounts, and transfer funds easily between the two in ways that may or may not relate to the operational performance of their business.” The private sector maintains consistent efforts to address these small business lending challenges. For two decades, for example, banks have made greater use of new credit scoring technology. Many lenders have also increasingly tested methods such as cash-flow underwriting.

The purpose of a loan guarantee—the most common form of government support for small business lending—is to establish “a mechanism for pricing loans that is independent of borrower behavior” and reduce expected risk for lenders. By doing so, credit access for small businesses, especially those who cannot access it elsewhere, should expand.

Who Applies for and Receives SBA-Guaranteed Loans?

Between 2014 and 2019, among those small employer firms applying for credit, about one-quarter, on average, reported in the Small Business Credit Survey (SBCS) that they applied for an SBA-backed loan or line of credit. In 2020 and 2021—excluding emergency efforts like the Paycheck Protection Program (PPP) and COVID-19 Economic Injury Disaster Loans (EIDL)—that share rose to four in 10. In general, small businesses that are older and larger in revenues and employment have lower rates of application for SBA loans but higher approval rates. For example, 58% of small business respondents in the SBCS with annual revenues between $25,000 and $50,000 reported that they applied for an SBA loan in 2021 (excluding PPP or EIDL). Their approval rate was 31%. Small businesses with revenues between $500,000 and $1 million, by contrast, had a 39% application rate but a 45% approval rate. Similar differences are seen according to business age and employment size.

The interaction of these business characteristics—size and age—with the demographic profiles of business owners result in differential impact. Since small businesses owned by women and people of color are, on the whole, younger and smaller, we would expect that to be reflected in application and approval rates for SBA credit products. Black business owners in particular have applied for SBA-backed credit at a higher rate than other demographic groups—yet with less success.

Trends in Lending Supported by 7(a) Loan Guaranty

The 7(a) loan guaranty is often referred to as SBA’s “flagship” credit program. Participating lenders in the program assess whether a small business applicant qualifies for a traditional loan or requires the extra protections (for the lenders) of a government backstop. Lenders that enjoy “delegated” authority make this decision without prior SBA approval. If the borrower defaults, SBA fulfills its contractual duty and purchases the loan from the lender. Overall, the 7(a) program is a collection of individual programs, such as the Preferred Lender Program and SBA Express. Over the last several years, about nine in 10 7(a) loans have been provided through these two programs.

Over time, as Congress has authorized a higher annual amount for the 7(a) program, more lending dollars have been supported and the average loan size has steadily risen. (Pandemic-era averages are likely artificially high due to PPP and EIDL. The average loan size in PPP was less than $100,000.)

Effects and Outcomes of SBA-Guaranteed Lending

The research literature on SBA-backed loans is not large; findings on the effects of the 7(a) loan guaranty have been both positive and negative.

• Positive Effects
  • In the aggregate, SBA-guaranteed lending has a positive impact on local employment levels, though it varies by income: “Our results suggest that low-income markets are positively impacted by 7(a) program guaranteed lending … the impact for low-income markets is significantly larger than it is for higher income markets.”
  • Research found “a small but positive and statistically significant relationship between guaranteed loans and income growth.”
  • A Government Accountability Office report, looking at the program from 2001-2004, found that “the 7(a) loan program contributes a much greater proportion of loans to startups and women and minority-owned businesses than the conventional market.”
  • A 2008 analysis by the Urban Institute similarly found that 7(a) loan recipients were more likely to be “minority-owned, women-owned, and start-up businesses (firms that have historically faced capital gaps) as compared to conventional small business loans.”
  • According to data from SBA, the share of 7(a) dollars going to Black business owners has risen steadily over the last decade, from 1.6% in fiscal year 2012 to 3.8% in FY2022. For businesses that are majority-owned by women, the share of 7(a) dollars rose from 12% to 15% over the same time period.
  • Increases in the share of the number of 7(a) loans have been even more impressive over that same time period: from 2.5% to 7.2% for Black-owned businesses; 7% to 10% for Hispanic-owned businesses; and 16% to 20% for majority-female-owned businesses.
  • A geographically-focused analysis of SBA lending found that, at a neighborhood level, a higher number of SBA-backed loans was positively associated with low- and moderate-income households, in contrast with non-SBA small business loans.

Perhaps the most significant positive effect of the 7(a) loan guaranty program has been its success in establishing what generally had not existed in the world of small business lending: a secondary market in securitized loans. Securitization has mostly been stunted in the small business lending market because of the informational problems noted above: “Loan terms and conditions are not homogeneous, underwriting standards vary across originators, and information on historical loss rates is typically limited.” SBA, through the 7(a) program, has helped establish a secondary market for guaranteed loans by lowering risk and standardizing information, documentation, and collateral requirements. The 7(a) secondary market has helped “overcome” informational challenges, facilitating government guarantees and thereby access to credit.

On the other hand, some research studies have either failed to find positive effects from 7(a)-guaranteed loans or found negative impact.

• An analysis of SBA 7(a) data from 2010 to 2020 by Prosperity Now found that the program consistently underserved businesses owned by people of color, particularly Native American and Black business owners. Each year, on average, around three-quarters of 7(a) loans “have been distributed to borrowers in majority-White ZIP codes … suggesting that, for most of the decade, borrowers in majority-Black ZIP codes were consistently underserved by both volume and loan approval amount metrics.”
• One study found that SBA loans are not positively related to employment or income growth because government-guaranteed lending “crowds out” private sector credit.
• The same research found detrimental effects of SBA-backed loans in the form of “a negative effect on per capita income growth” and displacement of “loans that would have otherwise been made to more profitable and/or innovative firms.”
• A review of multiple studies concluded, “it is clear that the results concerning the impact of SBA lending on local economic conditions are inconclusive.”
• A broader review of government lending programs beyond 7(a) failed to find “evidence that financial capital constraints are a significant barrier to firm creation in the low-barrier lines of business most often targeted for entry by subsidized loan program clients.” Accordingly, “subsidized loans fail to ease” barriers to small business entry and growth.

As some have observed, local economic development is not necessarily the purpose of the 7(a) program. A positive regional effect—whether in job creation, income growth, property appreciation, or other indicators—might be a desirable (and anticipated) side effect. But those effects aren’t necessarily the yardstick by which 7(a) lending should be gauged. There are, however, broader, often unintended effects of government-guaranteed lending that may be undesirable to policymakers. The very existence of the 7(a) loan guaranty, for example, means that “SBA selectively influences credit allocation,” which “is likely to have costly unintended effects. The subsidy associated with SBA guaranteed lending may have re-distributional effects that are inconsistent with conventional notions of social welfare.” This is precisely what was found to be the case with PPP, in which “the incidence of the program across the household income distribution was highly regressive,” with a huge share of benefits (75%) accruing to the richest households.

Looking ahead, one expectation might be that demand for SBA-guaranteed loans will increase. The high application rates seen in 2021 and 2022 (excluding PPP and EIDL) likely point to greater awareness among small businesses of the existence and promise of SBA lending support. Recent actions by SBA also push in this direction, with the goal of not only expanding credit access to underserved small business borrowers but also attracting more lenders into the 7(a) program.