Revitalizing Small Businesses in Post-Pandemic America

Small banks can have a big impact if they can lend without fear of government penalties

By Thomas Hoenig

As the United States attempts to recover from the economic damage caused by the coronavirus pandemic, special attention will need to be paid to small businesses, which provide almost half of all jobs in this country. While small businesses need help from both the public and private sectors, banks—particularly smaller community banks—will play an outsized role in ensuring that this all-important sector gets back on its feet. Lawmakers and regulators can help by protecting these banks against certain risks in order to encourage them to lend to small businesses.

The Need to Help Small Businesses

Small businesses and entrepreneurs are essential cogs in the economic wheel of the United States. They supply essential goods and services to individuals, other small businesses, and the largest firms, which are intertwined and together determine the economy’s ultimate success.

As you would expect, therefore, a number of programs have been created to assist small businesses during the pandemic, and we can expect more in the future as the United States struggles to recover. The Small Business Administration, for example, has long been a source of credit to small businesses, and its role in the government’s Paycheck Protection Program (PPP) is among its more notable programs to help small firms survive the pandemic. Other programs directed through the Treasury and the Federal Reserve include direct government equity investments and highly accommodative lending, monetary, and interest rate policies, all involving heightened risk and designed to help businesses recover and rehire their employees.

While these efforts are substantial, they are and should remain temporary. Government programs are not free. They tend to be inefficient, allocating resources through nonmarket means. They come with massive increases in public debt that will be carried for decades and be future generations’ burden to repay. As the pandemic recedes, better and more enduring solutions must come through the private sector, including the banking industry as it lends to small businesses in communities across the country.

The Role of the Banking System

The United States banking system remains relatively decentralized and well positioned to help meet the funding needs of small-business borrowers as they seek to restart and build new businesses. In a 2018 survey, the FDIC found that its 6,100 insured depository institutions held well over $300 billion in loans to small businesses. Of those banks, 6,000 with less than $10 billion in assets and only 17 percent of industry total assets accounted for at least 53 percent of those loans. This is a striking accomplishment and suggests that small banks almost certainly can play a significant role aiding the recovery through their lending to small businesses.

In its survey, the FDIC also found that smaller banks tend to be relationship lenders that focus on small businesses within their local community. These banks appear more flexible and willing to make unsecured loans to small businesses. They often look at owner attributes and their involvement in the local community, and they are inclined to be more open to lending to entrepreneurs just getting started. They are likely to be considered more attentive in providing customer service and more focused on their local trade area.

Looking forward with this knowledge, we should expect banks to provide a significant share of new loans to small businesses. We can be confident also that much of it will come from smaller banks that know their communities, know their borrowers, and have the interest of their communities front and center. If they are encouraged to lend and to rely on their unique relationship advantage, they will contribute importantly to the expected recovery.

However, there is no guarantee for this outcome. Uncertainty is a significant impediment to bank lending following a financial crisis. It is natural for banks to be cautious, to defer decisions, and to be slow to assume risk. During such times bank supervisors also become more cautious, stricter in interpreting highly complex regulations, and more rigid in their loan reviews, including, for example, unsecured “character” loans. If such caution is carried too far or for too long, it will impede lending to small businesses and stifle broader efforts to get the economy back on a sustainable growth path.

Helping Banks

Thus, more than adding money to another PPP program, Congress and federal regulators should place a three-to-five-year moratorium on penalties related to small banks’ lending errors and some violations that occur when lending to individuals and small businesses. Regulations involving Truth in Lending disclosures, Home Mortgage Disclosure recordkeeping, incorrectly requiring spousal signatures under the Equal Credit Opportunity Act, and the ever-troublesome flood insurance requirements are examples where violations inadvertently occur because of the complexities of the regulations.

Should violations or errors around these and similar regulations be discovered during the course of a bank audit, if they are not deliberately deceptive, they could be cited and corrections made on a going-forward basis. The bank should be held harmless for errors up to that point. In addition, examiners should be given greater flexibility in judging the soundness of banks’ underwriting standards for small loans to businesses.

Such a moratorium would be unusual and carry added risk. There would be added loan losses among banks and possibly bank failures. But we also know smaller banks are oriented to making loans to small businesses, and the benefits of easing their path in deploying loans and reviving the economy are worth the costs. Moreover, failure to take these actions carries serious costs as well. People need to be back at work. Providing flexibility to those banks willing to lend to small businesses as they seek to recover and expand is worth the risk.

As the pandemic recedes, the building of the economy can accelerate, and small businesses will be a critical participant in this building process. Data show that smaller community banks are well positioned and inclined to take on the risk and provide the essential loans that enable small businesses to succeed. Finally, an important takeaway from the early part of the pandemic is that if bankers are allowed to accept greater risk, the recovery in the hands of the private sector will be more certain and less susceptible to the politics of government programs.

This is the fourth in a series of articles that will examine ways to help entrepreneurs who are seeking to start small businesses in the wake of the pandemic to access the capital they need. The first article in this series provides an overview of the challenges facing would-be entrepreneurs in the coronavirus economy. The second article concerns offering small businesses guaranteed access to credit. The third article examines the rules governing investors in startups. The fifth article proposes easing restrictions on the sale of securities by small startups. The sixth article argues that Congress should ease restrictions on peer-to-peer lending. The seventh article proposes several reforms to the Small Business Administration. The eighth and final article urges governments to create a better environment for small businesses by reducing uncertainty and reopening the economy.