Small Business Loans: Additional Actions Needed to Improve Compliance with the Credit Elsewhere Requirement
Released: 2018-06-05T00:00:00

Letter

Background

Under SBA’s 7(a) loan program, SBA guarantees loans made by commercial lenders to small businesses for working capital and other general business purposes. These lenders are mostly banks, but some are non-bank lenders, including small business lending companies— lenders whose lending activities are not subject to regulation by any federal or state regulatory agency, but were previously licensed by SBA and authorized to provide 7(a) loans to qualified small businesses. The guarantee assures the lender that if a borrower defaults on a loan, the lender will receive an agreed-upon portion (generally between 50 percent and 85 percent) of the outstanding balance. For a majority of 7(a) loans, SBA relies on lenders with delegated authority to approve and service 7(a) loans and to ensure that borrowers meet the program’s eligibility requirements. To be eligible for the 7(a) program, a business must be an operating for-profit small firm (according to SBA’s size standards) located in the United States and must meet the credit elsewhere requirement.

Because the 7(a) program is required to serve borrowers who cannot obtain conventional credit at reasonable terms, lenders making 7(a) loans must take steps to ensure that borrowers meet the program’s credit elsewhere requirement. Because SBA relies on lenders with delegated authority to make these determinations, SBA’s oversight of these lenders is particularly important. However, we found in a 2009 report that SBA’s lack of guidance to lenders on how to document compliance with the credit elsewhere requirement was impeding the agency’s ability to oversee compliance with the credit elsewhere requirement. To improve SBA’s oversight of lenders’ compliance with the credit elsewhere requirement, we recommended in 2009 that SBA issue more detailed guidance to lenders on how to document their compliance with the credit elsewhere requirement. As a result, SBA revised its standard operating procedure to state that each loan file must contain documentation that specifically identifies the factors in the present financing that meet the credit elsewhere test, which we believe met the spirit of our recommendation.

SBA’s current credit elsewhere criteria for determining 7(a) loan eligibility include the following factors: 1. the business needs a longer maturity than the lender’s policy permits; 2. the requested loan exceeds the lender’s policy limit regarding the amount that it can lend to one customer; 3. the collateral does not meet the lender’s policy requirements; 4. the lender’s policy normally does not allow loans to new businesses or businesses in the applicant’s industry; or 5. any other factors relating to the credit which, in the lender’s opinion, cannot be overcome except for the guarantee.

When the 7(a) program was first implemented, borrowers were generally required to show proof of credit denials from banks that documented, among other things, the reasons for not granting the desired credit. Similar requirements remained in effect until 1985, when SBA amended the rule to permit a lender’s certification made in its application for an SBA guarantee to be sufficient documentation. This certification requirement remained when the rule was rewritten in 1996. SBA stated that it believed requiring proof of loan denials was demoralizing to small businesses and unenforceable by SBA.

SBA and lender roles vary among 7(a) program categories—including regular 7(a), the Preferred Lenders Program, and SBA Express. Under the regular (nondelegated) 7(a) program, SBA makes the loan approval decision, including the credit determination. Under the Preferred Lenders Program and SBA Express, SBA delegates to the lender the authority to make loan approval decisions, including credit determinations, without prior review by SBA. For each 7(a) program category, lenders are required to ensure that borrowers meet the credit elsewhere requirement for all 7(a) loans. The maximum loan amount under the SBA Express program is $350,000, as opposed to $5 million for other 7(a) loans. The program allows lenders to utilize, to the maximum extent possible, their own credit analyses and loan underwriting procedures. In return for the expanded authority and autonomy provided by the program, SBA Express lenders agree to accept a maximum SBA guarantee of 50 percent. Other 7(a) loans generally have a maximum guarantee of 75 percent or 85 percent, depending on the loan amount. In fiscal year 2016, 1,991 lenders approved 7(a) loans, of which 1,321 approved at least one loan with some form of delegated authority.

SBA’s Office of Credit Risk Management is responsible for overseeing 7(a) lenders, including those with delegated authority. SBA created this office in fiscal year 1999 to help ensure consistent and appropriate supervision of SBA’s lending partners. The office is responsible for managing all activities regarding lender reviews; preparing written reports; evaluating new programs; and recommending changes to existing programs to assess risk potential. Generally, the office oversees SBA lenders to identify unacceptable risk profiles using its risk rating system and enforce loan program requirements. According to SBA’s standard operating procedures, one of the agency’s purposes of its monitoring and oversight activities is to promote responsible lending that supports SBA’s mission to increase access to capital for small businesses.

In the federal budget, the 7(a) program is generally required to set fees that it charges to lenders and borrowers at a level to cover the estimated cost of the program associated with borrower defaults (in present value terms). To offset some of the costs of the program, such as default costs, SBA assesses lenders two fees on each 7(a) loan. First, depending on the term of the loan, the guarantee fee must be paid by the lender within either 90 days of loan approval or 10 business days of the SBA loan number being assigned. This fee is based on the amount of the loan and the level of the guarantee, and lenders can pass the fee on to the borrower. Second, the servicing fee must be paid annually by the lender and is based on the outstanding balance of the guaranteed portion of the loan.

The 7(a) program accounts for a small portion of total small business lending. According to a May 2017 report by the Consumer Financial Protection Bureau, the total debt financing available to small businesses was estimated to be $1.4 trillion. Of that amount, the Consumer Financial Protection Bureau estimated that about 7 percent was SBA loans, including 7(a) loans.

SBA and some other researchers have suggested that there may be disparities in credit access among small businesses, based on characteristics of the borrower and firm. SBA lists as a strategic objective to “ensure inclusive entrepreneurship by expanding access and opportunity to small businesses and entrepreneurs in communities where market gaps remain.” In 2007, we reported that some studies had noted disparities among some races and genders in the conventional lending market, but the studies did not offer conclusive evidence on the reasons for those differences. Much of the research we reviewed in 2007 relied on the Board of Governors of the Federal Reserve System’s Survey of Small Business Finance, which was last implemented in 2003. Although this survey is no longer available, recently the 12 Federal Reserve Banks conducted the Small Business Credit Survey. In a series of reports based on the more recent survey, researchers found disparities in credit availability based on gender, the age of the firm, and minority status.

Businesses That Were New, Women- Owned, or Located in Distressed Areas Received a Majority of 7(a) Loan Dollars over the Past 10 Years

From fiscal years 2007 through 2016, a majority of loan dollars guaranteed under the 7(a) program went to small businesses that were new, partially or wholly owned by women, or located in a distressed area. As previously mentioned, recent studies we reviewed by the Federal Reserve Banks and other researchers suggest that certain small business borrowers—including businesses that are new or owned by women—have difficulty obtaining conventional small business loans, which may put them at a disadvantage. As shown in figure 1, almost two-thirds of loan dollars guaranteed under the 7(a) program for this period went to small businesses that were in these two categories or located in a distressed area. The remaining 37 percent of 7(a) loan dollars went to businesses that were established, solely male-owned, and not located in economically distressed areas. See appendixes II and III for additional data on 7(a) loans, such as the total volume, percentage of lending provided by year and by state, and other borrower characteristics, including SBA’s loan- and lender-level Small Business Risk Portfolio Solutions score (predictive score) information.

In the following figures, we present more detailed data on 7(a) loans to small businesses based on their status as a new business; gender of ownership; location relative to economically distressed areas; and minority ownership for fiscal years 2007 through 2016.

New businesses. As shown in figure 2, the percentage of 7(a) loans that went to new businesses decreased from 36 percent in fiscal year 2007 to 23 percent in fiscal year 2011 before increasing to 35 percent by 2016.

Gender. From fiscal years 2007 through 2016, the share of the total value of approved 7(a) loans by gender of owner remained fairly consistent (see fig. 3). An average of 70 percent of the total loan value went to male- owned businesses, and the remaining 30 percent went to businesses that were majority (more than 50 percent) or partially (50 percent or less) owned by women.

Economically distressed areas. SBA did not provide data on whether 7(a) loans go to businesses located in economically distressed neighborhoods. However, we used data from the American Community Survey for 2011 through 2015, the most recent version available at the time of our analysis, along with zip code information provided by SBA to determine the average poverty rate by zip code (see fig. 4). From fiscal years 2007 through 2016, the proportion of the total value of 7(a) loans approved that went to borrowers in economically distressed areas remained between 23 percent and 26 percent. We defined distressed areas as zip codes where at least 20 percent of the households had incomes below the national poverty line.

Minority/Nonminority status of borrower. From fiscal years 2007 through 2016, the proportion of the total value of 7(a) loans approved that went to minority borrowers decreased overall—from 43 percent to 30 percent—with the lowest share at 24 percent in fiscal year 2010 (see fig. 5). The share of approved loan dollars that went to nonminority borrowers varied, increasing to 69 percent in fiscal year 2010 before decreasing to 56 percent in fiscal year 2016. Notably, the share of the total value of loans approved that went to borrowers whose race/ethnicity was categorized as undetermined increased from 5 percent in fiscal year 2007 to 13 percent in fiscal year 2016. This increase does not fully account for the declined share for minority borrowers. However, according to SBA officials, borrowers voluntarily provide self-reported information on race and ethnicity and therefore the associated trend data should be viewed with caution.

SBA Has Processes in Place to Evaluate Lender Compliance, but Its Lender Reviews Do Not Document Reasons for Noncompliance

SBA Conducts On-site and Targeted Lender Reviews to Evaluate Lender Compliance with the Credit Elsewhere Documentation Requirement

SBA relies on on-site reviews as its primary mechanism for evaluating lenders’ compliance with the credit elsewhere requirement. The reviews are performed by third-party contractors with SBA staff participation and additional oversight from SBA. According to SBA’s standard operating procedures, these reviews are generally conducted every 12 to 24 months for all 7(a) lenders with outstanding balances on the SBA- guaranteed portions of their loan portfolios of $10 million or more, although SBA may conduct on-site reviews of any SBA lender at any time as it considers necessary. In fiscal year 2016, SBA conducted 40 on-site reviews of 7(a) lenders, representing approximately 35 percent of SBA’s total outstanding 7(a) loan portfolio.

As part of SBA’s on-site reviews, reviewers judgmentally selected a sample of approximately 30 to 40 loan files using a risk-based approach. These loan files accounted for approximately 6 percent to 19 percent of each lender’s total gross SBA dollars in fiscal year 2016. For each lender, approximately 70 percent to 90 percent of the loan files in the sample were reviewed to evaluate compliance with the credit elsewhere requirement. According to SBA’s contractors, loans that were selected for other reasons, such as issues related to liquidation, were not required to be reviewed for credit elsewhere compliance.

SBA requires lenders to provide a narrative to support the credit elsewhere determination in the credit memorandum included in each loan file. SBA’s standard operating procedures state that lenders must substantiate that credit is not available elsewhere by (1) discussing the criteria that demonstrate an identifiable weakness in a borrower’s credit and (2) including the specific reasons why the borrower does not meet the lender’s conventional loan policy requirements.

In keeping with SBA’s documentation requirement, third-party contractors and SBA staff who conduct on-site reviews are supposed to assess whether lenders have adequately documented the credit elsewhere criteria and provided specific reasons supporting the criteria in the credit memorandum. According to SBA’s contractors, adequate documentation of the credit elsewhere determination in the credit memorandum would include not just which of the criteria a borrower met but also a discussion of the basis or justification for the decision. For example, if a lender determined that a borrower needed a longer maturity, the lender should explain in the credit memorandum the reasons why a longer maturity was necessary. SBA’s contractors also told us that they carefully review a lender’s loan policies in preparation for on-site reviews and refer to a lender’s policies throughout the reviews. Reviewers do not attempt to verify the evidence given in support of the credit elsewhere reason beyond the information provided in the credit memorandum.

Based on our review of fiscal year 2016 reports, on-site reviews can result in three levels of noncompliance response:

Finding: This is the most severe result and is associated with a corrective action for the lender to remedy the issue.

Observation: This is a deficiency recorded in the review’s summary but may not warrant a corrective action for the lender.

Deficiency Noted: This is the lowest level of response. It is a deficiency noted as part of the review that is not included in the review’s summary and also may not warrant a corrective action.

According to SBA officials, SBA’s policy has been that any noncompliance with SBA loan program requirements results in a finding. However, according to SBA officials and our review of the fiscal year 2016 on-site review reports, if a single instance of noncompliance was identified in fiscal year 2016, SBA generally would not issue a finding. Instead, SBA’s contractors said they would attempt to determine whether that instance was an inadvertent error, such as by examining additional loan files.

Lenders that are subject to corrective actions are generally required to submit a response to SBA within 30 days to document how they have addressed or plan to address the identified issues. SBA subsequently asks for documentation to show that the lender has remedied the issue, and in some cases will conduct another review that usually includes an assessment of 5 to 10 additional loan files to determine whether the credit elsewhere reason has been adequately documented. According to SBA officials, SBA may also review lenders’ compliance with corrective actions from recent on-site reviews during targeted reviews (discussed below) and delegated authority renewal reviews (for lenders with delegated authority).

In addition to on-site reviews, SBA also monitors lenders’ compliance with the credit elsewhere requirement through targeted reviews (performed on- or off-site). Targeted reviews of a specific process or issue may be conducted for a variety of reasons at SBA’s discretion, including assessing a lender’s compliance with the credit elsewhere requirement. In fiscal year 2016, SBA conducted 24 targeted reviews that included an examination of lenders’ compliance with the credit elsewhere documentation requirement. For these reviews, SBA examined loan files for 5 judgmentally selected loans that were provided to SBA electronically, as well as copies of the credit elsewhere reasoning (among other underwriting documentation) for 10 additional recently-approved loans.

SBA also conducts periodic off-site reviews that use loan- and lender- level portfolio metrics to evaluate the risk level of lenders’ 7(a) portfolios. According to agency officials, SBA also began using off-site reviews to evaluate lenders’ compliance with the credit elsewhere requirement in fiscal year 2016. In that year, SBA conducted off-site reviews of 250 lenders and required these lenders to report the credit elsewhere justification for a sample of 10 loans per lender that were identified by SBA’s selection process. Lenders were not required to provide supporting documentation, and SBA did not follow up with lenders or review loan files to ensure the validity of the self-reported reasons. According to SBA, off-site reviews followed the same procedures in fiscal year 2017 as in 2016 and that the agency planned to use the same procedures for these reviews in the future. According to the agency, it also routinely evaluates and revises its review processes and procedures.

In addition, SBA’s Loan Guaranty Processing Center and National Guaranty Purchase Center conduct Improper Payments Elimination and Recovery Act and quality control reviews at the time of loan approval and at the time of guaranty purchase, respectively. These reviews examine the credit elsewhere requirement, among other issues. Lastly, since 2014 SBA’s Office of Inspector General has also examined whether high-dollar or early-defaulted 7(a) loans were made in accordance with rules; regulations; policies; and procedures, including the credit elsewhere requirement.

SBA’s Lender Reviews in 2016 Identified a High Rate of Noncompliance with the Credit Elsewhere Documentation Requirement

Our review of the on-site reviews conducted in fiscal year 2016 found that 17 of the 40 reviews—more than 40 percent—identified compliance issues with the credit elsewhere documentation requirement. Of those 17 reviews,

10 reviews resulted in a Finding (all with associated corrective

3 reviews resulted in an Observation (none with associated corrective actions or requirements), and

4 reviews resulted in a Deficiency Noted (one with an associated requirement).

For all of the 17 on-site reviews that identified an instance of noncompliance, the issue was related to the lender’s documentation of the credit elsewhere criteria or justification. For example, one review found that the lender’s “regulatory practices demonstrate material noncompliance with SBA Loan Program requirements regarding documentation of the Credit Elsewhere Test.” Another review found that the lender “failed to demonstrate with adequate documentation that credit was not available elsewhere on reasonable terms and conditions.” For 2 of the 17 reviews, the issue was partly related to a discrepancy between the credit elsewhere justification used for some of the sample loan files and the lender’s own loan policy limits.

With regard to SBA’s targeted reviews, 7 of 24 reviews (29 percent) conducted in fiscal year 2016 found a compliance issue with the credit elsewhere requirement. Of those 7 reviews,

6 reviews resulted in a Finding (all with associated corrective actions),

1 review resulted in an Observation (without an associated corrective no reviews resulted in a Deficiency Noted.

For all of the 7 targeted reviews that identified a compliance issue, the issue was wholly related to the lender’s documentation of the credit elsewhere reason or justification. For example, 4 reviews found that for at least one loan reviewed, “the Lender failed to document justification that credit was unavailable elsewhere.” Another review found that for “three SBA Express loans and one Small Loan Advantage loan reported “other factors relating to the credit that in the lender’s opinion cannot be overcome except for the guaranty’ without specific identification of the factors.”

Lack of Internal Controls Led to Lender Noncompliance, but Were Not Documented by SBA’s Reviews

Based on our review of on-site review reports and an interview with one reviewer, the key factors underlying lenders’ high rate of noncompliance with the credit elsewhere documentation requirement were lenders’ lack of proper internal controls and procedures and lack of awareness of the credit elsewhere documentation requirement. In fiscal year 2016, SBA’s corrective actions related to the credit elsewhere requirement required the lenders to establish or strengthen their policies; procedures; underwriting processes; or internal controls. In addition, contractors conducting the on- site reviews with whom we spoke stated that some lenders appeared to be unfamiliar with SBA’s standard operating procedures or were unclear on how to interpret them.

For the 11 on-site reviews conducted in 2016 that included corrective actions, SBA generally required lenders to improve controls or procedures. For example, one lender was required to “correct its policy, modify its procedure, and amend its internal controls to ensure that its consideration and documentation of credit unavailable elsewhere identifies the specific fact(s) which are applicable to the specific loan and the determination is rendered and accurate for each individual SBA loan that it originates.” Another lender was required to “improve underwriting processes and controls to ensure that the borrower meets the [credit elsewhere] requirement” and to “document the loan file with the reasons for the determination.”

Similarly, for the six targeted reviews in 2016 that included corrective actions, SBA issued a general requirement for the lender to “identify the causes for the Findings and implement corrective actions.” Based on our review of these targeted reviews, lenders generally remedied or intended to remedy the issue by amending their internal controls or procedures. For example, one lender stated that the “Credit Elsewhere test will be incorporated into the Credit Department process.” Another lender stated that it would “centralize all SBA underwriting and has developed an SBA addendum that will be utilized for all SBA-guaranteed loans.”

Although some of SBA’s on-site reviews for fiscal year 2016 identified factors leading to noncompliance, they generally did not document reviewers’ assessment of lenders’ policies and practices for complying with the credit elsewhere documentation requirement. SBA’s standard operating procedures state that the on-site reviewers should determine whether or not lenders’ policies and practices adhere to the requirement, but they do not require them to document their assessment of these policies and practices. Only 4 of the 40 fiscal year 2016 review reports that we examined included such an assessment. As a result, although SBA required corrective actions by the lender to address deficiencies, there usually was no record of the underlying factors that resulted in the lender’s noncompliance.

Federal internal control standards state that management should design control activities to achieve objectives and respond to risks, including appropriate documentation of transactions and internal control. Because SBA does not require reviewers to document their assessment of lenders’ policies and practices for complying with the credit elsewhere documentation requirement, the agency does not have good information to help explain why so many lenders are not in compliance. This hinders SBA’s ability to take informed and effective actions to improve lender compliance with the requirement and ensure that the program is reaching its intended population.

SBA Collects Limited Data on Criteria Used for Credit Elsewhere Justifications and Does Not Analyze Patterns in Lender Practices

SBA Collects Limited Data on Criteria Used for Credit Elsewhere Justifications

SBA does not routinely collect information on the criteria lenders use in their credit elsewhere justifications. As previously discussed, lenders are required to maintain documentation of borrower eligibility (including the credit elsewhere justification) in each loan file for loans approved through lenders’ delegated authority. However, SBA cannot readily aggregate information on lenders’ credit elsewhere justifications for both delegated and nondelegated loans:

For delegated loans, lenders are required to certify the loan’s credit elsewhere eligibility on E-Tran, SBA’s online portal for origination of delegated and nondelegated loans. However, lenders are only required to check a box to certify that the loan file contains the required credit elsewhere justification and are not required to submit any additional information, including which of the criteria was used to make the determination. According to SBA officials, delegated loans account for loans approved by approximately 70 percent of lenders.

For nondelegated loans, lenders are required to submit credit elsewhere documentation to be reviewed by SBA’s Loan Guaranty Processing Center. For these loans, which comprise loans approved by the remaining 30 percent of lenders, SBA might maintain paper records of data on borrowers’ eligibility but does not compile such data electronically and thus cannot readily aggregate the data for analysis.

Instead, SBA relies on on-site reviews or lender-reported information to review lenders’ credit elsewhere justifications and collects limited data from these reviews. For its on-site reviews, SBA does not collect sample data on lenders’ use of the credit elsewhere criteria. For its off-site reviews, SBA collected sample data on lenders’ use of the credit elsewhere criteria based on 250 such reviews conducted in fiscal year 2016. For these reviews, SBA asked lenders to self-report a short description of the credit elsewhere justifications used for an SBA-selected sample of 10 loans. However, as discussed earlier, SBA did not request or examine loan files as part of these off-site reviews and did not follow up with lenders or review loan files to ensure the validity of the self- reported reasons.

One reason why SBA does not routinely collect complete information on lenders’ use of the credit elsewhere criteria is that SBA’s loan origination system, E-Tran, is not equipped to record or tabulate this information. In addition, according to an SBA official, on-site reviews do not collect data on the credit elsewhere criteria because the loans reviewed are judgmentally selected and would not accurately represent the larger population.

Federal internal control standards state that management should use quality information to achieve the entity’s objectives. To do so, management should identify the information needed to achieve the objectives and address the risks, obtain relevant data from reliable internal and external sources in a timely manner, and process the obtained data into quality information. More robust information on lenders’ credit elsewhere justifications, including the credit elsewhere criteria, would allow SBA to evaluate patterns in lender practices related to the credit elsewhere requirement and, in turn, help the agency ensure compliance with the requirement. In this context, generalizable data, which can be collected through random sampling, or complete data through required reporting for every loan would allow SBA to better understand patterns in lender practices across the 7(a) program. Further, nongeneralizable data, which are available through SBA’s current off- and on-site review processes, would allow SBA to examine specific groups of lenders and could help SBA determine if it is necessary to collect additional data.

SBA Has Not Conducted Analysis to Determine If There Are Any Patterns of Noncompliance or Identified Lenders That May Be at Risk

SBA does not analyze the limited data it collects to help it monitor lenders’ compliance with the credit elsewhere requirement. According to agency officials, SBA has not performed lender-level analyses of the criteria lenders use for their credit elsewhere justifications. Additionally, SBA has not analyzed 7(a) lenders’ use of the “other factors” criterion— that is, factors not specified in the other criteria that, in the lender’s opinion, cannot be overcome except for the guarantee—for example, by collecting data on the frequency of its use or examining why lenders rely on it. While some 7(a) lenders told us they avoided relying on the “other factors” criterion because it was vague and open to interpretation, some lenders have used it when a borrower’s profile did not meet any of the other criteria. For example, one lender stated that this criterion was used for a borrower who was no longer a start-up but had experienced fluctuations in cash flow due to relocation or change in ownership. Another lender stated that the criterion was used more frequently during the 2007-2009 financial recession to extend financing to borrowers whose owners had experienced a home foreclosure but were otherwise sound.

Federal internal control standards state that management should establish and operate monitoring activities to monitor the internal control system and evaluate the results. Analyzing data on lenders’ use of the credit elsewhere criteria as part of its monitoring procedures could help SBA determine whether there are patterns in lender practices related to the criteria that could predict lender noncompliance. For example, SBA could analyze lenders’ use of the criteria along with lender review results and other data on loan characteristics and performance to determine whether certain patterns indicate that a lender might be applying the requirement inconsistently. Additionally, such analysis could inform SBA’s selection of which lenders to review by improving its ability to identify lenders at risk of noncompliance with the credit elsewhere requirement. Better selection criteria for its lender reviews could, in turn, improve identification and remediation of such noncompliance, helping ensure that the 7(a) program serves its target population.

Lenders Generally View Credit Elsewhere Criteria as Adequate, and SBA Has Implemented New Procedures for Reviewing Eligibility

Lenders Said Credit Elsewhere Criteria are Generally Adequate for Determining Borrower Eligibility

Representatives at 8 of the 11 lenders that we contacted said they believed that SBA’s current credit elsewhere criteria are adequate in targeting small business borrowers who cannot obtain credit at reasonable terms. Representatives of these lenders also agreed that the criteria generally serve the types of small businesses that would otherwise have trouble obtaining conventional credit, such as new businesses or those with a shortage of collateral. One lender representative told us its most commonly used criterion related to the overall time in business because of the higher risk of failure. Another lender representative cited the lack of collateral as the most common criterion used. Additionally, representatives at an industry association told us that one of the most commonly used criteria was the one related to loan maturity and many small businesses seek 7(a) loans because they offer repayment terms of up to 10 years, compared to 1 to 3 years for conventional loans.

Representatives of two other lenders suggested that the credit elsewhere criteria should not be overly prescriptive, which could limit lenders’ ability to make 7(a) loans to some businesses. For example, one representative said the credit elsewhere criteria should remain flexible because banks have different lending policies.

In addition, representatives at three lenders indicated that they were hesitant to use the “other factors” criterion. One lender believed the requirement was open to interpretation and could be used inappropriately with lenders determining their own individual conventional loan policies. Another lender commented that the criterion was vague and rarely used by his institution, noting that SBA should provide some additional guidance on its use.

Factors Such as Lender Policies and Economic Conditions Also Affect Lenders’ Decisions to Offer a SBA 7(a) Loan

Lenders consider multiple factors in determining whether to offer small businesses a conventional loan or a 7(a) loan, according to stakeholders with whom we spoke. For example, representatives at an industry association stated that a bank goes through several analyses to determine what loan product to offer the borrower. These representatives stated that the credit elsewhere requirement is embedded in the analysis a bank performs, such as whether the borrower qualifies for a loan and has a financial need for an SBA loan and whether the 7(a) program is right for that borrower.

Representatives at two other lenders also stated that many small businesses have already been turned down for conventional loans before they seek a 7(a) loan. One representative noted that the “reasonable rates and terms” component of the 7(a) program was important as it allows lenders to look more broadly at a borrower’s needs. For instance, the representative explained, lenders can assess whether repayment terms are reasonable given a particular borrower’s situation and the resources the borrower will have to repay the loan.

Economic conditions also affect lending policies, including whether borrowers qualify for a conventional loan, according to representatives at seven lenders with whom we spoke. For example, during the recent economic downturn, banks tightened their underwriting standards for small businesses and were less willing to lend without a government guarantee, according to one lender representative.

SBA Has Issued New Procedures for Reviewing Liquidity of Small Business Borrowers, and Additional Lender Training Is Underway

SBA has issued revised primary operational guidance for the 7(a) program, effective January 1, 2018. As discussed previously, lenders are required to make a determination that the desired credit is not available to the applicant from nonfederal sources. Under the previous guidance, the lender had to determine that some or the entire loan was not available from nonfederal sources or the resources of the applicant business. However under the revised guidance, the scope of nonfederal sources a lender must review was further defined to include sources both related and unrelated to the applicant. The updated guidance states that lenders must consider:

Nonfederal sources related to the applicant, including the liquidity of owners of 20 percent or more of the equity of the applicant, their spouses and minor children, and the applicant itself; or

Nonfederal sources unrelated to the applicant, including conventional lenders or other sources of credit.

Representatives of five lenders told us they have been determining how to interpret the new procedures with a few stating they would like additional guidance, including what information to retain in the file. Representatives of two lenders stated that there is some ambiguity in how to determine nonfederal resources and how to assess whether small business owners have too many available liquid resources to qualify for a 7(a) loan. One representative said that lenders can have different interpretations of what constitutes “available resources,” which is not specified in the new SOP. As a result, he said, there may be some confusion about how to assess family members of the borrower who have high net worths and whether the borrower should decline a family member contribution to qualify for an SBA loan. A representative of one lender stated that lenders will not know what SBA expects until loans are approved under the new procedures, default, and are then reviewed. Another lender’s representative suggested additional guidance on documentation, such as whether the bank must obtain a personal financial statement for each owner of the business.

A SBA staff told us SBA has provided multiple training presentations to SBA staff, lenders, and trade associations on the statutory changes to the credit elsewhere requirements and standard operating procedure updates. These have included a presentation at a trade association conference, four monthly conference calls for SBA staff, and two conference calls for SBA lenders. SBA staff said SBA also plans to hold monthly training sessions with SBA field offices, quarterly training sessions with the industry, and at least four training sessions in 2018 at lender trade conferences. Additionally, a representative from an industry association told us it is providing industry training on SBA’s revised procedures, including the credit elsewhere liquidity requirement.

Conclusions

SBA’s 7(a) loan program is required to serve creditworthy small business borrowers who cannot obtain credit through a conventional lender at reasonable terms, and SBA largely relies on lenders with delegated authority to make credit elsewhere determinations. However, although there is a high rate of lender noncompliance with the credit elsewhere documentation requirement, SBA does not require its reviewers to document their assessment of the policies and procedures lenders use to meet the requirement. Without better information from lender reviews on how lenders are implementing the requirement to document their credit elsewhere decisions, SBA may be limited in its ability to promote compliance with requirements and, in turn, use such information to help ensure that 7(a) loans are reaching their target population.

Furthermore, SBA does not routinely collect or analyze information on the criteria used for credit elsewhere justifications to evaluate patterns in lender practices. SBA recently began collecting some information on lenders’ use of the criteria, but this information is limited, and SBA does not analyze the information that it does collect to better understand lenders’ practices. Without more robust information and analysis, SBA may be limited in its ability to understand how lenders are using the credit elsewhere criteria and whether 7(a) loans are reaching borrowers who cannot obtain credit from other sources at reasonable terms.

Recommendations for Executive Action

We are making the following three recommendations to SBA.

The Administrator of SBA should require reviewers to consistently document their assessments of a lender’s policies and practices. (Recommendation 1)

The Administrator of SBA should use its on-site and off-site reviews to routinely collect information on lenders’ use of credit elsewhere criteria as part of its monitoring of lender practices related to the credit elsewhere requirement. (Recommendation 2)

The Administrator of SBA should analyze information on lenders’ use of credit elsewhere criteria obtained from its reviews to identify lenders that may be at greater risk of noncompliance and to inform its selection of lenders for further review for credit elsewhere compliance. (Recommendation 3)

Agency Comments and Our Evaluation

We provided a draft of this report for review and comment. SBA’s written comments are reprinted in appendix IV. SBA generally agreed with the recommendations. SBA also provided additional comments on certain statements in the draft report, which are summarized below with our responses.

SBA noted that the draft Highlights did not discuss how credit elsewhere is determined for nondelegated loans. We have not revised the Highlights in response to this comment because our review focused on delegated lenders. In the body of the report we note that approximately 70 percent of 7(a) loans are approved under delegated authority. We also refer to SBA’s nondelegated loans in the report for additional context.

According to SBA, the statement on our draft Highlights did not fully reflect its monitoring of lender compliance. SBA identified a variety of reviews it uses in addition to on-site reviews by third party contractors, which we discuss in the body of the report. We have modified the Highlights to reflect these other reviews.

Also in reference to the draft Highlights, SBA stated that it provides oversight on every on-site lender review and that an SBA employee is present as a subject-matter expert on every review. We revised the Highlights by adding that SBA provides oversight to the on-site reviews conducted by third-party contractors.

In response to a statement in our draft report that SBA guarantees loans to small businesses for working capital and other general business purposes, SBA commented that working capital generally is not the primary purpose for SBA-guaranteed loans. We did not revise the statement because SBA’s SOP 50 10 5 (version J) specifies that SBA’s 7(a) loan proceeds may be used for permanent working capital and revolving working capital, among other things.

In relation to a footnote in our report that mentions two lender reviews for which we did not receive documentation, SBA stated that on February 15, 2018, it provided documentation to us related to the reviews and that we had confirmed its receipt. However, the text in the footnote in question refers to two targeted lender reviews from 2016 that included corrective actions. The information SBA provided to us on February 15, 2018, was related to on-site reviews conducted in 2016. As a result, we did not revise the footnote.

SBA’s letter also contained technical comments that we incorporated as appropriate.

We are sending copies of this report to congressional committees, agencies, and other interested parties. In addition, this report will be available at no charge on our website at http://www.gao.gov.

If you or your staff members have any questions about this report, please contact me at (202) 512-8678 or shearw@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made key contributions to this report are listed in appendix V.

Appendix I: Objectives, Scope, and Methodology

This report discusses (1) 7(a) lending to selected categories of small business borrowers from fiscal years 2007 through 2016; (2) how the Small Business Administration (SBA) monitors lenders’ compliance with the credit elsewhere requirement; (3) the extent to which SBA evaluates trends in lender practices related to the credit elsewhere requirement; and (4) lenders’ views on the criteria used to determine eligibility for 7(a) loans and other issues related to the 7(a) program.

For background on the 7(a) program and the credit elsewhere requirement, we reviewed the legislative history of the 7(a) program and our previous reports. We also interviewed officials from SBA’s Office of Credit Risk Management on guidance provided to 7(a) lenders.

For background on constraints in the small business credit market, we reviewed recent academic literature on the characteristics of small businesses that historically have had more difficulty accessing credit. In addition, we reviewed recent studies published by the Federal Reserve Banks of Atlanta; Cleveland; Kansas City; and New York.

To describe the population of borrowers served by the 7(a) program, we selected characteristics (such as gender, minority status, and percentage of new business) that we used in our 2007 report and that were the subject of the recent studies by Federal Reserve Banks. We obtained and analyzed SBA loan-level data to describe 7(a) loans and borrowers. Specifically, SBA provided us with 581,393 records from its administrative data systems, which contained information on all loans approved and disbursed in fiscal years 2007 through 2016. The SBA data included various types of information describing each loan, including the total gross approval amount; the amount guaranteed by SBA; the loan term; and the interest rate; delivery method; and status of the loan. The SBA data also included information on borrower characteristics:

Age of business. Firms were classified as new (less than 2 years in operation) or existing.

Gender. Firms were classified as 100 percent male-owned; 50 percent or greater women owned; 50 percent or less women-owned; or “unknown.” Information on gender was voluntarily provided by borrowers.

Economically distressed area. We identified borrowers in economically distressed areas by matching borrower zip codes provided by SBA to those in the 2011 through 2015 American Community Survey. We defined distressed areas as zip codes where at least 20 percent of households had incomes below the national poverty line. In about 1 percent of the cases, we were unable to classify a lender because a zip code had changed or had insufficient population to report a poverty rate. We consider 1 percent of unmatched cases to be low by data reliability standards.

Race/ethnicity. Borrowers were placed in one of nine categories of race/ethnicity, including an “unknown” category. We aggregated these to create minority, nonminority, and undetermined categories. The minority category included all borrowers who reported being a race/ethnicity other than white. The nonminority category included borrowers who reported being white. Information on race was voluntarily provided by borrowers.

Industry. Firms were assigned a North American Industrial Classification code. These six-digit codes begin with a two-digit sector code that we used to draw more general conclusions about industries.

Geographic information. The data provided the state where the borrower is located.

In addition, we obtained information from SBA on loan- and lender-level Small Business Risk Portfolio Solution scores (predictive scores) provided by Dunn & Bradstreet and Fair Isaac Company, for loans approved in fiscal year 2016, the latest available. We were able to obtain predictive scores for approximately 81 percent of the loans for which SBA had provided other information. According to SBA, some loans may not have been disbursed at the time we obtained the predictive scores and, as a result, we do not have scores associated with these loans. We analyzed the information to determine the range of predictive scores and the range of average predictive scores by lender.

To assess the reliability of loan-level data on borrower and loan characteristics and predictive scores we received from SBA, we interviewed agency officials knowledgeable about the data and reviewed related documentation. We also conducted electronic testing, including checks for outliers, missing data, and erroneous values. We determined that the data were sufficiently reliable for the purposes of describing the characteristics of borrowers who received 7(a) loans and the distribution of predictive scores.

To assess how SBA monitors lenders’ compliance with the credit elsewhere requirement and criteria, we reviewed SBA’s standard operating procedures and other guidance on 7(a) program regulations and lender oversight. Specifically, we reviewed SOP 50 10 5 (versions I and J) on Lender and Development Company Loan Programs, SOP 50 53(A) on Lender Supervision and Enforcement, and SOP 51 00, On-Site Lender Reviews/Examinations, as well as information and policy notices related to the credit elsewhere requirement. Additionally, we interviewed representatives including those at SBA’s Office of Capital Access and Office of Credit Risk Management on lender oversight and lender review processes. We reviewed all the on-site lender review reports (40 reviews), including corrective actions or requirements related to the credit elsewhere requirement (documentation for 11 lenders), and targeted review reports that had credit elsewhere findings (7 reviews) that SBA conducted in fiscal year 2016. We also interviewed officials and reviewed recent reports from SBA’s Office of Inspector General.

To assess the extent to which SBA evaluates trends in lender practices related to the credit elsewhere requirement, we interviewed SBA officials and reviewed documentation for SBA’s online portal for loan origination. We also incorporated information from interviews with a nongeneralizable, nonrepresentative sample of 7(a) lenders, which we discuss below.

To obtain lenders’ views on the criteria used to determine eligibility for 7(a) loans and other program-related issues, we interviewed SBA staff including from the Office of Capital Access, and representatives of the National Association of Government Guaranteed Lenders; American Bankers Association; Independent Community Bankers Association; and National Federation of Independent Businesses. We also interviewed 11 banks (one bank provided written responses) in order to obtain the lender perspective of credit elsewhere. Nine of the banks were selected by us using a random process that concentrated on larger lenders. These nine lenders selected by us represent about 13 percent of the loans approved and 16 percent of the dollars approved in 2016. In addition, we interviewed two additional banks that represented an industry group – one larger bank and one small bank. Although we partially selected at random, the lenders we interviewed should not be considered generalizable because of the small number.

We conducted this performance audit from August 2017 to June 2018 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix II: Selected Characteristics of 7(a) Lending, Fiscal Years 2007–2016

In this appendix, we provide information on the total amount and number of approved 7(a) loans and the top eight industry sectors receiving 7(a) loans. Data are also presented on fiscal year 2016 loan volume by state and per capita. As shown in figure 6 below, the total amount of approved 7(a) loans decreased during the period associated with the Great Recession (2007 through 2009). From fiscal year 2009 on, the total amount of approved 7(a) loans increased until a decline in fiscal year 2012. During this timeframe, the American Recovery and Reinvestment Act of 2009 and the Small Business Jobs Act of 2010 provided fee relief and higher guaranties. The Small Business Jobs Act of 2010 also provided a temporary increase in Small Business Administration (SBA) Express loan limits to $1 million (instead of $350,000). These programs have since expired. 7(a) Loans by North American Industry Classification System (NAICS) code. Table 1 shows the largest eight industrial sectors by proportion of the total amount of 7(a) loans approved, using the NAICS code. The combined share of the top eight sectors declined slightly from 85 percent to 80 percent of the total lending from fiscal years 2007 through 2016, with an average of 82 percent. During this period, the Accommodation and Food Services sector had the largest average share of total loan amount at 17 percent, followed by the Retail Trade sector at 15 percent.

Approved loan amount and per capita dollars by state. As shown in figure 7, California; Texas; Florida; Georgia; and New York received the highest total of approved loan dollars in fiscal year 2016. The average approval amount across all loans was $380,619. Georgia and Arkansas had the largest average approval amount in 2016. Also, during this period, Utah; Colorado; Georgia; California; and Washington received the highest per capita approved loan dollars.

Appendix III: Information on Borrower Characteristics Based on SBA’s Predictive Scores

In fiscal-year 2016, creditworthiness varied widely among 7(a) program borrowers. We analyzed creditworthiness using the Small Business Administration’s (SBA) Small Business Risk Portfolio Solution score (predictive score), which ranges from 70 to 300, with 300 indicating the least risky loan. According to SBA, loans with scores above 180 are considered “lower risk,” scores between 140 and 179 are considered “moderate risk,” and scores 139 and lower are considered “higher risk.” There did not appear be differences in score based on the gender of the borrower or the age of the business. While SBA relies on the Predictive Score data to identify lenders that may pose excessive risk to the SBA 7(a) portfolio, the data also provide potential insights related to lender implementation of the credit elsewhere requirement.

Variation. We found that some 7(a) borrowers were much more creditworthy than others. In 2016, the only year for which we obtained data, the predictive score at origination varied widely among borrowers. In 2016, the scores of borrowers ranged from a low of 91 to a high of 246. However, most scores were between 171 and 203, and the median score was 188.

Race/ethnicity. We found that there were slight differences in creditworthiness by race/ethnicity, with median scores ranging from 180 to 189 depending on the category. Specifically, loans to African Americans in 2016 had a median score of 180, and loans to Hispanics had a median score of 183. In contrast, loans to whites had a median score of 188, and loans to Asian and Pacific Islanders had a median score of 189.

Lender size. We found that lenders with larger numbers of SBA loans tended to have slightly more creditworthy borrowers. The top 5 percent of lenders had a median average score of 187, whereas the bottom 75 percent of lenders had a median average score of 182.5. Among the top 5 percent of lenders (with 374 loans per lender on average, collectively representing about 70 percent of the loans approved), the average score ranged from 171 to 195. Among all lenders, the average score ranged from 116 to 233. However, because many lenders only approved one or two loans in 2016, the average may reflect very few borrowers for that lender, making it difficult to tell whether the scores reflect a real difference between lenders.

Appendix IV: Comments from the Small Business Administration

Appendix V: GAO Contact and Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the contact named above, Harry Medina (Assistant Director); Janet Fong (Analyst in Charge); Benjamin A. Bolitzer; Gita DeVaney; David S. Dornisch; Amanda D. Gallear (intern); Marc W. Molino; Jennifer W. Schwartz; and Tyler L. Spunaugle made key contributions to this report.