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Policy and California's Economy (PACE) Briefing Series: Removing Barriers to Small Business Lending

Aug 31, 2015

Matt Horton

The Milken Institute California Center collaborated with the Small Business Administration’s Los Angeles office, the Federal Reserve Bank of San Francisco and the co-chair of the California Economic Summit’s Capital Action Team to assemble a group of banking executives, community leaders and policymakers to develop a scalable model for a revolving small business loan fund at either the regional or state level.

The topic for this roundtable was generated from recommendations for expanding small business lending made during previous Policy and California's Economy (PACE) roundtables. Those discussions emphasized the need to resolve the risk barriers associated with smaller loans and address economy-of-scale issues in community-based lending. One idea focused on a regional and/or state loan fund that could coalesce risk, clear technical and geographic hurdles and ultimately spur small business growth.

To establish and implement an effective funding tool, participants urged the structure of a potential fund that would in concept resolve a number of challenges: minimize administrative time, coordinate referrals from financial intermediaries and streamline the data and analysis process. In terms of providing initial structure to a loan fund, the conversation was divided into three themes:

Technical assistance and analysis  

The group focused on applying big data solutions to village lending models to build capacity. The benefits include harnessing the power of crowdfunding, crowdsourcing, artificial intelligence, systems thinking, advanced systemic modeling and community intelligence to improve evaluation, due diligence, risk mitigation, performance and outcomes. They emphasized that the technical assistance component should be focused on risk mitigation while developing a consistent solution that can be scaled across a wide range of contexts (e.g., SME lending and investing in the Southern California region).

Capital coordination

The group found that increasing the flow of communication in SME financing could potentially expand the deployment of capital. They identified a number of "low tech" solutions that involve supporting the efforts of financial intermediaries, entrepreneurs and economic development organizations to coordinate more effectively.

The conversation progressed to coordinating transactions with the goal of prioritizing lending as a community of financial institutions rather than among individual or competing groups. Such collaborative approaches have long been successful among financial institutions in cooperative syndicates for large transactions. It was clear to the group that such cooperative practices had not yet been applied to SME transactions and could dramatically increase the success of such financings if they were.

Risk mitigation

Participants discussed the industry resources available to mitigate risk and infrastructure to facilitate the flow of information. Credit enhancements such as guaranty programs from the state treasurer’s office and its California Capital Access Program (CalCAP), as well as the Infrastructure and Economic Development Bank or I-Bank (i.e., the Small Business Loan Guarantee Program), are underutilized and can provide sustainable support. One issue is these government programs’ small staffs, which limits outreach and other capabilities.

Participants also spoke about the need for better referral networks and creating regional hubs. Using enhanced referral networks, incubators and technical assistance programs, big banks can channel small business loans they cannot finance to lenders who can.

There remains a need for better application and sharing of best practices. One area is how best to educate and evaluate loan officers and provide incentives based on criteria other than volume. However, risk is real in small business loans, particularly if there is a product mismatch. Funds that leverage expertise in a specific sector, such as the California FreshWorks fund, could further mitigate risk.

Final thoughts and next steps

Banks often face tough situations as they are pressured to make more small business loans, then criticized for taking on too much risk. Even amid technological advances, relationships remain a prime factor in deal sourcing and risk mitigation. Accordingly, community banks and community development financial institutions have more experienced lenders, as well as established relationships, than big banks. How can we scale up the approaches and experience of community bank loan officers? Can technology solutions (i.e., algorithms that mimic loan officers’ decision-making processes), data-sharing clearinghouses or other nontraditional approaches also help mitigate risk?

With further collaboration, we can assess how technical assistance and data analysis can mitigate risk while providing a better platform for coordinating capital. In the near term, the California Center will facilitate this in a series of subgroup task forces as well as a larger private session at the upcoming 2015 California Summit.