Does SBA’s New Lender Risk Rating System Really Rate Risk of Loss to the Government & How Can it be Structured to Accomplish SBA’s Mandate?
By: Bob Tannenhauser
The Small Business Administration unveiled its revised system for risk rating lenders on April 29, 2014 in the Federal Register. The expressed purpose of the system is to assist SBA in assessing the risk of SBA loan performance for each lender, measure the overall strength of SBA’s loan portfolios and improve the effectiveness of its lender reviews. As with the prior system, the new rating system assigns a rating between 1 and 5 to lenders, with 1 representing the lowest risk. A higher risk rating will subject a lender to greater scrutiny and possibly corrective action. This could lead lenders to avoid loans that would increase their risk rating to the detriment of the mission of the SBA loan programs.
Some of the criteria used in the risk rating system will discourage lenders from making those loans that SBA publicly stated it wants to encourage. In October SBA announced that in order to encourage smaller business loans, it was reducing fees on loans under $150,000 to zero. Former Acting SBA Administrator Jeanne Hulitt stated that “…these lower dollar loans often help finance new startups and entrepreneurs in underserved communities, which can include women, minorities, veterans and others”. The new SBA Administrator at the NAGGL conference on May 7, 2014 echoed this sentiment when she said to the gathered lenders “[t]oday, I have a call to action for you: I’m asking you to work with us to get capital into the communities that need it the most. The truth is, we still have work to do in this area. The Department of Commerce looked at loan denial rates for firms with gross receipts of $500,000 or less. They found minority-owned firms were three times more likely to get turned down for a bank loan. For high-sales firms, loan denial rates were twice as high for minority-owned businesses”. The challenge for SBA is how to balance the need for risk monitoring with the goal of encouraging credit access to small businesses.
Before analyzing some of the components in the risk rating system, it should be emphasized that the system does not purport to measure risk of loss to the SBA, but instead merely measures risk of repurchase of the guarantee by SBA. While there is undoubtedly some correlation between the two, it is not necessarily a true measure of risk to the SBA. Shouldn’t the real measure be the risk of loss, so that a lender that excels at underwriting, servicing and liquidation and has excellent recovery rates be rewarded rather than penalized because of high repurchases?
Of the fourteen enumerated risk rating components, some seem counterintuitive and some of these will penalize lenders’ portfolios that contain smaller loans and loans to underserved communities. For example: (1) component (iii) Months on Book (MOB) rates loans as higher risk if they are new or if they have been on the books for a longer period of time (even if they are performing????)- this penalizes all new loans regardless of size, but isn’t it illogical to say that a self-amortizing loan that has continued to perform for all of its term is suddenly higher risk at the end of the term when the balance has been significantly reduced?; (2) component (v) Gross Approved Amount – the lower the loan amount the higher the risk of repurchase, while this may be an accurate indicator of repurchase rate, it is also a disincentive to making smaller loans; (3) component (xii) Business Age – the shorter time the borrower has been in business, the greater the risk, likewise, while this may be an accurate indicator of repurchase rate, it is also a disincentive to making startup loans; (4) component (xiii) Average State-level Unemployment rate – the higher the State’s unemployment rate, the higher the risk, this is logical. However, there may be huge variations in unemployment rates depending upon where in a State the lender does business, the same holds true for component (xiv) which uses a State’s Housing Price Index to help determine risk.
While the new system eliminates the comparison of lenders within their “peer” group (based upon portfolio size), perhaps there should be a peer group comparison with respect to the performance of loans in their portfolios that are small loans and loans to minorities, women and veterans. The relative performance of these loans compared to the peer group could then be used as a component of the risk rating. This would mitigate the potential adverse effect that making these loans has on the lenders’ risk ratings and thereby help satisfy the SBA’s mandate to encourage these presumably higher risk loans.
The new system allows for additional overriding factors to consider in establishing a rating such as results of SBA’s reviews of certain lenders, any enforcement actions, early default trends, default, repurchase and liquidation rates. However they do not mention recovery rates, the potential loss given default or any of the issues mentioned above.
Presumably the measure of a lenders’ portfolio is a snapshot in time that considers loans currently in the portfolio and not those that have been repaid or charged off. This also could present an inaccurate portrayal of risk. For example a lender that routinely has real estate and other hard collateral for loans, may have defaulted loans on their books for longer periods of time while they liquidate the collateral, but they have higher recoveries then uncollateralized lenders that liquidate quickly, get the loans off the books and have lower collateral. It might also penalize a lender that made good loans that were repaid early.
Small business lending through SBA programs is essential to the economy and job growth. Measuring true risk to the government for supporting the SBA programs is necessary and prudent, but the system should take into account all relevant factors and weigh the risks against the public policy. A question that should also be asked is whether the loan programs, taken individually, make money or lose money for the government when you consider the fees earned and the recoveries on defaulted loans.