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This post first appeared on the Columbia Law School Blue Sky blog on 16 April 2020 and also on the Oxford Business Law Blog on 22 April 2020

By Prof. Todd H. Baker (Columbia University) and Prof. Kathryn Judge (Columbia Law School and ECGI)

Small business assistance has been a central focus of the government’s response to the COVID-19 crisis, and for good reason. Small businesses underlie the vitality of our neighborhoods, spark innovation, and employ almost one-half of the U.S. workforce. In a new working paper, ‘How to Help Small Businesses Survive COVID-19,’ we explain why finding better ways to harness banks and fintechs is critical if this vital part of the economy is to emerge without too much harm on the far side of this crisis.

There is no easy way for the government to readily provide the perfect amount of support and credit to small businesses. Every path forward is fraught. Depending on how the next few months play out, a critical reassessment of the country’s reliance on banks and other financial middlemen in crisis situations may well be warranted. For now, however, the government’s capacity to help small businesses depends on harnessing and directing existing credit intermediaries. Failing to provide sufficient access to credit poses much greater downside risk than the complications that inevitably arise in efforts to harness the infrastructure embedded in lenders.

The Federal Reserve and the Treasury are currently using the banks—and soon nonbank online lenders—to deliver emergency aid to small businesses through the Paycheck Protection Program (PPP). This is because these financial institutions have the infrastructure to get money to small businesses that need it. But banks and online lenders face their own liquidity and capital constraints, which limits the amount and type of support they can provide.

More can and should be done.

One challenge is finding new ways to harness bank capacity while ensuring that banks remain sufficiently well capitalized to work with existing small-business borrowers and extend new loans. Policymakers need to maintain a long-term perspective that recognizes the genuine uncertainty of the public health crisis and the possibility of greater losses ahead. Overall, the evidence suggests that better capitalized banks do a better job lending through the cycle. Excessively relaxing capital requirements or allowing troubled banks to opportunistically renegotiate with weak borrowers is unlikely to bring long-term success. Instead, the aim should be to devise tools that utilize bank expertise and provide appropriate incentives for helping businesses in need.

So far, there has been a tendency to focus on ways that banks can help their clients and themselves at the same time. But the more difficult and important decisions entail tradeoffs between these goals. If Congress wants to do more to help small businesses, and more effectively leverage banks in that process, it must encourage banks to act—even when doing so is costly. This requires far more than moral suasion, which could be counterproductive longer term if banks become under-capitalized in the process. A critical complement to current efforts could be figuring out ways through and beyond the CARES Act to provide targeted subsidies that reward banks for making costly modifications or extending certain new loans to small businesses.

The situation with online small-business lenders is significantly more complicated. They have become the main source of credit for many, highly vulnerable small businesses. In 2018, nearly one-third of small businesses that applied for credit sought it from an online lender. For less traditionally credit-worthy businesses, the number was closer to one-half. But online lenders are paralyzed because they can’t access the  capital markets funding on which their business depends.  As a result, they are scaling back—just when their services are most needed.

If you peel back the skin of an online lender, what you find underneath is a finance company. Finance companies borrow in the capital markets and lend that money to customers. In good times, this model works well. But when funding in the capital markets is unavailable or prohibitively expensive, a finance company quickly hits the wall and can’t provide new credit to its customers. The ‘marketplace lending’ business model of many online lenders—they need loan sales to generate revenue – only exacerbates the crisis funding problem of traditional finance companies. That means online small-business lenders need the federal government to help them, in the short and medium-term, rescue their customers and then to play a meaningful role in any small business credit and economic recovery.

Recent actions by the Treasury, the Small Business Administration, and Federal Reserve with regard to both the PPP and the related Paycheck Protection Program Liquidity Facility appear designed to allow online and other nonbank lenders to participate in both programs. Whether this will work remains uncertain. So far, PPP funds are limited. Even the modest additional requirements placed on online lenders may make it difficult for them to scale PPP programs before those funds run out.

But the short-term PPP program is only the beginning of the government intervention needed to help the millions of small businesses dependent on online lenders to recover. Assuming capital markets funding for small business credit remains strained, the Federal Reserve and Treasury should consider creating a new small business loan liquidity facility and expanding the TALF to cover investment grade small business asset-backed securities. Both would allow nonbank online lenders to keep functioning and provide new loans.

The Federal Reserve and Treasury need to expand their interventions carefully. Assistance to lenders with weak business models strains the Fed’s traditional role in the financial and banking systems and its legal authority under Section 13(3) of the Federal Reserve Act. The legislative directive embodied in the CARES Act and Treasury support can help with these problems, but they shouldn’t become routine.  It is hard to justify rescuing lenders that could have designed their businesses to be more resilient to liquidity and credit shocks (the same could be said about money market funds and repo markets).  For this reason, before the next crisis hits, Congress and regulators should find ways to address the systemic risks created by the rise of nonbank online lenders, which may necessitate bringing these lenders and their small business customers inside the federal bank regulatory system.

Todd H. Baker is a senior fellow at the Richard Paul Richman Center for Business, Law and Public Policy at Columbia Business School and Columbia Law School.

Kathryn Judge is the Harvey J. Goldschmid Professor of Law at Columbia Law School.

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