The Cost of Financial Favoritism

America’s knack for invention and risk-taking has long been a source of competitive advantage. Entrepreneurs depend not just on ingenuity and nerve but also on capital and credit, which come, or don’t, from a variety of sources, including their own savings, venture capital, as well as loans from banks and other institutions.

Until recently, our deep and varied capital markets have complemented America’s entrepreneurial zeal. Investment bankers could help innovators sell shares to the public. Silicon Valley’s technical genius got a huge lift from venture capitalists. However, the extreme financial engineering that ultimately led to the collapse of 2008 has whipsawed America’s entrepreneurs. At first, financial innovation produced a credit boom. But as regulatory and lending standards dropped far below prudent levels and banks became more leveraged, the financial excesses produced first a bubble, then a bust. Bankers and their regulators belatedly turned risk averse, producing a credit drought, especially for smaller and newer businesses.

Economists tell two basic stories about economic growth and job creation. The first is macroeconomic. When total demand and supply are operating in a virtuous circle, households have adequate income to purchase the goods and services that the economy is capable of producing, and so entrepreneurs have the confidence to create or expand enterprises and jobs. Conversely, when a shock, such as a financial collapse, knocks the economy off that course, the virtuous circle becomes a downward spiral. Neither businesses nor households provide adequate purchasing power, and only government can make up the gap until the private economy returns to normal.

The other story is mainly entrepreneurial. New and fast-growing enterprises are key innovators and job creators. Even in a recession, new technologies, processes, and products can be invented and find markets. One need only look at the ferocious growth of Web-based goods and services during the current financial crisis. In the pit of the Great Depression, innovations such as television, antibiotics, and commercial aviation advanced.

John Maynard Keynes is the master of the first story, and Joseph Schumpeter, the prophet of the second one. However, economist Robert Litan fuses both accounts when he speaks of “entrepreneurial Keynesianism,” meaning that new enterprise itself can stimulate economic activity, despite depressed overall demand. Invent a one-person Internet start-up, and you’ve created a job. Hire a friend, and there’s another job.

It’s clear that entrepreneurship and purchasing power are both important. Just as policy affects macroeconomic outcomes, policy also influences entrepreneurship. Enterprise can be nurtured or hobbled—by tax, regulatory, educational, industrial, intellectual-property, and financial policies.

This special report is about the role of finance in entrepreneurship. Unlike every other postwar recession, the current prolonged economic slump was caused by a financial collapse. The reverberations of that collapse, ranging from the lingering mortgage crisis to the weakened condition of many banks, have undermined a fragile recovery. Successful start-ups generate a disproportionate share of new jobs. But as the Congressional Oversight Panel observed in its March 2011 final report, “In contrast to large corporations, small businesses are generally less able to access the capital markets directly and thus are more vulnerable to a credit crunch. The result of reduced access to credit can be that too few small businesses start and too many stall—a combination that can hinder economic growth and prolong an economic downturn.”



The financial downdraft has affected diverse sectors of the business community differently. Although the Fed has reduced interest rates almost to zero, small businesses have complained bitterly that loans are still hard to come by. For minority-owned businesses, typically based in the hardest-hit communities, this recession’s downturn has been a catastrophe. For Web-based innovators, who need relatively less capital than manufacturing industry or housing developers, times are still surprisingly good.

Government has also been inconsistent in its treatment of financial players. Smaller banks as well as Community Development Financial Institutions, which finance entrepreneurs in lower-income areas, were not given much help. When the financial system neared collapse in the fall of 2008, the Treasury and the Federal Reserve necessarily gave priority to saving the largest banks, whose failure could have brought down the whole system. After Congress reluctantly enacted the Troubled Asset Relief Program in October 2008, TARP funds kept some behemoth banks like Citigroup from going under. Even large banks in relatively better condition, such as Goldman Sachs, were directed by the Treasury and the Fed to take TARP money, partly to strengthen the capitalization of the banking system as a whole. The idea was also to put all large banks in the same box in the vain hope of disguising the fact that some institutions like Citi were effectively insolvent but for the federal bailout.

The Federal Reserve also invented special “facilities” to pump additional money into the large banks. Eventually, both the Fed and the Treasury would purchase several trillions of dollars of securities of dubious market value to shore up the big banks’ balance sheets.

In this exercise, smaller banks were an afterthought. By definition, they were too small to be “systemically significant.” If some failed, it was no big deal. According to Paul Merski of the Independent Community Bankers of America, 97 percent of the $205 billion in TARP capital infusions went to the largest banks. Only 3 percent went to the community banks that do more than 60 percent of America’s small-business lending.

As TARP’s oversight panel noted, the massive government banking-support programs “have had little effect on the smaller banks now bearing a greater share of small business lending.”

When Treasury Secretary Henry Paulson called in the presidents of nine of the largest banks on October 13, 2008, and doled out more than $130 billion in the first installment of TARP money, he extracted a (nonenforceable) pledge that they would increase their lending. Instead, their loan volume fell dramatically. At the end of June 2008, just before the crisis hit, America’s largest banks, those with assets of $100 billion and more, had outstanding commercial and industrial loans totaling $962 billion. By the end of 2010, that had dropped more than 28 percent, to $693 billion. Smaller community banks, despite having something like 60 percent of their lending collateralized by some form of real estate (whose value was plummeting) also cut back, but by only about 9 percent.

Since repeal of the Glass-Steagall Act in 1999, a large money-center bank still makes commercial loans but looks to investment banking, creation of complex securities, and proprietary trading for its major profits, using high leverage. It was this business model that crashed the financial system. Thomas Hoenig, the recently retired president of the Federal Reserve Bank of Kansas City, noted that for the ten largest banking companies, leverage ratios “almost doubled from 18 in 1993 to 34 in 2007, and this doesn’t include their off—balance-sheet activities. For the rest of the [banking] industry, leverage rose from 14 to just 17.”

Unlike Wall Street behemoths, community lenders do not pursue investment banking. Mainly, they lend to businesses and households. In a recession, some of their loans fall behind, and their balance sheets weaken. With reduced capital and earnings to loan against, they tend to tighten their lending standards, even for their most reliable customers. A report by the nonpartisan Congressional Research Service in early 2010 warned, “With the United States facing the most severe economic crisis in more than 70 years, small businesses are confronted with a frozen lending market and limited access to the capital they need to survive and grow at this critical time.”

Several regional Federal Reserve Bank presidents from the heartland, such as Hoenig, echoed the complaints that they were hearing from local businesses and bankers: The regulatory favoritism was protecting Wall Street and harming small-bank customers on Main Street. The Treasury’s bias was compounded by bank-examination policy. For the largest banks and their exotic securities business, regulatory standards were substantially waived during the crisis. Regulators conspired in the fiction that complex securities with depressed market value could be carried on the banks’ books at or close to their nominal par value. The Treasury set a low bar in the spring of 2009 when it created easy-to-pass “stress tests” to give the biggest banks a market-reassuring seal of approval. As “too big to fail” institutions, these banks would get whatever level of government support they needed.

But for smaller community banks, it was regulatory business as usual. If an examiner found nonperforming loans in a bank’s portfolio, the bank would either have to come up with additional capital—difficult in a recession—or cut back on lending. In economic parlance, forcing a bank to rebuild capital at the expense of lending in a deep recession is “pro-cyclical”: Instead of countering the downward economic pull, tightened credit worsens it. But as Representative Barney Frank quipped, “No examiner ever gets fired for a loan that wasn’t made.”

Sheila Bair of the Federal Deposit Insurance Corporation (FDIC) repeatedly tangled with then–Comptroller of the Currency John Dugan over how examiners should treat bank loans in a depressed economy. The FDIC, an independent agency, is the lead regulator for state-chartered commercial banks that are FDIC-insured. The Office of the Comptroller of the Currency (OCC), part of the Treasury Department, regulates national banks, which include the largest ones.

During the pit of the recession, in 2009, Dugan instructed his examiners to toughen their standards on commercial loans (while his boss, Tim Geithner, was loosening standards on the regulatory treatment of the complex securities held by the biggest bank-holding companies). Bair, by contrast, took a broader view. In February 2010, she directed FDIC examiners to proceed so that even if the value of the collateral backing a commercial loan had dropped below the amount of the loan, the bank should not get a demerit in its examination or be required to reserve additional capital against risk of loss, as long as the loan payments were current and the borrower had the capacity to continue paying. Bair also directed that routine rollovers of commercial loans should be accepted without a new property appraisal, so that a temporary downturn in the property’s market value would not block the loan or force a distress sale in a down market.

She won the gratitude of small bankers—and criticism from other regulators. “When I would sit in meetings, it amazed me how harsh the OCC examiners would be about small banks,” Bair says. “John Dugan famously said during one of my open FDIC meetings that small banks were failing and none of his big banks had failed. They didn’t ‘fail’ because they were bailed out!”

One other anomaly that treats large and small banks differently is the Fed’s policy of ultra-low interest rates. For a large bank positioned to speculate in highly leveraged derivatives and other complex purely financial transactions, the low interest rates amount to free money with which to gamble, often on a sure thing. But a smaller bank, without the capacity for exotic financial plays, depends heavily on less reliable “spreads”—the difference between its own cost of capital and the money it can charge on business loans. “In a very low-interest-rate environment, there’s not much spread,” says Merski of the Independent Community Bankers of America.

Lending to small businesses, like mortgage lending, has been heavily reliant on government guarantees. As part of the stimulus package, Small Business Administration loan guarantees were increased by $30 billion, and the government-guarantee portion of the loan was raised from 80 percent to 90 percent. The temporary injection of funds also subsidized application fees. The SBA credits the program with creating almost 800,000 jobs, and in principle it enjoys broad bipartisan support. But it expired last year and has not been extended because of the partisan budget standoff.



While too-big-to-fail banks and their shadow bankers caused the collapse with dubious schemes such as subprime loans that were converted to sketchy securities, an unheralded sector of the financial system was providing another sort of subprime loan—with lower losses than conventional banks. Community Development Financial Institutions (CDFIs), which serve small businesses typically in lower—income communities, were first given official government recognition and modest public subsidy in the Clinton era. While still governor of Arkansas, Bill Clinton got to know a Chicago banker named Ron Grzywinski, whose pioneering South Shore National Bank, later ShoreBank, became the national model for CDFIs.

Grzywinski’s idea was that a commercial bank could be the centerpiece of local economic development in a distressed neighborhood. He was willing to earn less than a competitive rate of return, but the bank had to turn a profit, and loans had to be sound.

The key was a modest subsidy—from philanthropic and public sources—of the cost of loan underwriting and ongoing technical assistance to small businesses. Ordinary banks could not afford to serve the customers because the expenses overwhelmed the moderate profit from a small and risky loan.

Clinton, impressed by ShoreBank, brought the model to Arkansas. One of his first acts as president was to sponsor legislation to give national certification and modest subsidy to CDFIs, which now number in excess of 900 nationally and have more than $20 billion in loans outstanding. Federally approved CDFIs include credit unions and non-depository loan funds as well as banks. CDFIs must make at least 60 percent of their loans in low- and moderate-income communities. Their loan volume is not huge compared to the total supply of commercial credit in the economy, but in economically marginal neighborhoods, CDFIs are a lifeline.

Interestingly, these institutions that specialize in lending to America’s most high-risk businesses have come through the financial crisis almost unscathed. The reason is that they stuck to their knitting. They’ve not gone in for quick-buck subprime financial products but continue to serve aspiring entrepreneurs. Mark Pinsky, who heads the Opportunity Finance Network, describes them as “profitable but not profit-maximizing,” adding that CDFIs are “responsible high-risk lenders”—just what the subprime predators pretended to be but never were.

CDFIs got about $560 million under TARP to strengthen their balance sheets. This came late in the game and was better than nothing but was never a high priority for the Treasury. The federal subsidy for basic CDFI operations and innovation also continues, about $123 million in fiscal year 2012, down from a peak of $240 million in fiscal year 2010. Another administration initiative, a $1 billion bond-guarantee fund for CDFIs was approved but is bogged down at the Office of Management and Budget.

It’s also noteworthy and a bit ironic that some of America’s largest banks have come to see CDFIs as partners that can safely lend to risky start-ups that would not be sufficiently profitable for a conventional large bank. When the crisis hit in 2008, big banks began pulling back on lending and laying off loan officers; one of the hardest—hit areas was small-business lending. But the largest banks were heavily dependent on government financing and goodwill and had obligations under the Community Reinvestment Act to serve moderate—income communities consistent with sound lending standards. So CDFIs were a godsend.

Bank of America is a case in point. Before its unwise acquisition of subprime lender Countrywide in 2007 and its shotgun merger with Merrill Lynch in 2008, Bank of America had grown both organically and through mergers. But it remained mostly a retail lender, not quite part of the Wall Street club. In December 2011, the bank was fined $335 million to settle claims of lending discrimination by Countrywide, which occurred between 2004 and 2007, before Countrywide was acquired by Bank of America.

As a commercial bank, Bank of America had been doing business with small community lenders for nearly two decades and now has a billion-dollar portfolio of loans to CDFIs, which in turn lend the money to local start-ups and small businesses seeking to expand. “CDFIs specialize in loans that are less profitable because of risk or size, often to borrowers who need a great deal of technical assistance,” says Dan Letendre who runs Bank of America’s CDFI loan portfolio. “The cost to the bank often exceeds what the bank will earn back on the loan.”

A dollar of subsidy that supports technical assistance by a CDFI can produce anywhere from $10 to $20 of loans that would not otherwise be made. Citigroup, Goldman Sachs, Wells Fargo, and other large money-center banks that lost hundreds of billions in their own speculative ventures now all have programs in the hundreds of millions to lend to CDFIs.

While CDFIs on the whole have ridden out the crisis, the model for the entire sector, Chicago’s ShoreBank, went under. In the boom years, ShoreBank had expanded to Detroit and Cleveland. When the collapse hit, the bank mounted a heroic “rescue” program to refinance loans of homeowners who had been victimized by subprime mortgages. But as the recession overwhelmed its home neighborhood and unemployment rates rose, loans that had been sound early in the crisis started going bad. ShoreBank raised nearly $200 billion in new capital and applied for assistance under TARP. But as an institution based in Barack Obama’s home neighborhood, ShoreBank was a right-wing target for allegations of favoritism, and the Treasury Department ultimately turned down its application, brushing aside support from ShoreBank’s primary regulator, the FDIC.

It is fair to say that the entrepreneurial sector of the economy, despite near-universal celebration of its importance, continues to be somewhat hobbled by the aftermath of a financial crisis that it did not create, by regulatory favoritism, and by poisonous partisan blockages. Programs that support CDFIs and use the SBA to guarantee loans to new businesses, are quintessential New Democrat: They use a typically Democratic instrument—government support—to carry out a typically Republican ideal of a society based on enterprise. Yet both are underfunded and undermined by partisan budget battles. The right-wing story today is that government is nothing but a burden, even when its policies promote risk-taking by private business. If the two parties cannot find common ground here, it is hard to imagine them finding it anywhere. 

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