Equitable Access to Small Business Credit: Keynote Presentation
- Introduction by Laura Choi, Senior Vice President, Public Engagement, Federal Reserve Bank of San Francisco
- Sheila Bair, Former Chair, Federal Deposit Insurance Corporation
Thank you to our first panel for such a rich discussion. For today’s keynote address, we’re honored to be joined by Sheila Bair. Miss Bair has had a long and distinguished career in government, academia and finance, and is perhaps best known as chair of the federal deposit insurance corporation from 2006 to 2011. She currently serves on a number of corporate governing and advisory boards, including Fannie Mae, where she serves as the first woman chair. Miss Bair has been twice named by Forbes magazine as the second most powerful woman in the world. She is also the author of a children’s book series on personal finance called Money Tales. You can read her full bio on our event website. And with that, thank you so much for joining us today. Sheila, I’ll turn things over to you.
Well, thank you very much, Laura. That’s a great introduction, and thank you to Mary Daly for extending the invitation for me to appear at this conference. Small business credit is a subject near and dear to my heart. I tried to be very engaged in it as chair of the FDIC, and have tried to stay involved over the years since leaving government service. Well look, small businesses have various challenges to accessing credit, which we learned about in the the first panel, which was great. A lot of that’s already been reviewed. I mean, basically though, you’ve got the problem of there’s no track record because you’re a new business. You’re going to be higher risk because small businesses fail at a higher rate than more established ones for obvious reasons. And finally, you’re more vulnerable to economic downturns, which is also one of the reasons why you have higher failure rates.
So traditional credit criteria treat these as high risk, and it makes lenders somewhat adverse to sometimes lending to a small business or charging really high rates. I think one thing that strikes me when thinking about a small business is there’s similarity to student loans, which is an area I’ve also worked in a lot. I was a college president for a few years after I left the FDIC and dug pretty deep into student debt and continued to advise the Peterson Foundation on student debt issues. And you really had the same problem with the lack of track record and certainly about future earnings potential, which is why for student loans as well as for small business. I think the first point that needs to be made is equity financing, really, is important. So you need lending too.
You need credit. And that’s what this conference is about. We’re going to talk about it, but equity financing is really important. It’s much more flexible. Your financier will succeed. If you succeed, your financier will take the loss if you don’t make it, but your payments are geared and the returns are geared on whether you actually succeed, which makes it a much more flexible funding source.
So I do think as we talk about credit in this conference, it’s important to recognize the really essential necessity of equity finance for small businesses. So let’s talk a little bit about credit because that’s the subject of the conference today. So there are three things that concern me about the lack of inclusiveness when it comes to inequity financially, when it comes to small business credit.
First and foremost, are the criteria that are used to make credit decisions when institutions are making a small business loan, and there’s a lot of overlap between this consumer learning, because let’s face it, a micro-business in particular, the credit criteria that a lender’s going to be looking at in terms of the individual starting that business and making loan, a lot of it’s going to overlap what they would do for a consumer loan as well.
And it’s dominated by credit scores, for better or worse. Try to stay away from them–can’t do it. And there’s a lot of embedded bias in the use of credit scores. And so look, what do you look at? So you look at what have you borrowed money in the past? Have you paid that loan back? How much credit have you used? So people new to this who haven’t borrowed a lot are immediately disadvantaged. Families of color in particular will not have wealth or their own capital family wealth backing them or accumulated wealth on their own to put up capital in addition to side by side with the financing, which is also going to put them in a disadvantage in terms of traditional credit and underwriting decisions. And so these are key impediments to small businesses getting loans or getting loans at reasonable rates.
So one thing that we are doing at Fannie Mae, which I think has really exciting potential for the broader lending space, including small business lending, you’ve probably read about it. We’ve started accepting positive rental data, in our underwriting decisions.
So we recognize that there are other ways to show that you are a person who understands how to manage finances and how to make a monthly mortgage payment. And that is through positive rental data. And so we are accepting that now, and our analysis shows that of loans have been turned down in the past, if we had included that positive rental data, we would’ve actually had a 17% uptake in our approval rates.
So we’re excited about this. This will be helpful, I think in particular to families of color who are disadvantaged by traditional criteria. And expanding home ownership also indirectly helps small business finance because a lot of small businesses use home equity to finance their businesses or get them going. A significant subset of the small business communities, small landlords who are a really, really important part of housing supply for renters, especially in lower income neighborhoods or minority neighborhoods. Small landlords are also heavily, very racially diverse.
They will benefit from this too, because most of them buy their rental properties through our single family housing program. So those are, and the ways that will be this will be of indirect benefit to small businesses. But more importantly, I’m really hoping this starts the train going in terms of getting away from the traditional credit score criteria we look at, which is heavily geared towards whether you borrowed in the past and whether you paid your loans back, you know what, there are other ways to prove you are financially responsible and capable other than borrowing money.
Somebody who’s paid their rent and their utility bill, their phone bill or whatever they can show a year or two of being able to manage those finances. I am much more confident lending to them than somebody who’s borrowed a lot of money and managed to pay it back.
So I think this will be hugely beneficial to making credit underwriting broadly more inclusive. But again, Fannie’s starting this with our huge footprint. Hopefully, testing it and proving it. I hopefully will be a catalyst to other lenders starting to use, not just positive rentals data, but cash flow underwriting generally actually having visibility into how a person, how a borrower, an applicant has managed their cash flows in the past.
That’s going to be much more indicative than these proxies that we use now that have a lot of bias embedded them. So I think that is going to be a big game-changer. And we’re pushing a rock up the hill. I can’t say it’s going to be easy, but I think it can happen. And ultimately we would hope as much as I don’t like credit scores, you probably would never guess based on my comments, but we’re still stuck with them.
So it’d be really good Fannie and other institutions, large and small starting to get this data directly from consumers. Applicants for loans will put pressure, I think on the credit bureaus to start building it into their credit scores. And that’s a good thing. And I think the large banks are already starting to use it for other credit decisions like credit cards. We need to be careful with this.
We don’t want to use this tool to load people up with debt. What we want to do is use this tool to make debt decisions, more inclusive, affordable debt, those decisions more inclusive. But there again, I think the institution’s doing it directly will put, will put pressure on the credit bureaus. Small lenders too I’m hoping will relate cause small lenders are small businesses themselves. CDFIs in particular do so much of the lending, especially to minority owned businesses.
We need to make sure they have the tools and the capability and the access to technology to use this as well. Because my guess is they’re going to be ones that are most motivated to think broadly and more inclusively about what kinds of factors, what kind of information we use to make underwriting decisions, and decisions about who gets a small business loan, which is really important.
In addition to more inclusive underwriting criteria, I do think we should consider more flexible business models, even in a debt framework. I think this is something regulators and lenders, I hope would be more open to maybe more of a hybrid where there is some repayment, flexibility or fluctuation based on how successful a business is, what its actual earnings are. Some automatic forbearance or protection.
If there’s a macroeconomic event, a serious downturn, those are the kinds of things that will in the eyes of supervisors, this will make those loans a little more risky because they’ll be lower in the credit stack than those that have a fixed payment obligation, but they will be so much more supportive of the needs and flexibility that are unique to small businesses.
And so, I really think that if we can think more broadly about repayment models and regulators can be more open minded about it. And I think they are, you’ve probably heard about Basel IV in progress. Basel committee used to be a member there. They move slowly and deliberately, but there’s a lot of good thinking going on now about making the capital rules more accommodated to small businesses, especially very small ones. And that can only be for the good, in terms of better incentivizing lenders to make credit available.
I’d also like to talk about the beneficial impact of technology because a lot of these new initiatives will be made possible by technology. So APIs, a lot of fintech now, there were some fits and starts early on in terms of financial technology companies, giving consumers the ability to provide access to their bank accounts and other types of financial accounts to lenders and other institutions.
I think that technology has come a long way with it’s done by APIs now, which are, can be very secure, getting away from the screen scraping that was creating some privacy issues before. I think that technology is really mature. It is hugely beneficial now using APIs to provide seamless access.
If you come in you’ve got cash flow underwriting situation. You come in, you apply for a loan for a lender that’s willing to use cash underwriting. These are giving them immediate visibility into your bank information or multiple banks. If you have multiple banks, aggregators can put it all in one place. That I think will be again, facilitate and accelerate this trend towards more inclusive underwriting. I was taken by the earlier panels comments today about bureaucracy around applying for a loan. It was more in the context of government, shame on them.
I agree with you completely, lenders, big banks in particular, can also be pretty heavy handed when it comes to paperwork, but the technology streamlining this process, making it less intimidating, less burdensome. Especially for somebody starting a brand new business, does not come from a family that’s got a lot of experience around doing loan applications and coming up with all this paperwork. I think that’s going to be hugely beneficial.
There again, if you could forgive the student loan analogy. But, I was the president of Washington college for a few years and had a program for first generation students. We nearly made a push and it was a full ride program. We raised money for it, covered your full ride through scholarships. But one impediment was all the paperwork. Thank goodness Congress has simplifies FAFSA so much, quite a bit, not as much as they need to, but I do think people underestimate how just burdensome paperwork can kill a deal, be a real disincentive.
So again, I think technology provides a good opening and I hope government will be willing to use it better because it’s something that can be hugely beneficial. Finally, blockchain, blockchain gets a bad rap because of its association with Bitcoin.
I guess I should use distributed ledger technology DLT, that’s got less of a chain than blockchain, but forget Bitcoin. Don’t like it don’t own it. Tell people to stay away from it. But the technology that underlies Bitcoin, the blockchain, the distributed ledger by which ownership of Bitcoin is traced can be used for multiple purposes, including very secure, targeted ways of sharing data. And here again, this is another problem with traditional credit bureaus, you pull somebody’s credit file, you know everything, you practically get their firstborn son.
I mean, it’s just your whole life is exposed you to whoever, the applicant gives the institution permission to access their, credit file. With blockchain you can, when smart contracts, you can really confine and control who sees the data, what data they see, need their address, they see your address. They don’t see your driver’s license number, your social security number and everything else.
So this will be another way to better protect data. And again, facilitate sharing of information in a way that’s safe and secure. And it can be used for institutions to share information with the borrower’s permission among each other, which will also, I think be very beneficial and make the application process an easier one in a better-informed decision than what we have now. So I would just like to include with look, small businesses are so important.
Like students, like young people entering the workforce. They are the lifeblood of our economy. We need their innovation, we need their fresh thinking. We need their energy. We need to support and celebrate them, not beat them down with a lot of paperwork or onerous loan terms. And that’s really how we should think about it. And I think technology is providing some wonderful new ways to make underwriting more inclusive, making the loan application process a lot easier. And I hope regulators, when they think about technology. I have been a big advocate.
We need bigger regulation, especially of cryptocurrencies. It’s just, we’re falling behind there but, look at the technology, not the assets, lot of speculation in asset bubbles there to stay away from it. But the underlying technology is really something that I think can be used for the public. Good. I’ve also been a big advocate for central bank digital currency, or CBDC the feds really taking that seriously now.
But I’m concerned that some of the catalysts for that is maybe to protect Fiat currency, to protect the Fed’s ability to control money supply. And those are all important things, but more important is the ability to get money immediately emergency assistance to people immediately or small businesses households directly when they need it.
And you can do that through intermediary or directly through digital wallets, but I do think we should think that’s another technology that we should think about in terms of getting emergency assistance out quickly, because we saw all the… I think overall, United States did pretty well in the pandemic response. The PP programs for a lot of the smaller businesses –bad. I couldn’t agree more with some of the observations that were made by the earlier panel, but the fact is people need money.
They don’t really need more debt. So we did emergency or emergency payments, the EICs to households. We did the forgivable loans to small businesses. There was still a lot of problem getting the money out the door and CBDC as a tool again, through smart contracts to get target assistance out in emergency situations when the economy is in crisis, I think is also hugely beneficial. And again, a way that can help protect students and small businesses who are the most vulnerable in times of economic recession.
So we need to also make sure that the ideas we brainstorm today, that we actually try to put these ideas in place. I was talking to Mary Daly yesterday, and I think our hope is not that this conference is a great source of new ideas and sharing of information, but also lead to the ideas being put into action.
And for that to happen, regulators need to have an open mind. I think they do, but they need continued vigilance on this. I think we need to again, recognize the public policy importance of small business access to credit the importance of the economy, the importance to inclusiveness and racial equity, by making sure we get these credit decisions right. And that the regulatory treatment is appropriate.
We also need to maybe shame lenders a little bit. I think, again, going back to the Fannie experience, I’ll just be very forthright. As people know, I can be that. I’ve been disappointed by the lender response to our announcement. The public response has been positive, but lenders need to step up. You know, you need to change your systems. You need to put some money into some marketing.
You need to get the information out there to tenants that they can now. They’ve got positive rental data. They can come in and apply for a loan, and that’s going to be really important in the underwriting decision.
They need to do that. And my guess is that these small banks and the CDFI’s are probably going to be stepping up to this quicker than the big banks. I, I maybe I’m wrong. I don’t know. But I’ve found that typically with innovation that expand access to credit, it’s usually been the small banks and the CFIs who stepped up first with the large banks following suit. So for all of you out there listening to this, I hope you do engage. I hope if you originate mortgages for Fannie, I hope you take a good look at our positive rental data and, and work with us on that.
And any technical assistance or help. I know Fannie would be stand ready to provide, and let’s just get this done. Let’s, stop talking about it. Rental data, getting rental data into credit. As long as I’ve been in financial services, 15, 20 years, we’ve been talking about getting rental data into credit scores. Only 5% of renters have that information in their files to date.
So it’s time to bypass the credit bureaus, institutions to do this directly. Lenders need to get out there and I’m hoping the credit bureaus will follow suit eventually. But again, I think this is one initiative with tremendous promise that could lead to a lot of your things down the road. So thank you for letting me share my thoughts with you today. Great conference, kudos to Mary D and her great staff for all the wonderful work they put into this. And I know you’re going to have a lot of actionable items coming out of it, thank you.
Thank you so much, Sheila. That was so great. And as you said, there’s so many actionable items, ideas that you raised. So thank you for sharing just all of your expertise. Really appreciate it.