Make the Next Bailout Serve Small Business

In mid-March, the government panel to monitor the Troubled Asset Relief Program (TARP) issued its final report, which argued that the program helped to steady financial markets and prevent wholesale failure of the financial system.In contrast to that valuable role, however, panel Chairman Ted Kaufman noted that the TARP "programs for Main Street have been far less effective." In other words, TARP did a better job of helping Wall Street firms than it did at solving the problems of small business borrowers. While the TARP panel disbanded on Apr. 3, policy makers should learn from the shortcomings identified in its report to prevent small business from getting hammered again during the next financial crisis.

Lesson 1. Define small business in a coherent manner. The White House, Congress, and various federal agencies all define small business differently. This makes it difficult to compare policy proposals or data. As I have previously written, when officials use definitions that encompass 99.9 percent of all companies—including businesses as disparate as a self-employed house painter with no employees and a manufacturing business with 495 employees—they create too much variation to identify common credit problems and solutions. Unfortunately, as the oversight committee report explains, policymakers have done little to narrow the definition of small business or to identify types of small businesses, hindering their efforts.

Lesson 2. Get up-to-date and accurate data on the small business credit market. During the financial crisis, policy makers were forced to make decisions without reliable numbers to gauge the degree to which supply and demand for credit had been affected. They didn't know how such different factors as deteriorating small business balance sheets, bank loss of capital, or business owner sentiment were contributing to the decrease in small business lending.

Government Data Can't Define Problems

Identifying the causes of the decline is crucial. If lending falls because small business owners demand less credit, then none of the programs the government uses to promote bank lending will solve the problem. The oversight committee report explains that, to figure out why small business loans have declined, policymakers need to collect timely data from small businesses on how much money they need to borrow, just as they must find out from banks how much they are willing to lend. The data available currently do not allow policy makers to disentangle the supply- and demand-side causes of credit contraction. Unfortunately the federal government has done little to fix the information gap, leading the report's authors to write: "In the absence of a rigorous data collection system or survey that examines small business finance and includes timely and consistent data, the federal government's efforts to develop sound policies to address small business lending will remain significantly hampered."

Lesson 3. Do more than intervene in the securitization markets. While TARP's emphasis on financial markets worked well to stabilize Wall Street, the report explains that too few small business loans are securitized in good times and bad ones for policymakers to rely solely on financial markets to ensure that credit flows to small business. As the oversight committee explains, policymakers also need to come up with the appropriate carrots and sticks to ensure that banks continue to lend money to small businesses.

During the financial crisis, policymakers put capital into banks and increased loan guarantees. However, these efforts were not very effective at encouraging lending to small businesses, the report shows. Banks' goals are very different from those of the federal government: While policymakers want to keep credit flowing, bank executives want to shore up their companies' financial strengths, which may lead them to curtail lending. This difference meant that during the financial crisis, some banks simply refused the additional capital the government offered them while other banks took the money but didn't increase lending. To make sure that banks keep credit to small businesses flowing, policymakers need to require financial institutions that are cutting back on small business lending to take government money and use it to maintain their loans to those companies.

As a business school professor, I must evaluate how well students learn lessons from case studies. If TARP were a case, I'd be willing to give policymakers an "incomplete" and allow them more time to finish the assignment. But if I had to grade them on how well they learned from the program so far, their marks would not improve their G.P.A.