On June 24, 1996, the OIG issued Inspection Audit Report 96-11-001, Inspection of Best Practices of Section 7(a) Lenders. This inspection focused on the credit management procedures identified by the nine successful lenders in the OIG’s case studies as the most effective means for controlling risk. Although not every procedure may be applicable to every 7(a) lender, the OIG believes that by encouraging such practices, the SBA will be able to improve the effectiveness of its lending partners while keeping loan losses to a minimum. Specifically, the practices may be useful as a guide for lenders who are new to the program or who need to improve their credit controls. The OIG also suggested that the SBA take these practices into account when considering candidates for the Preferred Lenders Program (PLP) or conducting reviews of existing PLP lenders.
Among other things, the OIG found that the successful lenders in the sample:
- Relied more on evaluating an individual borrower’s situation than on automated screening methods such as credit s coring.
Although some of the lenders use automated credit scoring for consumer loans, eight of the nine avoided it for small business loans largely because they do not think there is a strong correlation between a borrower’s past credit history, as measured by the score, and how a small business loan will perform. In most instances, the lenders used a more personal approach to evaluate businesses on a case-by-case basis.
- Generally avoided using external loan packagers.
Most of the lenders in the OIG’s sample tended to avoid third-party loan packagers who prepared prospective borrowers’ 7(a) loan applications for a fee. Although one lender noted that packagers have expedited its loan approval process, others stated that packagers often submitted substandard loans or insufficient documentation because, in part, they received their fees regardless of the quality of the applications.
- Required the borrower to pledge both personal and business assets as collateral, despite the availability of the SBA guarantee.
Although lenders may use the SBA guarantee to augment collateral, none of in the OIG sample appeared to use it as a full substitute for collateral. Moreover, they all required pledges of personal assets, such as a borrower’s residence or securities, if they deem it necessary.
- Centralized final lending decisions to ensure consistency and control.
Both large and small lenders required at least one official— other than the originating loan officer— to approve SBA loans. This helped to standardize a lender’s credit decisions.
- Assigned risk ratings to new loans and periodically reassessed them through the life of the loans.
In a risk rating system, a new loan is assigned a numerical value denoting its risk level.The number may be revised based on the borrower’s payment record or other factors, which differs from credit scoring that is usually used to screen applicants before issuing loans.
- Proactively watched for warning signs of future loan repayment problems.
Rather than waiting for loans to become past due, some lenders watch for indications of potential collection problems, like the borrower’s failure to renew hazard insurance or decreased profits from the previous year’s level.
- Identified past due loans early and initiated vigorous col lection efforts.
Quick action at the first sign of delinquency could reduce the need for time-consuming collection actions and enable the lender to adjust the loan terms or resolve other problems at an early stage.
The Associate Administrator for Financial Assistance stated that some of the lenders’ statements indeed described best practices in the industry. He expressed concern, however, over the findings on external loan packagers and on collateral. He noted that packagers serve a worthwhile purpose and that the practice of requiring borrowers to pledge personal and business assets whenever collateral is needed may not be the best practice in terms of carrying out Congress’ and SBA’s intent.
In response, the OIG noted that the lenders’ comments applied to full-time packagers rather than to any attorney or accountant who occasionally provided loan assistance to clients. The OIG also emphasized the extent of loan packager fraud, as evidenced by recent criminal investigations on packager-prepared loan applications and SBA’s formation of a committee in 1995 to examine the packager problem.
On the issue of obtaining collateral, the OIG viewed this practice not as detrimental to carrying out the intent of the 7(a) program but, rather, as just one of many considerations required in making a loan. Although the OIG report contains no formal recommendations, the OIG suggested that the Agency incorporate these best practices into its guidance for new lenders and its monitoring criteria for existing lenders.