Yet this won't be the first time the Fed set its sights on Main Street businesses.
In this post, I'll first review the origins and outlines of the Fed's latest lending scheme. Then I'll tell the story of its mostly forgotten predecessor: a lending program based on a now-defunct Federal Reserve Act amendment that was also supposed to encourage the Fed to lend to smaller non-bank businesses.
I hope the story of that former program may shine a light on some potential pitfalls along the road down which the Fed plans to venture. But even if it doesn't, it seems worth telling.
A Big-Business Bailout?
Of the many emergency facilities the Fed has launched since the start of the Great Corona Crash, none has been more controversial than the Primary Market Corporate Credit Facility (PMCCF), a Special Purpose Vehicle through which the Fed will support "severely distressed industries." The facility allows the Fed to either lend directly to firms in these industries or to purchase their bonds directly from them, with the aim of keeping them open so they can go on supplying necessary goods and services, and so that their workers can stay employed.
Why is the PMCCF controversial? Mainly because it supports only large, investment-grade companies, and is being backstopped to the tune of $10 billion by the U.S. Treasury. That's led the setup's (mostly Democratic) critics to assail it as part of a "bailout for corporate America" and a Wall Street "slush fund." West Virginia Senator Joe Manchin spoke for many when, before a procedural vote on Sunday, March 22nd, he declared himself "more worried about bailing out main street and keeping small businesses in operation."
Main Street's Turn
It didn't take long, though, for the Fed to address Senator Manchin's concerns: on the very next day it announced plans for a Main Street Lending Program aimed at small and midsize businesses. Fed staff haven't yet worked out all of the plan's details—on March 27th they were still "working furiously" on them. But Fed officials have said that, instead of lending directly to businesses, the Fed will use banks and credit unions to "funnel short-term financing" from it to them.
Thanks to Joseph Brusuelas, chief economist at RSM US (a "middle market" tax and audit consulting firm), we know a little more than that about the Fed's plan. Using comments from Fed officials (particularly Dallas Fed President Robert Kaplan and Atlanta Fed President Raphael Bostic), Brusuelas has come up with a compelling composite sketch of the Fed's planned arrangement, including its official name: the "Temporary Corporate and Small Business Liquidity Facility," or TCSLF. According to Brusuelas, the new facility will support businesses with revenues not exceeding $5 billion with up to $1 trillion in loans, backstopped by $85 billion in Treasury-supplied capital. The loans will be for terms up to five years, with quarterly payments, at an interest rate of 2.25 percent.
Here, compliments of RSM, is the whole sketch:
The TCSLF is meant to complement a $350 billion emergency Small Business Administration loan program, funded entirely by the Treasury, and aimed at companies with no more than 500 employees. Because borrowers under that program may have their loans partially forgiven provided they retain their workers or rehire those who'd been laid off, while the TCSLF offers no similar prospect of loan forgiveness, whether many small businesses eligible for either program will want to also take advantage of the newer facility is far from clear.
Section13(3)'s Big Business Bias
Like all Fed lending to non-banks in recent decades, lending by the TCSLF will be authorized by Section 13(3) of the Federal Reserve Act, covering the Fed's "discounts for individuals, partnerships, and corporations." That authority, first granted to the Fed in 1932 (when it was "tucked inside a highway construction bill"), and amended several times since, allows Federal Reserve banks, with the prior approval of the Secretary of the Treasury and an "affirmative vote of not less than five members" of the Board of Governors, to extend credit to non-bank firms "in unusual and exigent circumstances."
Importantly, the Fed for some time chose to construe its 13(3) authority as limiting it to discounting the same liquid collateral it had long stood ready to discount for member banks. Because few non-bank corporations possessed such collateral, that decision severely limited the new authority's usefulness. Indeed, the Fed went still further, interpreting its Section 13(3) powers so narrowly as to exclude support for nonmember banks and trust companies! For these reasons, and also because the Fed charged a relatively high rate on 13(3) loans, the Fed's new powers remained little used during the depression. According to David Fettig, the Minneapolis Fed's former V.P. of Public Affairs, during the amendment's first four years, Fed banks made only 123 13(3) loans totaling just $1.5 million.
By the depression's end, Section 13(3) appeared to be a dead letter. But it sprang back to life after 1991, thanks to a clause in that year's FDIC Improvement Act that struck-out the Section 13(3) language that the Fed had interpreted as calling for discount window collateral. The way was thus cleared at last for substantial 13(3) support to non-bank firms. The irony of this change was not lost on CMFA Adjunct Scholar Walker Todd, who observed in 1993 that, although the FDIC Improvement Act was supposed to "reduce the size and scope of the federal financial safety net," by expanding the Fed's 13(3) lending authority, it threatened to do just the opposite.
Still it wasn't until the 2008 financial crisis that the Fed proved Walker right, by using its new 13(3) powers to rescue Bear Stearns and AIG, and as the basis for several new emergency lending facilities. But because all of that episode's 13(3) lending went to very large firms, the TCSLF will mark the very first use of the Fed's 13(3) authority to support smaller, non-bank businesses.
It doesn't follow, however, that the Fed has never lent to such businesses before. On the contrary: it did so for more than three decades, thanks not to its Section 13(3) powers, but to a different Great Depression amendment to the Federal Reserve Act: the now defunct, and almost entirely forgotten, Section 13(b).
Déjà Vu All Over Again
Section 13(b) was inserted into the Federal Reserve Act by the Industrial Advances Act of 1934, not quite two years after the Fed gained its 13(3) lending privilege. Part (a) of the new section allowed Reserve Banks to extend credit directly to any "industrial or commercial business" located in their district, by lending to it or buying its obligations, for up to five years, "for the purpose of providing it with working capital." Part (b) in turn allowed Fed banks to offer similar support in partnership with commercial lenders, by purchasing or discounting obligations entered into by them for the purpose of supplying working capital to any industrial or commercial business, on the condition that its commercial partner obligated itself for at least 20 percent of any loss.
While the Fed banks might make 13(b) business loans in partnership with commercial lenders at any time, they were to resort to the direct lending option only "in exceptional circumstances when it appears…that [a business] is unable to obtain the requisite financial assistance on a reasonable basis from the usual sources." Although no limit was placed on the size of individual 13(b) loans, total 13(b) lending was limited to a sum equal to the Reserve Banks' surplus as of mid-1934 of $139.4 million, plus roughly the same amount ($139.3 million) of additional capital contributed by the U.S. Treasury in the guise of a rebate of the Reserve Banks' FDIC subscription.
Just as the TSCLF will supplement an expanded SBA lending program, the Fed's 13(b) lending was intended to supplement small business lending by the Reconstruction Finance Corporation (RFC), $300 million of which was authorized by the Industrial Advances Act's Section 5d. The RFC's loans were also to have maturities of up to five years. But unlike 13(b) loans they were subject to a per-applicant limit of $500,000.
According to James Dolley's 1936 appraisal of the Industrial Advances Act, the measure grew out of what was first "a widespread belief among government officials that commercial banks, thru fear of the Roosevelt Administration or deliberate antagonism to it, were refusing to extend loans to qualified business borrowers and that this refusal was retarding industrial recovery." Later that belief softened into the view that banks were not so much unwilling as unable on their own to supply businesses with the working capital they needed. According to a 1939 Editorial Research Report,
Bank credit was often difficult to obtain in the early years of the depression not only because of the natural caution of lenders in hard times, but also because so many banks were suspended and the rest found it imperative to keep their assets in as liquid a condition as possible. In many smaller communities all of the banks failed and there were literally no local banking facilities whatever.
In March 1934, David Fettig tells us, FDR "wrote to the chairmen of the Banking and Currency committees of both houses of Congress: 'I have been deeply concerned with the situation in our small industries. In numberless cases their working capital has been lost or seriously depleted.'"
The Federal Reserve Board concurred with FDR's assessment. In a letter Governor Eugene Black sent to the Senate Banking and Currency Committee, he referred (once again according to Fettig) to the "undoubted need" for credit beyond what commercial banks and the Federal Reserve as then equipped were able to provide. "In brief," he wrote, "the need is for loans to provide working capital for commerce and industry, and such loans necessarily must have a longer maturity than those rediscountable by Federal reserve banks." In May 1934, Black followed up by testifying before the House Committee on Banking and Currency, telling it that replies from a questionnaire the Board had sent to 4,958 banks and 1,066 chambers of commerce suggested that unless small businesses could somehow secure another six or seven million dollars' worth of loans, they'd go out of business, throwing another 350,000 employees out of work.
On the whole, the lending the Fed was authorized to do by its 13(b) authority has much in common with the lending to be undertaken by the Fed's new Temporary Corporate and Small Business Liquidity Facility. Both arrangements allow the Fed to lend to smaller non-bank businesses. Both are aimed at funding businesses' short-term operating expenses, including their payroll, rent, and debt payments (their "working capital," in the language of the earlier program). Both allow for medium-term loans of up to five years in one case and four in the other. Both allow the Fed to make business loans through commercial banks (though Section 13(b) also allowed it to make such loans directly). Both supplement other government-financed emergency small-business lending programs. Finally, both involve Treasury backstops: $85 billion (or .24 percent of current GNP) for the TCSLF, versus $139.3 million (or .21 percent of 1934 GNP) for the Fed's 13(b) lending.
Of course the programs also differ in important ways. One difference is that, while both the TCSLF and 13(b) allow small business support, the TCSLF is the first Fed arrangement intended solely for such businesses. Also, while all of the Fed's 13(3) lending must be confined to "unusual and exigent circumstances," only its direct (part a) 13(b) lending was limited to "exceptional circumstances" when businesses were "unable to obtain requisite financial assistance on a reasonable basis from the usual sources." Finally, the Fed's total outstanding 13(b) loans were never supposed to exceed the $280 million in capital backing them. Besides that, the Fed's commercial lending partners also had to have skin in the game to the tune of 20 percent of any 13(b) lending they took part in. In contrast, the TCSLF can lend up to $1 trillion, or almost 12 times its capital. That difference makes the new program both much larger in potential scale than its predecessor, and far more capable of exhausting the capital supporting it.
That the Fed's 13(b) lending was limited to the capital assigned to it reflected both the then-orthodox view that the Fed banks should never assume even the slightest risk of becoming insolvent and the highly risky nature of business lending, especially of medium-term (as opposed to short-term) lending, during a depression. (In fact, by the end of the program's first 18 months, 43 percent of the value of its outstanding advances took the form of loans for either four or five years.) Such lending could be expected, in James Dolley's words, to "entail a substantial volume of loss charge-offs." And ordinary business-lending losses could well be compounded as a result of "political pressure imposed thru the Federal Reserve Board on the reserve banks to expedite loans and to extend as much credit as possible."
Yet the Fed banks were determined, not only to stay solvent despite their 13(b) lending, but to avoid losing any money at all. To that end they insisted, first of all, that their 13(b) loans be collateralized. The protection this requirement offered was, however, far from complete. According to Dolley the Fed banks
found it impossible to establish and enforce standard requirements as to collateral margins. As a result, the actual value of the collateral pledged to secure advances has ranged from more than 100 per cent of the loan to a small percentage of the sum advanced. Almost every sort of collateral has been accepted as security for these industrial advances. Most frequently real estate and chattel mortgages have been used, but the reserve banks have accepted assignments of receivables, inventories, warehouse receipts, life insurance policies, and stocks and bonds of all types.
To compensate for such iffy collateral, the Fed banks also subjected every applicant for a 13(b) loan to an exceptionally thorough credit investigation. For that purpose each equipped itself with a five-member Industrial Advisory Committee, the job of which was to review and appraise 13(b) loan applications from firms in its district, and to forward them to it together with the committee's recommendation. The Fed bank would then take the Advisory Committee's recommendation into account in considering the applications, though it was free to approve a loan that the committee recommended against, or reject one that the committee favored.
And reject they did: as of October 23, 1935, the Reserve Banks had set aside three-quarters of the 7,140 applications their Advisory Committees forwarded to them, granting only $119 million of a total of over $280 million in requested advances. By May 31, 1940, that ratio had improved only slightly, with 2,900 of the 9,590 applications, or just 30 percent of them, approved.
Yet many 13(b) loans still turned sour. Up to 1940, according to a 1958 NBER study by Raymond J. Saulnier, Harold G. Halcrow, and Neil H. Jacoby (p. 273), against $7,411,783 in 13(b) interest and fees, the Reserve Banks had to set off $6,383,098 in administrative and interest expenses (the latter owed to the Treasury for funds supplied by it), plus $430,293 for losses charged off, and another $2,447,459 for anticipated loan losses. The result—a net loss of $1,849,117—amounted to 3 percent of total advances, a level "greater than could be sustained by private agencies functioning under the requirement of earning a reasonable return on invested capital" (ibid., p. 90).
During the program's later years, its overall loss rate fell to just .6 percent. That improvement was mainly due to the inflationary boom during and after War II. But it also reflected Reserve Banks' doubling-down on an already pronounced bias in favor of confining their 13(b) loans to larger businesses. Through 1950, according to Saulnier, Halcrow, and Jacoby, the average size of a Federal Reserve 13(b) loan was $175,000—many time larger than that of the average commercial bank business loan. Dolley concludes that, during its first year, the Fed's business lending program was "of but little assistance to the small industrial concerns for which it had been ostensibly created," we may safely conclude that this verdict holds for the program taken as a whole.
A Redheaded Stepchild
Despite their determination to avoid losses, the Federal Reserve banks "pushed the industrial advances program vigorously," publicizing it by means of "circular letters addressed to banks, radio talks, addresses before meetings of bankers and businessmen, and news releases" (Dolley). Thanks to these efforts, and to firms' desperate want of credit, the program started off with a bang. According to David Fettig, by the end of 1935, it had granted about $124.5 million to 1,993 businesses.
But, as the following table, from the previously-cited Editorial Research Report, shows, after that initial flurry of activity the program's scale declined rapidly, so that by 1939 it only approved 48 loans worth a total of just over $4 million.
|Applications Number||Received Amount||Applications Number||Approved Amount||Advances and Commitments Outstanding At end of year|
|1939 (to 5/17)||88||5,203,000||48||4,053,000||27,040,000|
Although 13(b) lending revived in 1942, when the Fed booked a record $128 million in loans, mostly to firms engaged in the war effort, and the Korean War kept the program active through the end of 1953, after that it tapered off rapidly, as can be seen in the next table, taken from the Board of Governors 1955 Annual Report. By the fall of 1955, the program had all but dwindled away.
According to Fettig, the decline in 13(b) lending didn't happen because the Reserve Banks resorted to even tougher lending standards. Instead, as the table's first column makes clear, it happened because fewer and fewer non-bank businesses applied to the Fed for loans. The slowness of the Fed's loan approval process, added to the low probability of approval, appears to have had much to do with this. Despite "the prodding of the Federal Reserve Board" and Fed banks' best efforts, Dolley says,
the average period of time elapsing between the receipt of application and its final disposition was variously reported as from two to four weeks. After final approval of loan applications, further delays often occurred as a result of the borrower's failure to meet specified loan conditions.
That the Fed's slow approval process and strict lending terms, rather than a general decline in small businesses' desire for credit, was responsible for the drop-off in 13(b) lending is suggested by the record of the RFC's alternative small business lending effort. By 1936, when it approved $32 million in loans, that program had already eclipsed its Fed counterpart. And thanks in part to a subsequent relaxation of its business lending rules, when the RFC ceased operations in 1953 it had lent businesses about $15 billion (Saulnier, Halcrow, and Jacoby, p. 71), or many times what the Fed had.
But the true insignificance of the Fed's 13(b) business lending only becomes evident when one realizes that, while it went on, total federal government debt to businesses never exceeded 5 percent of the amount business firms owed to private financial intermediaries (ibid., p. 48).
Although the Board of Governors tried, in 1938, to get the government to relax its 13(b) lending rules so it might reinvigorate that program, its appeal fell on deaf ears. And though the Board did at last succeed in securing a loosening of those rules in 1947, its enthusiasm for industrial lending gave way to disenchantment soon afterwards. Thus when a 1951 bill offered to relax the conditions for 13(b) lending still further, instead of supporting the measure the Board opposed it, saying that the relaxed rules might lead to inflation. By 1955, with only a few hundred industrial loans still on its books, the Fed was ready to quit the business altogether.
As David Fettig explains, it was Fed Chairman William McChesney Martin himself who delivered the coup de grâce to the program when, in 1957, he revealed the Board's sentiments to a subcommittee of the Senate Banking and Currency Committee. "Basically," Martin said,
our concern stems from the belief that it is good government as well as good central banking for the Federal Reserve to devote itself primarily to objectives set for it by the Congress, namely, guiding monetary policy and credit policy so as to exert its influence toward maintaining the value of the dollar and fostering orderly economic growth.
One year later, in August 1958, Section 13(b) was deleted from the Federal Reserve Act by Title VI of the Small Business Investment Act (SBA). The same act transferred the Fed's remaining Section 13(b) capital to the Small Business Administration for it to use in funding various grants.
In the meantime, the Small Business Act, passed two years earlier, had given the SBA permanent status, while increasing its lending capacity by more than 60 percent. The same measure raised the ceiling on individual SBA loans to a then-hefty $350,000, while reducing its maximum allowable lending rate to just 5.5 percent. The obvious intent of these steps was to allow the SBA to take exclusive responsibility for government-sponsored lending to small businesses, so that the Fed could instead give its full attention to "guiding monetary policy and credit policy."
And so it did, until now.
Posterity hasn't been kind to the Fed's original attempt to lend a hand to Main Street. Today it is all but forgotten; and it was little loved while it lasted. After a whirlwind romance, small businesses began to spurn its advances, eventually leaving it with few suitors; and even in its heyday it lent mainly to relatively large firms, rather than the smaller ones it had intended to woo.
Expert opinion has been no kinder. According to James Dolley, the Fed's venture into business lending marked "a radical departure from the original theory of reserve bank lending," which called for it to lend to banks only, and to "avoid all semblance of direct competition with privately owned commercial banks." Saulnier, Halcrow, and Jacoby found that the Fed's 13(b) loans were but a drop in the bucket compared to lending done by commercial banks, and that they made up a still less significant share of lending to small businesses. Even so, the Fed was lucky not to lose money on them. But the harshest verdict of all was delivered by the late, lamented Anna Schwartz, who called the Fed's industrial lending program "a sorry reflection on both Congress’s and the Fed’s understanding of the System’s essential monetary control function."
But what's done is done, and though history may rhyme, it needn't repeat itself. So here's to hoping that the Fed's 13(b) lending turns out to be, not a portent of things to come, but a prologue.
(For a follow-up on this essay, see here.)