This is the third in a series of blog posts on tools available to local governments to assist small businesses. Previous posts have covered revolving loan funds (parts I and II). A second option is a loan-loss reserve fund.
What is a loan-loss reserve fund?
A loan-loss reserve fund (LLRF) involves a partnership between a non-financial institution, such as a local government, and a financial institution. The non-financial institution deposits money in a financial institution for the purpose of creating a loan loss reserve for loans made to small businesses associated with the non-financial institution.
Whenever a financial institution makes a loan, it has to set aside a certain percentage of that loan to cover any potential losses from a default. Financial institutions prefer to set aside as little funding as possible because these funds sit idle. This set aside is called a loan-loss reserve.
By having a non-financial institution provide the funding for the loan-loss reserve, the financial institution has an incentive to provide loans because its risk is significantly decreased. If the loan defaults then the financial institution will decrease the non-financial institution’s deposit by the amount of the loan loss. The presence of the loan-loss reserve fund is theoretically supposed to make the underwriting process less stringent and/or decrease interest rates on the loan.
What are the advantages/disadvantage of a loan-loss reserve fund?
Loan-loss reserve funds offer several advantages to local governments interested in supporting small businesses:
- The non-financial institution’s deposit is leveraged by the financial institution commonly three to one. If we assume a loan government wants to establish a $3 million loan fund, using this structure, the local government would only need to deposit about $1 million. The other funding would come from the financial institution.
- Local governments pay little to no operating costs for the fund. These expenses are paid for by the interest generated on the idle loan-loss reserve that the financial institution collects.
- The financial institution is responsible for the more specialized roles associated with a loan fund, underwriting and servicing. Therefore, the local governments do not need to have the lending expertise and/or capacity to operate these funds.
These advantages do not come without shortcomings though. An important disadvantage of LRRFs is that the local government has little to no input into the approval process of loans. By giving the financial institution control over the underwriting process, local governments have no influence about which loans to approve. Additionally, it is questionable whether the two goals of a loan loss reserve (make underwriting less stringent and decrease interest rates) are achieved.
What makes a loan-loss reserve fund successful?
Research has identified three requirements for success for local governments interested in establishing a LLRF. These requirements for success are similar to those of the revolving loan funds discussed in previous post.
- Partner with a financial institution that is actively lending and willing to participate. While the financial institution does not need to be located in the community, it does make the marketing efforts easier because potential borrowers are more familiar with the financial institution.
- Develop an active marketing strategy that involves more than printing brochures and a press release. A great strategy is to develop strong relationships with the local financial institutions to refer potential borrowers they are unable to approve.
- Generate deal flow to ensure loans are made. A steady pipeline of qualified borrowers is vital to the success of the loan program. Consider partnering with your local small business center to use the loan program as an incentive to have small businesses write business plans.
A loan-loss reserve fund is an alternative to the traditional revolving loan fund structure, particularly for smaller local governments that need assistance in leveraging their limited funds and do not have the necessary expertise to manage a loan fund.
Jordan Jones, a UNC-Chapel Hill graduate student pursuing a joint master’s degree in Public Administration and City and Regional Planning, is a Community Revitalization Fellow at the School of Government.