Does PPP stand for Principal-Agent Problem Program?
It has been a mixed bag so far for the Paycheck Protection Program (PPP). The PPP is a program that provides government backed loans…
It has been a mixed bag so far for the Paycheck Protection Program (PPP). The PPP is a program that provides government backed loans through lending institutions like banks to firms suffering economic hardship due to the Covid-19 crisis and resulting government curtailment of economic activity. The initial $349 billion dollar allocation was meant to be issued by banks and other lenders, and funds were to be dispersed by the government on a first-come, first-served basis. The initial tranche of funds were used up within a week.
While there was clearly a demand for the program there was also controversy. Data from the first tranche of loans indicate that access to funds was driven by existing relationships with banks, especially larger banks, leaving smaller firms, especially those that use smaller banks, at a disadvantage.
This brings us to last week when Congress passed a $310 billion supplement to the Paycheck Protection Program (PPP). The supplement earmarks $60 billion to be distributed by small and medium banks and Community Development Financial Institutions (CDFIs). Members of Congress, such as Sen. Marco Rubio, have also been asking pointed questions of larger banks regarding how they have run their PPP programs to date. Why? Well, it has something to do with the principal-agent problem.
Recall that the overarching goal of the PPP is to keep businesses and the jobs they create stable until the crisis passes. To do this the PPP uses a Small Business Administration (SBA) backed loan scheme designed to help businesses to retain employees on their payroll. The loans will be forgiven if the recipient business uses the proceeds to cover payroll and other approved expenses. While some non-bank lenders were also eligible to participate, this eligibility was all but meaningless because the Treasury and SBA did not promulgate requirements or an application for non-banks until several days after the program opened up, giving banks a head start. Still, banks are major lenders to businesses, so it was fine, right?
Well, maybe not. Many banks have been criticized, and in some cases sued because of how they have processed (or refused to process) applications. Criticisms involve banks limiting access to only existing customers (or customers who do not have credit products with other lenders) giving preferential treatment to their larger clients who have private banking relationships compared to other customers who had to use online portals or prioritizing loan applications in a way that maximized fees for the bank. Critics argue that these actions run counter to the law that established the PPP and the spirit and purpose of the law, that loans be broadly available and distributed on a first-come, first-served basis.
However, it isn’t clear that as a matter of law banks are prohibited from administering PPP programs in ways that are advantageous to themselves (e.g., processing loans in an order that maximizes fees, favoring some clients over others, etc.). As I pointed out in a previous post, BoA defeated a temporary restraining order that would have prevented them from favoring certain clients over others with the judge finding that the CARES Act and relevant regulations do not prevent banks from exercising some discretion as to what clients they help. Even though the SBA says that loans are distributed first-come, first-served it is unclear if that means that banks must process applications first-come, first-served or only that the SBA will disburse funds on that basis, with banks having discretion as to which loans they put forward. While the SBA and Treasury could certainly condition participation in the program on neutral access they haven’t explicitly done so yet, though there has been mounting pressure from Congress.
But wait, why should we care if banks process PPP loans in a way that is advantageous to them? If the money is still getting to businesses who need it and jobs are still being preserved why does it matter? Besides, this isn’t a free lunch for the banks. While the loans are guaranteed, so credit risk isn’t a real problem there may still be non-trivial regulatory risk given the fact that there is a lot of pressure to distribute federal money quickly, and administering the program costs time and resources that may not prove useful in the long term. Besides, the government is asking banks to do what they do in the normal course of business, extend credit, why shouldn’t they do so in a way that benefits them?
The answer to the above question depends on what the purpose of the PPP is. Is it just a way to inject X amount of money into the economy to save some number of jobs and businesses, while being agnostic as to the composition? If so then allowing banks to exercise broad discretion makes sense, or is at least harmless. In fact, you can make an argument that we want the most efficient banks to do the lion’s share of the distributing since that implies the money is being delivered faster, where it might do the most good. In this case you risk coming out of the crisis with the relatively rich firms doing better and the relatively poor firms faring worse, potentially leading to greater consolidation, which to some degree may be an acceleration of existing trends. But if the purpose of the program is just job preservation than this may not be a relevant consideration.
However, if your concern is to preserve the economy as it existed before going into the crisis, (or to avoid an acceleration of consolidation), to the greatest extent possible then bank discretion may work against that intent. Banks want to protect their existing, most valuable customers, maximize profits, and minimize risk. Therein lies the principal-agent problem. What is in the interest of the agent (the bank) may not be exactly in line with the interest of the principal (the government). This can be somewhat overcome with close monitoring, but in this case that would take the form of proscriptive law or regulation that takes time and may introduce other inefficiencies.
If you want to preserve the economy as it was you don’t want to be picking winners and losers,* and you don’t want the banks to end up picking winners and losers in how they choose to allocate funds. However, unless there are enough funds allocated for literally everyone some parties will win and others will lose and the debate is over what criteria will be allowed to make the determination and who does the determining.
This brings us back to part of the reason why $60 billion was earmarked for smaller banks and CDFIs. While larger banks are more likely to have relationships with relatively large and healthy firms, smaller banks and CDFIs are more likely to have relationships with smaller firms, less affluent firms, and firms in underserved areas or owned by relatively underserved populations. In the first go round there was concern that at the bank-SBA interface the larger banks would have the capability to outcompete smaller banks and CDFIs for loans because larger banks could operate at a scale and pace of operations smaller banks and CDFIs could not match. By earmarking money for smaller banks and lenders Congress is hoping to ensure that funds reach the types of firms who rely on small banks and CDFIs.
Going forward the debate over the role and challenges of using banks and other lenders as agents for financial relief is likely going to intensify. On the one hand, banks and other lenders have access and relationships to customers. On the other hand, their interests may not be fully aligned with the purpose of the program. On the other, other hand if you don’t use banks and other private lenders an alternative needs to be developed, which will no doubt have its own problems. How to resolve this question is going to be important going forward, especially if further economic relief is determined to be necessary.
Update: The SBA and Treasury have announced they will limit applications for a period of time to only lenders with under $1 billion in assets.
*Of course, by intervening in the economy the government is picking winners and losers in the sense that firms that would have failed but for government support due to Covid-19 would have left space for competitors and new entrants to grow. But then the government has also intervened by forcibly curtailing economic activity so that picks winners (e.g. Amazon) and losers (e.g. mom and pop storefronts) that the second intervention is meant to offset. But then it is unclear even in the absence of a mandatory curtailment how much economic life would have remained the same as people adapted to the reality that a dangerous and highly contagious disease was present…my head hurts, does anyone else’s head hurt?