PACC Committee Report

Lack of financing under reasonable terms and conditions is considered a serious impediment to small business expansion. Consequently, governments in industrialised countries have often played a complementary role to private lending institutions either as direct providers of capital financing or to secure access to financial capital through loan guarantees, usually with the objective of promoting economic growth and employment.

In recognition of the contribution of small businesses to the dynamism of the Canadian economy, the Federal government delivers several programs designed to promote and stimulate small business development and growth. The Small Business Loans Act (SBLA) program, administered by Industry Canada and delivered through private financial institutions, is one of these federal programs.

Recent amendments to the Small Business Loans Act have resulted in significant increases in SBLA loan activity and in levels of claims to the Federal government. This sudden surge in program lending activity and claim levels prompted the Auditor General to audit the SBLA program management.

Acknowledging that the associated cost incurred by the SBLA program can become substantial to the Federal Government, the Committee decided to examine Chapter 29 of the Auditor General's December 1997 Report (Industry Canada - The Management of the Small Business Loan Program). Accordingly, on February 19, 1998, the Committee met with Mr. Denis Desautels (Auditor General of Canada), Mr. Richard Flageole (Assistant Auditor General), and Mr. Harry A. Ruthnum (Principal, Audit Operations) from the Office of the Auditor General. Mr. Kevin G. Lynch (Deputy Minister), Mr. Peter Sagar (Director General, Entrepreneur and Small Business Office), and Ms. Marie Josée Thivierge (Director, Strategic Planning and Corporate Services) represented Industry Canada.

Established in 1961, the Small Business Loans Act (SBLA) encourages private sector lending institutions to make loans of up to $250,000 to small businesses for the purchase or improvement of land, buildings and equipment. In case of borrower default, the program reimburses the lender 85 percent of the net amount of the loan. The maximum loan loss that can be refunded to individual lenders is limited to 10 percent of total outstanding registered loans.

In 1993, Parliament approved important changes to the SBLA program that simultaneously broadened eligibility requirements, increased maximum loan amounts from $100,000 to $250,000, increased the permissible financing from 80 percent to 100 percent for equipment and 90 percent for land and buildings and reduced the personal guarantee requirements. Within two years of these legislative changes, lending activity soared eight-fold from an annual average of $ 500 million to $ 4.4 billion dollars. Starting with the same period, claims on defaulted loans increased considerably. Because loans may be repaid over a period of ten years and claims may be submitted for a further three years, the impact of loan losses will continue to be felt for a considerable period of time. According to the Auditor General, the program will incur an estimated net loss of $ 210 million for loans issued between 1993 and 1995. Since 1993, some 177,000 new loans have been guaranteed for a value of approximately $11.2 billion. The total amount of guaranteed loans outstanding at 31 March 1997 was $6 billion, of which the government was contingently liable for a maximum of $1.4 billion.

In response to increasing risk and cost, legislative changes introduced effective 1 April 1995 modified SBLA program elements to encourage full cost recovery. The amendments were: introduction of an annual fee of 1.25 percent charged to the lender and based on the outstanding balance of loans; a reduction of insurance coverage from 90 to 85 percent of loan value, and the percentage of available financing was decreased from 100 percent to 90 percent (for loans made after 31 December 1995). As a result of these changes, the dollar value of loans issued under the program has dropped into the range of $ 2 billion annually. The Auditor General is uncertain whether the objective of full cost recovery is achievable under the present fee structure and loss-sharing ratio, nor if it is at all compatible with the program's fundamental goal of assuring that loans made under the program are complementary to existing lending.

New lending under the Program was supposed to end on 31 March 1998, however Bill C-21, which was passed in the House of Commons on 17 March 1998, extends the application of the Small Business Loans Act to 31 March 1999. This one-year extension is to allow Industry Canada to carry out a review and implement changes to the SBLA program.

The Committee learned of three principal concerns expressed by the Auditor General regarding his review of the Small Business Loans Act program. The Auditor General focussed on the lack of clear definition about expected results, weaknesses in the management and delivery of the program, and the provision of information to Parliament, particularly in terms of program objectives, achieved results and job creation data.

Apart from the very broad objective of increasing the availability of loans to small enterprises, the SBLA program lacks a clear statement of objectives and expected results by which one can assess the program's performance and achievement of its stated goals. The SBLA program objective is stated in very general terms, that is " to increase the availability of loans for establishing, expanding, modernising, and improving small business enterprises". The stated objective does not specify how these goals are to be achieved. It is worth noting that when program delivery is delegated to third parties (i.e. private lending institutions) program managers have less discretion in influencing the direction and scope of the program. Nevertheless, program managers would benefit from a more precise definition of expected results that is articulated within a framework of broad legislated objectives. Clearly defined performance criteria are a prerequisite for sound program design, especially in a context of continuous legislative or administrative changes. Therefore the Committee recommends:

The Auditor General is particularly concerned about the degree of the program's loan incrementality, that is the proportion of loans that would not have been made in the absence of the program. In the past five years, the Department commissioned several studies to determine the incrementality of SBLA loans. A 1994 study indicated that between 30 to 40 percent of SBLA loans were non-incremental. Another study completed in 1996 indicated that 46 percent of SBLA loans competed directly with private sector financing. Since the program's objective is to increase the availability of loans to small enterprises beyond that which would be normally available from private lenders, the Committee believes that it is important to assure the complementary character of SBLA loans in order to avoid waste of scarce capital resources. It therefore recommends:

The Auditor General has also noted that while the SBLA program underwent many major changes since its inception in 1961, it is still directed toward the financing of capital assets (land, buildings and equipment). While this type of financing is suitable in an economy dominated by the manufacturing sector, it may not be as suitable in a service economy, particularly for knowledge based industries (KBI) such as computer or software based businesses. Recently, private sector financial institutions have introduced new products and services directed to respond to current financial needs of small business. The SBLA program may require amendment to address any gaps in the private financing of small businesses. Therefore, the Committee recommends:

Following the 1993 program amendments, a significant increase was observed in both lending activity and in the level of claims on borrower default. As a result of this surge in loan activity and cost, a policy of full cost recovery was implemented after 1 April 1995. This new policy introduced certain changes to elements of the program, such as a decrease of the loan-loss ratio from 90 percent to 85 percent and saw the imposition of a 1.25 percent annual administration fee charged to the lending institution on the average amount of loans outstanding. Industry Canada projected that these measures would eventually lead to full cost recovery over a 10-year period. However, both the Auditor General and the Department have recently reviewed the program's loan guarantee portfolio and observed a significant increase in the proportion of riskier loans and a rise in rates of defaults that are occurring at earlier stages in the life of the loans. The Auditor General feels that program managers should take into account the impact of a riskier portfolio and the business cycle when making default rate projections. The Auditor General believes that under the current fee structure and loss sharing ratio, it is uncertain that full cost recovery will be achieved. As a result, the Committee recommends:

The Auditor General recommended in paragraph 29.52 of his Report that the Department needs to further develop systems and procedures to forecast the future performance of its guaranteed loan portfolio. The Committee heard the testimony of the Department's Director of Strategic Planning and Corporate Services, Ms. Marie-Josée Thivierge, regarding the progress in the development of the required systems and procedures to forecast program performance. Noting the progress already achieved, the Committee therefore recommends:

The program is structured in such a way that the responsibility of credit risk management and compliance to SBLA provisions are delegated to the lending institutions. The expectation is that lenders will ensure that all loans made under the program are in compliance with the SBLA eligibility requirements and conditions and that lending decisions under the program are made with the same due care and diligence as with non program loans. The Department itself obtains assurance of the quality of credit risk and compliance to the Act by focussing on claims submitted for payment.

The Auditor General is concerned whether the systems and procedures in place are sufficient to ensure that loans made under the program comply with SBLA provisions. He examined the lenders' loan files and noted that in certain cases some files contained insufficient information to perform a thorough analysis of credit risk. In other instances, financial institutions had charged, contrary to the Act, extra administration fees for granting loans under the program. Additionally, it was observed that in some other cases the Department did not request full and complete information on the loan files when assessing a claim. In such cases, there is greater risk of accepting claims that may not be in compliance with the provisions of the Act. To minimise the risk associated with non-compliant loans, the Committee recommends:

The Department told the Committee that it acknowledges certain of the Auditor General's concerns about the compliance of financial institutions to the provisions of the Act and assured the Committee that it will address these concerns in its upcoming review. However, the Department felt that the processes and systems already in place were sufficient to detect most irregularities and that the potential rejection of a claim request was deemed a sufficient deterrent to ensure that lenders apply due care and diligence in making loans under the SBLA program. Nevertheless, the Committee feels that the Department could exert more effort to further reduce the risk of accepting non-compliant loans by increasing its monitoring of financial institution's lending practices. Therefore the Committee recommends:

The Auditor General's sample audit of the lender's loan portfolio also identified cases where related borrowers were able to obtain loan amounts far in excess to the $250,000 limit per business. In one case, 23 related borrowers managed to obtain more than $ 4 million in loans. While these practices are contrary to the intent of the Act, the Auditor General noted that there are currently no provisions under the SBLA to prevent a group of entities with substantial common ownership from gaining multiple access to loans under the program. Such rules do exist under the Income Tax Act, which has provisions designed to limit access to the low corporate rate of tax for small businesses and to prevent abuse by the creation of related corporations. The Auditor General stressed the importance of clarifying this issue in order to ensure that the Program meet its intent of providing financial assistance to small enterprises within acceptable level of risk exposure to the government. The Department responded to this question by sending in a Notice to Lenders in May 1996 to address this specific issue and is proposing to introduce amendments to the Act during its upcoming review. At the same time, the Department feels that the actions it has already taken have sufficiently clarified the Act’s provisions so that there is no longer any room for misinterpretation by lending institutions regarding access to loans by related entities. The Committee recognises the Department's current efforts to resolve this issue, and urges it to continue to take steps in removing all ambiguity in the interpretation of the provisions of the Act. Therefore, the Committee recommends:

The Department reports to Parliament on the Small Business Loans Act program primarily through Part III of the Estimates and the Minister's annual report. The Auditor General assessed these documents in terms of their information content and concluded that better data could be provided especially in the areas of performance indicators and job creation data.

While these documents do provide some useful information in describing the context under which the SBLA program operates, the Auditor General concludes that they do not contain enough information to assess the program's ability to attain its stated objectives or if it is managed efficiently.

The Auditor General feels that the absence of clear program objectives hinders the Department's ability to find suitable performance indicators to assist in the evaluation of the SBLA program. Given the stated goals of incrementality and full cost recovery, proper evaluation would require information on revenues, administrative and claims expenditures, and a provision for loan losses. The information should also be presented on accrual basis. In 1997, the Department implemented a new information system which would provide additional information on program results such as lending activity by types of lenders, by provinces, by size of business enterprises, as well as claim activity levels, management program costs and revenues, and Minister's liability on outstanding loans. The Committee urges the Department to continue efforts in this vein, and thus recommends :

The Department also reports on the number of jobs created as a result of the program. In its 1995-96 Annual Report, the Department reported that 81,600 jobs had been created as a result of the program. The Department gets job creation data through a survey of loan guarantee registration forms that is prepared by lending institutions. The Auditor General finds this approach of reporting job creation as being too simplistic because the information on jobs created is based on the borrowers own labour projections which might overstate the number of jobs actually being created. The Auditor General cites economic studies undertaken by the Department itself which suggest that the actual employment gains resulting from the SBLA program is far smaller than the ones indicated in the annual reports. The Auditor General feels that the Department should apply a more rigorous methodology to properly evaluate the employment impacts of the SBLA program. Also, there are questions raised about placing too much emphasis on employment growth as a justification of the SBLA program. Loans that can augment small business performance such as the introduction of new technology can improve its competitive position or cost structure but can also result in temporary job losses as new technology or processes displace workers. The Committee shares the Auditor General concerns and therefore it recommends:

The Committee is confident that the adoption of its recommendations and those of the Auditor General, will assist the current review of the Small Business Loans Act program, and that improvements will occur and assure better assistance to small enterprises throughout Canada.

Pursuant to Standing Order 109, the Committee requests that the Government table a comprehensive response to this Report.