Credit, crises, and infrastructure: the differing fates of large and small businesses — Brookings (April 2022)
Summary
Working Paper #1 of the Center on Regulation and Markets at Brookings, dated April 2022, titled Credit, crises, and infrastructure: the differing fates of large and small businesses, by Todd H. Baker, Kathryn Judge and Aaron Klein. The essay examines how credit creation infrastructure shaped who received government support during the pandemic and who continued to benefit afterward. It argues that grants to small businesses addressed short-term cash flow but did little to encourage ongoing private credit, while programs for the largest businesses supported financing beyond the acute phase. It discusses Federal Reserve facilities, the Paycheck Protection Program (PPP) and Treasury's early choice to favor banks over fintechs as intermediaries. The paper concludes that non-crisis times are when greater attention is required to improve financial infrastructure.
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“Credit, crises, and infrastructure: the differing fates of large and small businesses — Brookings (April 2022).”
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Center on Regulation and Markets Working Paper #1 April 2022
Credit, crises, and
infrastructure:
THE DIFFERING FATES OF LARGE
AND SMALL BUSINESSES
Todd H. Baker, Kathryn Judge, and Aaron Klein
This working paper is available online at: https://www.brookings.edu/center/center-on-regulation-and-markets/
The Center on Regulation and Markets at Brookings
creates and promotes rigorous economic scholarship
to inform regulatory policymaking, the regulatory
process, and the efficient and equitable functioning of
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broadly across microeconomic fields.
Disclosure
Todd Baker is an unpaid member of the board of directors of Accion Opportunity Fund, a nonprofit
community development financial institution. The authors did not receive financial support from any firm or
person for this article or from any firm or person with a financial or political interest in this article. Other than
the aforementioned, the authors are not currently officers, directors, or board members of any organization
with a financial or political interest in this article.
The Brookings Institution is financed through the support of a diverse array of foundations, corporations,
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CREDIT, CRISES AND INFRASTRUCTURE: THE
DIFFERING FATES OF LARGE AND SMALL
BUSINESSES
TODD H. BAKER, KATHRYN JUDGE & AARON KLEIN
ABSTRACT
This essay sheds new light on the importance of credit
creation infrastructure in determining who actually receives
government support during periods of distress, and who
continues to benefit after the acute phase of a crisis and the
government’s formal support programs come to an end. The
pandemic revealed, and the government’s response
accentuated, meaningful asymmetries in the capacities of small
and large businesses to access needed funding.
At first glance, it would seem that small businesses benefited
more than large ones from the government’s pandemic-support
programs, as more government funds flowed into small
businesses. Yet closer inspection of the range of government
programs implemented and their longer term impact reveals a
very different picture. By primarily providing grants to small
businesses, the government helped address their short-term
cash flow challenges but did little to encourage ongoing private
credit creation for these businesses. The aid provided was real,
but finite in nature. By contrast, the nature of the programs used
to facilitate financing for the largest businesses provided major
support at the moment and created expectations of future
Senior Fellow, Richard Paul Richman Center for Business, Law and Public
Policy, Columbia Graduate School of Business and Columbia Law School.
Harvey J. Goldschmid Professor of Law, Columbia Law School.
Senior Fellow, Brookings Institution.
1
support. These interventions enhanced the viability and
attractiveness of inherently fragile intermediation structures and
set them up to continue to provide cheap and easy financing for
the largest businesses long after the acute phase of the crisis
had passed.
This essay further reveals how numerous seemingly neutral
choices were anything but in practice, creating a disconnect
between policy makers stated aims and the actual impact of
many of their actions. A key takeaway is that the government
should do more during times of peace to understand and shape
the credit creation infrastructure in ways that facilitate small-
business lending in good times and bad.
2
CONTENTS
3
INTRODUCTION
This essay affirms and adds critical nuance to existing
understandings of the way crisis-era programs inevitably
shape—and are shaped by—the existing infrastructure for
credit creation. The 2008 financial crisis renewed a
longstanding debate about the appropriate role of the
government generally, and central banks in particular, in
providing liquidity and other forms of support during periods of
systemic distress. In the wake of that crisis, two dominant
schools of thought emerged. Some focused on the moral
hazard that comes from any government intervention. They
feared that government interventions distort incentives and
encourage risk taking, leading to the conclusion that the
government should rarely intervene, even in the face of severe
shocks.1 A related set of concerns arose around mission creep,
as many saw the Federal Reserve’s (Fed) actions as moving it
far beyond the roles it was originally designed to play.2
Others—including key policy makers—took the position that
when things get really bad, the government should provide
support almost wherever it could be useful to avoid the
macroeconomic costs that can arise from the failure of financial
intermediaries and the real economy businesses they help
support.3
1 For an overview of this literature, and efforts to address these challenges, see FIN.
STABILITY BD., EVALUATION OF THE EFFECTS OF TOO-BIG-TO-FAIL REFORMS (2021),
https://www.fsb.org/wp-content/uploads/P010421-1.pdf [https://perma.cc/BR5L-
GHTJ] (evaluating effects of too-big-to-fail reforms for systematically important
banks); Emmanuel Farhi & Jean Tirole, Collective Moral Hazard, Maturity Mismatch,
and Systemic Bailouts, 102 AM. ECON. REV. 60 (2012).
2
E.g., LEV MENAND, THE FED UNBOUND CENTRAL BANKING IN A TIME OF CRISIS
(FORTHCOMING, 2022). CHRISTINA PARAJON SKINNER, CENTRAL BANK ACTIVISM, 71 DUKE
LAW JOURNAL 247 (2021).
3
See, e.g., TIMOTHY F. GEITHNER, STRESS TEST: REFLECTIONS ON FINANCIAL CRISES
(2015).
4
Strikingly, in contrast to the heated debate triggered by the
2008 interventions, the various programs implemented by the
Fed and Treasury Department to help financial intermediaries
and businesses survive the pandemic have inspired minimal
reflection or debate. An array of valuable efforts to assess
empirically who participated in these programs—particularly the
novel paycheck protection program (PPP)— have yet to inspire
a broader debate about the significance of the government’s
crisis-era interventions.
In seeking to fill that gap, this essay charts a course that falls
between the two, more established views of the way crisis-era
programs are shaped by, and in turn reshape, financial
intermediation infrastructure. We see crisis-era support as
sometimes necessary to protect the long-term health of the
economy, and something that should be provided broadly when
critical to maintaining that health. Yet, we see that as a starting
point for discussion, rather than a conclusion that ends the
debate. Looking at 2020 through a lens that is informed but not
fixed by the events of 2008 reveals new and important lessons.
The first is that seeming neutral choices are often anything
but. For example, a primary way that Congress sought to
support businesses during the early phase of the pandemic was
by having Treasury support credit creation through Federal
Reserve facilities created pursuant to the Fed’s established
authority to make loans to nonbanks under “unusual and
exigent circumstances.”4 On its face, this decision did not favor
any particular industry or business type. In practice, this
decision greatly facilitated the flow of funds to the largest
businesses while doing little for mid-sized and smaller
businesses. Similarly, in its first effort to implement an
innovative new program to provide support for “small
businesses,” the Treasury favored banks over fintechs as the
4 Part II, infra.
5
intermediaries through which these funds should flow.5 This too
was seemingly neutral decision, but resulted in a
disproportionate share of the initial funds going to a subset of
small businesses that favored larger, older businesses who had
existing lending relationships with banks while disfavoring
smaller, younger, and importantly businesses owned by women
and minorities.
These insights also bring lessons. One ramification is the way
crisis-era interventions can and ought to influence the post-
crisis regulatory reform agenda. Second, given that crisis-time
support is likely, we argue that policy makers should use “peace
time” to make the infrastructure changes needed to ensure the
smooth flow of money and credit to those who most need it
when crisis strikes.
These insights and implications flow from our analysis of the
key decisions made in early 2020, and the ramifications of those
decisions. We begin by providing a brief overview of the major
programs adopted in 2020 to provide credit or operating support
to various types of businesses, with a focus on who benefitted
most and the incentives these programs created with respect to
ongoing access to credit once the program ceased.6 Given the
5
Part III, infra.
6
Financial assistance came through multiple mechanisms. The two most signifi-
cant were the Paycheck Protection Program (PPP) and a fund authorizing the Fed-
eral Reserve to support the general economy and markets. Both programs utilized
the financial system (banks, capital markets, other lenders) as a conduit to provide
assistance to businesses with the hopes those businesses would in turn, provide
benefits to workers. There are many employers, and hence employees, who work
at entities that are not ‘businesses’ in both the legal and economic sense. Many of
the definitions of these indirect programs, and some of the programs themselves
were targeted for these type of employers. For example, the PPP provided money
to select non-profits, including private schools and non-profit lobbying organizations
were eventually eligible for PPP assistance. George E. Constantine, Cynthia M.
Lewin & Andrew L. Steinberg, SBA Clarifies Lobbying and Economic Need Rules
for Nonprofit PPP Borrowers, Venable, LLP. (Mar. 5, 2021),
6
exigencies of the pandemic response, our aim here is not to
second-guess policy makers who responded remarkably fast in
the heat of the moment. The pandemic was a massive, sudden,
shock, and broad support was critical to minimizing its economic
impact. But, once the acute phases of a crisis wanes, the focus
should shift to the lessons both the crisis and the response
might hold. These are the questions we tackle here.
Putting the pieces together, the analysis suggests that policy
makers should seek to re-balance the scales. Small businesses
are a key driver of economic activity. They support the growth
and vitality of our neighborhoods, spark innovation, and provide
a pathway that can help people achieve financial success and
independence.7 Lending to small business often entails greater
credit risk, greater informational challenges and
disproportionately high lender costs relative to loan size.
Complicating these challenges, many of the smallest business
loans sit in the blurry zone between corporate cash-flow loans
and personal loans. Yet these inherent differences are more
reason—not less—to be concerned about the way policy
interventions may have inadvertently greased the wheels on
large business lending while leaving small business lending
more exposed to credit shocks.
https://www.venable.com/insights/publications/2021/03/sba-clarifies-rules-for-non-
profit-ppp-borrowers [https://perma.cc/XEU2-8ZK3]. For purposes of this paper we
will use the term business as more synonymous with employer in line with the legal
and regulatory implementation of the emergency assistance, whose purpose was to
provide economic support to employers and employees.
7
See Sifan Liu & Joseph Parilla, Businesses Owned by Women and Minorities
Have Grown. Will COVID-19 Undo That?, Brookings Inst. (Apr. 14, 2020),
https://www.brookings.edu/research/businesses-owned-by-women-and-minorities-
have-grown-will-covid-19-undo-that/ [https://perma.cc/59Y3-QYFU] (discussing how
minority- and women-owned business enterprises helped stabilize the economy
during the recovery period ensuing the Great Recession).
7
The analysis also brings to the fore the value of paying greater
heed outside of crisis periods to the ways disparate access to
credit shape who can open a small business and which small
businesses are likely to have access to the liquidity often
needed to weather shocks. People of color make up roughly
40% of the U.S. population, but only 20% of the nation’s 5.6
million business owners with employees.8 Women are 51% of
the population but only 33% of business owners with
employees. Minority- and women-owned businesses also
typically have fewer employees, less revenue, and were less
likely to survive the recession that followed the 2008 financial
crisis. Although there are many reasons for these disparities,
access to credit and cost of credit may well be a significant
contributor and could well be worse today than it was pre-
pandemic because of the government’s reliance on private
infrastructure it did not fully understand.
Particularly as interest rates start to rise and monetary and
lending conditions tighten, differential access to funding
between large business and small, and among small business
could have far reaching effects. From eating away at the
remarkable recent growth in new small business formation to
contributing to structural inequities and accentuating the
excessive concentration that already poses a challenge to the
long-term health and vibrancy of the economy, credit creation
infrastructure is central to the shape of the economy.9 This
essay brings to the fore the importance of understanding how
the government has shaped that infrastructure, how it has relied
8 Id.
9 THOMAS PHILIPPON, THE GREAT REVERSAL: HOW AMERICA GAVE UP ON FREE MARKETS
279-82 (2019) (discussing statistics regarding highly concentrated markets and the
negative relation between labor market concentration and wages).
8
on that infrastructure, why it is likely to do so again, and why this
reliance and support is often in tension with other policy aims.
I. THE LATEST CRISIS
The acute phase of the COVID-19 crisis in the spring of 2020
served as a powerful reminder that existing infrastructure
shapes, and ultimately limits, the government’s ability to provide
aid for people and businesses. This relationship between
existing infrastructure and governmental capacity manifested
across most financial and market policy interventions, including
direct payments to individuals and families, unemployment
insurance, small business assistance, and the Federal
Reserve’s bond purchase and liquidity facilities.
A return to the early stages of the pandemic response, and a
review of the processes through which these programs were
adopted, make clear that many of the ramifications of the
government’s interventions were unintended consequences of
the need for the government to move quickly to achieve its
goals, with incomplete information and in reliance on imperfect,
existing infrastructure. Although both the speed at which the
pandemic hit the economy and the speed of the recovery were
more rapid than the 2008 financial crisis or other periods of
distress, similar dynamics are common during periods of crisis,
and all the more reason to reflect on the structure and adequacy
of existing crisis response tools outside periods of distress.
Just as in 2007 and 2008, the Federal Reserve was the first
responder in the government’s effort to contain the economic
fallout of the pandemic. To provide accommodative monetary
conditions and ease the unexpected and potentially massive
dysfunction in the Treasury market, the Fed again adopted a
program of quantitative easing (“QE”)—buying up Treasury and
mortgage-backed securities—on an unprecedented scale.10
10 Lorie K. Logan, Exec. Vice President, Fed. Rsrv. Bank of N.Y., Remarks at
SIFMA Webinar: The Federal Reserve’s Market Functioning Purchases: From
Supporting to Sustaining (July 15, 2020) (transcript available at
9
QE, a tool the Fed first used during the 2008 global financial
crisis, at the time was considered radical but now has been used
in the last two recessions.11 Yet the Fed’s purchases of
Treasury securities and agency mortgage-backed securities
this time were not only aimed at easing monetary conditions,
they were also used to help ease market dysfunction.12 The
Fed bought $1.7 trillion worth of Treasury securities between
March and June 2020.13 To help stem withdrawals from money
market mutual funds as COVID-19 began to hit financial
markets in March 2020, the Fed created the Money Market
Mutual Fund Liquidity Facility to provide liquidity and financial
assistance to prevent funds from “breaking the buck” and losing
value, building expressly on the same design used in 2008.14
https://www.newyorkfed.org/newsevents/speeches/2020/log200715
[https://perma.cc/227W-CYZ7]) (“Another important measure, and the focus of my
talk today, is the asset purchases that we have conducted at an unprecedented scale
and speed to support the smooth functioning of markets for Treasury and agency
mortgage-backed securities (MBS)—both of which play crucial roles in the American
financial system and economy.”).
11 Ben Bernanke, The New Tools of Monetary Policy, BROOKINGS INST. (Jan. 4,
2020), https://www.brookings.edu/blog/ben-bernanke/2020/01/04/the-new-tools-of-
monetary-policy/ [https://perma.cc/J9T8-2Y9L].
12 Logan, supra note 10 (discussing how the Federal Open Market Committee
made substantial purchases of Treasury securities and agency mortgaged-backed
securities, and directed the Open Market Trading Desk to make purchases “in the
amounts needed to support the smooth functioning of markets”).
13 Jane E. Ihrig, Gretchen Weinbach & Scott A. Wolla, How the Fed Has
Responded to the COVID-19 Pandemic, FED. RSRV. BANKOF ST. LOUIS. (Aug. 12,
2020), https://www.stlouisfed.org/open-vault/2020/august/fed-response-covid19-
pandemic [https://perma.cc/J8HC-RY4U] (“The blue shaded region of the graph
below shows how quickly the Fed ramped up its purchases of Treasury securities—
it bought around $1.7 trillion worth between mid-March and the end of June.”).
14 KENECHUKWU ANADU , MARCO CIPRIANI, RYAN M. CRAVER & GABRIELE LA SPADA,
FED. RSRV. BANK OF N.Y., THE MONEY MARKET MUTUAL FUND LIQUIDITY FACILITY (2021),
available at
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr980.pdf
[https://perma.cc/CE66-EMJC] (“The Federal Reserve faced the same challenges in
10
And the Fed also re-adopted many of the other programs it had
used during the 2008 financial crisis to inject additional liquidity
into the market for various financial instruments and to provide
liquidity to both banks and nonbanks.
Through these programs, the Fed supported market
functioning and signaled its continued willingness to prop up key
parts of the financial system if needed, just as it had done in
2008. The similarity in the programs the Fed used was also a
reminder that once the Fed intervenes in a particular way—even
if the aim is to protect market functioning—market participants
will often anticipate similar support in the future. This was the
case even in the area of money market mutual funds, where
Congress, the Fed, the Securities and Exchange Commission,
and the Financial Stability Oversight Council had spent
substantial time and energy revamping regulations designed to
reduce the need for government assistance in the name of
financial stability.15
The Fed was not the only major government actor to move
quickly and aggressively. The United States Congress also
responded rapidly with a large fiscal stimulus. The first
significant legislative action was the Coronavirus Aid, Relief,
and Economic Security Act (CARES Act)—a $2.2 trillion fiscal
2008, when it set up the AMLF in response to the MMF run triggered by Lehman
Brothers’ default. Although the type of shock was different, it was natural to design
the 2020 facility based on its 2008 predecessor.”).
15 See also Press Release, U.S. Dep’t of the Treasury, President’s Working Group
on Financial Markets Releases Report on Money Market Funds (Dec. 22, 2020),
available at https://home.treasury.gov/news/press-releases/sm1219
[https://perma.cc/2GC2-JF36] (“The PWG agrees that while many of the reforms
implemented after the global financial crisis increased market stability, the events of
March 2020 show that more work is needed to reduce the risk that remaining
structural vulnerabilities in prime and tax-exempt money market funds will lead to or
exacerbate stresses in short-term funding markets.”).
11
stimulus bill passed by the end of March 2020.16 The CARES
Act was designed to provide fiscal firepower, quickly and in
large amounts, to try to blunt the economic damage of the
pandemic. Direct aid included payments to individuals, state
and local governments, health care providers, and others. This
was a traditional Keynesian economic stimulus17 largely
delivered through existing methods, such as enhanced
unemployment insurance benefits, and through revisions to
existing federal/state matching grant programs providing
general-purpose aid to state governments.
Alongside direct stimulus payments to individuals, expanded
unemployment insurance benefits, specific funds for grants and
other types of support for particular industries, the bill included
multiple modes of support for businesses and their employees.
The two provisions of the CARES Act most relevant to the
viability of businesses were the Payroll Protection Program and
a separate, innovative effort to have the Fed and Treasury work
together to provide credit support to businesses. Considering
each program in turn, and in context, brings to light the short-
and longer-term effects of the support businesses received
during this acute phase of the economic shutdown.
Before doing so, it is worth reflecting briefly on how various
government efforts illuminated the central importance of
existing financial infrastructure in the government’s ability to
provide aid quickly to those who needed it. This was true for the
provision of direct assistance as well as credit. The federal
government authorized expanded unemployment benefits,
deeming them critically important to the well-being of qualifying
16CARES Act, H.R. 748, 116th Cong. (2020).
17 See Sarwat Jahan, Ahmed Saber Mahmud & Chris Papageorgiou, What Is
Keynesian Economics?, INT’L MONETARY FUND 53-54 (Sept. 2014),
https://www.imf.org/external/pubs/ft/fandd/2014/09/pdf/basics.pdf
[https://perma.cc/3PB4-CVFK] (explaining that “the central tenet of [Keynesian
economics] is that government intervention can stabilize the economy”).
12
individuals and to the health of the overall economy. But the
ability of people who had lost their jobs to actually receive the
benefits they were owed varied dramatically, largely depending
on the existing apparatus for distributing unemployment
payments at the state level. The apparatus failed miserably in
many states, with particularly well-documented problems in
New Jersey and Florida.18 The reasons were manifold:
outdated computer systems, application backlogs caused by
staffing shortages, and implementation of new federal rules all
contributed.19 This led observers to compare the
unemployment payment and processing system to the classic
infrastructure example of “replacing aging water pipes.”20
According to one estimate, by the end of May 2020, months into
18 See Sophie Nieto-Munoz & Matthew Stanmyre, N.J. Failed to Fix
Unemployment System for 19 Years, Records Show. Now Murphy Pleads Patience,
NJ ADVANCE MEDIA (May 14, 2020, 6:45 AM),
https://www.nj.com/coronavirus/2020/05/nj-failed-to-fix-unemployment-system-for-
19-years-records-show-now-murphy-pleads-patience.html [https://perma.cc/6XY8-
J3T6] (reporting problems with New Jersey’s archaic unemployment website and
automated call system which prevent many New Jersey residents from receiving
unemployment benefits); Mary Papenfuss, ‘S**t Sandwich’: Florida’s GOP
Reportedly Rigged Jobless Site to Block Applicants, HUFFPOST (Apr. 6, 2020),
https://www.huffpost.com/entry/florida-unemployment-
website_n_5e87b67ec5b6e7d76c63bcf7.
19 Lisa Rowan, Why Is It So Hard To Get Your Pandemic Unemployment
Benefits?, FORBES (Mar. 1, 2021, 8:00 AM),
https://www.forbes.com/advisor/personal-finance/why-its-so-hard-to-claim-
unemployment/ [https://perma.cc/DEK9-LGMP] (discussing various factors that
prevented access to pandemic unemployment benefits: computer reprogramming,
application backlogs caused by staffing shortages, and the flood of additional eligible
workers under the CARES Act).
20 Katherine Landergan, America’s Unemployment System Failed When It Was
Needed Most. Can It Be Fixed?, POLITICO (May 19, 2021, 4:30 AM),
https://www.politico.com/news/2021/05/19/america-unemployment-system-failed-
pandemic-483100 [https://perma.cc/Y9A8-Y7RC] (“The not-so-sexy topic of
unemployment insurance system reform — the economic equivalent of replacing
aging water pipes — has been quietly dominating policy conversations at every level
of government and is about to break into the mainstream.”).
13
the pandemic, only 57% of the 33 million unemployment claims
that had been filed were paid, leaving many unemployed
workers and their families in search of other avenues to scrape
by.21 This payment bottleneck delayed the stimulative effect on
the larger economy and increased hardship on families during
their time of need.
Similarly, the stimulus “checks” designed to provide aid
broadly arrived far more quickly for those who could receive the
funds electronically into their bank accounts via direct deposit,
using IRS taxpayer and tax return data,22 than for the 70 to 100
million people for whom the government either lacked correct
bank account information or was otherwise unable to figure out
how to properly send them their funds. This explains why 25%
of American households needed to wait for a physical check or
debit card to be delivered to their home despite the fact that only
5% of U.S. households lack a bank account.23
21 See Eli Rosenberg, Workers Are Pushed to theBbrink as They Continue to Wait
for Delayed Unemployment Payments, WASH. POST (July 13, 2020),
https://www.washingtonpost.com/business/2020/07/13/unemployment-payment-
delays/ (“By the end of May, about 18.8 million out of 33 million claims—57%—had
been paid nationwide.”); Manuel Alcalá Kovalski & Louise Sheiner, How Does
Unemployment Insurance Work? And How Is It Changing During the Coronavirus
Pandemic?, BROOKINGS INST. (Nov. 3, 2021), https://www.brookings.edu/blog/up-
front/2020/07/20/how-does-unemployment-insurance-work-and-how-is-it-changing-
during-the-coronavirus-pandemic/ [https://perma.cc/65V6-LN8G] (“Andrew Stettner,
a senior fellow at the Century Foundation, estimates that by the end of May 2020,
only about 18.8 million out of 33 million claims (57 percent) had been paid nationwide,
an improvement from 47 percent of claims at the end of April 2020 and just 14 percent
at the end of March 2020.”).
22 See Coronavirus Tax Relief, INTERNAL REVENUE SERVS.,
https://www.irs.gov/coronavirus-tax-relief-and-economic-impact-payments
[https://perma.cc/L6LS-V8MR] (last updated Jan. 18, 2022).
23 Aaron Klein, Opinion, Want Your Next Stimulus Check Faster? Congress Needs
to Change Just One Line of Law, BROOKINGS INST. (July 27, 2020),
https://www.brookings.edu/opinions/want-your-next-stimulus-check-faster-
14
While ensuring that ordinary Americans get the direct and
timely support their government has promised to them is not the
focus of our analysis, these examples help illustrate the
fundamental importance of the existing infrastructure—federal
and state, public and private—in shaping the government’s
option set and ability to deliver when crisis strikes.24 With two
major crises already this century, one of the overarching
lessons is the importance of considering in advance the
condition of the existing financial infrastructure and acting in
advance to correct deficiencies and inequities that merit
attention. Addressing these issues can have positive spillover
effects and may also help mitigate distributional challenges
when times are good. We now turn to the role that the existing
infrastructure played in the government’s effort to aid
businesses, big and small.
II. THE FED-TREASURY FACILITIES
The CARES Act program that sought to provide the most, and
widest ranging support, for businesses entailed an effort
spearheaded by the Fed using support appropriated by
Congress to the Treasury Department. The program authorized
the Fed to support the broader economy by allocating $454
billion in seed capital, which allowed the Fed—working with the
Treasury Department—to theoretically buy over $4 trillions in
congress-needs-to-change-just-one-line-of-law/ [https://perma.cc/S2WV-DPDC] (“70
million to 100 million people waited one to three months for money that eventually
arrived as a paper check or debit card.”).
24 The contrast with other countries that deliver all benefits directly through
dedicated electronic interfaces, such as India’s e-RUPI, is stark. See John Xavier,
Explained| How India’sNew Welfare-Focused Digital Payment System Works?,
HINDU (Aug. 8, 2021, 4:50 PM), https://www.thehindu.com/sci-tech/technology/e-
rupi-how-indias-new-welfare-focused-digital-payment-system-
works/article35682640.ece [https://perma.cc/89FZ-BBY7] (describing India’s e-RUPI
system, which “is a digital voucher that can be redeemed by beneficiaries when they
make use of any specific government services” and “does not require a card, app or
internet access to redeem the vouchers”).
15
assets.25 This was to be accomplished via lending facilities the
Fed created pursuant to its existing authority under Section
13(3) of the Federal Reserve Act to make loans to nonbanks in
“unusual and exigent circumstances.”26 The scale of the
authorized interventions far exceeded anything done in
response to the 2008 crisis, with the Fed itself lauding its
potential to provide trillions in new loans.27 As the context
reflects, these funds were designed to enable the Fed to provide
fresh loans to businesses, nonprofits, and municipalities. The
gap between the amount appropriated and the hoped-for impact
of the related credit facilities reflects the fact that the seed
money allocated by Congress was meant to cover only
expected losses, enabling the Fed to make loans far in excess
of the money allocated without suffering a financial hit itself.
This program positioned the Fed to play a meaningful role in
determining who received support.28 But Congress avoided
25 Prior to the enactment of the CARES Act, the Department of the Treasury made
a $10 billion equity investment from the Exchange Stabilization Fund into the Fed’s
Term Asset-Backed Securities Loan Facility to support lending of up to $100 billion.
Over $4 trillion in asset purchases or lending could be supported by the $454 billion
appropriation assuming approximately similar leverage ratios. SeeTerm Asset-
Backed Securities Loan Facility, FED. RSRV. BD. (Mar. 23, 2020),
https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200323
b3.pdf [https://perma.cc/G36K-FBK2].
2612 U.S.C. § 343(3)(A).
27 Press Release, Fed. Rsrv. Bd., Federal Reserve Takes Additional Actions to
Provide up to $2.3 Trillion in Loans to Support the Economy (June 29, 2020, 8:30
AM),
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200409a.ht
m [https://perma.cc/878E-AECJ].
28 Kelsey Snell, What’s Inside the Senate’s $2 Trilllion Coronavirus Aid Package,
NPR (Mar. 26, 2020, 5:34 PM), https://www.npr.org/2020/03/26/821457551/whats-
inside-the-senate-s-2-trillion-coronavirus-aid-package [https://perma.cc/923A-
2ECH] (describing how the CARES Act would provide relief to seven main groups of
beneficiaries: individuals, small businesses, big corporations, hospitals and public
health, federal safety net, state and local governments, and education).
16
crossing the Rubicon of having the Fed directly capitalize the
facilities with its own funds, by using the Treasury Department
to capitalize newly created emergency facilities and by retaining
the many limitations on the Fed’s authority already embedded
in the Federal Reserve Act, particularly section 13(3) thereof.
Section 13(3) was added to the Federal Reserve Act in 1932
to give the Fed the ability to lend directly to the real economy in
a crisis.29 The Fed, however, made only modest use of this
power during the Great Depression and failed to use it at all
between 1936 and 2008.30 When Section 13(3) was invoked by
the Fed in response to the 2008 crisis, it used this authority quite
broadly to establish new borrowing entities controlled by the
Fed that supported many nonbank financial institutions (and
indirectly, their counterparties, including banks), that had played
an important role in the financial bubble that caused the crisis.31
29 Parinitha Sastry, The Political Origins of Section 13(3) of the Federal Reserve
Act, 24 FED. RSRV. BANK OF N.Y.: ECON. POL’Y REV. 2 (2018) (“This article concludes
that the framers of the section intended to authorize credit extensions to individuals
and nonfinancial businesses unable to get private-sector loans. In other words,
Section 13(3) sanctioned direct Federal Reserve lending to the real economy, rather
than simply to a weakened financial sector, in emergency circumstances.”). Between
1932 and1936, the Fed made a total of $1.5 million in section 13(3) loans. Id. at 27
("The Federal Reserve Board renewed the 13(3) authority every six months until July
1936, at which point the Federal Reserve System had made a cumulative total of 123
loans under the authority, aggregating to $1.5 million.”). Beyond the limited amount,
this fiscal stimulus was also distinct from 2008 and 2020 because the lending was
restricted to commercial enterprises and did not include nonmember banks or
nonbank financial institutions. See id. at 25 (“The Federal Reserve Board took the
crucial step of determining that ‘the term “corporations” does not include banks,’
meaning that 13(3) did not allow discounts for nonmember banks.”).
30 David C. Wheelock, Lessons Learned? Comparing the Federal Reserve’s
Responses to the Crises of 1929-1933 and 2007-2009, 92 FED. RSRV. BANK ST.
LOUIS REV. 92 (2010) (“The Fed made 123 loans totaling a mere $1.5 million in the
four years after the section was added to the Federal Reserve Act in 1932. Section
13(3) was not used again until 2008, when it became an important tool in the Fed’s
effort to limit the financial crisis.”).
31 See Sastry, supra note 29, at 29 (“In the spring of 2008, Sections 10B and 13(3)
formed the statutory basis for the Federal Reserve’s lender-of-last-resort powers for
17
Many of the new 13(3) facilities the Fed created were designed
to provide fresh liquidity into any array of institutions and sectors
of the market that, in various ways, were part of a new system
of market-based intermediation, often referred to as the shadow
banking system. Far more controversially—and in a move that
would be prohibited today—the Fed also used this authority to
facilitate JP Morgan’s acquisition of Bear Stearns and to help
AIG avert bankruptcy.32
The Fed’s only historical experiment making loans to the real
economy was providing working capital pursuant to what was
then Section 13(b) of the Federal Reserve Act. This program
was initially created during the Great Depression and sputtered
along until Congress brought it to an end in 1958, with the full
support of then-Fed Chair William McChesney Martin.33 In
short, although direct Fed lending to the real economy was one
of many experiments that tried to help the economy recover
from the Great Depression, it is not a tool that has ever been
widely used or that was particularly successful, and it is not one
that today’s far more powerful Fed had ever embraced, until the
pandemic response.
member banks, nonmember banks, broker-dealer firms, commercial paper issuers,
and money market mutual funds as the Fed moved to bolster a financial system
that had arrived at the brink.”).
32 MARC LABONTE, CONG. RSCH. SERV. R44185, FEDERAL RESERVE: EMERGENCY
LENDING 14 (Mar. 27, 2020), available at
https://sgp.fas.org/crs/misc/R44185.pdf [https://perma.cc/5M5F-N9H2] (discussing
that the Fed financed JP Morgan Chase’s takeover of Bear Stearns with a $29 billion
federal loan, while “prevent[ing] AG’s failure by intially providing it with a line of credit
of $85 million”).
33 George Selgin, When the Fed Tried to Save Main Street, ALT-M (Mar. 30, 2020),
https://www.alt-m.org/2020/03/30/when-the-fed-tried-to-save-main-street/
[https://perma.cc/FH5C-AMB8].
18
In order to understand the impact of the decision to use the
Fed to provide fresh liquidity to businesses in particular, it is
helpful to have a rudimentary understanding of the lending
landscape. Large, established corporations have more options
accessing credit than smaller, newer companies. An array of
factors makes the debt of large companies—whether in the form
of syndicated loans or bonds—easier to fund, originate, and
hold than that of smaller companies. Two of the most important
challenges are related: smaller businesses generally present
risk profiles more expensive to assess, and smaller companies
generally pose distinct informational challenges.
Large, public companies, on the other hand, are subject to
rigorous, ongoing disclosure requirements, typically have long
track records, and benefit from a body of equity holders who are
even more motivated than a company’s debt holders to monitor
the business and prospects of the companies they invest in.
These companies often issue debt securities that they pay to
have rated by rating agencies, creating free information
regarding the credit quality of that debt for investors to rely on.34
Accentuating the advantage, the past decade has seen a
massive growth in the issuance of collateralized loan obligations
(“CLOs”), open-end bond funds, and exchange traded funds
(“ETFs”) backed by bonds. These products have helped create
ready buyers for newly issued corporate debt and eased the
financing process for large corporations.35 They also create an
34 Investors who rely exclusively on rating agency opinions may find themselves
investing in assets with greater risk than they realize, as evidenced by the mis-rating
of many securities in the 2008 financial crisis. We express no opinion on the wisdom
or efficacy of this reliance, simply noting that it exists and in the current “originator
pays” model, ratings are provided to investors without cost.
35 See BD. OF GOVERNORS OF THE FED. RSRV. BD., FINANCIAL STABILITY REPORT 22
(Nov. 2019), available at https://www.federalreserve.gov/publications/files/financial-
stability-report-20191115.pdf [https://perma.cc/6WUE-BU75] (“In line with the
discussion of price terms and risk appetite in section 1, demand for institutional
leveraged loans has remained strong and credit standards have remained weak.”);
Antonio Falato, Itay Goldstein & Ali Hortaçsu, Financial Fragility in the COVID-19
19
intermediation infrastructure that made it easy for the Fed to
come up and prop up the functioning of this overall system, and
in ways that seem likely to alter expectations of future support.
The credit intermediaiton structure for small businesses is
quite different along many fronts. Even for an established small
or mid-sized business, the biggest shareholder is often the
entrepreneur or family who runs it. The mechanisms for
funneling money from the capital markets into smaller company
debt are far less established, much more sensitive to overall
economic conditions, and far more expensive. Small business
lending is often further complicated in a variety of ways, as
lenders typically require multiple years of business history,
personal guarantees, collateral and other support to reduce risk.
This helps explain why small businesses often have challenges
obtaining capital from outside sources. Only four in nine small
businesses report having obtained credit from a bank in the last
five years, according to the Fed’s 2020 survey.36
That financing is already tilted in favor of large businesses—
giving them a meaningful leg up over mid-sized and small
businesses—is all the more reason to be concerned about the
particular microstructure of the mechanisms through which
credit flows to both types of businesses and the impact of the
government’s interventions.
Crisis: The Case of Investment Funds in Corporate Bond Markets 47 fig.1 (Becker
Friedman Inst., Working Paper No. 2020-98, 2021), available at
https://bfi.uchicago.edu/wp-content/uploads/BFI_WP_202098.pdf
[https://perma.cc/3KFG-RLGL] (graphing the growing importance of funds in the
corporate bond market).
36 FED. RSRV. BANKS, SMALL BUSINESS CREDIT SURVEY: 2020 REPORT ON EMPLOYER
FIRMS 8 (2020), available at
https://www.fedsmallbusiness.org/medialibrary/FedSmallBusiness/files/2020/2020-
sbcs-employer-firms-report [https://perma.cc/9CPK-3VDE] (summarizing lending
sources for small businesses in graph).
20
A. Support for the Largest Businesses
During the COVID-19 response, the primary way the Fed
supported the ability of large corporations to access credit was
through the creation of two corporate credit facilities.37 The
Primary Market Corporate Credit Facility was created as “a
funding backstop for corporate debt,” and allowed the NY Fed
to purchase both qualifying bonds and portions of syndicated
loans at issuance.38 The Secondary Market Corporate Credit
Facility allowed the Fed to buy portfolios of bonds and ETF
shares that were already issued and outstanding.39 Both
programs were implemented via the creation of a special
purpose vehicle that would hold the bonds and received equity
funding from the Treasury Department to reduce the credit risk
to which the Fed was exposed.40
The mere announcement of the primary and secondary
corporate credit facilities dramatically reduced spreads for
investment-grade borrowers.41 The Fed’s subsequent
37 See Press Release, Fed. Rsrv. Bd., Federal Reserve Announces Extensive New
Measures to Support the Economy (Mar. 23, 2020), available at https://www.feder-
alreserve.gov/newsevents/pressreleases/monetary20200323b.htm
[https://perma.cc/VN53-U3U4] (announcing Fed’s measures to support economy
during Covid crisis).
38 Primary Market Corporate Credit Facility, FED. RSRV. BD. (July 28, 2020),
https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200728
a9.pdf [https://perma.cc/G7PP-EZZ7].
39 Secondary Market Corporate Credit Facility Term Sheet, FED. RSRV. BD. (July
28,
2020),https://www.federalreserve.gov/newsevents/pressreleases/files/monetary202
00728a1.pdf [https://perma.cc/EWB9-CAEQ] (describing eligible assets).
40Id.
41 See Steven Sharpe & Alex Zhou, The Corporate Bond Market Crises and the
Government Response, BD. OF GOVERNORS OF THE FED. RSRV. SYS. (October 7, 2020),
21
announcement that it would also buy “fallen angels” (recently
downgraded bonds) and ETFs holding below-investment-grade
debt similarly reduced spreads for companies in these
categories.42 The Fed purchased corporate debt primarily
through the creation of a new index it created to track qualifying
bonds.43 The Fed’s large wallet and assured position as a new
entrant into this market drove down the cost of credit for new
corporate debt and provided existing holders of corporate debt
a willing counterparty to buy, further supporting asset prices.44
As a result, the Fed ended up holding the bonds of large, robust
companies, many of which had not shown need for government
support.45
Moreover, the biggest beneficiaries of the Fed’s bond buying
program may not have been any of the companies whose bonds
the Fed acquired, or the investors whose asset values were
artificially boosted, but the intermediaries through whom these
funds flowed. Recall that the growth of open-end bond funds,
https://www.federalreserve.gov/econres/notes/feds-notes/the-corporate-bond-
market-crises-and-the-government-response-20201007.htm
[https://perma.cc/SJ7C-GDKR] (describing how government responded to corporate
bond market crises arising from COVID-19); Falato et al., supra note 35, at 2
(describing the effects of the Fed’s announcement of coverage to some high yield
bonds).
42 Valentin Haddad, Alan Moreira & Tyler Muir, When Selling Becomes Viral:
Disruptions in Debt Markets in the COVID-19 Crisis and the Fed’s Response, 34 REV.
FIN. STUD. 5309, 5333-34 (2021) (showing the effects of the Fed’s April intervention
on some high yield bonds).
43See Michael D. Bordo & John V. Duca, How New Fed Corporate Bond Programs
Dampened the Financial Accelerator in the Covid-19 Recession 1 (Fed. Rsrv. Bank
of Dall., Working Paper No. 2029, 2020). https://www.dallasfed.org/-/media/docu-
ments/research/papers/2020/wp2029.pdf [https://perma.cc/8J2N-ZA95].
44See id. at 2.
45Jeff Cox, The Fed Is Buying Some of the Biggest Companies’ Bonds, Raising
Questions Over Why, CNBC (Jun. 29, 2020, 5:21 PM),
https://www.cnbc.com/2020/06/29/the-fed-is-buying-some-of-the-biggest-compa-
nies-bonds-raising-questions-over-why.html [https://perma.cc/T2VG-QQLG].
22
CLOs and ETFs holding bonds had been critical to the growth
of the corporate bond market in recent years and increased
leverage in the corporate sector.46 In the earliest stages of the
pandemic, investors were fleeing from these investments.47
Economists Antonio Falato, Itay Goldstein, and Ali Hortaçsu
document massive and potentially debilitating outflows from
corporate bond funds and ETFs backed by bonds in March
2020, and further show that these outflows were only slowed
and then stanched by the Fed’s announcement of the corporate
credit facilities and its early modifications in the terms of those
facilities.48 According to the Fed, “[e]ven funds specializing in
short-term investment-grade bonds experienced outflows in
March totaling eight percent of assets, dwarfing the selling
pressure they saw during the global financial crises.”49
In stanching these outflows, the Fed helped to save these
fragile intermediaries—each of which promise daily liquidity
despite being backed by very illiquid corporate bonds. This may
have prevented investors in these instruments and corporate
bonds from fully appreciating the risks embedded in these
instruments, in part by increasing expectations of further
support if needed. If anything, the Fed’s interventions seem to
have led investors to be less concerned than ever about the
fragility of open-end bond funds and the potential for serious
46 GLENN HUBBARD, DONALD KOHN, LAURIE GOODMAN, KATHRYN JUDGE, ANIL
KASHYAP, RALPH KOIJEN, BLYTHE MASTERS, SANDIE O’CONNOR & KARA STEIN, HUTCHINS
CTR. ON FISCAL & MONETARY POL’Y AT BROOKINGS, TASK FORCE ON FINANCIAL STABILITY,
31 (2021), available at https://www.brookings.edu/wp-
content/uploads/2021/06/financial-stability_report.pdf [https://perma.cc/M7NS-
FAKE] (describing the effects of the rapid growth of bond mutual funds).
47See id. at 38-39.
48 Falato et al., supra note 35, at 9-10 (describing potential outflow effects from
the Fed’s policy).
49 Sharpe & Zhou, supra note 41 (summarizing the effects of the government’s
response).
23
losses if seeking to liquidate bonds, CLOs, or bond ETFs during
a period of distress. This helps to explain why these
intermediaries have, and likely will continue, to grow. As
Blackrock—the pioneer in ETFs—stated, “[i]n their biggest test
to date, flagship fixed income ETFs provided deep liquidity,
continuous price transparency and lower transaction costs than
were available in individual bonds . . . . As a result, asset
owners — including pension funds and insurance companies —
and asset managers immediately ramped up adoption.”50
It is useful in this context to observe the evolution of the bond
market and corporate debt in the wake of these government
interventions. Even though the amount of outstanding
nonfinancial corporate debt was at an all-time high going into
the COVID-19 crisis, it has since increased subsequently.51
Data from SIFMA shows that “investment grade issuance was
strong in March through May 2020 (+178% to 2019 levels on
average)” and even though the issuance of high yield debt fell
dramatically in March, it too “had recovered well by May (+60%
to 2019 levels)” following the inclusion of many high-yield bonds
and ETFs in the Secondary Market Credit Facility in early
April.52 As explained in the November 2021 Financial Stability
Report from the Federal Reserve: “Corporate bond issuance
remained robust”; “spreads of corporate bond yields over
comparable-maturity Treasury yields . . . remained very narrow
50 A Turning Point for Fixed Income ETFs, BLACKROCK,
https://www.blackrock.com/americas-offshore/en/insights/turning-point-in-bond-etf-
adoption [https://perma.cc/X6DE-R5VG] (last visited Feb. 20, 2022).]
51Patricia Buckley, Monali Samaddar & Akrur Barua, The Pandemic Has Forced
Corporate Debt Higher but Is That a Bad Thing?, DELOITTE INSIGHTS (July 15, 2021),
https://www2.deloitte.com/us/en/insights/economy/issues-by-the-numbers/rising-
corporate-debt-after-covid.html [https://perma.cc/WZ8R-QEKK].
52 Sharpe & Zhou, supra note 41; see KATIE KOLCHIN, SIFMA INSIGHTS: COVID-19
RELATED MARKET TURMOIL RECAP: PART II—FIXED INCOME & STRUCTURED PRODUCTS 5
(2020), available at https://www.sifma.org/wp-content/uploads/2020/07/SIFMA-
Insights-Market-Turmoil_FI-FINAL-FOR-WEB.pdf [https://perma.cc/9NZ4-M2PN].
24
relative to their historical distributions”; “[t]he excess bond
premium, which is a measure that captures the gap between
corporate bond spreads and expected credit losses . . . now
stands at the bottom decile of its historical distribution,
suggesting elevated appetite for risk among investors”; and,
“[i]nvestor sentiment in the leveraged loan market has remained
optimistic.”53 Moreoever, despite the outflows from bond ETFs
creating meaningful price dislocations in March 2020, the Fed’s
prompt interventions resulted in total bond ETFs outstanding
crossing the $1 trillion threshold for the first time in the fall of
2020.54 In short, the largest companies are having little trouble
accessing credit on very, very favorable terms.
Shifting momentarily to look at small business access to credit
over the same period of time reveals a very different picture.
According to the 2021 Small Business Credit Survey conducted
by the Fed, 23% of small businesses had trouble accessing the
debt they needed in the past year, only 37% of applicants
received all the financing they sought (down from 51% in the
2019 survey), and 13% saw credit availability as the single most
important challenge they expect to face in the next year.55
The implications of these developments are mixed. The good
news is that these interventions helped the economy recover at
a remarkable clip once the early phases of the pandemic
waned, despite ongoing public health uncertainty and related
53 BD. OF GOVERNORS OF THE FED. RSRV. BD., supra note Error! Bookmark not
defined., at 11-13.
54 Ben Johnson, Bond ETF Assets Pass $1 Trillion in October, MORNINGSTAR (Nov.
3, 2020), https://www.morningstar.com/articles/1008706/bond-etf-assets-pass-1-
trillion-in-october.
55 FED. RSRV. BANKS, SMALL BUSINESS CREDIT SURVEY: 2021 REPORT ON EMPLOYER
FIRMS 21 (2021), available at
https://www.fedsmallbusiness.org/medialibrary/FedSmallBusiness/files/2021/2021-
sbcs-employer-firms-report [https://perma.cc/PS9G-P6T6] (summarizing financing
outcomes in 2020).
25
political turmoil.56 Given the uncertainty and the myriad
challenges the pandemic posed, these benefits are hard to
overstate. Other implications are more mixed. One obvious
drawback is that the potential systemic threat posed by open-
end bond funds, CLOs and bond ETFs remains unaddressed
while the sector is poised for further growth, while investor
expectations of liquidity assistance from the government during
future crises are likely to distort market mechanisms and pricing
of risk. Moreover, the sharp rise in corporate debt levels could
create debt overhang, potentially impeding investment and
growth in the years ahead.57 And, discussed further below,
56 Gian Maria Milesi-Ferretti, A Most Unusual Recovery : How the US Rebound
from COVID Differs from Rest of G7, BROOKINGS INST. (Dec. 8, 2021),
https://www.brookings.edu/blog/up-front/2021/12/08/a-most-unusual-recovery-how-
the-us-rebound-from-covid-differs-from-rest-of-g7/ [https://perma.cc/XA8E-M4NC].
57 Some economists believe that a debt overhang can weigh on aggregate
demand via weaker investment growth. See Stewart C. Myers, Determinants of
CorporateBorrowing, 5 J. FIN. ECON. 147, 147 (1977) (forecasting risks of rising
corporate debt levels); Larry Lang, Eli Ofek & René M. Stulz, Leverage, Investment,
and Firm Growth, 40 J. FIN. ECON. 3, 4 (1996) (discussing potential risk with debt
overhang preventing fundraising); Christopher A. Hennessy, Tobin’s Q, Debt
Overhang, and Investment, 59 J. FIN. 1717, 1718 (2005) (explaining debt overhang
theory tested in article); Christopher A. Hennessy, Amnon Levy & Toni M. Whited,
Testing Q with Financing Frictions, 83 J. FIN. ECON. 691, 693 (2007) (explaining the
way they tested friction from debt overhang); Murillo Campello, John R. Graham &
Campbell R. Harvey, The Real Effects ofFinancial Constraints: Evidence from a
Financial Crisis, 97 J. FIN. ECON. 470, 486 (2010) (concluding bypassing of NPV
projects slow economic growth); Xavier Giroud & Holger M. Mueller, Firm Leverage,
Consumer Demand, and Employment Losses During the Great Recession, 132 Q.J.
ECON. 271, 274 (2017) (describing concern that high leveraged firms more sensitive
to demand shifts); Sebnem Kalemli-Özcan, Luc Laeven & David Moreno, Debt
Overhang, Rollover Risk, and Corporate Investment: Evidence from the European
Crisis 4-5 (Eur. Cent. Bank, Working Paper No. 2241, 2019),
https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2241~cbea165b30.en.pdf
[https://perma.cc/P63C-AF6H] (discussing debt overhang hurts recovery from
crises). Others have challenged this view. See Atif Mian, Amir Sufi & Emil Verner,
Household Debt and Business Cycles Worldwide, 132 Q.J. ECON. 1755, 1757-58
(2017) (summarizing results that run contrary to other debt overhang arguments);
ÒSCAR JORDÀ, MARTIN KORNEJEW, MORITZ SCHULARICK & ALAN M. TAYLOR, FED. RSRV.
BANK OF N.Y., ZOMBIES AT LARGE? CORPORATE DEBT OVERHANG AND THE
MACROECONOMY, 1, 1 (2020), available at
26
these interventions could place a heavier thumb placed on the
financial scale favoring the largest companies relative to their
smaller counterparts in good times and bad.
B. Fed-facilited support for Midsized and Smaller Businesses
We begin to explore this last issue by comparing the easy
access and relatively low financing costs the largest companies
enjoyed during the crisis with the arguable failure of the Main
Street Lending Program and the conspicuous lack of any
program using CARES Act funds to increase credit support for
truly small companies (apart from efforts to implement short-
term operating assistance through the Paycheck Protection
Program (“PPP”)).
The Main Street Lending Program was the Fed’s effort to help
companies that are not large enough to readily access public
debt markets.58 Under the Fed’s former guidelines (the program
terminated in January 2021), companies with up to 15,000
employees or $5 billion in annual revenue (as of 2019) were
eligible to participate.59 These are not small businesses in the
‘mom and pop’ version but the definition of small business can
be quite expansive and these businesses are equally not part
of the biggest ‘big businesses’ under the Fed’s definition. To
implement the program, the Federal Reserve Bank of Boston
set up a special purpose vehicle to purchase participations in
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr951.pdf
[https://perma.cc/KRX4-XU2Q] (layout out questioning of debt overhang theory).
58BD. OF GOVERNORS OF THE FED. RSRV. BANK OF N.Y, supra note 35.
59Mark Kolakowski, What Is the Main Street Lending Program, INVESTOPEDIA (July
26, 2021), https://www.investopedia.com/main-street-lending-program-4802310
[https://perma.cc/B4TR-LR4S].
27
loans originated by banks and their affiliates (nonbanks were
not made eligible by the time the program ended).60 The idea
behind the structure was not all that different than what the Fed
had done with corporate bonds; the Fed did not want to be in
the position of directly assessing a company’s creditworthiness,
so instead it relied on the existing credit creation infrastructure
to do that. In this case, that meant relying on banks rather than
credit rating agencies or investment fund managers to pick
“winners and losers.”61 The Fed further sought to ensure that
banks would identify only companies that had at least a decent
chance of paying back the moneys borrowed by requiring the
banks that originated the loans to retain some credit exposure
and by imposing other substantive conditions, e.g., limits on the
total amount of debt a company could have relative to its
income.62 This is a significant structural difference from the
corporate credit facilities, as bond ETFs are not required to, and
typically do not, hold direct liability to the assets they are
creating for their investors.63 The Fed also set the terms of the
loans that would be extended under the Main Street facility,
using a structure that allowed repayment flexibility in the early
years while still requiring full repayment of principal at a
meaningful interest rate.64
60Policy Tools, Main Street Lending Program, BD. OF GOVERNORS OF THE FED. RSRV.
SYS., https://www.federalreserve.gov/monetarypolicy/mainstreetlending.htm
[https://perma.cc/XD9F-NXGD] (last visited Feb. 20, 2022).
61See William B. English & J. Nellie Liang, Designing the Main Street Lending Pro-
gram: Challenges and Options 22 (Brookings Inst.: Hutchins Ctr. on Fiscal & Mone-
tary Pol’y, Working Paper No. 64, 2020), https://www.brookings.edu/wp-content/up-
loads/2020/06/WP64_Liang-English_FINAL.pdf [https://perma.cc/GV5U-KMLM].
62Id. at 2.
63See id. at 14-15.
64 Policy Tools, supra note 60.
28
Importantly, lenders were told to view the eligibility criteria in
the term sheets as the minimum requirements and were
expected to apply their own underwriting standards in
evaluating potential borrowers and conduct an assessment of
each potential borrower’s financial condition at the time of the
potential borrower’s application.65 This was deemed necessary
to control risk to the Fed, despite the money allocated to the
Treasury by Congress to absorb losses and allow greater
lending and risk taking. 66 Along with the risk retention
requirement, this criteria and design meant that the Main Street
facility did not provide banks meaningful flexibility to make loans
that they would not have made otherwise, or to make those
loans on terms that were significantly more favorable.
The Main Street Program was announced in late March 2020
alongside the two corporate credit facilities.67 In contrast to
those facilities, however, there was no immediate favorable
impact on the ability of eligible companies to actually access the
financing they need to survive.68 It was not until July, well after
the Fed had started buying ETFs and a broad array of other
65 Main Street Lending Program: Frequently Asked Questions, FED. RSRV. BD.
(Dec. 28, 2020), https://www.federalreserve.gov/monetarypolicy/files/main-street-
lending-faqs.pdf [https://perma.cc/TX7D-VMWS].
66 Treasury’s expression of an aversion to actually bearing losses may be one
reason why the Fed designed a program that ultimately received little usage and
hence had little potential to actually use the funds allocated.
67Brian D. Christiansen, Seth E. Jacobsen, Stephanie L. Teicher & Collin P. Janus,
Updated Guide to the Main Street Lending Program, SKADDEN, ARPS, SLATE,
MEAGHER & FLOM LLP (June 10, 2020), https://www.skadden.com/insights/publica-
tions/2020/06/updated-guide-to-the-main-street-lending-program#
[https://perma.cc/S8XB-82RN].
68Falk Bräuning & Teodora Paligorova, Uptake of the Main Street Lending Program,
BD. OF GOVERNORS OF THE FED. RSRV. SYS (Apr. 16, 2021), https://www.federalre-
serve.gov/econres/notes/feds-notes/uptake-of-the-main-street-lending-program-
20210416.htm# [https://perma.cc/N5MC-25WE].
29
corporate debt, generally issued by companies showing no sign
of needing any further financial support, that the Main Street
Lending Facility even became fully operational.69 Moreover, the
overall impact of the program was far more muted, to say the
least.
At announcement, Main Street was projected for up to $600
billion in total loans with $75 billion set aside for potential
losses.70 It never got close. Mains Street conducted only 1,830
loans with a total lending of $17.5 billion.71 And roughly half of
the entire volume conducted through Main Street occurred in
December 2020, just weeks before the facility was ceasing to
accept loans.72 At the end of the day, less than 3% of potential
lending credit was advanced and the Treasury set aside money
to cover losses in excess of 425% of the total lending that
occurred. Putting this in context, 16% of the total CARES Act
$454 billion allocated in March was set aside for the Main Street
program to cover possible lending of $600 billion to these types
of businesses, of which less than $10 billion was actually
advanced by Thanksgiving. Even this small amount of support
was not well targeted, as according to the Fed’s own definitions,
approximately 30% of loans were to industries that were not
categorized as ‘COVID-19 impacted.’ An analysis by the non-
partisan Congressional Research Service concluded that the
Main Street facility may well have been “too small to be
69See id.
70 MARC LABONTE & LIDA R. WEINSTOCK, CONG. RSRCH. SERV. IF11632, THE FEDERAL
RESERVE’S MAIN STREET LENDING PROGRAM (2020),
https://crsreports.congress.gov/product/pdf/IF/IF11632 [https://perma.cc/RVN4-
23B4].
71Bräuning & Paligorova, supra note 68.
72 Bräuning & Paligorova, supra note 68(describing the timing of the uptake of the
lending program).
30
effective.”73 As Bharat Ramamurti, a former member of the
Congressional Oversight Commission for the CARES Act and
currently a senior member of the Biden Administration National
Economic Council, put it, “[b]y any measure, the Main Street
program has been a failure.”74
There have been a number of explanations for the relative
failure of the Main Street facility. For example, many borrowers
generally felt the terms of the facility were too restrictive. As
noted in a review of the limited lending: “[f]rom the convoluted
eligibility requirements to the prohibition on paying dividends,
the benefits provided from the emergency liquidity (namely,
deferred principal and interest payments) did not outweigh the
costs of the strings attached thereto.”75Yet, the core challenge
grew out of the existing credit creation infrastructure that the
Fed relied on, and in the longer term, the lack of implicit
commitments that resulted from the Fed’s interventions.
Ultimately, nothing in the Main Street facility offered banks
sufficiently great upsides relative to risk to encourage broad
lending using this program. This greatly limited the
effectiveness of the program. But, even if the program had been
better designed and more effective, its long-term impact may
well have been limited. Because the program was seen as
limited to its terms, and contingent on continuing support from
Congress and the Treasury Department, its existence did
nothing to incentivize banks to invest further to improve their
origination processes and internal infrastructure for making
73 LABONTE & WEINSTOCK, supra note 70.
74 Rachel Siegel, Months into Recession, Fed’s Main Street Loan Program Is at a
Crossroads, WASH. POST (Aug. 7, 2020),
https://www.washingtonpost.com/business/2020/08/07/federal-reserve-main-street-
progral/ (discussing issues with Main Street Loan Program).
75 Nathan Volz, How the Main Street Loan Program Failed Main Street, WIS. L.J.
(Mar, 1, 2021 1:25 PM), https://wislawjournal.com/2021/03/01/how-the-main-street-
loan-program-failed-main-street/ [https://perma.cc/GMD4-ES7X].
31
loans to mid-sized businesses. This stands in stark contrast to
the corporate bond markets, where the Fed’s interventions—
intentionally or not—seem to have led to expectations of further
support in coming crises.
Shifting to smaller businesses, the Fed created a facility that
facilitated implementation of the government’s separate PPP
initiative, which as discussed below, was designed to provide
temporary operating support for small businesses and those
they employed. But it made no attempt to create a true
emergency lending facility that would have increased access to
funding for small enterprises, despite the fact that pandemic-era
surveys suggesting that just shy of half such enterprises were
concerned about cash flow and the overall health of their
businesses.
The Fed could perhaps have promoted more enduring credit
creation for small businesses by creating a lifeline for the
issuance of asset-backed securities backed by small-business
loans. Securitization vehicles allow for the transfer of risk from
the loan originator to the holders of securities backed by those
loans, and securitization vehicles pool risk between multiple
individual loans.76 The Fed recognizes securitization markets as
key to credit creation, and re-deployed a facility in 2020 that it
had first used in 2008 to help promote credit creation via the
issuance of asset-backed securities (“ABS”).77 When
relaunching the program, known as the term auction loan facility
(“TALF”) in 2020, the Fed explained the program was “intended
to help meet the credit needs of consumers and businesses by
facilitating the issuance of asset-backed securities.”78 Under
the TALF, the Fed agreed to make non-recourse loans secured
by ABS backed by a wide variety of different assets, including
auto loans, student loans, credit card receivables (both
76See Term Asset-Backed Securities Loan Facility, supra note 25 (discussing collat-
eral for recourse loans under Fed loan facility).
77Id.
78 Id.
32
consumer and corporate), equipment loans and leases, and
leveraged loans made to large businesses.79
Yet, when it came to ABS backed by loans to small
businesses, the Fed followed its 2008 precedent to the letter
(from a time when Fintech and other nonbank origination of
small business loans was negligible) and would accept such
loans only if “guaranteed by the Small Business
Administration.”80 These terms not only did little to change
banks’ willingness to extend non-guaranteed small business
loans, but they also effectively excluded billions of dollars in
nonbank-originated small business ABS and the lenders who
originated the underlying loans from market support.81 The
Fed’s approach favored some forms of ABS, including CLOs
that have become a key mechanism through which funds flow
to the largest businesses, but not others such as non-
guaranteed small business loans and personal installment
loans.82 This likely reduced the credit risk to which the Fed was
exposed, an understandable aim much of the time, but one that
requires greater scrutiny in light of the funds allocated by the
CARES Act. For, as discussed further below in connection with
PPP and the small-business-lending-landscape, these
limitations significantly reduced support provided to small
businesses during the earliest part of the pandemic and had the
effect of denying the intermediaries that facilitate funding for
small businesses the support akin to that the Fed provided to
79Id.
80 Id.
81Todd H. Baker, Fed’s New TALF Has a Major Gap, AM. BANKER (Mar. 26, 2020,
12:30 PM), https://www.americanbanker.com/opinion/feds-new-talf-has-a-major-
gap (last visited Feb. 20, 2022) (“Unless the TALF is changed to include the invest-
ment-grade, ABS based on [consumer] loans, lenders will shut down originations
just when they are needed most.”).
82 See id.; see also Todd H. Baker & Kathryn Judge, How to Help Small
Businesses Survive COVID-19, at 4 (Columbia L. and Econ., Working Paper No. 620,
2020),
https://scholarship.law.columbia.edu/cgi/viewcontent.cgi?article=3643&context=fac
ulty_scholarship [https://perma.cc/PX4Q-VLXW].
33
open-end bond funds and the other nonbank intermediaries
supporting loans to large businesses.83
Relatedly, the Fed also limited the ABS it was willing to accept
based on the decisions of credit rating agencies.84 Specifically,
the Fed required ABS to have a credit rating in the highest long-
term or, if no long-term rating was available, the highest short-
term investment-grade rating category from at least two eligible
nationally recognized credit rating agencies, provided that the
ABS did not have a credit rating below the highest investment-
grade rating category from any such agency.85 This requirement
contrasts with the inclusion of lower rated, non-investment
grade corporate loans and ETFs in the secondary corporate
credit facility. Holding ABS to a higher credit quality standard
than corporate loans or ETFs effectively would have excluded
most securitizations of unsecured private small business loans
at the time.86 Again, these types of limitations reduced the
83Baker, supra note 81 (concluding that unless TALF reformed, the Fed “will fail in
its goal of ensuring that credit flows to millions of vulnerable consumers”).
84 Baker & Judge, supra note 82( noting “ABS issued by nonbank small business
lenders typically don’t reach” the credit rating grade required).
85Id. at 9.
86 Prior to the pandemic, the highest-rated tranches of small business loan
securitizations by Fintechs, such as Kabbage, FundingCircle, Credibly,
RapidFinance and National Funding, were rated below the highest rating category.
See Kroll Bond Rating Agency, 2019 Small Business Lending ABS Year in Review
and 2020 Outlook 6 (Feb. 13, 2019) see also KBRA Assigns Preliminary Ratings to
Kabbage Asset Securitization LLC, Series 2019-1 Additional Notes, BUS. WIRE (Nov.
12, 2019, 2:49 PM),
https://www.businesswire.com/news/home/20191112005999/en/
[https://perma.cc/3BYG-CFAR]. OnDeck, the only Fintech lender whose ABS had a
top rating from one rating agency, suspended all non-PPP lending to new and
existing customers in April 2020 and was subsequently sold for a small percentage
of its historical market capitalization. See Sean Murray, OnDeck Reports Q1 Net Loss
of $59M, Suspends Non-PPP Lending Activities, DEBANKED (Apr. 30, 2020),
https://debanked.com/2020/04/ondeck-q1-earnings-to-be-released/
[https://perma.cc/D5X4-QJM3] (“OnDeck has suspended the funding of its Core
loans and lines of credit to new or existing customers (unless the loan agreement has
already been executed).”); see also Press Release, Enova Int’l, Enova to Acquire
OnDeck to Create a Leading FinTech Company Serving Consumers and Small
Businesses (July 28, 2020), https://www.prnewswire.com/news-releases/enova-to-
34
credit risk to the Fed, but the fact that Congress had provided
the Treasury and Fed, collectively, with substantial loss
absorbing capital so that the Fed could extend credit to
impacted sectors of the economy in need undermines the
sufficiency of this explanation for the decisions made. Given
then-current credit market conditions, the Fed’s decisions
sharply limited the ability of nonbank lenders to support their
customers with credit and did little to incent bank lenders—in
either the immediate or longer term—to develop or maintain the
infrastructure needed to make small business loans that lacked
a government guarantee.87
The potential economic consequences of the Fed’s decision
are signficiant. In recent years, more than 61 million
individuals—almost one-half of the U.S. workforce—worked in
a small business, and small businesses collectively produced
43.5% of U.S. GDP.88 Even more importantly, small businesses
have accounted for 62% of net new job creation since 1995.89
The failure to do more for these enterprises cannot be readily
explained away as lying outside the Fed’s employment
mandate,90 nor does it appear that the Fed is unconcerned
about these companies. If anything, the opposite seems to be
true. Chairman Powell explained: “[t]he pandemic is presenting
acute risks to small businesses” and when “a small or medium-
acquire-ondeck-to-create-a-leading-fintech-company-serving-consumers-and-small-
businesses-301101550.html [https://perma.cc/ZGZ7-JM8C].
87 Baker & Judge, supra note 82, at 2 (discussing Fed’s mechanisms for extending
lines of credit to small business as critical but insufficient).
88 Frequently Asked Questions About Small Businesses, U.S. SMALL BUS. ADMIN.:
OFF. OF ADVOC. (Dec. 2021), https://cdn.advocacy.sba.gov/wp-content/up-
loads/2021/12/06095731/Small-Business-FAQ-Revised-December-2021.pdf
[https://perma.cc/79HG-U638] (finding small firms also constitute 39.7% of private
sector payroll).
89 Id. (stating 12.7 million net new jobs have been added to economy by small
businesses).
90See id.
35
sized business becomes insolvent . . . we lose more than just
that business.”91 “[t]he heart of our economy and . . . the work
of generations” is at stake.92 The struggles the Fed confronted
in its effort to operationalize both the Main Street Facilities show
how hard it can be for the Fed to partner with the lenders who
specialize in making these loans, even when big dollars are
involved.
C. Why the Fed?
Strikingly, given the effect of delegating so much credit
creation to the Fed, there is little sign that Congress had any
desire to favor credit creation for large businesses over mid-
sized and small ones. Given all that the Fed was already doing
to fulfill its core mission of monetary policy while aggressively
using emergency authority to stabilize short-term markets, why
did Congress lay such a daunting new challenge on the Fed’s
shoulders? Although there are an array of reasons, one merits
particular attention for purposes of our analysis here: perhaps
Congress felt it did not have a better alternative.
As Neil Komesar has illuminated in his work on the
importance of “deciding who decides,” institutional choice is
always relative.93 The alternatives facing Congress in passage
of the CARES Act were to: (a) come to a bipartisan, bicameral
compromise and decide itself; (b) empower the President to
91Jerome H. Powell, Chairman, Bd. of Governors of the Fed. Rsrv. Sys., Semian-
nual Monetary Policy Report to the Congress, Testimony Before the Committee on
Banking, Housing, and Urban Affairs (June 16, 2020) (available at https://www.fed-
eralreserve.gov/newsevents/testimony/powell20200616a.htm
[https://perma.cc/2PFJ-AHXG]).
92 Id..
93 NEILK. KOMESAR, IMPERFECT ALTERNATIVES: CHOOSING INSTITUTIONS IN LAW,
ECONOMICS, AND PUBLIC POLICY (Univ. of Chi. Press 1994).
36
decide directly or through a cabinet agency; or (c) empower an
alternative institution such as the Fed. The Fed may be ill suited
to address many of the challenges it is now being asked to help
solve, but it is still better suited to take them on than
administrators closer to the President or Congress through a
more detailed set of appropriations, at extremis earmarking
funds to specific projects. The Fed may be less susceptible to
corruption, more competent, more able to make credible
commitments, and more able to act quickly when that is what
the situation requires, all factors that matter with these types of
decisions. Examining Congress, the Presidency, and the Fed in
broad strokes and then looking at specific institutional
advantages the Fed may possess helps to explain how the
central bank became a key part of the line of first defense for
providing fiscal support to businesses in a recession.
Nevertheless, the Fed or the U.S. system of governance
generally is not necessarily well-served by this allocation. As
Komesar also emphasizes, because any effort to pursue a
substantive aim will be mediated by the processes and people
of the institution charged with implementing that aim,
institutional choice is of utmost importance.94 And the use of the
Fed as “quarterback” for relief efforts—given its institutional
culture and the way it interacts,or does not,with existing “private”
mechanisms for credit creation—highlights just how central
infrastructure is in determining who gets help when crisis
strikes.
III. OTHER SMALL BUSINESS SUPPORT: PPP
Congress also created other programs to try to help
businesses survive the unprecedented shock.95 The most
94Id.
95 Press Release, U.S. Dep’t of Treasury, With $349 Billion in Emergency Small
Business Capital Cleared, SBA and Treasury Begin Unprecedented Public-Private
Mobilization Effort to Distribute Funds (Mar. 31, 2020), https://home.treas-
ury.gov/news/press-releases/sm961 [https://perma.cc/KH7A-S8XL] (describing
37
important program for small businesses in the early stages of
the pandemic was the PPP. This program was designed to
funnel operating assistance to the employees of small
businesses and discourage mass layoffs in addition to helping
the owners and operators of those businesses weather the
storm.96 Small businesses were particularly hard hit in the early
part of the pandemic, as shutdowns were declared and
customer traffic imploded in the country’s business districts.97
According to one study, by May 2020, 34% of small businesses
were still closed compared to January 2020.98 The impact on
business owners was not consistent demographically.99 For
example, Asian and Black business owners were more highly
concentrated in places, and in industries, with larger
declines.100
purpose of Paycheck Protection Program as protecting businesses and their em-
ployees).
96 Id.
97 Iman Ghosh, 34% of America’s Small Businesses Are Still Closed Due to COVID-
19. Here’s Why It Matters, WORLD ECON. F. (May 5, 2021), https://www.wefo-
rum.org/agenda/2021/05/america-united-states-covid-small-businesses-economics/
[https://perma.cc/E5LA-UQF2] (showing large-scale businesses closings across
USA in early 2020); John Eric Humphries, Christopher Neilson, and Gabriel Ulys-
sea, The Evolving Impacts of COVID-19 on Small Businesses Since the CARES
Act (NYU Cowles Foundation Discussion Paper No. 2230, April 26, 2020),
http://dx.doi.org/10.2139/ssrn.3584745 (survey results showing numerous adverse
impacts on small businesses by April 2020).
98 Ghosh, supra note [104], (listing San Francisco, Boston, and Washington as
cities with sharpest decline in small businesses remaining open).
99Daniel Wilmoth, The Effects of the COVID-19 Pandemic on Small Businesses,
U.S. SMALL BUS. ADMIN.: OFF. OF ADVOC. 5 (Mar. 2021), https://cdn.advo-
cacy.sba.gov/wp-content/uploads/2021/03/02112318/COVID-19-Impact-On-Small-
Business.pdf [https://perma.cc/WLX9-CBJ3].
100 Id.
38
The PPP was a unique program unprecedented in U.S.
history. With the avowed goal to assist small businesses and
small business employees impacted by the COVID-19
shutdown, Congress created the PPP and set aside $349 billion
of CARES Act appropriations for PPP purposes.101 Congress
placed the Treasury Department in charge of PPP and directed
the Small Business Administration to help small businesses
qualify for PPP funding.102 Congress gave the Treasury
Department broad discretion to disburse PPP funding.103 The
PPP was designed to funnel operating assistance to small
businesses to discourage mass layoffs in addition to helping the
owners and operators of those businesses.104 As one of its main
sponsors, Senator Marco Rubio (R-FL) described the program:
“PPP had two main goals: help workers keep their jobs, and
protect small businesses from being forced to permanently
close their doors.”105
The PPP was ostensibly a “forgivable loan” program run
through existing financial intermediaries, primarily banks and, in
the later stages, financial technology firms (“Fintechs”)106 and
101 See A July Update on the Paycheck Protection Program, COMM. RESPONSIBLE
FED. BUDGET (July 10, 2020), https://www.crfb.org/blogs/july-update-paycheck-pro-
tection-program [https://perma.cc/2769-VWVD] (stating that PPP’s original $349 bil-
lion original funding “quickly ran out”).
102 See Press Release, supra note .
103 See A July Update on the Paycheck Protection Program, COMM. RESPONSIBLE
FED. BUDGET (July 10, 2020), https://www.crfb.org/blogs/july-update-paycheck-
protection-program [https://perma.cc/2769-VWVD].
104Id.
105 Press Release, Marco Rubio, Chairman, Senate Committee on Small Business
and Entrepreneurship, Opening Remarks at Congressional Hearing: Small Business
in Crisis: The 2020 Paycheck Protection Program and its Future (Dec. 10, 2020),
https://www.rubio.senate.gov/public/index.cfm/2020/12/now-rubio-chairs-hearing-
on-the-paycheck-protection-program-and-its-future [https://perma.cc/3AX8-KVRF].
106 For this paper we will define Fintechs as companies that provide credit primarily
through technological platforms (not in-person or store front) and are not chartered
banks, credit unions, or community development financial institutions (CDFIs). We
define fintechs this way to make the conceptual arguments regarding bank/credit
39
other nonbank lenders. In practice, it functioned as a grant with
easily met conditions.107 Because, it too relied on existing
infrastructure, assistance—particularly in the critical early days
of the PPP—was principally available to small businesses with
existing relationships with participating lenders.
The PPP was structured to reach businesses using lender
financial intermediaries as the disbursement arm, accessed
through PPP “loan” applications.108 The Treasury then funded
such “loans” through the lender to the applicant. To achieve the
dual goals of the program, the “loans” were forgivable as long
as borrowers maintained employee compensation levels.109
Originally set at 75% for payroll, that figure was reduced to 60%
in later legislation.110 Thus, up to 40% of funds supposedly
designed to protect paychecks could be spent on “other eligible
union/CDFI vs. Fintech cleaner. We realize that in the real world many banks/credit
unions/CDFIs use financial technology extensively, that there are nonbank lenders
that do not operate as FinTechs, and that some Fintechs are or may be considering
becoming banks/credit unions/CDFIs. We also recognize that there are a whole host
of financial technology companies that are not lenders but are commonly referred to
as FinTechs.
107 Pandemic Oversight, Paycheck Protection Program, PANDEMIC OVERSIGHT,
https://www.pandemicoversight.gov/data-interactive-tools/interactive-
dashboards/paycheck-protection-program (last visited Feb. 20, 2022) (showing
hundreds of billions of dollars forgiven). As of November 24, 2021, $629.2 billion of
the total of $792.8 billion in PPP loans (79.4%) had been forgiven. Id.
108 A July Update on the Paycheck Protection Program, supra note 103 (“[T]he for-
givable loans were provided through banks and other private financial entities who
have collected billions of dollars in fees for their services.”).
109 PPP Loan Forgiveness, U.S. SMALL BUS. ADMIN. https://www.sba.gov/funding-
programs/loans/covid-19-relief-options/paycheck-protection-program/ppp-loan-for-
giveness [https://perma.cc/49UN-ZTDA] (last visited Feb. 20, 2022).
110Id.
40
expenses.”111 Reflecting the belief at the time that the
economic shutdown would be short, businesses were given
eight to twenty-four weeks to use the funds for those
purposes.112 If these criteria were met, the “loan” was
forgiven.113 Thus, the “loan” effectively became a grant.
Economically there is little distinction between a loan that is
forgiven if key conditions are met and a grant that must be
repaid if certain conditions are not met. Both are contingent gifts
that require repayment if certain criteria are not met. Politically
there are important distinctions between programs that are
marketed as “loans” compared to those marketed as “grants.”
Short-term grant programs like the PPP are designed to support
the status quo without making too many distinctions and “kick
the can” down the road until the situation is clearer or possibly
in hopes that a short-term lifeline is all that will be needed for
long-term business survival. These grants are expenditures not
expected to be recouped by the provider.114 Loans, by contrast,
are intended to be repaid over time and availability is dependent
upon the lender’s assessment of repayment risk. This was the
approach that the Main Street Loan program followed, as noted
above. The political sensitivity of this distinction is illustrated by
the following counterfactual. Had the PPP grants actually been
true loans with an expectation of repayment, then Congress,
Treasury, or the Fed would have had to come up with
underwriting criteria to control credit risk or delegated
underwriting to lenders (as with the MSLP).
111 Id. (requiring also that “loan proceeds are spent on payroll costs and other
eligible expenses”).
112Id.
113Id.
114Id.
41
Because loan underwriting necessitates some degree of
trying to separate expected winners from losers—even when
the government is ready to absorb some of the credit risk—
using true lending structures to deliver assistance is challenging
even in normal cyclical downturns, and is particularly so in a
sharp crisis when the future direction of the economy is
particularly unclear.115 During the early phases of COVID-19, for
example, there were legitimate questions about whether
infections would continue for mere months or many years and
thus whether the economic recovery would be V-shaped, a
swoosh, a sawtooth, or something else entirely.116 There were
signifcant questions about how it would differentially impact
different industries, outside of the obvious areas of travel and
leisure.117 This uncertainty rendered many of traditional tools of
credit analysis, temporarily, far less reliable. It can also help
explain why neither the Fed nor the Treasury were anxious to
try to take more actions that directly supported small businesses
via true credit extensions. Given Congress’s decision to have
the Fed play a central role in aiding the flow of funds to
busiensses under the exigencies of the COVID-19 induced
recession, there are still lessons to be learned for the next crisis,
whatever its cause.
The Treasury, in the first stage of PPP, worked with the SBA
and a multitude of banks and credit unions to disburse PPP
funds. The government paid fees to entice banks and nonbanks
to originate PPP “loans.” The fees provided to financial
intermediaries facilitated distribution of PPP funds, and banks
worked hard to get money out the door to their customers. Low-
115 Jose Maria Barrero, Nicholas Bloom, and Steven J. Davis, COVID-19 Is Also a
Reallocation Shock (University of Chicago Becker Friedman Institute for Economics
Working Paper No. 2020-59, June 25,
2020), http://dx.doi.org/10.2139/ssrn.3592953.
116 See, e.g., Baker & Judge, supra note 82, at 2 (“Nor can anyone foresee what the
economy will look like when people emerge from their shelters.”).
117
See id. (“A severe recession is certain, but questions remain about just how
deep it will sear, how long it will last, and how it will reshape the economy that
emerges.”).
42
cost funding ultimately provided by the PPP loan fund set up by
the Treasury and the Fed coupled with capital relief provided to
banks by regulators provided additional incentives for financial
intermediaries to engage. 118
Despite the fact that the initial round of funding was expected
to be far shy of demand, the Treasury decided to make funds
available in a “first come, first served” basis. The result was a
rush to seek funding. The entire $350 billion was given out in
fourteen days, beginning April 2, 2020 (barely after the CARES
Act was signed and again before any automatic stabilizer tied
to the unemployment data would have been able to kick in).
The rollout process was chaotic and exposed significant
weaknesses in the SBA’s loan application system. It also
created frustration for many of the lenders attempting to submit
and receive approval for applications and the borrowers seeking
funds.119 Getting so much funding out so quickly was no small
feat.120 And, interestingly, in light of the push for digital lenders
to be included in the first round, banks succeeded in getting
118 Regulatory Capital Rule: Paycheck Protection Program Lending Facility and
Paycheck Protection Program Loans, 85 Fed. Reg. 20,387-394 (Apr. 13, 2020) (to
be codified at 12 C.F.R. pts. 3, 217, 324).The bank regulators allowed banks to
exclude PPP loans from regulatory capital calculations. Id.
119 Rebecca Jarvis & Layne Winn, What Went Wrong with the Paycheck Protection
Program, ABC NEWS (Apr. 25, 2020), https://abcnews.go.com/Business/inside-
paycheck-protection-program-race/story?id=70330643 [https://perma.cc/P4CX-
FYKL]
120Id. (“Collecting the right information, auditing thousands of quickly thrown to-
gether documents, and doing it all under the extreme conditions of the coronavirus
pandemic presented several challenges, but the biggest challenge by far, was sub-
mitting the paperwork.”).
43
PPP loans for their customers in most cases by “throwing
people” at the problem instead of automating processes.121
The Treasury made several decisions in implementing PPP
that had the effect of prioritizing larger companies by
incentivizing those with preexisting banking relationships and
those asking for larger PPP amounts. “First come, first served”
funding of applications incentivized speed. Speed in application
processing is a function of relationships—borrowers knew
where to go for help and banks could process the requests of
existing customers quickly—but equally the result of bank self-
interest. The Treasury also decided to require anti-money
laundering rules, such as know your customer, to be part of the
PPP underwriting process. This burden increased the fixed cost
to process PPP applications and increased the time it took to
gather information from customers who had not previously been
subject to anti-money laundering review. This very likely had the
effect of prioritizing PPP access for businesses that had
previously obtained a loan over those that just had a transaction
account or some other relationship at the bank.122 Finally, in
more of a structural issue than a decision about implementation,
121 David Smith, The Ballad of the Small Banker: An SBA Lender’s Experience
with PPP Loans, FICO (May 7, 2020), https://www.fico.com/blogs/ballad-small-
banker-sba-lenders-experience-ppp-loans [https://perma.cc/8JMT-KD2M]
(explaining big banks’ “digital systems are not designed to handle the PPP loan
program, and they do not immediately have the regulatory processes in place to
detect risk and fraud for these circumstances”); Miriam Cross, Small Lenders
Embrace Automation for Latest PPP Round, AM. BANKER (Jan. 13, 2021, 3:16 PM),
https://www.americanbanker.com/news/small-lenders-embrace-automation-for-
latest-ppp-round (noting PPP distribution prior to automation was inefficient and
cumbersome).
122 Aaron Klein & Staci Warden, Anti-money Laundering Rules: An Emergency
Assistance Roadblock, BROOKINGS INST. (Apr. 8, 2020),
https://www.brookings.edu/opinions/anti-money-laundering-rules-an-emergency-
assistance-roadblock/ [https://perma.cc/XTG4-Y23E] (“When a new small business
comes calling, asking for a small two-month loan at a 1% interest rate, the more
prudent course from a bank’s risk management perspective, even with a government
guarantee, may simply be to not make the loan at all.”).
44
the natural economics of bank/business relationships also tilted
the scales toward providing PPP assistance to pre-existing
customers who already had outstanding loans from the bank.
By improving the liquidity and solvency of a loan customer
receiving PPP funds, it became less likely that a bank’s
outstanding loan would go into default.
These dynamic factors favored large businesses and those
who had been in business longer.123 It also favored wealthier
businesses—that is, the businesses that were in better financial
position to handle the economic disruption even without
government aid.124 These factors help to explain why in the
first round of PPP allocations to companies seeking $1 million
or more, quite a large sum for what was supposed to cover
mainly six to eight weeks of payroll, comprised 44.5% of all PPP
funds.125 By contrast, funds for businesses seeking $150,000 or
less made up only 17% of all successfully processed PPP
applications.126
This approach disfavored the large number of the smaller
businesses that relied on Fintechs and other nonbank lenders
123 See Garrett Borawski & Mark E. Schweitzer, Fed. Rsrv. Bank of Cleveland,
How Well Did PPP Loans Reach Low- and Moderate-Income Communities? 1-2 (May
28, 2021),
https://www.clevelandfed.org/~/media/content/newsroom%20and%20events/public
ations/economic%20commentary/2021/ec%20202113/ec2021-13.pdf
[https://perma.cc/7VTH-D37N].
124 Stacy Cowley & Emily Flitter, Banks Gave Richest Clients ‘Concierge
Treatement’ for Pandemic Aid, N.Y. TIMES (Apr. 22, 2020),
https://www.nytimes.com/2020/04/22/business/sba-loans-ppp-coronavirus.html (last
visited Jan. 3, 2022) (describing “two-tiered system” where wealthier clients had
easier loan application process).
125Aaron Klein, The Small Business Relief Program Is Still Broken, POLITICO (Apr.
27, 2020, 4:30 AM), https://www.politico.com/news/agenda/2020/04/27/small-busi-
ness-relief-206960 [https://perma.cc/Y9VN-S23N].
126 Id.
45
for credit, and the many very small businesses who were not
actively borrowing prior to the crisis. These categories include
proportionally more minority and women-owned businesses.127
Given weaker historical relationships between banks and
minority-owned small businesses and microbusinesses (those
with ten or fewer employees), this likely contributed to such
businesses having more difficulty and less overall access to the
first round of PPP funding.128 Although, to be sure, other
factors also played a role contributing to the disparaties in who
actually received funding.129
In initially using banks as the primary distribution channel,
Treasury seemingly paid little heed how various small
businesses access funding, and how the small business credit
market has changed since 2008. As two of us noted before
those decisions were made: “Banks are no longer the only
source of credit for true small businesses, especially the type of
very small “Mom & Pop” corner stores, laundromats, beauty
salons, and coffee and sandwich shops that line main
streets.”130 Over the last decade, the smallest enterprises have
127 Megan Cerullo, Up to 90% of Minority and Women Owners Shut Out of
Paycheck Protection Program, Experts Fear, CBS NEWS (Apr. 22, 2020, 3:48 PM),
https://www.cbsnews.com/news/women-minority-business-owners-paycheck-pro-
tection-program-loans/ [https://perma.cc/FTP3-GAYQ].
128 Sifan Liu & Joseph Parilla, New Data Shows Small Businesses in Communities
of Color Had Unequal Access to Federal COVID-19 Relief, BROOKINGS INST. (Sept.
17, 2020), https://www.brookings.edu/research/new-data-shows-small-businesses-
in-communities-of-color-had-unequal-access-to-federal-COVID-19-relief/
[https://perma.cc/HRC8-N6Y3] (supporting conclusion with empirical data that “small
businesses in majority-white neighborhoods receiv[ed] PPP loans more quickly than
small businesses in majority-Black and majority-Latino or Hispanic neighborhoods”).
129 Humphries et al, supra note [104].
130 Baker & Judge, supra note 82, at 7; See FED. RESRV. BANKS, SMALL BUSINESS
CREDIT SURVEY: 2019 REPORT ON EMPLOYER FIRMS 16 (2019), available at
https://www.fedsmallbusiness.org/medialibrary/fedsmallbusiness/files/2019/sbcs-
46
increasingly turned to online lenders for their credit needs.131
The 2019 Federal Reserve Banks’ Small Business Credit
Survey indicated that, in 2018, nearly one-third of small
businesses that applied for credit sought it from an online lender
(the type of lender we describe here as a Fintech).132 For less
traditionally credit-worthy businesses, the number was closer to
one-half.133 Despite an average loan size much smaller than
that of a typical bank,134 online lenders extended more than
$20 billion in loans to small businesses in 2019, owing
overwhelmingly to very small enterprises.135 Combined with the
approximately $12-15 billion in aggregate merchant cash
advances made to small retail businesses in 2019, nonbank
lenders provided somewhere between one-quarter and one-
third of all credit to the smallest businesses.
Racial disparities also appear larger in bank small business
lending than in Fintech lending.136 While large banks approve at
employer-firms-report.pdf [https://perma.cc/Q25K-9HJC] (showing statistical im-
portance of “nonbank” lenders in survey on small business).
131 FED RSRV. BANKS, supra note 130 (showing upward trend in online applications
from 2016 through 2018).
132 Id. at iii.
133 Id. (“Medium- and high-credit-risk applicants seeking loan or line of credit
financing were as likely to apply to an online lender as to a large bank (54% and 50%,
respectively), and more likely to apply to an online lender than to a small bank (41%),
CDFI (5%), or credit union (12%).”).
134 Maddie Shepherd, Average Small Business Loan Amounts, Broken Down and
Explained, FUNDERA (Jan. 27, 2021), https://www.fundera.com/business-
loans/guides/average-small-business-loan-amount [https://perma.cc/EL5Z-54SP]
(noting U.S. average small business loan is $633,000.).
135Baker & Judge, supra note 82, at 7.
136Mels de Zeeuw & Brett Barkley, Mind the Gap: Minority-Owned Small Business-
es' Financing Experiences in 2018, FED. RESERVE (2019)
47
least some credit for about 65% of loan applications from White
small business owners, this number drops to 45% for Black
small business owners.137 In contrast, online lenders approved
credit for around 85% of White-owned small business borrowers
versus 83% for Black-owned borrowers.138 As a result,
regardless of intent, it was foreseeable that in disproportionately
relying on banks, the Treasury’s particular approach to
allocating early PPP funding would also disproportionately go to
larger, whiter, small businesses. It was a decision that albeit
neutral on its face, was far from neutral in practice.
https://www.federalreserve.gov/publications/2019-november-consumer-community-
context.htm [https://perma.cc/RCA2-55ET].
137Id.
138 Mels de Zeeuw & Brett Barkley, Mind the Gap: Minority-Owned Small
Businesses’ Financing Experiences in 2018, FED. RESERVE (2019),
https://www.federalreserve.gov/publications/2019-november-consumer-community-
context.htm [https://perma.cc/RCA2-55ET] (concluding that “that minority-owned
firms—particularly black-owned firms—experience greater challenges obtaining or
accessing financing and have potentially large, unmet financing needs”).There is a
large disparity in approval rates between White, Black and Hispanic small business
loans in general. FED. RESERVE BANK OF ATLANTA, SMALL BUSINESS CREDIT SURVEY:
REPORT ON MINORITY OWNED FIRMS, at iii-v (Dec. 2019),
https://www.fedsmallbusiness.org/medialibrary/fedsmallbusiness/files/2019/201912
11-ced-minority-owned-firms-report.pdf [https://perma.cc/7LQF-9WA7] “On average,
Black- and Hispanic-owned firm applicants received approval for smaller shares of
the financing they sought compared to White-owned small businesses that applied
for financing. Larger shares of Black- and Hispanic-owned firm applicants did not
receive any of the financing they applied for—38% and 33%, respectively—compared
to 24% of Asian-owned firm applicants and 20% of White-owned business applicants.
A larger share of White-owned business applicants received approval for all the
financing they applied for: 49%, compared to 39% of Asian-, 35% of Hispanic-, and
31% of Black-owned firm applicants.” Id. Similar issues exist for women-owned
businesses, which are less likely to be approved for business loans than men-owned
firms. FED. RRSRV. BANKS OF N.Y. & K.C., 2016 SMALL BUSINESS CREDIT SURVEY:
REPORT ON WOMEN-OWNED FIRMS 22 (Nov. 2017),
https://www.newyorkfed.org/medialibrary/media/smallbusiness/2016/SBCS-Report-
WomenOwnedFirms-2016.pdf [https://perma.cc/9K7T-RXHH].
48
“First come, first served” also resulted in PPP grants that were
often disconnected from the level of COVID-19 infection the
business’s home area was experiencing or how tight state-
based lock-down regimes were—both presumably proxies for
negative business impact. For example, Texas companies
received the largest share of any state of initial PPP funding
despite a relative lack of the virus at the time and having far
fewer state based lock-down restrictions.139 The definition of
‘small business’ in the legislation was quite lenient, allowing
relatively large publicly traded companies and professional
sports teams to qualify (among the most famous were Shake
Shack and the Los Angeles Lakers).140 As firms were
eventually named, a slew of media stories began, and many
firms decided to return the money. The situation was significant
enough that a joint statement by Treasury Secretary Mnuchin
and SBA Administrator Carranza noted “the large number of
companies that have appropriately reevaluated their need for
PPP loans and promptly repaid loan funds.”141 That same
139 Stephen Gandel, Paycheck Protection Program Billions Went to Large
Companies and Missed Virus Hot Spots, CBS NEWS (Apr. 20, 2020, 12:54 PM),
https://www.cbsnews.com/news/paycheck-protection-program-small-businesses-
large-companies-coroanvirus/ [https://perma.cc/Y6S9-VUKT] (explaining that
barebones application set course for disaster).
140 Sarah Hansen, Potbelly, Shake Shack, Axios: Here Are All the Companies
Returning PPP Money After Public Backlash, FORBES(Apr. 29, 2020, 11:15 AM),
https://www.forbes.com/sites/sarahhansen/2020/04/29/potbelly-shake-shack-axios-
here-are-all-the-companies-returning-ppp-money-after-public-
backlash/?sh=6b229e497ea0
[https://web.archive.org/web/20200430114300/https://www.forbes.com/sites/sarahh
ansen/2020/04/29/potbelly-shake-shack-axios-here-are-all-the-companies-
returning-ppp-money-after-public-backlash/#6a35ac427ea0] (noting that Shake
Shack returned $10 million loan and Los Angeles Lakers returned $4.6 million loan).
141 Press Release, Steven T. Mnuchin & Jovita Carranza, Sec’y & Adm’r, U.S.
Dep’t of Treasury, Joint Statement on Review Procedure for Paycheck Protection
Program Loans (Apr. 28, 2020), https://home.treasury.gov/news/press-
releases/sm991 [https://perma.cc/885A-UCYB].
49
release promised greater scrutiny for firms that took more than
$2 million in PPP.
After the initial round of PPP funding provided in the CARES
Act was quickly exhausted, Congress appropriated another
$321 billion in PPP funding in the Paycheck Protection Program
and Health Care Enhance Act of April 2020.142 In an apparent
attempt to rectify the problems in reaching low-income and
minority communities, $60 billion of that funding was set aside
for small banks, credit unions (defined as assets of under $10
billion) and community development financial institutions
(“CDFIs”) to allocate. This decision may have reflected
Congress’s belief that smaller lenders were more likely to be the
conduits to reach these communities. At about the same time,
the SBA began authorizing PPP lending by nonbank CDFIs,
Fintechs, and other nonbank small business lenders, further
improving access to PPP by the small businesses that relied on
those intermediaries for credit prior to the crisis.
Unfortunately, systems and operational issues persisted,
despite efforts to correct known problems.143 In addition,
according to a paper by three economists at the University of
Texas, the inclusion of nonbanks as lenders appears to have
increased levels of potential fraud in the program four-fold in the
142Paycheck Protection Program and Health Care Enhance Act of April 2020, Pub.
L. No. 116-139, 134 Stat. 620.
143 Ben Popken & Stephanie Ruhle, ‘Extremely Disappointing’ and ‘Entirely
Predictable’ – Slowdowns and Lockouts Plague Second Round of PPP, NBC NEWS
(Apr. 27, 2020, 4:31 PM), https://www.nbcnews.com/business/business-
news/extremely-disappointing-entirely-predictable-slowdowns-lockouts-plague-
second-round-ppp-n1193421 [https://perma.cc/G4R4-HK9Y] (“Lockouts, login
issues and sluggish systems marred the Small Business Administration’s loan
approval process, with each bank unable to submit more than a few hundred
applications.”).
50
second round, with some estimates as high as $69 billion total
in potentially fraudulent PPP loans.144
Initial research suggests that reliance on the existing system
of financial intermediaries to distribute PPP support may have
resulted in racial bias in allocation of funding, and focusing on
bank size to ameliorate the disparity was not an effective
solution. Economist Sabrina Howell and co-authors found that
Black-owned businesses were less likely to receive PPP
funding through a bank, even after controlling for other variables
145
using standard economic techniques. Their study found that
8.6% of total PPP loans went to Black-owned firms, only 3.3%
and 5.3% of PPP loans originated by small and large banks,
respectively, went to Black-owned firms, compared to 6.2% at
top-4 banks, 10.6% at CDFIs and 26.5% at fintech lenders.
Overall, fintech lenders were responsible for 53.6% of PPP
loans to Black-owned firms in their sample.
According to the authors, a principal reason fintech firms were
more successful in reaching minority owned firms than smaller
144 John M. Griffin, Samuel Kruger & Prateek Mahajan, Did FinTech Lenders
Facilitate PPP Fraud, (Dec. 6, 2021),
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3906395
[https://perma.cc/56AZ-HMNG] (“Overall, we find more than 1.51 million questionable
loans representing over $68.9 billion in capital.”). It would also seem likely that greater
PPP familiarity and preparation time for fraudsters was a contributing factor.
145 Sabrina T. Howell, Theresa Kuchler, David Snitkof, Johannes Stroebel & Jun
Wong,
Automation In Small Business Lending Can Reduce Racial Disparities: Evidence
From The Paycheck Protection Program
(Nat’l Bureau of Econ. Rsch., Working Paper No. 29364, 2022),
https://www.nber.org/system/files/working_papers/w29364/w29364.pdf
[https://perma.cc/7AFS-EB55] (noting that less than 9% of all loans went to Black-
owned businesses).
51
banks was their level of automation.146 The study also found
“suggestive evidence that preference-based discrimination
helps to explain lower rates of lending to Black-owned
businesses among smaller conventional lenders.” which may
help to explain why Congress’s solution of prioritizing small
banks did not rectify the racial disparities in the first round of
funding.147 However, as noted above, other research suggests
that fintechs had their own issues in processing PPP
applications, as they approved significantly more potentially
fraudulent loans.148
Using existing lenders in the financial system to allocate
funding inevitably leads to favoritism towards specific
subsections of the population, and it often means favoring those
who already have a leg up. Just as with the decision to empower
the Fed and Treasury, Congress could have made different
decisions in how to structure PPP, and it could have provided
more guidance to the Treasury Department to minimize some
of the disparities on display, particularly in the allocation of the
first round of PPP funding.149 There are inevitable tradeoffs
allocating assistance this way, no matter what decisions
146 Id. (“We argue that varying degrees of automation across lender types help to
explain these patterns. First, we find that racial differences in loan shares across
lenders align with differences in the rates of automation…. Second, we show that
after conventional lenders automated their lending processes, their rates of lending
to Black-owned businesses increased substantially….”).
147 Id.
148 Griffin et al., supra note 144, at 24 (noting that 858,820 potentially fraudulent
loans originated from fintech lenders).
149 Press Release, Select Subcomm. on the Coronavirus Crisis, New PPP Report
Shows Trump Administration and Big Banks Left Behind Struggling Small Businesses
(Oct 16, 2020), https://coronavirus.house.gov/news/press-releases/new-ppp-report-
shows-trump-administration-and-big-banks-left-behind-struggling
[https://perma.cc/5HHD-R63D] (idenitfying three critical failures in implementing PPP
in accordance with Congress’s intent).
52
Congress made, precisely because it was so dependent on
existing private infrastructure given the limited public
alternatives. In choosing to prioritize speed—an understandable
priority under the circumstances—Congress also set the stage
for exacerbating existing inequities in access to credit.
Just as with the decision to ask the Fed to play such a central
role in facilitating the extension of credit to businesses, the
choice was among imperfect alternatives. The scope of the
banking system, and the relationships and liquidity it
possessed, at least positioned it to serve as a plausible partner
in the government’s effort to quickly distribute a lot of fresh cash
to small businesses and others that happened to qualify.
A. The Role of Fintechs and Nonbanks
As discussed above, Fintech small business lenders were the
main source of credit for a large and highly vulnerable part of
the small business ecosystem that banks were not serving
effectively.150 Unlike banks, Fintech small business lenders
were faced with an existential crisis when the COVID-19
pandemic began. Due to their capital markets-dependent
business models, many Fintech small business lenders were
forced out of the loan market just when the liquidity they provide
was needed most.151 Many large Fintech lenders curtailed or
150 Fintech lenders include the new breed of standalone nonbank small business
lenders like FundingCircle, OnDeck, Fundation, Kabbage, BlueVine, Can Capital,
StreetShares, Lendio, and Biz2Credit, as well as more established tech companies
like Square, PayPal, Stripe, Intuit, and Amazon, which include lending as part of their
service.
151 Two of the best known Fintech lenders, OnDeck and Kabbage, suspended all
non-PPP lending to new and existing customers in April 2020. OnDeck was
subsequently sold to another nonbank lender for a small percentage of its historical
market capitalization, while Kabbage was sold to American Express, a bank. See
Murray, supra note 86; Lea Nonninger, Kabbage Discontinues Lending Operations
amid the Coronavirus Pandemic, BUS. INSIDER (Apr. 6, 2020),
https://www.businessinsider.com/kabbage-pauses-lending-suspends-existing-
credit-lines-2020-4 [https://perma.cc/C9PF-SYPJ] (noting that Kabbage did not give
borrowers notice before cutting off credit).For examples of the instability of capital
53
ceased lending entirely as their ABS were downgraded and
funding costs rose precipitously.152 In the early stages of the
crisis, as a recent paper by Ben-David, Johnson and Stulz
showed,153 the pandemic “led to a sharp contraction in fintech
markets funding for Fintech lenders, see Lawrence Delevingne, Exclusive: Eyeing
Defaults, U.S. Direct Lender Colchis Capital to Shut Funds, REUTERS (Apr. 7, 2020),
https://www.reuters.com/article/us-health-coronavirus-colchiscapital-exc/exclusive-
eyeing-defaults-us-direct-lender-colchis-capital-to-shut-funds-idUSKBN21P21X
[https://perma.cc/W8KT-CUHN] (explaining decision to shut funds was based on high
risk and uncertainty about future economic recovery); Diana Asatryan, Kabbage
Bond Tumbles to Pennies, as the Rest of SMB Is ‘On Hold’, DEBTWIRE (Apr. 2, 2020);
Payne Lubbers & Jennifer Surane, Online Lenders Fizzling in Crisis with On Deck
Agreeing to Sale, BLOOMBERG (July 29, 2020, 10:17 AM),
https://www.bloomberg.com/news/articles/2020-07-29/online-lenders-fizzling-in-
crisis-with-on-deck-agreeing-to-sale
[https://web.archive.org/web/20200730115720/https://www.bloomberg.com/news/ar
ticles/2020-07-29/online-lenders-fizzling-in-crisis-with-on-deck-agreeing-to-sale]
(“On Deck Capital Inc. said late Tuesday it had agreed to sell itself for $90 million,
almost six years after an initial public offering that valued the online small business
lender at $1.85 billion.”).
See also Todd H. Baker, Marketplace Lenders Are a Systemic Risk, AM. BANKER
(Aug. 17, 2015, 9:30 AM), https://www.americanbanker.com/opinion/marketplace-
lenders-are-a-systemic-risk (noting that MPL “can’t slow down lending and slash
operating costs to stay afloat while collecting cash from existing loans”); Todd H.
Baker, OK, Marketplace Lenders, I’ll Say It: Told You So, AM. BANKER (May 4, 2016,
2:37 PM), https://www.americanbanker.com/opinion/ok-marketplace-lenders-ill-say-
it-told-you-so(“[L]iquidity is everything, institutional money can’t be relied on,
expenses are harder to cut than add, high rates of loan growth aren’t sustainable and
a business model based on volatile gain on sale margins is inherently unstable.”).
152 Robert Armstrong, Online Lender Stops Making Loans to Small US
Businesses, FIN. TIMES (Apr. 1, 2020), https://www.ft.com/content/c31a20cf-cb17-
4958-9454-73763302b5dc (“We securitise our receivables and we are on the hook
for loan performance, which is suffering because of delinquencies, because our
customers have no revenue, because they are closed…”); Kroll Bond Rating Agency,
10 U.S. Small Business ABS Deals on Watch Downgrade Due to COVID-19
Concerns, (Mar. 30, 2020.
https://www.krollbondratings.com/documents/report/32339/abs-u-s-small-business-
abs-watch-downgrade-surveillance-report.
153 Itzhak Ben-David, Mark J. Johnson & René M. Stulz, Why Did Small Business
Fintech Lending Dry Up During March 2020?, (Fisher Coll. of Bus., Working Paper
No. 2021-03-014, 2021),
54
lending to small businesses around the onset of the crisis.
Digital lending in the second quarter of 2020 declined by 75%
relative to its $16 billion level in the fourth quarter of 2019,” and
“out of 16 small business fintech lenders originating loans
before the COVID-19 shock in 2020, only six were still
originating loans in the third quarter of 2020.” Strikingly, by
contrast, their analysis found “no evidence of an equivalent
collapse in bank loans to small businesses during the same
period.”154
This raises important questions about the implications of the
decisions by the Fed and Treasury (in the context of TALF and
the first round of the PPP, respectively) to take actions that
effectively limited their capacity to provide fresh liquidity to
Fintechs that specialized in small business lending. There are
some practical explanations, but whether those suffice or how
informed policy makers were about the myriad consequences
that were likely to flow from those decisions, remains unclear.
For example, with respect to PPP, assuming that the decision
had already been made to require certification of bank-level
anti-money laundering compliance for nonbank lenders
included in the PPP, those lenders might not have been
prepared to participate directly in the first round in any event.
Many of the Fintech small business lenders that survived the
early stage of the pandemic did so largely by virtue of helping,
directly or indirectly, in the distribution of the PPP funds by
banks without acting as approved lenders or otherwise taking
on the primary anti-money laundering compliance role.155 The
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3910549
[https://perma.cc/B4NN-JVZ5]. The authors showed that “the drying up of the loan
supply is most consistent with fintech lenders becoming financially constrained and
losing their ability to fund new loans.”
154 Id.
155 The CARES Act permits “other lenders” to become licensed to make 100%
guaranteed PPP SBA loans. CARES Act, Pub. L. No. 116-136 § 1109(b), 134 Stat.
281, 305. The Interim Final Rule sets out the terms and conditions on which such
55
speed and simplicity of Fintech lenders’ processes were, at
least theoretically, an advantage relative to the often more
bureaucratic loan origination practices of banks, helping to
explain why so many Fintechs found ways to work with banks,
by generating leads or providing loan origination and tracking
software to allow banks that had previously used manual
processes to convert to digital origination and tracking in the
PPP, rather than going it alone.156
lenders may participate in the PPP program. Bus. Loan Program Temp. Changes;
Paycheck Prot. Program, 85 Fed. Reg. 20811-817 (Apr. 15, 2020) (codified at 12
C.F.R. pt. 120).
156 In fact, many banks relied on Fintechs for the software used to process PPP
loans. Darren Hecht, How Independent and Community Banks Used Fintech to
Tackle PPP, INDEP. BANKER (July 8, 2021),
https://independentbanker.org/2021/07/how-independent-and-community-banks-
used-fintech-to-tackle-ppp/ [https://perma.cc/89Z4-FXQY] (describing how this
approach strengthened relationships with clients); Loraine Lawson, Lessons
Learned: PPP Spurs New Automations and Fintech Partnerships, BANK AUTOMATION
NEWS (June 7, 2021), https://bankautomationnews.com/allposts/retail/lessons-
learned-ppp-spurs-new-automations-and-fintech-partnerships/ (last visited Feb. 20,
2022); Press Release, Fintech Companies, Lendsmart and Griffin Technologies,
Partner to Improve SBA PPP Loan Process (May 20, 2020),
https://lendsmart.ai/fintech-companies-lendsmart-and-griffin-technologies-partner-
to-improve-sba-ppp-loan-process/ [https://perma.cc/CFA2-CRP8] (explaining how
technology helps banks process loans). A significant portion of the PPP loans made
by small and mid-sized banks were sourced by FinTechs. According to the House
Select Committee on the Coronavirus Crisis, a Fintech called Womply worked with
seventeen lenders to process 1.4 million or more PPP loans. Press Release, Select
Subcomm. on Coronavirus Crisis, Select Subcommittee Expands Investigation into
Role of FinTech Industry in PPP Fraud (Nov. 23, 2021),
https://coronavirus.house.gov/news/press-releases/select-subcommittee-expands-
investigation-role-fintech-industry-ppp-fraud [https://perma.cc/PXA2-3SJJ]
(summarizing reasons for expansion of investigation into Fintech’s “facilitation of
fraud”). While Fintech lenders had the same incentives as banks to facilitate PPP
loans to their existing customers as a means of reducing potential defaults, they also
had significant financial incentives to make PPP loans to new customers. This is
because as monoline lenders become unable to fund traditional loans and lack other
revenue sources, they need the revenue from PPP lending to “keep the lights on” in
their origination operations until conditions improve.
56
Whatever the reasons, the government’s initial crisis
response did little to support these nonbank lenders, creating a
risk not only to them but to the many small businesses that
relied on them for funding. This is a classic quandary when
important financial activity moves outside the perimeter of
banks and other prudentially regulated institutions. Usually,
migration outside this space—whether by Fintechs, money
market funds or open-end bond funds—brings lower regulatory
costs and other flexibility. This can lead to rapid growth
accompanied by reliance on mechanisms that were, by design,
not resilient to shocks and not regulated in the way needed to
ensure resilience. Providing support can allow the fragility to
persist, but can also be key to protect the real economy actors
that rely on the fragile intermediaries. Although there are no
easy or right answers to these quandries, the numerous places
where this type of interplay is at work highlights the need to
better understand and address these challenges before crisis
strikes.
Ultimately, the Fed and Treasury did provide some short-term
assistance to Fintech and other nonbank small business
lenders. While they left the TALF unchanged, late in the first
round of the PPP, the Treasury, the Fed, and the SBA took
action to include Fintechs and other nontraditional lenders like
CDFIs with direct access both to the PPP and the related
Paycheck Protection Program Liquidity Facility (“PPPLF”).
However, Fintech and other nonbank lenders remained subject
to various specific application requirements and other
conditions (principally related to the Bank Secrecy Act and anti-
57
money laundering compliance)157 that continued to delay and
limit their participation relative to banks.158
When Fintechs and other nonbanks were authorized to
participate directly in the PPP at the end of the first phase, they
began to reap a larger benefit from the program. research
conducted by the Federal Reserve Bank of New York shows
that Fintechs made less than 2% of PPP loans by dollar amount
and less than 4% by number (reflecting lower average loan
sizes) in the first phase of the PPP, with large and small banks
making almost all the rest. As Fintechs and nonbanks became
eligible PPP lenders, their share of PPP lending by both amount
and number quintupled.159 Nonetheless, the fees provided
directly under the PPP and in partnerships with banks may well
157 Binoy Dharia & Graham Silnicki, Paycheck Protection Program: Participation
by Non-Bank Lenders, WHITE & CASE (Apr. 13, 2020),
https://www.whitecase.com/publications/alert/paycheck-protection-program-
participation-non-bank-lenders [https://perma.cc/QP9B-DJMQ] (announcing interim
rule expanding group of financial institutions permitted to act as lenders under PPP).
158 See, e.g., U.S. Small Bus. Admin., supra note 89 (explaining how to apply for
loan forgiveness); Press Release, Fed. Rsrv. Bd., Federal Reserve Takes Additional
Actions to Provide up to $2.3 Trillion in Loans to Support the Economy (Apr. 9, 2020),
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200409a.ht
m [https://perma.cc/HE3M-HXJ6]. Under the PPPLF, established April 9, 2020, the
Fed will extend credit to eligible financial institutions that originate PPP loans, taking
the loans as collateral at face value. While banks are included in the PPPLF at
commencement, the Fed’s release indicates that it is working to include other lenders
originating PPP loans “in the near future.”
159 Jessica Battisto, Nathan Godin, Claire Kramer Mills & Asani Sarkar, Who
Received PPP Loans by Fintech Lenders, FED. RSRV. BANK OF N.Y.: LIBERTY ST.
ECON. (May 27, 2021),
https://libertystreeteconomics.newyorkfed.org/2021/05/who-received-ppp-loans-by-
fintech-lenders/ [https://perma.cc/HD64-2N7H] (breaking down which demographics
received loans from fintech companies).
58
have been played a critical role helping many Fintechs remain
viable until conditions improved.
The researchers at the New York Fed also found that fintechs
played a critical role getting PPP funds to Black-owned small
businesses:
Applicants who approached Fintech lenders for PPP
loans were more likely to lack banking relationships,
be minority owned, and have fewer employees.
Moreover, a higher share of applications by Black-
owned businesses were approved by Fintech lenders
as compared to firms with white, Asian, or Hispanic
owners. Since Black owners were approved for loans
by fintech lenders at a higher rate even before the
pandemic, our results suggest that historical factors
that prevent Black owners from receiving bank credit
continued to operate with the PPP.160
Finally, fintech loans appeared to be correlated more closely
than bank loans with areas of particular pandemic need, as
measured by death rates. Other research published by the New
York Fed corroborates this.161 For example, in New York, during
the first round of PPP, fintech lenders’ shares of small loans
were almost twice as large in the counties with the highest death
rates as compared to counties with the lowest death rates. By
comparison, bank loan shares were statistically uncorrelated
with death rates during the first round of PPP funding. In
160 Id.
161 Jessica Battisto, Nathan Godin, Claire Kramer Mills, and Asani Sarkar, Who
Benefited from PPP Loans by Fintech Lenders?, May 27, 2021,
https://libertystreeteconomics.newyorkfed.org/2021/05/who-benefited-from-ppp-
loans-by-fintech-lenders/
59
subsequent rounds of PPP, loans of all lenders had a similar
correlation with death rates.162
IV. SOME IMPLICATIONS FOR POLICY
This is a complex story where stated goals did not align with
routes taken. Policy makers in Congress, Fed Chair Powell, and
senior Administration officials suggest an acute and distinct
interest in the health of smaller enterprises. And much money
did flow from the federal government into these businesses.
Nonetheless, when the different pieces of government support
are put together, the overall picture that emerges is one that
tilted the scales in the opposite direction, favoring larger
businesses.
The decision to rely on lending facilities established by the
Fed under its 13(3) authority, while neutral on its face, had the
effect of doing far more to facilitate funding for the largest
businesses relative to mid-sized and smaller ones. Similarly, the
Treasury Department’s decision to favor banks over fintechs in
the early stages of PPP implementation resulted in more funds
going to larger, more established, and whiter qualifying
businesses.
These actions have ramifications both for this recession and
when the next shock or severe cyclical recession hits. As a
starting point, this highlights the need for ongoing awareness,
engagement and discussion around the nature of the public and
private credit intermediation infrastructure in place. Although the
perceived lack of better alternatives may help explain
Congress’s decision to rely so heavily on the Fed in its efforts
to support businesses, that decision was far from neutral in its
allocational impact. Similar dynamicsm are at play around the
decision by Treasury to rely, initially at least, on banks as the
primary conduits for PPP funds.
162 Id.
60
Another key contribution is to highlight the difference between
the funds that flow from the government to businesses and the
extent of government support provided for a domain. When
interventions change the viability of intermediaries or alter
expectations of future support, they can have long-term
ramifications far in excess of the amount of actual support
provided. This was true in 2008, and was a primary defense for
interventions that helped stave off the failure of key financial
instituitons. This was also a key reason for the many reforms
aimed at eliminating too-big-to-fail subsidies. And it was true
again—although far less discussed, and in slightly different
forms—in 2020.
A lot of money flowed into small businesses, but the nature of
the PPP program did little to incent banks or nonbanks to find
new and better ways to underwrite loans to small businesses.
Nor is there much sign that the Main Street Lending Facility
incentivized investments in credit intermediation infrastructure
designed to help the mid-sized businesses that qualified for the
program.
By contrast, the Fed’s purchases of corporate bonds in ways
that stabilized open-end bond funds and ETFs holding bonds
and its purchases of collateralized assets in ways that may have
aided the functioning of the CLO market are precisely the types
of interventions that can fundamentally alter market
expectations, adding grease to the already well-oiled machine
for extending credit to the country’s largest companies. That so
many large companies issued so much new debt in the wake of
these interventions, while so many small business owners
report ongoing problems accessing credit, is a testament to this
disparaity.
Having created an expectation of support, the Fed may well
feel compelled to support bond markets and investors yet again,
rolling out the array of facilities created in 2008 and re-deployed
in 2020. Whether this happens with specific congressional
authority of the kind provided in the CARES Act or without, as
61
was the case for many of the programs in the 2008 financial
crisis and even in 2020 prior to the enactment of the CARES
Act, the structures the Fed uses and the financial infrastructure
the country is operating with will play key roles in shaping who
benefits the most from government intervention.
A. The Persistent and Evolving Challenge of Smalll Business
Financing
This essay also informs, although by no means seeks to
resolve, the current debate regarding the appropriate role and
regulation of nonbank fintechs in credit creation. Fintechs burst
onto the scene in between these 2008 and 2020, and may well
continue to play a growing role in the extension of credit to small
business. This raises a host of issues. As this essay reflects, a
key challenge to policy formulation in this area is the role that
Fintech lenders increasingly play in providing credit to small
businesses. There are also signs that the role of Fintech lenders
may be especially salient to very small minority and women-
owned businesses, whose viability may be of particular
importance given persistent structural inequities. Despite this,
the extent to which growing Fintech lending volumes can be
explained by lower regulatory burdens, different business
models, historically low interest rates, or other factors has not
been adequately examined by policy makers or academics.
Absent meaningful reform, many of today’s Fintechs are
poorly situated to weather a severe cyclical downturn. Without
the significant and multi-faceted, although inconsistent,
government support provided during the pandemic, far more
Fintechs may well have failed. As the pandemic revealed, most
Fintechs rely on wholesale funding that dries up quickly during
periods of distress. This liquidity problem will likely be even
more acute in a more traditional, longer lasting cyclical credit
downturn where loan performance and economic activity
62
remained depressed for a lengthy period. This stands in stark
contrast to banks that, because of a different business model
and far more rigorous regulation, are better (even if far from
perfectly) situated to make loans through the business cycle.
Now that the acute phase of the COVID-19 crisis has past,
policy makers should seek to understand and address the
challenges that arise from allowing fragile, capital-market
dependent lenders to play such a significant role in the provision
of credit to small businesses.163 There can be little question
that allowing a large portion of lending to a critical area of the
economy to be provided by companies (a) beyond direct federal
regulation and (b) doing business in an inherently fragile and
procyclical manner creates structural risks.
Looking ahead, one implication is the desirability of potentially
doing more to facilitate ongoing credit creation for small
businesses in peacetime, particularly those that have
traditionally had a harder time accessing financing. There are a
number of possibilities for dealing with this issue, and the best
path forward may well include some mix of these approaches.
One possibility would be to encourage banks to make further
investments in their ability and willingness to lend to small
businesses, including those that traditionally have had a harder
time accessing credit. If banks build out the infrastructure and
develop the relationships needed to make these loans, this
could enhance credit access during good times and reduce the
likelihood that economic shocks will overly contract credit
creation for these businesses. The role banks, credit unions,
and CDFIs can play could be assisted by their information
advantages, knowing their customers and their
163 This is just one aspect of a larger problem involving the resiliency of capital
markets in the face of major crises. Commercial paper, Fed funds, and mortgage and
other markets also struggled to function effectively, requiring intervention from the
Fed and Treasury.
63
communities.164 This type of relationship lending model has
faced structural challenges given the rise of lending
commoditization aided by enhancements in capital markets and
computing power, which have driven down costs for certain
types of loans that ‘fit the standard box,’ while making loans to
entities that do not fit the box relatively more expensive for
lenders, borrowers, and investors.
How best to facilitate deeper engagement by banks with
underserved small businesses depends on understanding the
frictions currently inhibiting robust extensions of credit by banks
to these businesses. Given the risks and costs of such credit
creation, and the positive social benefits of such lending, the
government may well have a role to play. Regulation can and
does incentivize financial institutions’ lending patterns, including
creating hurdles to non-standard or ‘traditional box’ loans. The
way the government supports housing finance by supporting the
securitization of certain home loans may well serve as a model
here too, though it may be appropriate for the government to
take on even more risk—in a calculated fashion—than it often
does with housing.
A related approach would be for the government to do more
to expand the nonbank, non-Fintech mechanisms of getting
funding to small businesses. A key public institution right now,
is the SBA, which proved vital but also deeply flawed and limited
during the pandemic. A key set of institutions are CDFIs, many
of which are specifically focused on serving under-served
164 Congress has already taken some steps in this direction. Legislation signed
into law in December 2020 included $12 billion set-aside for CDFIs and Minority
Depository Institutions (“MDIs”). Consolidated Approriations Act, 2021, Pub. L. No.
116-260 ( 2020). Specifically, the law included a $9 billion Emergency Capital
Investment Program, administered by the Treasury, to provide low-cost, long-term
capital investments to MDIs and CDFIs that are depository institutions, with special
set-asides for the smallest institutions. Id. In addition, $3 billion was appropriated to
provide grants and other financial and technical assistance to CDFIs, including CDFI
loan funds that serve consumers, small businesses and nonprofits in their
communities. Id.
64
populations, and the unfortunately dwindling number of
minority-owned depository institutions. By enhancing these
mechanisms alongside enhancing the ability of banks to serve
small businesses, the government would be better positioned to
credibly warn Fintechs that they are unlikely to be utilized in the
same way the next time a crisis strikes, increasing their
vulnerability.
Given that a lot of money can be made in good times,
particularly when differential regulatory schemes make it
cheaper to be a Fintech than a bank engaging in similar
activities, another question is whether Fintechs should be
regulated in a manner more akin to banks, including some mix
of oversight, capital regulation and liquidity regulation.165 The
aim need not be perfect uniformity, but ensuring that any set of
lenders that are providing capital to businesses (or households)
in sufficient amounts are able to continue to make such loans
when conditions soften. As things now stand, even shocks far
smaller than March 2020 could lead to meaningful disruptions
in credit creation—harming not only the Fintechs who chose to
be exposed to such risks but also their clients, who may not be
aware of the risks they are indirectly taking in choosing to rely
on a nonbank lender. Important but beyond our scope, is the
question of whether this is best achieved by compelling
Fintechs to become banks, allowing them to do so, or creating
an alternative regulatory scheme with some but not all of the
features long associated with bank regulation.
Yet another option would be for Congress to institutionalize
direct or indirect recession lending (e.g., through SBA/CDFI
subsidies) by other lenders like CDFIs focused on the
populations heavily served by Fintechs, and leave the Fintechs
to their fate. Finally, the government could commit to provide
165 This same argument could be made about other areas of financial markets,
such as money-market mutual funds, that have repeatedly required government
assistance in crises.
65
ongoing liquidity support to Fintechs in a recession, to allow
them to continue to serve their customers by revising programs
like the TALF, to support private small business lending and
securitization funding. This would assist credit creation without
the concomitant oversight and responsibilities that
comprehensive supervision and capital and liquidity rules bring
to regulated banking.
Any solution to the Fintech liquidity problem needs to take into
account the large populations of small businesses that banks
don’t serve today, particularly small minority and women-owned
businesses. Comprehensive supervision, “Fair lending”-type
anti-discrimination legislation, and programs like the
Community Reinvestment Act have—so far at least—failed to
sufficiently change this dynamic or extend the reach of banks
into those populations. Exempting classes of insured deposit
lenders from the Community Reinvestment Act, such as what
was done for credit unions, has arguably made the situation
worse. Unless structural changes to assure small business
lending liquidity in crises also deal with inadequate peace time
access to funding for underserved enterprises, any solution will
be incomplete.
B. Fragility, Funding and the Largest Businesses
Shifting to large companies, open-end bond funds may be the
most vivid example of an inherently vulnerable product propped
up by the Fed’s pandemic interventions. Corporate bonds are
not, and have never been, anywhere near as liquid as equity
instruments. Yet, corporate bond funds promise investors daily
liquidity. Adding to the challenge, the price that investors in
open-end bond funds receive for their shares is also determined
by a daily net asset value, a pro rata share of the estimated
value of the bonds held by the fund on the day of redemption
without taking into account the cost of liquidating those bonds.
66
This structure works fine in normal conditions, as investors are
often entering as well as exiting, and bond funds often hold
sufficient Treasury instruments to cover short-term demands for
liquidity. But as March 2020 illustrated vividly, once liquidity
becomes strained, this structure encourages investors to run for
the exit—regardless of their need for liquidity—by allowing
those who exit to impose the cost of liquidation, and
corresponding losses, onto the investors who remain.
The classic problem of promising short-term liquidity in long-
term less liquid investments is nothing new. Money market
mutual funds, corporate bond funds, and bank deposits are all
subject to similar runs. After the Great Depression, the
government largely solved bank deposit runs through a
combination of federal deposit insurance and substantial
regulation. After the financial crisis of 2008, structural changes
to money market mutual funds were supposed to have solved
this problem. As then SEC Chair Mary Jo White stated in 2014:
“Today’s reforms . . . will reduce the risk of runs in money
market funds and . . . make our markets more resilient and
enhance transparency and fairness of these products for
America’s investors.”166 These reforms failed their initial test in
the Covid-19 crisis. Whether any such reforms are made to
corporate bond funds or bond ETFs remains to be seen, despite
the importance of the fragilities revealed. As then Brookings
scholar and current Treasury Under Secretary for Domestic
Finance Nellie Lang remarked in October 2020,
[T]he success to date of the Fed’s corporate bond
program to calm the markets does not suggest that
reforms are not needed. Instead, the reforms are even
more critical, since the Fed’s actions likely raised
166 Press Release, Sec.’s & Exch. Comm’n, SEC Adopts Money Market. Fund
Reform Rules: Rules Provide Structural and Operational Reform to Address Run
Risks in Money Market Funds (July 23, 2014), https://www.sec.gov/news/press-
release/2014-143 [https://perma.cc/66YY-B5BF].
67
expectations of such interventions in the future. It is
important that the Fed, through financial reforms or
clarifying its own intent for future emergency actions,
reduce any perception by private entities that they would
not have to bear the costs of their own risk-taking.167
Time will tell whether this wisdom is heeded.
There are an array of tools that could help mitigate these first-
mover advantages,168 and it is beyond our purview to evaluate
the right mix. But the analysis here does highlight that such
interventions could be helpful for a number of related reasons.
In addition to addressing a potential threat to stability, such
efforts may be particularly warranted to counteract the impact
of the Fed’s actions during the pandemic. Even when the Fed
should intervene to stop the spread of dysfunction, that it
needed to do so is often a flag of a need of further reforms.
When these two are decoupled, interventions can perpetuate
the expectation of further support and accentuate the fragility
already embedded in a market. Moreover, given the ongoing
growth of the bond market, addressing the ways ETFs and
open-end bond funds create expectations of liquidity in markets
where it may not exist could help slow that growth.
CONCLUSION
The breadth and swiftness of the government’s response to
the COVID-19 crisis in 2020 is a testament to the capacity of
policy makers to act quickly and decisively.The economic
recovery from the pandemic has been rapid, particularly when
compared with the rest of the world who largely suffered a
167 Nellie Liang, Corporate Bond Market Dysfunction During COVID-19 and
Lessons from the Fed’s Response, BROOKINGS INST. (Oct 1, 2020),
https://www.brookings.edu/research/corporate-bond-market-dysfunction-during-
covid-19-and-lessons-from-the-feds-response/ [https://perma.cc/N2KC-JK45].
168 Hubbard et al., supra note 46.
68
similar shock. Providing meaningful support to virtually all
Americans and increasing the payments made to those who
had lost their jobs proved to be not only the right thing to do, but
also the wise thing to do. Putting money into the hands of people
who needed to spend it promoted economic activity even as
people were scared, anxious, and leaving their homes far less
frequently. It also played a powerful, even if indirect, role in
alleviating strains in the financial system. Putting money in the
hands of people and businesses enhanced their ability to pay
back existing obligations, reducing the losses that banks and
other creditors had to absorb. And the full panoply of
government support ensured that the economy was positioned
to grow as the acute phase of the pandemic subsided.
Yet alongside reflecting on the many lessons learned from
previous periods of systemic distress, the pandemic has its own
lessons to teach. Taking a step back to consider not only what
worked and how, but also the challenges faced and the
collateral consequences of the actions taken, is key to ensuring
that policy makers—and the tools available to them—are ready
when the next crisis hits. America’s financial infrastructure
constrained the rapidity and effectiveness of our policy
responses. It led to an uneven set of beneficiaries among
individuals, families, and businesses big and small. Times of
crisis require rapid response, inherently leaning on existing
infrastructure. As our economic response increasingly relies on
financial institutions and structures, the constraints of the
institutions and structures will shape the options available for
response as well as the efficacy of policies chosen. This is why
non-crises times are when greater thought and attention are
required to improve our financial infrastructure.
69
The Center on Regulation and Markets at
Brookings provides independent, non-
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applied broadly across microeconomic
fields. It creates and promotes independent
economic scholarship to inform regulatory
policymaking, the regulatory process, and
the efficient and equitable functioning of
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Be sure to include the title of this paper in your inquiry.
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