Over the past year, COVID-19 has devastated small businesses across the country. Business closures and mass layoffs spread as the virus spread. Amongst its other catastrophic effects, the COVID-19 crisis has devastated financially fragile small businesses. For small businesses owned by minorities and women, the economic impact has been particularly salient. Now, small businesses have another obstacle to face: Section 1071 of the Dodd-Frank Act. Though Section 1071 is well-intentioned and aims to identify inequities in small business lending, its effects may prove to do more harm than good.
WHAT IS SECTION 1071?
Ironically, Section 1071 began as a reaction to yet another crisis: the Great Recession of 2008. Some Americans were left without a penny to their name, unemployment rates rose to over 10%, and many lost their homes to foreclosures. The economy was in a tailspin and many businesses suffered as a result. Then came Dodd-Frank. The Dodd-Frank Act was signed into law following the financial crisis and was meant to increase oversight of the financial sector to prevent the events of 2008 from ever happening again. The law is often referred to as “the biggest law ever” and was a complete overhaul of the financial regulatory system. Some portions of the law, like stress testing for large banks, were successful changes to the financial system. But other portions of Dodd-Frank have crossed from being helpful cautionary measures to now excessive burdens when put into practice.
Section 1071 was included in Dodd-Frank to facilitate fair lending and to expand opportunities for small women and minority owned businesses. Under Section 1071, banks must keep a detailed record of the small women or minority owned to whom businesses they lend to. The mandatory data gathering includes the amount of the loan, the revenue of the business, and the business location, as well as additional race, sex, and ethnicity characteristics of the business owners. Once this information is collected, banks must submit it to the Consumer Financial Protection Bureau to do with it as they see fit. Hypothetically, the CFPB will use the information to identify patterns in lending and to crack down on any discrimination.
Fast forward to 2021. Though Dodd-Frank was enacted back in 2008, some parts of the law including Section 1071 have not yet been put into action. Now, the Consumer Financial Protection Bureau is finally putting Section 1071 into motion. Of course, any legislation that can be used to lift up struggling women and minorities is much needed and a welcome addition to financial regulation. But to support the smallest banks and prevent a backfire effect for small businesses, Section 1071 needs to be implemented with care.
WHAT’S THE PROBLEM?
Dodd-Frank had a crisis to solve but in doing so forgot about small banks, and certain provisions of the law haven’t worked out so well in practice. Some portions of the original bill burdened small banks so much that in 2018 a separate bill was signed into law to ease regulations and prevent small banks from being crushed by the weight of compliance. With Section 1071 now under consideration, these previous Dodd-Frank regulatory drawbacks should remind the CFPB to keep small banks in mind when implementing the law.
Small banks are so important to the vitality of small businesses because they are often where small businesses apply for loans. Small banks are better able to serve the needs of small businesses because they take a more holistic approach to lending– like considering the borrower’s character and ability to manage their finances– whereas at a larger bank a small businesses identity is often reduced to its credit history. Data also shows that small businesses are more likely to be approved for credit when they apply for lending at a small bank.
However, small banks are not able to serve the needs of these small business if their hands are tied by regulation. Small banks are disproportionately affected by regulation because they lack the resources that larger banks have to comply with regulation at a low cost. Small banks tend to have little to no dedicated compliance employees, and they are more likely to pass compliance costs on to their customers.
WHAT’S THE FIX?
The relationship between bank regulation and small business lending is very delicate. Previous Dodd-Frank regulatory requirements caused small business lending to fall by nearly 18%. To avoid the same effect with the implementation of Section 1071, a subset of small banks should be exempted from its data reporting requirements. Exempting all small banks is not the answer; small banks are generally considered to be those with $1 billion or less in assets, but exempting all of these banks would exclude too much of the important data about women and minority owned small businesses. An exemption of small banks with below $100 million in assets would still allow the CFPB to collect data on over 99% of small business loans and allow them to identify patterns of discrimination, while preventing the smallest banks from being crushed by compliance costs. The exemption should only cover banks with under $100 million in assets as those are the banks that would be most devastated by the costs associate with Section 1071.
In times of national crisis like the Great Recession or the current pandemic, the role and vulnerabilities of small banks and businesses must be a forethought and not an afterthought. Through overbearing regulation, Section 1071 could end up harming the small businesses it aims to help in the first place. Small banks with less than $100 million in assets should be exempt from Section 1071 to avoid sabotaging them and the small businesses to whom they lend.