Small Business Administration: Few Reviews of Guaranteed Lenders Have
Been Conducted (Letter Report, 06/11/98, GAO/GGD-98-85).

Pursuant to a congressional request, GAO reviewed: (1) how the Small
Business Administration (SBA) conducts on-site reviews to monitor
participating lenders' compliance with its 7(a) loan program policies
and procedures; and (2) what actions SBA is taking to comply with the
preferred lender oversight provisions of the Small Business Programs
Improvement Act of 1996 (SBPIA).

GAO noted that: (1) prior to December 1997, SBA's operating procedures
for the 7(a) program required annual on-site reviews of lenders having
more than three outstanding guaranteed loans; (2) GAO could not
determine from the district offices' files which lenders met this
criterion and should have been reviewed; (3) in five SBA district
offices GAO visited, about 96 percent of the lenders had not been
reviewed by SBA in the past 5 years; (4) for some lenders that had
participated in the program for more than 25 years, GAO found no
evidence that they had ever been reviewed; (5) without conducting
periodic on-site lender reviews, SBA does not have a systematic means to
help ensure that lenders' actions do not render loans ineligible,
uncreditworthy, or uncollectible, thus increasing the risk of loss to
the agency; (6) such monitoring is particularly important as the agency
moves from direct involvement on loan approvals to increased reliance on
participating lenders to perform the approval and other functions
related to the loan process; (7) in the last 5 years, SBA's Inspector
General conducted audits at only 3 of the 12 current small business
lending companies (SBLC) that all operate as preferred lenders; (8)
beginning December 1997, SBPIA required SBA to review preferred lenders
annually or more frequently; (9) SBPIA did not change the oversight
requirements for regular and certified lenders; (10) as of May 1998, SBA
was in the process of implementing a central review program for
preferred lenders, but SBA had not yet conducted any reviews because of
delays in developing the program; and (11) although the central review
program may offer a more comprehensive and systematic approach to
assessing lender compliance with SBA's standards, it is too early to
tell how successful the program will be until reviews are conducted and
information on the program is available.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-98-85
     TITLE:  Small Business Administration: Few Reviews of Guaranteed 
             Lenders Have Been Conducted
      DATE:  06/11/98
   SUBJECT:  Reporting requirements
             Loan accounting systems
             Small business loans
             Regulatory agencies
             Lending institutions
             Government guaranteed loans
IDENTIFIER:  SBA Preferred Lenders Program
             SBA 7(a) Loan Program
             SBA Small Business Loan Program
             
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Cover
================================================================ COVER


Report to the Chairman, Committee on Small Business, U.S.  Senate

June 1998

SMALL BUSINESS ADMINISTRATION -
FEW REVIEWS OF GUARANTEED LENDERS
HAVE BEEN CONDUCTED

GAO/GGD-98-85


(233524)


Abbreviations
=============================================================== ABBREV

  FDIC - Federal Deposit Insurance Corporation
  FRB - Federal Reserve Board
  OCC - Office of Comptroller of the Currency
  OTS - Office of Thrift Supervision
  SBA - Small Business Administration
  SBLC - Small Business Lending Company
  SBPIA - Small Business Programs Improvement Act of 1996

Letter
=============================================================== LETTER


B-278633

June 11, 1998

The Honorable Christopher S.  Bond
Chairman, Committee on Small Business
United States Senate

Dear Mr.  Chairman: 

This report contains the results of our review of the Small Business
Administration's (SBA) oversight of lenders participating in its 7(a)
loan program\1 and its efforts to comply with the preferred lender
review requirements of the Small Business Programs Improvement Act of
1996 (SBPIA).  The 7(a) loan program is intended to serve small
business borrowers who cannot otherwise obtain financing under
reasonable terms and conditions from the private sector.  In fiscal
year 1997, 7(a) loan approvals totaled nearly $9.5 billion. 

In discussions with your office, we agreed to determine (1) how SBA
conducts on-site reviews to monitor participating lenders' compliance
with its 7(a) loan program policies and procedures and (2) what
actions SBA is taking to comply with the preferred lender oversight
provisions of SBPIA.  To address these objectives, we conducted work
at SBA's headquarters in Washington, D.C., 5 of the 69 SBA district
offices; SBA's Preferred Lender Review Branch in Kansas City,
Missouri; and its Sacramento Loan Processing Center in Sacramento,
California. 


--------------------
\1 Section 7(a) of the Small Business Act (15 U.S.C.  636(a))
authorized this loan guarantee program. 


   BACKGROUND
------------------------------------------------------------ Letter :1

The 7(a) program is SBA's largest lending program and its primary
vehicle for providing small businesses with access to credit.  The
program is intended to serve small business borrowers who could not
otherwise obtain credit under suitable terms and conditions from the
private sector.  Under the program, SBA provides guarantees of up to
80 percent on loans made by participating lenders.  During fiscal
year 1997, 7(a) loan approvals totaled nearly $9.5 billion--the
highest level of loan approvals in the program's history.  This was
an increase of 23 percent over the $7.7 billion in loan approvals in
fiscal year 1996.  The total for 7(a) loans outstanding, as of
December 31, 1997, was $21.5 billion. 

SBA's 7(a) lenders have been given additional authority and
responsibility over their 7(a) portfolios.  According to SBA, it is
in transition from its direct involvement in loan guarantees to
increased reliance on private sector lenders to fulfill its mission. 
Within the 7(a) program, there are three classifications of lenders-
-regular, certified, and preferred.  Although SBA completely analyzes
regular lenders' loans and decides on their guarantee, certified
lenders are expected to perform a complete credit analysis. 
Preferred lenders are given full authority to determine eligibility
and creditworthiness and to approve loans without prior review by
SBA.  Certified and preferred lenders are to have their status
renewed at least every 2 years by SBA.  At the end of 1997, according
to SBA, there were approximately 6,000 lenders participating in the
7(a) program- -about 4,750 regular, 800 certified, and 450 preferred
lenders.  In 1997, the percentage of loans accounted for by preferred
lenders represented about 30 percent of 7(a) loan approvals and 50
percent of loan dollar volume. 

Participating lenders charge borrowers fees to obtain SBA loan
guarantees, and the borrowers repay the loans through payments to the
lenders.  To be eligible for a 7(a) loan guarantee, lenders are
required to document that borrowers are unable to obtain financing
under reasonable terms and conditions through normal business
channels.  In the event of a default, SBA purchases an agreed-upon
share of the unpaid balance of the loan.  The maximum exposure
allowable for SBA on a guaranteed loan is $750,000 unless otherwise
authorized by statute for a specific loan program. 

To participate in the 7(a) program, lenders must meet certain basic
requirements, including (1) having staff experienced in commercial
lending, (2) maintaining a good character and reputation, and (3)
having the financial capacity to disburse funds on loans.  In
addition, SBA regulations require that lenders be subject to
supervision and examination by a state or federal regulatory
authority acceptable to SBA.  According to SBA, for a period prior to
January 1982, it licensed a number of nondepository institutions,
known as Small Business Lending Companies (SBLC), that are not
subject to state or federal supervision or examination other than
oversight conducted by SBA.  SBA's regulations provide that, to meet
its regulatory oversight requirement, these entities are to be
subject to periodic audits by SBA's Office of Inspector General. 
According to SBA, it licensed 16 SBLCs and 12 are currently active in
the 7(a) program as preferred lenders.  As of December 31, 1997,
SBLCs accounted for about 19 percent of outstanding 7(a) loans. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

Prior to December 1997, SBA's operating procedures for the 7(a)
program required annual on-site reviews of lenders having more than
three outstanding guaranteed loans.  We could not determine from the
district offices' files which lenders met this criterion and should
have been reviewed.  However, in five SBA district offices we
visited, about 96 percent of the lenders had not been reviewed by SBA
in the past 5 years.  Further, for some lenders that had participated
in the program for more than 25 years, we found no evidence that they
had ever been reviewed.  Without conducting periodic on-site lender
reviews, SBA does not have a systematic means to help ensure that
lenders' actions do not render loans ineligible, uncreditworthy, or
uncollectible, thus increasing the risk of loss to the agency.  Such
monitoring is particularly important as the agency moves from direct
involvement in loan approvals to increased reliance on participating
lenders to perform the approval and other functions related to the
loan process.  In addition, in the last 5 years, SBA's Inspector
General conducted audits at only 3 of the 12 current SBLCs that all
operate as preferred lenders. 

Beginning December 1997, SBPIA required SBA to review preferred
lenders annually or more frequently.  SBPIA did not change the
oversight requirements for regular and certified lenders.  As of May
1998, SBA was in the process of implementing a central review program
for preferred lenders, but SBA had not yet conducted any reviews
because of delays in developing the program.  Although the central
review program may offer a more comprehensive and systematic approach
to assessing lender compliance with SBA's standards, it is too early
to tell how successful the program will be until reviews are
conducted and information on the program is available. 


   SBA POLICY REQUIRES PERIODIC
   REVIEWS OF LENDER PERFORMANCE,
   BUT FEW HAVE BEEN DONE
------------------------------------------------------------ Letter :3

Within SBA's headquarters, the Office of Financial Assistance has
responsibility for developing the policies and procedures that govern
the 7(a) loan program.  SBA's 69 district offices are responsible for
implementing the 7(a) program, including maintaining oversight of
participating lenders' compliance with SBA's loan standards.  The
district offices report to the Headquarters Office of Field
Operations and provide it with information on loan default rates and
recoveries from liquidations.  The district offices are not required
to report on their lender oversight activities. 

According to SBA's operating procedures, on-site reviews of lenders'
policies and practices are a central component for ensuring that
lenders are processing loans according to its standards.  Prior to
December 1997, the procedures required district offices to conduct
annual reviews of participating lenders having more than three
outstanding SBA guaranteed loans.  The current policy requires a
review at least once every 3 years for regular and certified lenders
with three or more loans and annually for preferred lenders. 

The objective of the reviews is to determine whether lenders are
complying with SBA's 7(a) loan policies and procedures.  The emphasis
of the reviews is to be on inspecting lenders, using a checklist, to
determine whether they have fulfilled requirements, such as
documenting loan collateral and credit files.  Reviewers are to
determine, for example, whether collateral has been obtained and
properly secured and whether required insurance has been obtained. 
Without conducting periodic lender reviews, SBA has no systematic
means to evaluate lenders' determinations of loan eligibility,
creditworthiness, or collectibility, thus increasing the risk of loss
to the agency.  In addition, reviews could also help deter lenders
from extending guaranteed loans to applicants who could obtain
funding through other means.  Such monitoring becomes more important
as the agency moves from direct involvement in each loan guarantee
transaction to increased reliance on participating lenders in
processing, servicing, and liquidating loans. 

In spite of the policy requiring periodic reviews of participating
lenders, SBA had conducted few on-site reviews of the 7(a) lenders in
the district offices included in our review.  In the 5 district
offices we visited, SBA staff had not conducted reviews of 778 of 812
lenders,\2 or about 96 percent, in those districts in the past 5
years:  1993 through 1997.  As shown in table 1, four of the five
districts offices visited reviewed fewer than 3 percent of their
participating lenders in that period of time. 



                                Table 1
                
                Comparison of Lenders Receiving On-site
                 Reviews to Total Lenders for Selected
                          Districts. 1993-1997

                                                        Lender
                                                 Total       s
                                                lender  review  Percen
District                                             s      ed       t
----------------------------------------------  ------  ------  ------
Kansas City, MO                                    300       1     0.3
Los Angeles, CA                                    199       0       0
Richmond, VA                                       191       2     1.0
Sacramento, CA                                      43       1     2.3
San Francisco, CA                                   79      30    38.0
======================================================================
Total                                              812      34     4.2
----------------------------------------------------------------------
Source:  GAO analysis of SBA files. 

The Los Angeles District Office, the largest district for loan
approvals in fiscal year 1997, had not performed any on-site reviews
in the last 5 years; and the Richmond District Office had conducted
two during the same period.  However, the San Francisco District
Office had reviewed 61 percent of its preferred lenders, 82 percent
of the certified lenders, and 20 percent of the regular lenders
during the same time period. 

In the 5 district offices, of the 744 lenders that had been in the
program at least 1 year, we found no evidence that 625 had ever been
reviewed since they began participating in the 7(a) program.  Also,
there was no documentation in the files to indicate that some lenders
that had participated in the program for over 25 years had ever been
reviewed.  For example, one lender in the Los Angeles District Office
had become a regular lender in 1980 and a preferred lender in 1987
and had never been reviewed by SBA.  Another lender in the Kansas
City District was certified over 29 years ago, but there was no
documentation to indicate that it had ever been reviewed.  The
records at the 5 district offices also indicated that, of 147 lenders
that entered the program between October 1, 1992, and September 30,
1996, only 3 were reviewed. 

Our analysis of the files did not indicate that any specific types of
lenders- -regular, certified or preferred- -received special emphasis
in the review process.  Table 2 shows the lenders reviewed in the
past 5 years by the type of lender for each district. 



                                Table 2
                
                 Lenders' Reviews by Type for Selected
                               Districts

                               Number of lenders reviewed since 1993-
                                                1997
                              ----------------------------------------
                               Preferred     Certified      Regular
                              ------------  ------------  ------------
                                 Reviewed/     Reviewed/     Reviewed/
District                             Total         Total         Total
----------------------------  ------------  ------------  ------------
Kansas City, MO                       1/11           0/8         0/281
Los Angeles, CA                       0/53          0/19         0/127
Richmond, VA                          2/16           0/6         0/169
Sacramento, CA                         1/7           0/5          0/31
San Francisco, CA                    11/18          9/11         10/50
----------------------------------------------------------------------
Source:  GAO analysis of SBA files. 

SBA's procedures state that reviews can be waived but that this
waiver privilege should be used only when workload priorities
preclude conducting a review.  During the last 5 years, three of the
five districts we had visited waived some field reviews.  According
to file documentation, the Kansas City District Office waived 182
reviews because of higher priority work, and the Los Angeles District
Office waived 147 reviews because staff were not available.  The San
Francisco district office waived 68 reviews for a number of reasons,
including that the balances due on lenders' loans outstanding were
low; lenders' offices were not located in the district; and the
quality of lenders' 7(a) loan portfolios was considered good by the
district staff. 

District officials also told us that, although on-site reviews are
not regularly performed, they do maintain contact with lenders
through a number of mechanisms:  telephone contact; periodic training
seminars; and SBA visits to lenders to discuss the loan program,
changes in SBA procedures, or a specific loan.  For example, the
Richmond District Office made 15 visits to lenders in 1997 to explain
changes in SBA's liquidation procedures; the Kansas City District
Office's records showed that staff made 25 visits to 22 lenders in
the last 5 years, primarily to promote the 7(a) loan program. 

When SBA conducted on-site reviews, SBA's checklist was used by staff
and they found deficiencies in lenders' compliance with SBA's loan
standards.  These deficiencies included inadequate loan collateral,
loans written with maximum maturities with no documentation as to why
lesser maturities would not be proper, and loans lacking
documentation that credit was not otherwise available to borrowers. 


--------------------
\2 SBA's policy required annual on-site reviews of lenders having
more than three outstanding loans.  We could not determine from the
district offices' files which lenders met this criterion and should
have been reviewed. 


      FACTORS AFFECTING OVERSIGHT
      OPERATIONS
---------------------------------------------------------- Letter :3.1

SBA district directors told us that staff downsizing had made it
difficult to conduct on-site reviews of lenders.  In the five
districts we reviewed, increases in the number of loan approvals
ranged from 24 to 255 percent from the beginning of fiscal year 1994
to the end of fiscal year 1997.  During the same period, the
Sacramento and San Francisco districts had staffing increases, while
the other three districts experienced staff reductions.  In Los
Angeles, loan approvals increased from 973 to 2,073, while staff size
decreased from 49 to 40. 

In addition, the district directors said that the agency's emphasis
on promoting the growth of small businesses and increasing the number
of loans to groups that have been underserved by the private
marketplace has resulted in less emphasis on oversight issues.  The
district offices are responsible for both promoting the interests of
small businesses and, at the same time, conducting oversight of
participating lenders to ensure the integrity of the program. 
District officials told us that they find it difficult to maintain a
balance between these objectives because they are given explicit
annual goals by SBA headquarters for increasing the number of loans
to categories of the population that have been underserved by the
marketplace. 

SBA officials told us that SBA has annual goals related to loan
performance.  In contrast with goals related to loan volume and
program promotion, loan performance goals may not measure the
effectiveness of SBA oversight activities for two basic reasons. 
First, most loan defaults do not occur during the year a loan is
originated.  Second, and more importantly, for any one district
office, economic conditions in the district have a major impact on
default rates from previously originated loans, even in districts
where SBA may perform effective oversight. 

We also noted that neither SBA's headquarters program office nor its
Office of Field Operations monitors field offices' compliance with
the lender review requirement or requires district offices to provide
headquarters with information on the extent to which they are doing
lender reviews and on the results of lender reviews.  In addition,
SBA does not have a mechanism to evaluate how well reviews are done. 
However, SBA is piloting a Quality Service Review program that
assesses field office activities, including whether lender reviews
are being performed.  In 1997, when SBA began the program, it
reviewed the operations of 13 district offices and plans to conduct
20 reviews in 1998.  The objective of the reviews is to ensure that
critical program risks areas are reviewed; employees are motivated,
informed, and treated fairly; customers are satisfied with the
delivery of SBA's programs; and SBA's relationships with its partners
are healthy.  SBA plans to review each district office's operations
every 3 years. 


      SBA IS PLANNING ACTIONS TO
      IMPROVE LENDER OVERSIGHT
---------------------------------------------------------- Letter :3.2

SBA officials told us that they recognize the need to adequately
oversee lender compliance with its standards, are in the process of
evaluating the oversight function, and will decide what changes are
needed in the agency's oversight of 7(a) lenders.  According to SBA's
Five-Year Strategic Plan (fiscal year 1998- -fiscal year 2002), dated
September 30, 1997, SBA has a fiduciary responsibility to monitor the
performance of lenders and to take steps against those lenders who
are not performing in a manner consistent with the laws and
regulations governing SBA's programs.  In this regard, SBA plans,
among other things, to develop a protocol for lender oversight that
begins with the gathering and analysis of performance data from
participating lenders and to establish loan program credit standards,
as well as mission standards to measure lender performance. 

One element of SBA's oversight plans is the development of a loan
monitoring system to support off-site monitoring of lenders.  The
system is also intended to help support SBA's oversight of increased
lender responsibility for servicing loans.  In a June 27, 1997,
report\3

on SBA's efforts to develop the system and a congressionally mandated
risk management data base, we concluded that SBA had not performed
the essential planning needed to provide a basis for Congress to fund
the development of the loan monitoring system.  SBA disagreed with
our recommendation to delay funding the system's development until
the necessary planning was completed.  However, Congress, in the
Small Business Reauthorization Act of 1997,\4 mandated that SBA
complete the planning steps and required it to report on its progress
by June 1998.  The act also requires us to evaluate SBA's report for
compliance with the mandate. 


--------------------
\3 Small Business Administration:  Better Planning and Controls
Needed for Information Systems (GAO/AIMD-97-94, June 27, 1997). 

\4 P.L.  105-135, 111 Stat.  2592 (1997). 


   SBA IS IMPLEMENTING A PREFERRED
   LENDER REVIEW PROGRAM
------------------------------------------------------------ Letter :4

Prior to the enactment of SBPIA, SBA decided to consolidate its
processes for managing the preferred lender program.  SBPIA required
SBA to implement a program to provide a review, at least annually, of
each lender participating in the Preferred Lenders Program.  The
requirement was based on this Committee's concern about SBA's past
failure to provide timely and regular reviews of lenders
participating in the 7(a) loan program. 

In April 1995, SBA consolidated the processes for preferred lender
certification, approval for geographic expansion, and renewal of
preferred lender status in its Sacramento Processing Center.  In
October 1995, SBA decided to develop a centralized preferred lender
review process in its Kansas City, Missouri, Review Branch.  In
addition, SBA has incorporated the preferred lender oversight
requirements that were included in SBPIA, which became effective on
September 30, 1996.  The act required SBA to establish a preferred
lender review program not later than 90 days after the act became
law.  The review program is to include annual or more frequent
assessments of the participation of lenders in the program, including
defaults, loans, and the recoveries of loans that lenders make under
the program. 

The stated objectives of SBA's new preferred lender review program
are to determine (1) whether preferred lenders are processing,
servicing, and liquidating loans according to SBA standards; and (2)
whether such lenders should continue to participate in the preferred
lender program.  The review requirements are to be more extensive
than those governing on-site reviews of regular and certified
lenders.  According to SBA's Preferred Lender Program review manual,
reviews are to focus on a sample of loans approved by lenders and a
sample of loans for which lenders have taken servicing or liquidation
actions.  The reviews are also to include an assessment of lenders'
loan policies and procedures, their internal routine and controls,
and any responses to previous reviews. 

The preferred lender reviews are to be conducted by a review team
comprising an SBA Review Branch representative and one or more
contract reviewers.  SBA contracted with a private sector partner to
provide support for the review and oversight activities.  Contract
reviewers are to conduct the reviews of lenders' SBA loans under the
supervision of a SBA representative.  The review team is to be
responsible for reviewing lenders' loan policies and practices, their
internal routine and controls, and any responses to previous reviews. 
Contractor costs are to be reimbursed directly to the contractor
through a fee assessed to preferred lenders when they are reviewed. 
The fees are to be based on the number of preferred lender program
loan approvals and are projected to range between $1,800 and $23,000. 
SBA plans to review, by the end of fiscal year 1998, all preferred
lenders that had originated at least one loan under the program in
fiscal year 1997.  These reviews are to be done either on-site or
off-site, depending on the loan volume of the lenders. 

As of the end of March 1998, SBA staff conducted nine preliminary
reviews to test the review methodology and determine the length of
time needed to conduct on-site reviews.  In commenting on a draft of
this report, SBA stated that the reviews are underway with 60
off-site reviews started in early May and on-site reviews to commence
in mid-May.  SBA's Review Branch plans to conduct reviews of each
lender institution by the end of fiscal year 1998 as required by
SBPIA.  The preferred lender review program may offer a more
comprehensive and systematic approach to assessing lender practices. 
However, it is too early to tell how successful it will be until
reviews are conducted and information on the program is available. 


   LENDER OVERSIGHT AND ECONOMIC
   CONDITIONS AFFECT FINANCIAL
   RISKS
------------------------------------------------------------ Letter :5

On-site lender reviews are an essential element to ensure that
participating SBA 7(a) lenders are complying with SBA' loan standards
and thereby mitigating risks to SBA.  When a financial institution
provides a loan to a borrower, credit risk (i.e., the possibility of
financial loss resulting from default by the borrower) is present
over the life of the loan.  In a 1997 study conducted under contract
to SBA, defaults on 7(a) loans were found to occur most often 3 to 5
years after origination.\5 Therefore, default rates observed through
off-site monitoring during a current period of time do not indicate
whether a lender is currently following prudent lending practices. 
In addition, economic and business conditions affecting small
business borrowers affect loan performance on loans made by all
lenders, including those that follow more prudent lending practices. 
The SBA loan performance study found that default rates for 7(a)
loans originated in the 1986 through 1990 time period were in the
20-percent range.  According to the study, default rates have
declined since 1990.  The decline is consistent with the strong
performance of the national economy over the past 5 to 6 years.\6 In
the future, if economic conditions were to become less favorable,
such conditions could likely place upward pressure on 7(a) default
rates. 

Although lenders who follow prudent practices for originating and
servicing 7(a) loans can experience defaults, such risks to SBA would
be expected to be lower than risks associated with lenders following
less prudent practices.  In order to monitor lenders without
conducting on-site reviews, SBA has tended to rely on information
from individual 7(a) loans provided at the time of application and at
the time of liquidation on loans that default.  These data do not
provide systematic information on the extent to which each lender
follows prudent lending practices for two basic reasons:  (1) even
the most prudent lenders make loans that default, and (2) prudent
lending requires observation of lender practices and collecting
information over the life of performing and defaulted loans. 
Furthermore, over time, SBA has delegated greater authority and
responsibility to all lenders and a larger proportion of lenders have
become preferred lenders. 

Careful oversight by the institution's board, stockholders, and
regulators can help ensure prudent lending practices.  Many 7(a)
lenders are regulated by financial institution regulators, such as
the Office of the Comptroller of the Currency (OCC), Office of Thrift
Supervision (OTS), Federal Deposit Insurance Corporation (FDIC), and
Federal Reserve Board (FRB).  These regulators provide risk-focused
supervision to help ensure that financial institutions under their
supervision have sufficient controls for risk management as well as
other practices that foster safe and sound operations.  In addition,
these regulators have a continuing examination presence that helps
them monitor changes in the institution's lending practices and scope
future examinations to emphasize activities that may entail higher
risks. 

Although financial institution regulators help ensure safe and sound
operations, their oversight does not necessarily ensure that 7(a)
portfolios are managed prudently.  According to an OCC official, in
providing risk-focused supervision, examiners would not necessarily
focus on a regulated institution's 7(a) portfolio unless it were
identified as endangering the overall soundness of the financial
institution.  Therefore, from SBA's perspective, lenders subject to
such regulation still require effective SBA oversight. 

Perhaps of greater importance, the SBLCs licensed by SBA are
generally not subject to oversight by financial institution
regulators.\7 SBLCs are nondepository lending institutions that are
licensed by SBA.  To satisfy SBA's supervision and examination
requirement, SBLCs are subject to direct supervision and examination
by SBA.  SBA regulations provide that SBLCs are subject to periodic
audits by SBA's Inspector General and that SBA will assess the cost
of the audit based on asset size against the SBLC except for the
first audit.\8 In the last 5 years, SBA's Inspector General conducted
audits at three SBLCs.  Audits at two of the SBLCs involved a review
of their lending practices for compliance with SBA's requirements. 
The audit at one of these SBLCs concluded that the SBLC was in
compliance with applicable SBA requirements.  The second audit
concluded that the SBLC's originating and servicing of SBA loans
needed improvement, and some required internal controls had not been
implemented.  The third audit was requested by an SBA district office
and was limited to a review of three guaranteed loans.  The audit
concluded that one of the three loans did not qualify for the
guarantee, and interest collected by the lender should have been
returned to SBA. 

In the future, it is possible that economic conditions would become
less favorable and that such conditions could place upward pressure
on 7(a) default rates.  SBA's knowledge of how prudently each
lender's 7(a) portfolio is managed and how the portfolio would
perform under less favorable economic conditions is more limited
without on-site reviews.  In addition, effective oversight of SBLCs
could help SBA assess how prudently their overall operations are
managed and how these institutions would perform under less favorable
economic conditions. 


--------------------
\5 Walker & Company, Independent Study of 7(a) and 504 Loan Programs
for the Eleven Cohort Years Ended September 30, 1996 (June 16, 1997). 

\6 Likewise, the number of problem financial institutions insured by
the Federal Deposit Insurance Corporation (FDIC) and failures of
those institutions have both declined over the past 6 years,
consistent with the strong performance of the national economy.  In
1991, FDIC defined 1,426 institutions with assets of $819 billion as
problem institutions; in 1997, the respective measures were 92
institutions with assets of $7 billion.  In 1991, 271 FDIC-insured
financial institutions with assets of $142 billion failed; in 1997,
the respective measures were 1 institution with assets of $27
million. 

\7 To the extent that any of these SBLCs are, or become, subsidiaries
of bank holding companies, they could be subject to FRB oversight. 
We did not analyze the implications of such potential oversight
during the course of this assignment. 

\8 13 C.F.R.120.475. 


   CONCLUSIONS
------------------------------------------------------------ Letter :6

In the five district offices included in our review, SBA had not
conducted the regular, periodic reviews of lender compliance with its
7(a) loan standards as required under its operating procedures. 
Without such systematic oversight, SBA cannot ensure that
participating lenders are complying with its loan standards and
thereby mitigating risks to the agency.  In addition, SBA does not
have clear organizational responsibilities and mechanisms in place to
ensure that information on the lender review process is collected,
reported, and analyzed.  Without such information, SBA cannot measure
and monitor the impact of its oversight of lenders' compliance with
its loan policies and procedures. 

As of the end of March 1998, SBA was in the process of implementing
its centralized review program for preferred lenders, but it had not
yet conducted any reviews.  It had developed and tested a review
methodology and is planning to conduct annual reviews of preferred
lenders as required by SBPIA.  In commenting on a draft of this
report, SBA stated that the planned reviews were under way.  SBA's
preferred lender review program should provide improved oversight of
preferred lender practices. 

The audits conducted at three SBLCs in the last 5 years do not appear
to satisfy SBA's audit frequency and continuing supervision and
examination requirement.  Because these SBLCs are not subject to
supervision or examination by a financial institution regulator, we
believe oversight by SBA is especially important. 

SBA officials told us that they recognize the need to adequately
oversee lenders' compliance with its 7(a) loan standards and are
planning actions to improve oversight of lenders' practices; however;
it is too early to tell how successful the initiatives will be. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :7

We recommend that the Administrator of the Small Business
Administration ensure that the required 7(a) lender oversight reviews
are conducted.  In this regard, the Administrator should establish
organizational responsibilities and a mechanism for ensuring that
information on the lender review process is collected, reported, and
analyzed.  This information should be useful in assessing the results
of the review process and determining whether additional initiatives
may be needed. 

We also recommend that the Administrator develop and implement a
mechanism to satisfy its supervision and examination function for
SBLCs. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

We requested comments on a draft of this report from SBA, which
provided written comments that are reproduced in appendix I.  SBA's
comments did not specifically address our recommendations, but it
stated that the funds it has requested for loan system modernization
are essential for it to institute the oversight we endorse in the
report.  In general, SBA also expressed a concern that the report may
give an incomplete picture of its oversight activities. 

SBA stated that it was important to highlight the improvement in the
credit quality of its loan portfolio.  It stated that, although the
excellent economy has contributed to this improvement, SBA believed
that its recent changes to the 7(a) program have mitigated the degree
of vulnerability to an economic downturn.  These changes included
increasing lenders' economic interest in loans and revising program
operating procedures.  We acknowledged in the report that SBA's
default rates have declined, but it was beyond our scope either to
determine how much of this decline is based on the state of the
economy or on SBA's practices or to project how its portfolio would
likely perform under less favorable economic conditions. 

SBA commented that the results of our review at 5 of its district
offices are not necessarily representative of activities throughout
the 69 SBA district offices.  We visited the Los Angeles and San
Francisco, California, and Kansas City, Missouri, district offices
because they are three of the largest districts in terms of the
number of loans outstanding.  We also visited a medium and a smaller
office- -Sacramento, California, and Richmond, Virginia,
respectively.  We do not know how representative these offices are. 
Because district offices are not required to report on their lender
oversight activities, SBA's lack of information regarding on-site
reviews makes it difiicult to determine whether the districts we
visited were representative or not. 

SBA commented that although it has placed a high priority on
improving oversight, on-site lender reviews have a limited role.  SBA
stated that other than on-site reviews, it performs oversight in a
number of other ways, which it states provide a systematic means of
mitigating risk imposed as a result of lenders' decisions.  That is,
it verifies eligibility in all loan decisions, considers lender
performance in decisions to relicense certified and preferred
lenders, and reviews loans when a lender requests an SBA purchase. 
SBA said that it is also modernizing its loan system as part of its
efforts to improve its monitoring of individual loans and individual
lenders.  We agree that these activities, including off-site
monitoring, provide a measure of oversight; however, they do not
provide the type of systematic assessment of a lender's practices
that periodic on-site reviews provide.  Our experience in evaluating
financial institution regulators indicates that off-site monitoring
is helpful when it is used to perform risk assessments to target
on-site reviews but it is not an effective substitute for such
reviews.  In addition, we are reporting on SBA's noncompliance with
its own requirement for lender oversight reviews.  SBA's operating
procedures state that on-site lender reviews are necessary to
maintain the integrity of its loan programs and are a critical
component of its oversight requirement. 

SBA said it was also working with banking regulatory agencies, who
examine the vast majority of its lenders, to explore opportunities
for partnership in regulation and oversight and that they play an
important role in examining its lenders' overall performance in
making creditworthy loans.  As the report states, although financial
institution regulators help ensure lenders' safe and sound
operations, their oversight does not necessarily ensure that 7(a)
portfolios are managed prudently.  In addition, it should be noted
that SBA currently has no access to the findings of examinations
conducted by bank regulators. 

With regard to SBLCs, which are not subject to supervision and
examination by a state or federal financial regulatory authority, SBA
said that in addition to specific audits by its Inspector General,
oversight is provided in a number of ways, including a requirement
that SBLCs submit annual audited financial statements.  We agree that
audited financial statements can help examiners focus on specific
aspects of a financial institution in its on-site examinations. 
However, the purposes of external audits and safety and soundness
examinations differ and they are guided by different standards and
methodologies.  For example, federal financial regulators require
examiners to evaluate the adequacy of methodologies used by financial
institution auditors to estimate loan loss reserves. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :9

As requested by the Chairman of the Senate Committee on Small
Business, our objectives were to determine (1) how SBA conducts
on-site reviews to monitor participating lenders' compliance with its
7(a) loan program policies and procedures, and (2) what actions SBA
is taking to comply with the preferred lender oversight provisions of
the Small Business Programs Improvement Act of 1996. 

To determine how SBA has assessed whether lenders are managing loans
according to its standards, we examined SBA's standard operating
procedures relating to reviews of regular and certified lenders and
its manual for examining preferred lenders.  We reviewed other
related guidance pertaining to the 7(a) loan program and interviewed
staff from SBA Headquarters, Office of Inspector General, and 5 of
the 69 SBA District Offices.  We also interviewed staff from the
Sacramento Loan Processing Center in Sacramento, California; and the
Preferred Lender Review Branch in Kansas City, Missouri.  Finally, to
obtain a perspective on the extent to which SBA field offices have
conducted assessments of lender compliance, we reviewed lender files
from the five SBA district offices.  We visited the Los Angeles and
San Francisco, California; and Kansas City, Missouri, district
offices because they are three of the largest districts in terms of
the number of loans outstanding.  We also visited a medium and a
smaller size office- -the Sacramento, California; and Richmond,
Virginia, offices, respectively.  We also selected these district
offices to visit to help conserve travel funds. 

To determine SBA's compliance with the preferred lender oversight
requirements of SBPIA, we reviewed documentation relating to SBA's
implementation of a centralized review program for preferred lenders. 
We discussed the program with staff from SBA headquarters and the
Preferred Lender Review Branch in Kansas City.  We also reviewed
reports of reviews of preferred lenders that were done on a test
basis by the Kansas City Review Branch. 

We conducted our work in Washington, D.C.; Los Angeles, Sacramento,
and San Francisco, California; Kansas City, Missouri; and Richmond,
Virginia, between September 1997 and March 1998 in accordance with
generally accepted government auditing standards. 

As arranged with your office, unless you publicly announce the
contents of this letter report earlier, we plan no further
distribution until 14 days after its issue date.  At that time, we
will send copies of this report to the Ranking Minority Member of the
Committee on Small Business; the Chairmen and Ranking Minority
Members of other interested congressional committees; the
Administrator, Small Business Administration; the Director, Office of
Management and Budget; and other interested parties.  Copies will
also be made available to others upon request. 

Please contact me or Bill Shear at (202) 512-8678 if you or your
staff have any questions.  Major contributors to this report are
listed in appendix II. 

Sincerely yours,

Thomas J.  McCool
Director, Financial Institutions
 and Markets Issues




(See figure in printed edition.)Appendix I
COMMENTS FROM THE SMALL BUSINESS
ADMINISTRATION
============================================================== Letter 



(See figure in printed edition.)



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

GENERAL GOVERNMENT DIVISION

William B.  Shear, Project Director
Lamont J.  Kincaid, Project Manager
John J Strauss, Deputy Project Manager
Melissa Duvall, Intern

OFFICE OF THE GENERALCOUNSEL

Rosemary Healy, Senior Attorney

SAN FRANCISCO FIELD OFFICE

Bruce K.  Engle, Evaluator


*** End of document. ***