I recently read a Wall Street Journal commentary that claimed the Federal Reserve’s failure to understand what caused the 2007-08 financial crisis ushered in policies that have slowed growth we see today.
The author, Peter Wallison, a senior fellow at the American Enterprise Institute, states that it was the sub-prime mortgage backed security market that caused the crisis, but the new legislation, the 2010 Dodd-Frank Act, had a much broader mandate to closing “the gaps in financial regulation.” The impact of the Dodd-Frank Act has been most acutely felt by small banks, who have historically been the largest providers of capital to small businesses, due to higher regulatory costs and higher underwriting standards on par with large banks who historically lend to more financially sound large companies.
A regular occurrence
As a business owner, a small business private equity investor and an advocate for entrepreneurship, I have seen the challenges small businesses face in receiving credit from banks. Most banking officers will concede that their hands are tied by bank industry regulation, citing the Dodd-Frank Act, in making underwriting decisions.
For those of us who have the good fortune of working with entrepreneurs and small business owners, it is easy to agree with the causal relationship offered by Wallison because we see it regularly.
I do want to discuss, however, the newly approved crowdfunding rules. It is ironic that the government has stepped in to the financial markets in two different arenas, banking regulation and securities law, to correct what they perceive to be problems with existing regulation.
To me, the consequences have been that small businesses that used to rely on small bank loans for funding, which are relatively low cost in comparison to the high cost of crowdfunding, included sharing ownership of your business with third-party investors. There is no higher cost of capital than sharing ownership.
Reconsider the approach
The government has effectively made small business ownership more difficult and less rewarding when it changed the cost of capital paradigm by shifting small business from small banks to small equity investors using crowdfunding.
Small banks generally will lend to small business at or around the “prime rate” which is a published benchmark rate widely used in the banking industry at a 3.25 percent annual rate today, plus 1 percent or 2 percent. In private equity investments (crowdfunding), investors return expectations are typically more than 30 percent annual rate.
This cost of capital is a major barrier in a small business’s ability to add capacity and create new jobs that will get America growing at a more robust rate and get wage growth out of neutral gear.
I believe that the financial services industry needs to have oversight, and I also believe that small businesses need to have credit to grow, so my comments are not a categorical rejection of government’s important role in transparency and fairness.
I am a strong advocate for both, but I believe the government needs to reconsider its approach in both the Dodd-Frank Act and new crowdfunding legislation.
Jeffrey Kadlic is co-founder and managing partner of Evolution Capital Partners LLC, a private equity fund investing growth equity nationwide in Second Stage Companies. Jeffrey is an alumnus of Crain’s Forty under 40 and an EY Entrepreneur Of The Year finalist.