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Highlights

The Small Business Administration (SBA) guarantees individual loans that lenders originate. The agency uses its Loan and Lender Monitoring System (L/LMS) to assess the individual risk of each loan, and SBA's contractor developed a lender risk rating system based on L/LMS data. However, questions have been raised about the extent to which SBA has used its lender risk rating system to improve its oversight of lenders. The Government Accountability Office (GAO) was asked to examine (1) how SBA's risk rating system compares with those used by federal financial regulators and lenders and the system's usefulness for predicting lender performance and (2) how SBA uses the lender risk rating system in its lender oversight activities. To meet these objectives, GAO reviewed SBA documents; interviewed officials from three federal financial regulators and 10 large SBA lenders; analyzed SBA loan data; and interviewed SBA officials.

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Recommendations

Recommendations for Executive Action

Agency Affected Recommendation Status
Small Business Administration 1. To ensure that the lender risk rating system effectively evaluates risk, when validating the system and undertaking any redevelopment efforts, the Administrator of the Small Business Administration (SBA) should ensure that SBA's contractor follows sound model validation practices. These practices should include (1) testing of the lender risk rating system data, processes, and results, including a routine reassessment of which factors are the most predictive of lender performance; (2) utilizing an independent party to conduct validations; and (3) maintaining complete documentation of the validation process and results.
Closed - Implemented
In 2013, SBA completed a redevelopment of its lender risk rating system. Consistent with our recommendation, SBA's contractor used sound validation practices. For example, the contractor validated the new models on two separate SBA loan pools that were not a part of the original pool utilized to develop the models. In addition, during the development and validation process the contractor considered numerous variables and identified those that were the most predictive of lender performance. Finally, the contractor documented the results of the initial validation, and SBA's contract calls for independent annual validations of the model going forward.
Small Business Administration 2. To ensure that the lender risk rating system effectively evaluates risk, when validating the system and undertaking any redevelopment efforts, the Administrator should use SBA's own data to assess how well the lender risk ratings predict individual lender performance.
Closed - Implemented
In 2013, SBA completed a redevelopment of its lender risk rating system. When validating the new models, SBA's contractor used two separate SBA loan pools that were not a part of the original pool utilized to develop the models. The models performed well on both samples. In addition, consistent with our recommendation, SBA has completed its own assessments of how well the lender risk ratings predict individual lender performance. For example, SBA used 2013 and 2014 data to complete analyses showing how the lender risk ratings for 7(a) and 504 lenders correlated with loan performance.
Small Business Administration 3. To make better use of the lender risk rating system in SBA's oversight of lenders, the Administrator should develop a strategy for targeting lenders for on-site reviews that relies more on SBA's lender risk ratings.
Closed - Implemented
Since our report, SBA has revised its procedures for conducting risk-based reviews of lenders. Consistent with our recommendation, one change that the agency made was to rely more on its lender risk ratings when targeting lenders for review. For example, lender risk ratings were one of the primary criteria used to select 7(a) lenders for review in fiscal year 2014. Similarly, lender risk ratings were one of the criteria used to select certified development companies for review under the 504 program.
Small Business Administration 4. To make better use of the lender risk rating system in SBA's oversight of lenders, the Administrator should consider revising SBA policies and procedures for conducting on-site reviews. These revised policies and procedures could require staff to (1) use lender risk ratings to tailor the scope of file reviews performed during on-site reviews to areas that pose the greatest risk, (2) incorporate an assessment of lenders' credit decisions in file reviews, and (3) use the results of expanded file reviews to identify information, such as emerging lending trends, that could be incorporated into its lender risk rating system.
Closed - Implemented
In 2013, SBA began revising its procedures for conducting reviews of lenders, now known as risk-based reviews. Specifically, consistent with our recommendation, SBA developed a risk measurement methodology and rating guide for 7(a) lenders and a separate methodology and rating guide for the certified development companies (CDC) that issue 504 loans. PARRiS is the acronym used to describe the specific risk areas or components that SBA reviews for 7(a) lenders. The components are: Performance, Asset Management, Regulatory Compliance, Risk Management, and Special Items. SMART is the acronym covering the specific risk areas or components that SBA reviews for CDCs: Solvency and Financial Condition, Management and Governance, Asset Quality and Servicing, Regulatory Compliance, and Technical Issues and Mission. Each PARRiS and SMART component generally has three metrics that are compared to benchmarks and scored. One of the metrics considered for both 7(a) lenders and CDCs is the lender risk rating. Those lenders with composite risk ratings above an established threshold will undergo a targeted review specifically focused on the areas of risk or a full review if risk is potentially more pervasive. According to SBA, the new risk-based reviews also include the review of a judgmental sample of loans targeting specific risk characteristics.

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