Create equity market for small business by having banks form mutual funds.

A nat Bird's commentary on July 8, asserting that banks are looking for sound small-business loans and that government-sponsored securitization will not benefit banks, was on the mark. The situation begs for a next step, however.

As Ms. Bird observed, "Small businesses do not have ready access to the capital markets." And it is the lack of access to equity markets that makes many small businesses unable to obtain credit. They simply are inadequately capitalized to justify bank credit.

One way to rectify this situation is to provide government-subsidized credit to the noncreditworthy, either directly or through guarantees of securitized pools of loans.

Good News, Bad News

This would stimulate business activity enormously but probably would ultimately lead to significant losses for the government-sponsored entity that enhanced the borrower's credit. That would be a legitimate strategy, but one for which future generations are unlikely to thank us.

More productive in the long term would be enabling private parties to create a market for small businesses' equity securities.

I believe there is a natural way to create a equity market for small businesses by using the same banks that lend to them.

Market Obstacles

Factors preventing small businesses from tapping the equity markets are their inability to provide information efficiently and a lack of potential liquidity.

The size of an offering is not sufficient either to warrant the cost of providing and analyzing the necessary information or to provide liquidity to the purchasers. Nor can the entrepreneur afford the time necessary to seek out private venture money, even if it might be available.

I do not advocate that the banks themselves invest in small-business equity. They need more-liquid assets that can be valued correctly.

Individuals and pension plans, however, do have an appetite for long-term investments that are not immediately liquid or subject to current valuation, so long as those investments are sufficiently diversified.

But individuals and small pension plans don't have the time or the expertise to evaluate small businesses and to monitor performance and protect against fraud and illegal self-dealing.

Thus we should put banks, which have the necessary expertise, and investors together by encouraging banks to form mutual funds that invest in small businesses' equity securities.

Ideally, community banks would concentrate their small-business mutual funds in local companies. This would be both sensible in terms of their resources and good marketing -- in that it would allow customers to invest in their local economies. Banks with greater geographic scope logically could manage investments in companies in larger geographic areas.

Naturally, there are some technical, legal, and marketing issues that would have to be dealt with.

These mutual funds should be exempted from Glass-Steagall Act restrictions; the Investment Company Act's pricing and liquidity rules would have to be modified to take account of the illiquidity of the underlying securities; and perhaps some form of tax benefit or deferral should be provided to the investors.

In addition, the natural issue of potential conflicts of interests of the local bank as manager of the mutual fund, lender, and depository would have to be worked out. And there would have to be mechanisms to provide eventual liquidity to the investing mutual funds and to their stockholders.

An Ideal New Investment

The basic point is that access to capital markets has permitted American companies to grow and flourish. There is tremendous liquidity in our capital markets in general, and this liquidity is seeking new productive forms of investment.

The small company, in the form of a diversified portfolio, is an ideal new investment. It would have good potential for long-term returns and would spur the economy. Interestingly, community banks are the institutions in the best position to create these new entities.

Mr. Lowy, a partner in the New York law firm of Lowy & Tallackson, is the author of "High Rollers: Inside the Savings and Loan Debacle."

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