Loan guarantee programs may not be the best way to finance new businesses, writes Wenli Li of the Federal Reserve Bank of Richmond.

Ms. Li compares direct government lending, outright grants, and loan guarantees. She finds that direct lending ensures that cash-poor entrepreneurs proceed with viable projects. Grants encourage entrepreneurship but attract the lowest quality projects, she writes.

Guarantee programs, such as those operated by the Small Business Administration, attract relatively riskier businesses - with fewer assets - than direct loan programs, she finds. This means loan guarantee programs are more likely to encourage projects that will eventually go bankrupt, she writes.

Despite the benefits of direct lending and grants, government policy favors loan guarantees. Ms. Li says this may be because government budget rules make loan guarantee programs less expensive to operate than loan or grant programs. Also, the same amount of money can fund far more loan guarantees than loans or grants, she writes. "This more equitable distribution of benefits perhaps appeals to the public's sense of fairness," she writes.

For a copy of "Government Loan Guarantee Programs," call 804-697-8111 or visit www.rich.frb.org/eq.

Small businesses should not fear consolidation of the banking industry. That is the conclusion of Loretta J. Mester, an economist at the Federal Reserve Bank of Philadelphia, who studied the relationship between small companies and banks.

Ms. Mester finds that businesses with hard-to-evaluate financial conditions will be drawn to community banks, which will continue to offer flexible loan terms. These small companies, however, will pay above-market rates for credit, she says.

"Small banks should retain their niche in relationship lending," she writes. "But that niche is likely to be smaller than it is today."

Larger companies with easy-to-evaluate financial conditions will increasingly turn to big banks, which use credit scoring and automated loan applications to keep loan rates down, she says.

For a copy of "Bank Industry Consolidation: What's a Small Business to Do?" call 215-574-4197.

Credit derivatives offer banks a low-cost alternative for managing risk, writes James T. Moser, an economics adviser to the Federal Reserve Bank of Chicago.

Mr. Moser compares credit derivatives to loan-loss provisioning and finds that their risk-reduction benefits are about equal.

Credit derivatives, however, may also be used to reduce a bank's capital requirements, a cost saving not available with traditional loan-loss provisioning, he writes.

For a copy of "Credit Derivatives: Just-in-Time Provisioning for Loan Losses," call 312-322-5111 or visit www.frbchi.org.

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