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‘Backing business’ is meaningless without the cash

Sam Gyimah MP

Introduction 

Finance oils the wheels of business. Without finance, innovative new ideas can never get off the ground and existing businesses cannot expand to create jobs or invest in better technology and processes to improve productivity. Whether it is the established industrial firm looking for a bank loan to open a new factory, or the internet-startup seeking an initial investment from friends and family, our economic recovery relies upon good businesses being able to access the finance they need.

Yet in the aftermath of the financial crisis, British banks continue to have significant exposure to the Eurozone area, and still need to repair their balance sheets. So it is not surprising that the UK has slipped in the World Economic Forum rankings from the top 10 to 50th for securing a loan and to 23rd for attracting business investment. That is why I called for an active government strategy that looks Beyond the Banks for solutions to our lending drought, in a report I co-authored with NESTA.   

Of course risky early stage ventures, where the investor stands to lose everything if the project is unsuccessful, require equity finance. Established businesses with revenues, cash flows and security are more suitable for debt finance. Government policy has to address the needs of businesses at all stages of development.

The Government gets this. The strict and complicated rules around the Enterprise Investment Scheme, which allows early stage businesses to raise money from friends and family, have been relaxed (although more could be done). The £20 billion National Loan Guarantee Scheme, launched as part of the Credit Easing plan, should help businesses refresh outstanding loans at a lower cost. And additional measures focusing on employee management incentives should help businesses to attract and retain talent. These measures are all a nod in the right direction towards support entrepreneurship. But backing business is meaningless without the cash.

Four years on from the financial crisis, it is clear that the current institutional framework for lending to businesses is broken and cannot be relied upon to spur our economic recovery. Urgent action is needed to create a new landscape. This means that capital, whether from government or from wealthy individuals, can get into the real economy to support businesses.

The ongoing lending malaise

As most small businesses would acknowledge, getting a loan or an overdraft from a bank in the current environment is not easy. And whilst banks would protest that they are lending to as many businesses as they used to, the statistics tell a different story. From a pre-crisis annual growth rate of 15%, the amount of new lending to small and mid-sized businesses is now contracting at a rate of about 3% per year.[1] The three months to February 2012 saw a further £9bn reduction in business loans. And for businesses that are approved to borrow, the high cost of finance only adds to the frustration of dealing with their banks.

The real long term problem is structural: UK credit markets are highly concentrated and lack diversity.  For firms looking to borrow money, there is often very little choice. The lending landscape is dominated by the big five banks (Royal Bank of Scotland, Lloyds, Barclays, HSBC, Santander), who provide 90% of all business lending, with only one new banking license being granted in the last 150 years. Over 40p in every £1 lent to small businesses comes from Royal Bank of Scotland alone. The importance of diversity and choice in the market cannot be underestimated - as Adam Posen of the MPC has recently argued,[2] one of the big differences between the US and the UK is not the level of stimulus to the economy, but the sheer number of alternative providers of finance – in the US there are over 15,000 debt providers competing to offer businesses a loan, of which approximately half are traditional banks. Moreover, the main debt alternative to bank loans, the corporate bond market, is unusually small in the UK.

Government policy should address both the immediate needs of business and the longer term structural problems of the lending landscape. Three principles should guide our approach:

  1. Limiting government exposure. Policies that involve the government lending money directly or providing a guarantee on borrowing carries a risk that loans will go bad, leaving the government to suffer the losses. As far as possible, direct government exposure should be limited and any risks involved should be borne by the private sector, not the taxpayer. 
  2. Avoiding moral hazard. Offering government loans or guarantees can reduce the incentive for loan providers to thoroughly screen prospective borrowers, safe in the knowledge that the government will ultimately pick up the tab when things go wrong.
  3. Improving the mix of finance. An approach that works for Britain must also improve the range of finance options available to provide greater choice and competition for the benefit of businesses. Competition among providers of finance is beneficial for borrowers, encouraging innovation and better offers.

Any industrial policy that seeks to address the access to finance issues in the UK has to be evaluated through these three filters.

Towards a solution

A state-backed investment bank is not the answer

A British investment bank is often touted as the solution to the lending drought. Citing other developed countries’ examples of state-backed lending institutions, such as Germany’s Kreditanstalt fuer Wiederaufbau (KfW), a fully fledged state bank; the US Small Business Administration (SBA), a government agency providing guarantees on business loans; or Italy’s confidi (credit mutuals), proponents argue that an active industrial policy requires the state to offer direct financial support to suitable businesses. And this, they argue, could be accomplished by acquiring the remaining 17% of RBS not owned by the taxpayer, fully nationalising it and turning it into a state bank, or creating an entirely new entity.

This approach, if it involves risking taxpayer funds, potentially increases the government exposure to the risky banking sector on a long-term basis and could create moral hazard without addressing the big problem in UK credit markets – a lack of diversity of provision.

First, where will the money come from? The taxpayer is already on the hook for the £65 billion it used to bailout RBS and Lloyds, not to mention the billions used to support the banking industry as a whole. It is unlikely that there will be the appetite for injecting further taxpayer funds to start a new bank before we have seen a return on our current investment.

Secondly, any such institution would have to be run on a commercial basis to be successful, raising the thorny issue of how to attract and incentivise the best talent without paying competitive bonuses at the taxpayers’ expense (or would the bank be run by civil servants?). To operate effectively the bank would have to be run at arms’ length from politicians and government, but the experience of RBS has shown the difficulty of keeping taxpayer-supported banks out of political discussion.  

The third point is profitability. For many traditional banks, business lending is not a hugely profitable activity (the return on equity is around 6-8%) which is why most businesses will tell you that their bank managers are more interested in selling them higher margin products such as insurance or foreign exchange services, when all they need is a loan. The question this begs is how can a state bank, using a similar business model to the existing banks, offer firms a better deal (short of an indefinite taxpayer subsidy) to plug the lending gap?

It is no surprise that many of the international examples often cited as worthy case studies were created in the immediate post-war period, when the financial firepower was available to embark upon this kind of experiment. Consequently, these institutions have evolved over a number of decades to suit the unique banking systems in which they operate. The US and Germany are characterised by having numerous banks at the level of their individual states, meaning that the scope for a centralised authority to complement these institutions is much greater. The UK banking sector, on the other hand, is characterised by massive concentration without a comparable set of smaller banking institutions, creating a real need for greater diversity of provision. There are no guarantees that transplanting one of these ideas into the UK would work, and even then we should be under no illusions as to the risk that this could involve for the taxpayer. The $400 million dollars loaned by KfW to Lehman Brothers on the day of its collapse offers a case in point.  

This is not to deny that there is scope for government action to create an institution that can invest or lend to businesses. The Business Growth Fund (BGF), the recreation of a hitherto successful state-backed British institution (3i), is a smart way to do it. Funded by the banks, at arms’ length from government, the BGF has offices around the country to make investments of up to £10 million in those fast growing British companies that create 50% of jobs.[3] There is no reason why the BGF cannot be expanded to offer loans alongside equity investment, potentially with Government help to raise capital from the private sector.

The £600 million Big Society Bank, funded from dormant bank accounts and the banks under the Project Merlin agreement, again makes the point: at a time of austerity, an active industrial policy is as much about the creative nous, because there simply isn’t the money to throw at the problem.

7 polices to solve the lending drought: mechanisms to ensure capital gets to real businesses in the real economy

1. Ease the regulatory burden on existing banks

The government can reduce the amount of capital reserves that need to be held against business loans, allowing more loans to be made. There is some precedent for this kind of policy: the Financial Services Authority has already eased the regulations governing banks’ (equity) investments in the Business Growth Fund. This approach also has the advantage of being quick, requiring little more than a regulatory decision. While it is understandable that policymakers will have reservations about proposals that link capital adequacy requirements and the promotion of growth, as a temporary measure this could provide an important boost to business lending.  

2. Make it easier for new banks to enter the market

Since the financial crisis, many of the mid-tier banks that would have serviced smaller businesses have scaled back their operations or left the market. Yet there are a range of new banks that offer innovative ways to service the market, including Handelsbanken, Metro Bank, and Virgin Money. It is striking that in 2010, Metro Bank became the first new institution to gain a UK banking license in 150 years, and only then after an application process that took two years to complete. The Government should look closely at the process of securing a banking license with a view to making it easier for new banks to enter the market.

3. Support for non-bank lending institutions

There is no reason why a loan has to come from a bank. Significant financial firepower has been expended by government on traditional incumbents, but there are a range of non-bank institutions capable of offering finance to business, a prominent example being the UK Companies Financing Fund set up in 2009 by M&G. The £1.2 billion Business Finance Partnership established by the Government to support non-bank lending is a welcome step, and there is scope to do more. Expanding the range of institutions that can benefit from this fund would further encourage diversity and channel funds via institutions unencumbered by the financial crisis – so the money gets into the real economy.  

4. Create a level playing field for disruptive, innovative new players

There are already disruptive new solutions emerging to exploit the power of the internet to process applications faster and serve customers more effectively, such as peer-to-peer lenders like Market Invoice or Funding Circle. Creating the right regulatory environment for these new providers to grow is absolutely vital. As we seek to reform the banking landscape so that no institution is too big to fail, we should be careful that these reforms do not stifle the innovation that allows new lenders to enter the market.

5. Stimulate alternative sources of credit

Despite the relatively small size of the market for small and medium-sized corporate bonds in the UK, it does exist. The London Stock Exchange’s ORB electronic market is increasingly dealing with smaller bond issues from a wider range of businesses (a recent issue for the Places for People housing association raised £140m). Government guarantees could help stimulate retail investor appetite and encourage companies to raise finance via this alternative platform.

6. Align the tax treatment of debt and equity

Risky, early-stage ventures are best financed with equity. Yet our financial system discourages equity investment by providing tax deductions for debt interest payments, but not for the dividends paid to shareholders. As a result, it is little surprise that just 3% of small businesses use equity finance, compared to 55% that use credit cards.[4]

7. Introduce a business finance advice scheme

Most businesses are not fully aware of the support schemes being offered by the government. In fact, few businesses have the time to spend looking at government websites to determine which government policies could help them. For an industrial policy to be successful it has to be accompanied by a substantial marketing campaign, to raise awareness within the business community of government policy and action – an issue touched upon in the Breedon Review.

The last two budgets have shown that the government understands and is willing to support business. But the firestorm from the Eurozone means that we cannot sit back and wait for credit markets to recover and lend to business. Removing all the barriers that stand in the way of diversity of provision and prevent capital getting into the real economy is the important next step.