In an R5 Live interview not so long ago, a business owner in Bristol complained his bank would only lend him money for expansion if he was prepared to put up a personal guarantee. ‘Why,’ he asked, ‘does my bank not believe in my business?’ The answer, of course, was because he did not believe in his business himself. By refusing to put up a personal guarantee, he sent a clear message to his bank he was uncertain of his plan’s prospects.
Similarly, a Midlands-based small printer was recently seeking around £15,000 to upgrade his computers. He was prepared to put up his £150,000 printing machine as collateral against the loan – a not insignificant proposal on his part as this is his business’s single most valuable asset.
But the bank told him it was unable to accept the printer as the asset for an asset-backed finance scheme and so couldn’t help. ‘But’, it said, ‘we can lend you up to £20,000 for a car up to eight years old if you fancy that instead.’
Whether this was a tacit way of saying they would lend against the business owner’s Jaguar instead is still out for debate, but the key point was missed by the business owner: if the loan was called in against the printer, not only was the printer a tricky piece of kit to realise its asset value, it also meant the business was no longer viable and so all other loans were likely to fall over as well.
Access to finance
The small and medium enterprise (SME) sector is one of the most varied and important, but it is also one of the most fragile. Lacking the critical mass and resources of some of their larger peers, SMEs can be more susceptible to economic changes. SMEs highlight economic uncertainty, lack of consumer demand, and fuel costs as three of the four areas of concern for the future. The fourth barrier SMEs cite is access to finance.
My vision for the future of banking is one where businesses can get efficient access to finance and the help offered to them by myriad government schemes. Banks will, of course, try to help businesses understand their requirements to secure loans and advances, and business organisations also provide some help on this point. But, SMEs are a key driver of growth in the UK and their efficient funding is vital to the sector supporting economic recovery. To achieve this we need a banking system which understands business and a business world that is not put off looking for finance.
Currently, the picture on SME lending is unclear. Whilst (in its Voice of Small Business Index Q1 2013) the Federation of Small Businesses (FSB) highlights business loan rates coming down, just 41% of those surveyed were successful in applying for a loan with another 17% waiting for a decision. Indeed, just 20% of those surveyed had made an application for credit. The British Bankers’ Association (BBA), however, reports that typically around 9% of SMEs will have made an application for a loan in the last year.
However, whilst the FSB indicates that nearly half of SMEs applying for credit are unsuccessful, the BBA claims that 71% of businesses are successful in new or renewed loan applications. Indeed, bank chiefs, when asked, will claim that as many as 85% of loan applications are granted.
The truth is there are a number of factors at play. At the most basic level, an SME owner or manager may see the bad headlines and simply not bother to seek finance in the belief that they will be rejected. This is reinforced by the fact some businesses believe a rejection somehow registers on a credit score for the business. This is further compounded by the fact that banks do not necessarily treat a loan enquiry as a formal application and many no-hopers are rejected before a formal application is made, explaining some of the difference between the FSB and BBA surveys.
Crucial to much of the problem is a lack of understanding between the bank and the business manager of what each other does and what each other expects.
Banks, at their most basic level, are simple. They are merely a balance sheet with customers attached to both sides. A customer – depositor – lends money to the bank and in so doing appears as a liability. The bank then seeks to gain a return on the money it has borrowed by lending it out at a higher rate than it has paid the depositor, and that loan to a borrower appears as an asset. The simplicity of this example
is important: for a bank to function in any meaningful way as a bank, it has to lend money.
But, the very act of lending money is a risk. The depositor, notwithstanding the government guarantee of £85,000 for deposits, is at risk of the bank being unable to pay back the loan. In order for the bank to be able to secure deposits, it has to demonstrate that it is lending prudently – even more so now that the banking and regulatory reform is keen to ensure the taxpayer will not stand behind the banks in any future crises.
Despite this, in lending to a business, the bank is writing what amounts to a call option. In the event of a successful loan to a business, the bank wins by getting back what it has loaned plus the agreed rate of interest; but the shareholders of the business win the increase in the value of their equity as a result of the successful use of gearing – a significantly higher return than the bank. Should the business fail, the bank loses its loan and its interest.
The business owner loses their equity, of course, but their upside is significantly greater than the bank’s, whilst the downside is the same. So the bank has to align the owner’s risk with the bank’s risk, and assess all the risks to the loan (economic, skills resource of the business, opportunity, etc.). It is at this point that the mismatch of expectations starts to become apparent, as the stories at the start of this essay demonstrate.
There are other problems banks face outside of those influenced by businesses. The reforms after the banking crises put more pressure on banks to shrink their balance sheets and, with one of the crises banks – the Royal Bank of Scotland (RBS) – holding a significant share of the SME lending market, there is inevitably pressure on the overall picture. Add to that the Basel III requirements, being delivered through CRD IV, that weigh SME lending as the highest level of risk with regard to risk weightings and the pressure is on for SMEs seeking loan financing.
It is no wonder around a third of SMEs do not use formal methods of external financing at all, relying on retained earnings or personal finance to fund investment and growth. The rest, who do seek external
finance, are almost entirely reliant on the banks. Just 2% of SMEs use external equity as a source of finance. The Dragon’s Den, it seems, has not yet sunk into the general psyche of SMEs
One of the issues against equity financing, aside from the perception by a business owner that they will be reducing their control of the business, is that the cost of debt financing carries favourable tax benefits. This in itself creates a perverse incentive that could be reversed through alternative methods of tax treatment of the cost of equity finance.
To help counter the headwinds against SME lending, the government has, since 1981, put in place a series of debt-guarantee schemes of various shapes and sizes, from the Small Firms Loans Guarantee
Scheme to the Enterprise Finance Guarantee in 2009. But, irrespective of who guarantees the loan, and therefore the cost to the SME of the loan, the bank still has to process the application. Cheap loans are oft en accompanied by expensive set-up charges.
There are a number of solutions in place. The current government has provided support for businesses through a number of schemes. But whilst these are admirable in their intention, the sheer number of them (10) can make things confusing: Enterprise Finance Guarantee, Enterprise Capital Funds, Business Angel Co-Investment Fund, Business Finance Partnership, Seed Enterprise Investment Scheme, National Loan Guarantee Scheme, Community Investment Tax Relief, Tackling Late Payment / Promoting Prompt Payment, National Loan Guarantee Scheme, and the Growth Accelerator offer a bewildering array of opportunities for businesses.
The Local Enterprise Partnerships provide a service for businesses to access advice, but the problem still remains: average business owners find themselves in a very lonely place, more oft en than not unaware of the options available to them largely as a result of not being a member of any professional body, such as the FSB.
Despite an array of alternative providers of finance, such as peer-to peer (P2P) lenders and community investment funds, banks dominate the market place in terms of size and brand recognition and are the first stop for a vast majority of businesses seeking finance. Because of this, some argue banks should be seen as utilities and there is a great deal of support for nationalised banks – RBS especially – to be broken up. This is the right course of action.
It should be broken into two parts with one part providing a depository for bad loans, to clear the banking system of bad forbearance, currently under the radar as a result of cheap financing costs; and the second part providing a state-owned utility bank that is a one-stop shop offering a full range of government and commercially driven initiatives and advice for all businesses, especially SMEs and micro businesses.
But whilst a state-owned bank (run on a commercial basis), within the confines of the proposed ring-fence under the Financial Services (Banking Reform) Bill, could be a very efficient quick fix solution, for it to be able to develop a better SME support culture, the ‘New RBS’ must be open to significant competition.
It is vital that an efficient banking market opens up for SMEs. The Financial Services Authority started the process of allowing easier access for new entrant banks and this should be continued by its successors – the Financial Conduct Authority and the Prudential Regulation Authority – with their approvals process. It should certainly be the case that it is not prohibitively expensive to merely open the door for negotiations with the regulator. Importantly, greater competition would lead to greater choice, not just with a plethora of banks offering the same product, but with banks offering specialist funding services.
A typical bank seeking to help a local specialist business will still need to go through the process of understanding that customer’s business model: a specialist bank will already understand it, driving down the cost of funding applications for that type of business. We are a maritime nation, yet there is still no specialist marine financer amongst the UK banking sector.
The government runs the risk of trying to solve problems with yet another initiative. This would not be a solution, merely an extra ingredient to confuse the already over-flavoured offering. A business friendly, state-owned utility bank operating in an environment of increased competition through a simpler banking licence approval process and a more lenient regulatory requirement for early start-up banks will drive banks to better utilise their existing strongest asset: their distribution network.
This will allow not just more, transparent banks, but also a wider variety of bank types – including alternative providers such as P2P lenders and community investment schemes.
Finally, education. Education comes in many forms and getting information out to businesses is the simplest. As the government regularly contacts businesses for a wide variety of tax and regulation-related reasons, it seems a simple ask for government to use these opportunities to tell businesses what is available, and to encourage businesses to seek help from professional organizations and Local Enterprise Partnerships.
But there has been a big educational deficit up to now, i.e failing to realise that financial education should be part of the curriculum. That is now changing and that is a good thing, but it will take a generation for our new entrepreneurs to be entirely comfortable with finance and money management as a result.
It is from this basis of education – whether through schools or other routes – that we can, as a society, drive a step change in financing options for businesses: a step change that sees business leaders seeing equity investment as a proper and sensible alternative to debt financing. For a challenger bank, the opportunity to offer equity finance (whether as principal or broker) through its existing distribution network offers, possibly, one of the greatest transformational changes to SME financing for the future.
[box]More information on the Book can be found http://www.neweconomics.org/blog/entry/banking-2020-a-vision-for-the-future[/box]