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Is a Business Bank best?

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This article was first published in Real Business’ sister title Real Deals.

Small business financing in Britain is the itch that will not go away, no matter how much it is scratched. It is dysfunctional and probably always has been. A government committee that included John Maynard Keynes produced a report that pretty much said as much. That was in 1931; policy makers have never looked back since. Small loans are risky and costly for lenders, which puts SMEs at a disadvantage. The solution then is the same as it is now.

Back then it was the Industrial and Commercial Finance Corporation, later to become 3i. Three years ago it was the Business Growth Fund, which sort of does the same thing, only for slightly larger businesses and it only invests equity. Today it is the Business Bank, Vince Cable’s new vehicle for business loans. These are all different shades of the same thing – coercing banks to invest, in spite of the economics. Recent efforts have been underwhelming. Last year the major banks fell short of their lending targets by £1bn (€1.23bn), even though most of them are part or fully owned by the state.

It’s a well-known fact that most SMEs in the UK make do on basic overdraft facilities, the bluntest of tools. Then consider Wonga, the payday loan company under investigation by Labour MPs. Something must be seriously rum if a company can charge 4,000 per cent APR and still make a mint. And what does its move into business loans say about British finance?

All this points to a problem, but exactly what it might be is harder to grasp. The government seems to think it’s a lack of capital. The new business bank has £1bn at its disposal and will invest alongside the private sector. But early indications suggest the new organisation will not invest directly but support established banks in their SME loan programmes. This runs the risk of making existing loans cheaper rather than helping to extend new lines of credit. It also incentivises banks to dump their worst assets in the pot and let the government foot the bill, which is exactly what happened with the loan guarantee scheme. Besides, if it’s just a shortage of liquidity, the Royal Bank of Scotland is state-owned, why not force it to invest more?

Others question whether debt is the best tool for the job. In an editorial last month, Allister Heath, editor of City AM, said that the government plan was “the wrong answer to the wrong question”, arguing that the market needed more equity finance, which made more sense given the risk profile of early-stage investments. He believes more venture capitalism, with investors sharing in the upside, is the way forward. But he overstates the “sophistication” of SMEs. It is not true that bank managers are not suited to gauging the viability of modern businesses. As Santander’s Darren Hart points out, most high-growth companies are not tech-centric disrupters. In any case, how would it work? Invest more in existing VCs? There’s a reason LPs avoid European venture, why reward failing investors? And the market for small buyouts in the UK is already saturated.

More to the point, SMEs that require capital are rarely over-leveraged. According to Mike Fell, an investment partner at Key Capital Partners, what companies need is working capital, which is hard to fund with equity – entrepreneurs think it’s too expensive.

No country for SMEs

The essence of the problem has not been tackled. It will always make less sense to invest in small, young companies rather than established corporates for large banks with centralised systems.

The UK banking sector is dominated by a handful of institutions. With so much in so few hands, why on earth would they waste their time in the shallow end? And it can’t help that issuing a loan in Leeds is determined by a credit committee in London. Ralph Silva, managing director of SRN, says this is a reality of modern finance and will not change, but surely there is something to be said for a more local approach. It certainly hasn’t hurt Handelsbanken, a Swedish bank that has been opening UK branches at the rate of one every ten days for the past year. Its branch managers have full control of lending decisions.

That said, there is little evidence to suggest that more banks means a more balanced banking sector. After all Japan has six major banks, Canada has five, France four and Australia, just three. All have a decent record on SME finance.

The government has been reluctant to issue new banking licences. That may be a mistake, but changing it is unlikely to lead to a lasting fix. Equally, increasing banks’ coffers encourages investment (at someone else’s expense), but doesn’t remove the small business funding ghetto, it is still an area that is riskier and less lucrative than large corporate loans. Nor does it help that the government has hiked up capital requirements for small business loans, making them even less attractive for banks.

Incentives are skewed. The government is undermining its efforts by focusing on downside risk rather than formulating a sustainable and profitable model for small business investment.

What if one doesn’t exist? Or rather, it does exist but only on a small scale. Identifying the issue as difficult does not mean it is a problem that needs to be solved. Better Capital’s Jon Moulton says most regional bank directors are struggling to meet lending targets. There is simply not enough to invest in. He fears cheap and accessible finance will distort the market. “When the state intervenes in the market, it tends to destroy the economics and displace commercial activity,” he says. “It is hard for small businesses to access funding – it bloody well should be.” Moulton goes on to say there is no evidence to suggest that high levels of small business financing leads to dynamic economies. That assumption runs deep in government thinking; perhaps it’s time it should be challenged.

The plight of the small business entrepreneur is a narrative that has proved all too seductive. Whether there is any truth to it is another matter.

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