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Published: 21 Oct 2021

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In this two part series Dominic Lindley looks at what interventions can be made to ensure SME funding doesn’t present a barrier to growth and levelling up. This is part one. Part two will appear in the November Banking Focus bulletin.

There are 5.9 million small and medium enterprises (SMEs) in the UK. The Bank of England has described them as an “engine of growth” employing 60% of the private sector workforce and contributing 50% of UK GDP. Lack of access to finance for SMEs, particularly working capital, has long been seen as barrier to growth. This has led to numerous policies aimed at increasing access to finance at both the national and the regional level.

The Labour Government set up Regional Development Agencies and Regional Venture Capital Funds as well as national schemes including the Small Firms Loan Guarantee Scheme. The Coalition Government’s Plan for Growth cited lack of access to finance as one of the reasons why it was problematic to do business in the UK. It launched new schemes like the Enterprise Finance Guarantee, Start-Up Loans and Enterprise Capital Funds.

But, despite all this activity the aftermath of the financial crisis led to the start of a long-term decline in bank lending to SMEs. The outstanding stock of loans to SMEs dropped from £197.8 billion in April 2011 to £166.1 billion in March 2018. Schemes which increased SMEs access to equity capital also had a bias towards London, with more than half of the support under the Enterprise Capital Funds and Business Angel Co-investment Fund going to businesses in London and the South East.

Over the past 4 months the All-Party Parliamentary Group on Fair Business Banking has been holding an inquiry into the role of financing and capitalising SMEs. The report published by the APPG in September concluded that when it came to levelling up “the unequal availability of private finance by smaller firms in different parts of the country, and policies to address this, are a relatively overlooked aspect”.

Why supply of SME funding to the regions is a problem

The report commissioned by the APPG listed three characteristics of the bank lending market which it said had led to problematic consequences for customers and which contributed to a lack of availability of finance outside London and the South East, particularly for equity finance. These characteristics are:

Concentration: SME banking in the UK has been characterised as a four-firm oligopoly in the past with the CMA finding in 2015 that the big four banks accounted for approximately 80% of all lending to SMEs. The largest banks also have a dominant position in the market for business current accounts with many SMEs only considering the option provided by their existing bank and finding shopping around difficult.

Centralisation: Banks can be characterised as centralised or decentralised based on the distance between different agents of the bank, and the functional distance between a bank’s customers and where decisions in relation to those customers are made. The major banks were considered to be highly centralised institutions.

Non-relationship based: The financial system in the UK does not rely on the development of relationships between banks and their customers which allow for long-term two way exchanges of information. This means that the UK banks and SME customers miss out on the benefits that arise from this such as the building of trust and data on which to make better financial and business decisions.

The APPG also highlighted recent developments which risked increasing the divide which exists between banks and their SME customers. Banks have been closing branches at an increasing rate and relationship managers have very high client loads. SMEs have low levels of satisfactions with their banks – the FCA and CMA found that just 13% of SMEs trust their bank to act in their best interests. Scandals around the treatment of SMEs by organisations such as RBS’s Global Restructuring Group and the HBOS Reading fraud have cast a long shadow over the perceptions of SMEs in dealing with and borrowing from banks.

Support for SME funding during the pandemic

Into this environment a global pandemic stretched SME funding to breaking point. National lockdowns meant that thousands of businesses were forced to close. In response, the Government established three business loans schemes in response to the pandemic:

The British Business Bank oversaw the schemes. A range of accredited lenders made decisions on applications made to them. The three schemes disbursed over £75 billion and BBLS accounted for almost 94% of loans made and 62% of funds disbursed. 89% of businesses seeking finance did so because of COVID-19, and 75% of those did so to help with cashflow.

Many businesses have certainly survived with the help of the schemes. But many also face an uncertain future and the FSB reports that the share of its membership with debt describing their borrowing as “unmanageable” has soared from 13% to 40%. The OBR has suggested that up to 40% of BBLS borrowers may default.

There are also concerns about the impact on competition as the five largest UK lenders were responsible for 89% of the value of the loans distributed. The NAO has expressed concern that this could increase their foothold in the SME lending market.

Regional impact of the Covid support schemes

One positive of the Covid loan schemes is that the loans have been evenly distributed around the UK and there do not appear to have been problems in any particular region accessing loan funding. The data shows that the proportion of overall loans in each of the nine English regions and three Devolved Nations matches closely their respective share of the UK business population. However, other schemes available to businesses such as the Future Fund seem to have led to applications, at least those which have been identified publicly, concentrated in London. This reflects longstanding issues around schemes aimed at providing equity capital to businesses which have tended to have a bias towards London and the South East.

From 2017 to the start of the pandemic, all of the net growth in SME lending came from smaller banks or from alternative sources such as peer-to-peer lending. The pandemic reversed that trend and strengthened the dominance of the largest high-street banks – but having grown their SME lending so much during the pandemic will these large banks be willing to grow their lending further to support the recovery? Only time will tell, but experience suggests that promoting a diversity of lenders with different business models can help promote the availability of finance to SMEs.

In the second part of the series, Dominic examines four interventions which could increase the availability of finance to SMEs.