Time to give the banks a break

There is much to criticise in the ethics and conduct of British banks. Indeed the catalogue of misselling and foreign exchange irregularities continues to this day.

But according to Business Secretary, Vince Cable, British banks have also been hoarding cash and refusing to lend to credit-starved small and medium sized enterprises. ‘If Britain is to emerge from this dreadful crisis’, he declared two years ago, ‘business needs access to finance, just as plants need water – and the banks aren’t supplying it’. Dr Cable’s consistent stance that the banking system is suffocating enterprise is a view as widely shared as it has been accepted.

A reassuring story perhaps for those frustrated at the lack of investment even as the UK economy grows powerfully. But how much truth is there to this gloomy assertion? Are there really countless businesses to which our banks should have been lending, but have not?

Typically on receipt of a request for borrowing, banks quantify the risk involved in lending to a specific business and forecast what they might lose if such a loan goes sour, an increasingly rigorous process subject to oversight by the Prudent Regulation Authority (PRA). Having quantified the risk, a decision is made on whether to lend, at what price and with what conditions. This assessment is naturally also affected by general economic conditions.

During the financial crisis, the level of expected loss from SME lending increased, particularly since there was a pronounced drop in commercial property prices. Banks tightened general lending policies accordingly. However this tightening was at nowhere near the level or duration suggested by the Business Secretary, who has consistently implied that acceptance rates have been subject to rather more than a transient drop.

Smaller SMEs (fifty employees or fewer) saw the chances of their being accepted for lending fall from 78% in January 2008 to 63% a year later, before recovering to 76% in January 2010. Acceptance rates for larger SMEs (no more than 250 employees) were 98% in January 2008 but stood at 88% in January 2010. The longer period of depressed approval rates for this group partly reflects the fact that it was this cohort most involved with the ailing commercial property sector.

Many businesses also characteristically reacted to the downturn by rapidly reducing their own risk – deferring investment, cutting back on borrowing and accumulating cash. By the beginning of 2010, applications for all borrowing from medium sized business, and for loans to smaller SMEs, had fallen by 20% from the level seen at the beginning of 2008. The truth is that this fall in demand has not yet been reversed. Indeed it is possible that it would have been less pronounced without the misleading public perception, fuelled by politicians, that credit was barely available. Bank satisfaction surveys revealed that many customers still believe that credit is extremely elusive.

Nevertheless, if there has been a problem with lending, for almost four years it has been within the direct remit of the Business Secretary to address it. Arguably the coalition’s various policy prescriptions to increase bank lending have had little discernible impact.

The first of these, the Enterprise Finance Guarantee Scheme (EFGS), was established by the Labour government in 2009 and retained by the coalition as a key plank of its approach to increase lending to SMEs. The EFGS is designed to step in when a business has passed a bank’s normal lending criteria but has insufficient collateral to offer as security. The government guarantees up to 75% of the value of an individual loan and up to 9.5% of the total lending provided by each bank within the scheme.

For the past two years for which data has been available, EFGS lending has contributed just 1.1% of the lending by value provided to SMEs by major UK banks. Meanwhile, the quarterly contribution of EFGS under the coalition has declined to less than half that of the previous government. If our economy’s great problem has been the senseless hoarding of capital, then the EFGS would appear not to be the answer.

That is not to say it has produced no economic benefit. Researchers at the Durham Business School found that based on lending written in 2009, the EFGS created around one new job per business supported. Assuming the same level of benefit since the coalition entered office, EFGS has helped create 3300 jobs per annum – praiseworthy, but essentially a drop in the ocean when compared to the 213 000 jobs created annually by bank lending without the benefit of government support. Interestingly, in the same analysis of job creation, it was found that over 90% of new private sector jobs have no reliance on bank lending, suggesting that Dr Cable is exaggerating bank lending as the main barrier to economic growth.

The second policy prescription, Funding for Lending (FfL), hinges on the notion that a reduction in the cost of lending boosts demand. FfL allows banks to borrow from the Bank of England at rates lower than available in the wholesale market on the proviso that the benefit (typically a one percent reduction in margin) is passed to customers. All of the UK’s major SME banks, apart from HSBC, are now involved with FfL but it is difficult to see what effect the programme has had since launch in July 2012. The number of new lending approvals the year before launch, in July 2011, stood at 39 547. Twelve months after the launch, in July 2013, the equivalent figure for approvals stood at 27 019.

I suspect FfL’s failure stems from the flawed reasoning behind it – that a 1% discount in margin would stimulate significant extra demand. In reality, businesses usually borrow because they have a business need or see a business opportunity. The cost of borrowing is generally low relative to a business’s revenue and therefore a 1% reduction in margin is not deemed significant enough to encourage unplanned borrowing. The Bank of England and HM Treasury have acknowledged that take-up of FfL has been poor and have changed the terms from February 2014 to January 2015, refocusing the scheme towards SME lending and away from household lending.

The coalition’s policies to stimulate lending have therefore been of only minimal economic benefit, perhaps because the charge that banks have been senselessly hoarding capital is simply incorrect. Indeed, if the government believes there really is a problem with access to credit and is serious about resolving it, it probably ought to have been focusing on the three variables crucial to increased lending: the number of businesses that request a loan; the average amount that is requested; and the percentage of requests that are approved (or the level of risk the banks will accept).

Throughout the recession, banks have sought to encourage customers to borrow via advertising campaigns, ringfencing of SME funds and rewarding staff for lending. But many of their attempts have been drowned out by media and government suggestions that banks are failing to lend. Indeed a source at the British Chambers of Commerce recently advised me that bank lenders he spoke to suggested that in absolute terms, the money they have been trying to lend is as cheap as it has ever been. However there is a strong perception issue at play since the differences between Base Rate and loan rates were much smaller before the crisis. If there has been any significant cost difference, it appears to be on arrangement fees rather than interest rates.

Targeting the third variable would involve banks approving more loans where there is a greater risk of loss by relaxing their lending criteria. If government were serious about increasing credit flow at all costs, it could support that relaxation by either underwriting the increased loss or encouraging banks with large taxpayer stakes (Lloyds and RBS) to engage in higher risk, higher margin lending. Unsurprisingly to date, there is no evidence that the government has sought to do that. Indeed the coalition has stipulated that EFGS support will only be available to businesses that meet normal lending criteria.

There is little to support the assertion that banks have ‘senselessly hoarded’ capital. At worst, they stand fairly accused of marginally tightening their lending criteria during the recession in response to the increased risk from lending to SMEs. But even this had been broadly reversed by the end of 2010. I suspect much of the decline in new lending is in fact related to a fall in demand. Vince Cable also overstates the importance of increasing SME lending to economic recovery. After all, only around one in ten of new private sector jobs created each year in the UK rely upon new bank lending to SMEs.

If BIS really wishes to increase lending, it must first challenge the now-accepted wisdom about the availability of credit. Only then, if it insists on formal intervention, might the Department encourage lending to increasingly risky businesses. To date, it has shown no inclination to pursue either of these routes.

But then perhaps the banks – vulnerable because of their repeated failings – provide the Business Secretary with too convenient a scapegoat to relinquish.