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The UK’s financial sector is systematically failing SMEs which could provide the greatest source of innovation, jobs and growth, according to a submission to the Independent Commission on Banking (ICB) by Will Hutton from The Work Foundation. His paper, co-authored with Paul Nightingale from SPRU at Sussex University, shows that firms with the greatest potential for high growth are the most likely to face financial restraints on their growth. This is leading to a “discouraged economy in which innovation, investment and dynamism are stymied by a self-serving and inflexible banking sector.”

The paper calls for rigorous ring-fencing (or ideally full separation) of commercial and retail banking from high risk investment banking, along with an injection of more capital. This would change incentive structures so that supporting the UK economy, and specifically lending to innovative SMEs, becomes more attractive to the banking sector. Higher capital ratios would lower risk premiums so that any rise in bank funding costs would be trivial. In addition, it would create an environment where SME lending is not seen as a consumer of scarce risk capital with a high opportunity cost of foregone investment banking opportunities. Instead, SME lending would be a useful profit stream in its own right, competing for attention with other profit and revenue streams that all have lower returns.

Will Hutton, executive vice chair of The Work Foundation, said:

“The current UK financial services sector has grown bank assets to more than four times British GDP - of which lending to UK Corporates constitutes a mere 5% of lending. Despite, or because of this growth, a key sector of the economy - the innovative British “Mittlestand” - has been under-supported. This lack of support to SMEs encourages perception among firms which should qualify for lending that they will not get credit, leading to significant numbers of discouraged borrowers, who thus don’t seek out loans. This lack of investment leads to reduced levels of innovation in the economy, creating a self-reinforcing cycle of less innovation, less investment and less dynamism. Such a discouraged economy is particularly problematic at a time when the UK needs to do all it can both to grow and rebalance its economy.

“This is further adding to the growing disconnect between the financing needs of the UK’s knowledge economy and the development of the financial system.”

The paper draws on academic research and the interim findings of a survey of small firms undertaken by the Federation of Small Business (FSB) which shows that while the bulk of firms had not applied for loans, of those that did only 41% received all the funds they sought. Worryingly, it shows that 37% of the firms seeking funding were turned down. The implications of the squeezed financing were that 37% of the turned down firms experienced ongoing financial concerns, 29% missed growth opportunities, and 19% delayed while 16% scaled down their investment plans.

John Walker, national chairman, Federation of Small Businesses, said: “As FSB members have told us in the Voice of Small Business survey, small firms that are refused credit continue to have ongoing financial concerns. It is more important than ever that the ICB take forward the proposal to separate the different divisions of the banks and ring-fence the retail and investment arms. Only when this happens will small firms start to get a fairer deal as the banks will have to focus more on SME lending because they will no longer have the ability to move money around within the bank to grow their own balance sheets. 

“The UK’s small businesses are the country’s main source of innovation and the main route to strengthening the recovery. As experience has shown, this recovery will only happen with the help of the banks when they stop focussing on their balance sheets and start to see small businesses as a good investment.”

The paper presents a range of evidence showing that while most firms with collateral eventually receive the funding they seek, banks are not lending to two groups of firms. Firstly higher risk firms who are being refused debt rather than being offered higher interest rates and secondly, firms with growth ambitions and potential who do not have collateral. This reduces investment and produces a sub-population of discouraged borrowers. These are individuals and firms that have legitimate investment opportunities and would be funded if they went to banks to ask for money. But as they believe that they would not be funded, they do not seek it out. The evidence is that these are more likely to be high growth, innovative firms.

Recent research has highlighted the vital role of a small number of high growth innovative firms in generating new jobs and driving innovation. These are the most likely to face financial restraints on their growth. For example, The Work Foundation’s research using the Annual Business Inquiry found that in 2007-2008 about 27% of SMEs showing sustained growth said that finance had been a problem, compared with 21% of all other SMEs.

Will Hutton continued, “These problems are not being solved by market forces acting alone. The market does not self-correct because the scale of current banking creates strong incentives for conformity to a single business model and substantial barriers to entry for new banks offering better services to SMEs. The subsidies given to large highly leveraged banks through implicit government guarantees - amounting to more than £100bn in 2009 - further constrains entry. In short, dissatisfied customers have nowhere else to go.

“Requiring banks to carry increased capital while in addition requiring separation or as a second best, tough ring-fencing between investment and retail banking, will not only help de-risk the UK financial system but stimulate lending to high growth innovative SMEs. Higher capital ratios will lower risk premiums so that any rise in bank funding costs will be trivial. More importantly, an environment will be created where SME lending is not seen as a consumer of scarce risk capital with a high opportunity cost of foregone investment banking opportunities, but where it is seen as a useful profit stream in its own right. The Swedish Handelsbanken, with 17% Tier 1 capital as defined by Basel II, is growing its market share rapidly in the UK with such a structure. Reform would broaden the effect, challenging the business model that has grown up over the last twenty years in which SME lending has been the Cinderella that did not go to the ball.”

Notes to Editors

1. The discouraged economy: A submission from The Work Foundation to the Independent Commission on Banking by Will Hutton and Paul Nightingale is available at www.theworkfoundation.com.
2. The survey is based on interim responses from a survey of 1,204 FSB members carried out by Research by Design for the June 2011 FSB Voice of Small Business Survey Panel which took place between 13 and 20 June 2011. Full results available at www.fsb.org.uk/fsb-survey-panel
3. The paper is part of an ongoing study into the financial system supported by NESTA.
4. The Work Foundation is the leading independent authority on work and its future. It aims to improve the quality of working life and the effectiveness of organisations by equipping leaders, policymakers and opinion-formers with evidence, advice, new thinking and networks. In October 2010, Lancaster University acquired The Work Foundation, forming a new alliance that enables both organisations to further enhance their impact. 

5.       The FSB is the UK's leading business organisation with more than 200,000 members. It exists to protect and promote the interests of the self-employed, and all those who run their own business. www.fsb.org.uk

Media enquiries:

Tom Phillips: 020 7976 3554 tphillips@theworkfoundation.com

Anna Kharbanda: 020 7976 3646 akharbanda@theworkfoundation.com

For out of hours media enquiries: Nasreen Memon 07825 527 036

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