This post is all about the scarcity of capital and the role of the UK Banks who are failing to provide capital to small companies.
I see this as a form of Capital Punishment!
What is the role of the financial institutions we call Banks?
Banks are supposed to collect deposits from a wide range of savers, centralise these deposits and make them available to a range of borrowers, taking an interest spread in the middle, in payment for this service.
This efficiently recycles capital from those who have a surplus to those who have a deficit. In addition, the bank has a responsibility to ensure that the capital is lent to borrowers who have a significant probability of repaying both the interest and capital within the agreed time period.
The term Mortgage Bank was coined for those institutions whose primary function was to lend to the private housing sector.
The term Merchant Bank or Investment Banks was invented for those banks who lend to businesses.
The term High Street Bank covers those banks serving the Consumer with branches in the High Street.
So my first question is who do “Bulge Bracket” banks serve?
What is happening in the UK?
Following the financial crisis of 2008, the UK Banks, now significantly to a some degree in public ownership, have had a conflicting remit. On the one hand, Government is pressing them to lend more to help finance the recovery and on the other hand telling them that they need to improve their financial ratios by raising more capital and by making less risky loans. Pushme-Pullyou!
If you run a Footsie 100 company and want to borrow £50 or £100 million that’s fine. However Footise 100 companies are not going to help the economy out of the recession. It is widely accepted that the only way to do this is to get small and medium sized enterprises – the SMEs – to create more jobs to offset public sector job losses and to create growth beyond this. To do this SMEs need capital.
The Role of Government
Before we discuss how effectively Banks are supporting SMEs or not, let’s look briefly at the role of Government. Politicians can provide both direct and indirect support. By creating a favourable tax environment for business and entrepreneurs, Government can make it attractive to start and grow businesses. By reducing the complex red tape, rules and regulations created by generations of politicians, Government can also help to make it easier to develop and grow business.
When did you last hear of a Government or a politician concentrating on reducing the amount of legislation instead of focusing on building their own careers and making their mark by pushing yet another piece of Central Government “policy” on to the law books. The EU is the archetypical example of a group of legislators who, like the Banking system, have forgotten that their primary objective is to make society work more efficiently and instead focus on a self serving power accumulation game.
Like the banks, politicians have forgotten in whose name they govern and that taxation revenue is our money and not theirs to be used sparingly and responsibly.
Enterprise Finance Guarantee Scheme (“EFG”)
So putting aside the general and concentrating on the specific, the UK Government announced in January 2009 a scheme to increase loans to businesses by guaranteeing 75% of the amount lent by the bank through which the loan was arranged. This replaced the Small Firms Loan Guarantee Scheme.
That sounds great then, more capital available for business. Well not actually more capital but surely the banks will find it easier to lend their capital with much of the risk underwritten by Government. Let us forget the additional bureaucracy required to obtain the loan because the banks can manage much of this and the interest premium to be paid above the Banks normal interest rate. Let us focus on some simple practicalities.
Firstly, the scheme is only available when every, and I mean every, other loan avenue has been exhausted. This does not mean that good businesses are getting funded because as we will see the Banks are not fulfilling their role, but that the weakest businesses with the riskier lending propositions, no track record and where the business founders have no assets (and this as we shall see is a key point) are those which are getting access to Government support and I predict that many of these will get into trouble. Companies included also tend to have little in the way of a track record. This does not help the bulk of small established and well run SMEs.
Another classic case of Central Government intervening to create further distortions and inefficiencies in the market. And I should mention that there are a plethora of rules and exemptions which make the scheme even more difficult to benefit from.
I conclude that for most SMEs this scheme is not the answer.
Bank Lending Policy
Let’s go back to the Banks now. How do they evaluate to whom to lend money?
Thirty years ago the lending decision would have been made by an experienced Bank Manager who had a relationship with the SME business and it’s owners. He would make a judgment on the business and it’s plans. Today the Banks have improved this by centralising the decision making process to a risk assessment computer model which starts with top down macro assumptions and using factors as historic trading results gives the company a score and this decides whether or not the bank wants to extend a loan.
So there is no longer a relationship, bank managers are application processors at best. Oh yes, we have just been through a recession so the computer is going to look at the trading performance in 2008, 2009 and 2010 and judge most businesses to be weak and in decline, failing to recognise that their financial performance has been adversely skewed by macro economic influences.
So current bank models are set to a default “don’t lend” setting on the basis of historical data. Then the top down analysis looks at sectors and rules out those in which Bank economists are suggesting are higher risk or where the bank has historically high levels of bad loans. This is exacerbated by macro sector selection. The bank will take a view as to which sectors they feel are a good risk at this point in the cycle. Make sure that your business is in the right sector if you want money from the bank –
Yes – I know that is nonsensical.
Then, for smaller companies, the bank’s default setting is asset based lending only. This means that the assets of the business are insufficient security to lend on a debenture basis. Firstly they will insist on a Directors Personal Guarantee giving them additional security and then want to take a charge over whatever other assets the Directors have to further cover themselves. This will invariably include the Directors’ principal private residence although other property assets are also particularly welcome.
This “belt and braces” approach may be prudent in the eyes of the banks but I would ask what is the point of having a limited liability company and how does this help entrepreneurs grow their businesses? It strikes me as a very one sided arrangement. Perhaps it was ever so!
As a final word, I was recently told by one bank employee with whom I was discussing a lending proposition on behalf of a client that because the bank was prudent they calculated base rate at 3% rather than 0.5% because the bank was “prudent”.
This was the most idiotic thing I have heard in a professional meeting in years. I restrained myself from reminding him that the bank did not have the authority to set base rate as that responsibility has been granted to the Bank of England.
So much for Bank lending then.
In my follow up post to this I will try to suggest some possible avenues of funding for SMEs.