Who’s got the bigger problem – the banks or SMEs?

Scot-Buzz editor Bill Jamieson says there's a paradox at the heart of the recovery. A strong upturn has unfolded across the length and breadth of the UK that owes nothing to a resurgence in bank lending.

So how is it, he asks, that a recovery has unfolded at all while bank lending to the business sector and to small firms in particular, has been so lamentable?

The annual rate of growth in business lending has barely budged, at just 0.6 per cent. And lending to small and medium-sized enterprises (SMEs) was down £2.3 billion in the three months to end August yet again – after years of attrition.

Conventional wisdom has been that there could be little by way of an economic recovery until bank lending picked up. And the consensus also held that this abject level of bank lending reflected loan rejections by lenders. The  banks were either unable to lend until they improved their capital ratios or because they had lost their nerve after the lending excesses of the previous era left them with mountains of bad and irrecoverable debt.  

But there is evidence of a more lasting loan aversion among many thousands of businesses. Politicians and commentators have flayed the banks for not stepping up their lending. But the weakness in lending and the failure of the government’s Funding for Lending scheme owes much to a pronounced reluctance among companies to apply for loans or to make use of overdraft facilities for fear of a repeat of the horror stories of 2007-2011 when banks suddenly turned on business borrowers and demanded sharply higher terms or outright repayment.

Research by the Demos think tank last month showed that 40 per cent of SMEs can be classed as permanent non-borrowers - having not borrowed in the past five years and showing no intention of doing so in the foreseeable future.

Despite widespread criticism of the banks for not lending, the research showed refusals were based on evidenced concerns that the borrowers were incapable of repaying debt. And few would disagree with the case for a tightening of lending criteria after the loan excesses in the era leading up to the 2007-10 financial crisis.

Many SMEs now rate survival over the opportunity to grow.

When I recently interviewed Ken Barclay, head of business banking in Scotland for RBS, he told me that unused overdraft facilities had continued to increase, a point borne out by the Demos research that found less than 20pc of SMEs use overdraft finance, the most common form of external finance to fund expansion.

Andrew Freeman, finance director at Demos, said: "A fraction of the SME population wishes to borrow and 10pc of that fraction fails because the bank or lender deems them unacceptably risky or simply inappropriate.

Many SMEs are either drawing on the savings of their proprietors or opting not to expand their businesses despite repeated government exhortations. They would prefer to stay loan free, to have a cushion for future downturns and not to be at the mercy of sudden changes in the fortunes of banks.

Anthony Browne, chief executive of the British Bankers Association, says net lending is down because many SMEs are deciding to pay off their existing debts. “New lending is growing, but it is outpaced by debts being paid off."

Increasing numbers of firms are also turning to alternative funding sources like peer-to-peer lending, crowdfunding and asset finance as an alternative to banks.

This in turn threatens to leave banks with a growing business hole to fill, as their traditional core rationale was the provision of loan finance for business. Indeed, it is hard to think why else banks need exist. Now they are ever more reliant on lending to the housing market for future revenue – a drive likely to end in another property boom and bust.

“A balanced economy”, says Andrew Freeman, Director, Demos Finance, “needs a steady amount of the right kind of funding. Britain has a weak equity culture and business funding has been far too dominated by the banks and also treating SMEs as a homogenous mass. Policies instead should be adapted to emphasise growth potential among companies of all sizes.

“There should be greater attention on non-bank finance, particularly medium-term and equity capital, with an overhaul of the tax system to create new incentives. And banks — with their unrivalled branch networks – should play a key role in supporting and nurturing businesses.”

John Allan, national chairman of the Federation of Small Businesses says that “the figures clearly show more firms wanting to repay debt than take on more finance, reflecting a still cautious mood”.  

There is no doubting that there is a reduced appetite among SMEs for more credit as they are wary of the risks of borrowing, and many are choosing not to take up the overdraft facilities available to them.

SMEs employ 14.1m people with a combined turnover of £1,500 billion. Lending to the small firms sector still represented around 35 per cent of the total lending by banks. A protracted decline here would pose big problems for bank revenues in future years as repayments being made by small businesses continue to be higher than the total being lent out.

All this may put the appointment of an SME lending tsar in a different light. Who’s got the bigger problem in our economy today: the SMEs – or the banks?