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Credit where it's due

At the Conservative Party Conference, the Chancellor of the Exchequer stated he is looking at “ways to inject money directly into parts of the economy that needs it such as small businesses. It’s known as credit easing.”

In Credit where it’s due: easing marginal lending decisions to SMEs, published on Wednesday 23 November, James Conway and Michael O’Connor review evidence of whether this is necessary or desirable.

  • The authors accept that bank lending to SMEs has fallen since 2008 (by 31% between 2009 and 2011). Average monthly net lending to SMES has contracted by £332 million a month this year compared to last.

But it is unclear the extent to which this is a supply or demand issue:

  • There is a lack of confidence due to the current economic crisis, meaning many SMEs now more interested in reducing debt than in taking out new loans (just 2% of all SMEs have applied for a loan in the last 12 months and emerge with nothing).
  • BUT, credit for those applying is now more difficult to obtain than in the past (in 2007 just 4% of SMEs loan applications were rejected outright compared with 27% today).
  • And many SMEs appear discouraged from borrowing because of a perception that the banks aren’t lending or they’ll be rejected.

Restoring SME confidence in the availability of financing for viable projects will be crucial to the growth of this sector as the economy recovers. In addition, pressures on banks to rebuild balance sheets and to build up capital requirements may also reduce the readiness of banks to make loans to SMEs, particularly as this sector of the economy is seen to be the most risky.

The authors therefore conclude that  government could ease marginal lending decisions currently rejected by banks.

  • A quick, simple, low cost and effective way of achieving this would be for the government to set up an “Ignition Capital Scheme”.
  • In this scheme, the government would provide mezzanine financing (of typically 20% of the total loan value) for those projects which would under normal economic conditions be considered a good risk but which in today’s conditions do not quite meet the bank’s lending criteria.
  • The existing banking infrastructure would continue to be responsible for risk management and due diligence. The interests of the bank and of the government would be closely aligned.

This approach would unlock a minimum of £25 billion of investment in SMEs for every £5 billion provided by the government. In addition, as a portfolio of the government’s mezzanine loans would be an attractive investment opportunity for the private sector, it should be easily saleable. The original funding could thus be quickly repaid to the government; or it could be used to launch a second phase of the Ignition Capital Scheme.

The authors review other credit easing options, concluding that the mezzanine proposal presents the potentially most effective whilst curbing risk:

  • Bonds: there are too many queries around cost of issuing, a lack of retail demand, relatively low rating.
  • An In-House Bank (Adam Posen’s proposal): would act as a huge market distortion and take years to get off the ground.
  • Government Loan Guarantees: would not encourage as much lending as the Ignition Capital Scheme, and fails to align the interests of the lender and the government as precisely
  • Loan Purchases: would rely on undertaking due diligence, with no alignment of interest between banks and government.

Tim Knox, Director of the CPS, comments: “Micro-initiatives will not solve the problems of SME financing. Demand for loans is uncertain. The grave weaknesses of the government finances, and general economic uncertainty, must suggest a simpler and bolder solution which is flexible to the true level of demand for business loans for viable SME propositions.

The authors are available for interview or comment. Please contact me to make the necessary arrangements.

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