Member Article

Banks and SMEs: More competition is needed

David Llewellyn, Professor of Banking and Finance at Loughborough University offers his perspective on the challenges of SME financing.

There are four immediate perspectives to bear in mind when considering the financing needs of the SME sector:

1. SMEs have a pivotal role with respect to the economy’s growth prospects, employment, product innovation, and the growth of productivity in the economy.

2. They are particularly dependent on banks for their financing requirements and not just standard overdraft and term loans,

3. because of the recession, and capital, gearing and liquidity problems faced by banks, lending to the sector has been weak since 2009 with total bank lending falling in each of the 30 months between July 2009 and November 2011. This was even more marked for SMEs where the growth of bank lending declined from 15 percent pa in 2008 to negative since the end of 2009,

4. there is a serious lack of effective competition between banks for SME lending with only four banks accounting for over 85 percent of the total.

The government (through the Merlin project) has sought to avoid a credit crunch in SME lending. However, it has not been very successful. In 2011, the five largest banks fell short of the £76 billion target for gross loans to SMEs due largely to weak lending by the state-owned Royal Bank of Scotland. The position is in fact worse than that because net lending (i.e. new money) to SMEs declined last year by £10 billion and the cost of loans to SMEs rose.

The real problem is competition, or the lack of it, in the provision of bank finance. Several reports have highlighted serious entry barriers into the SME sector of banking, despite the fact that incumbent banks have long earned excess returns (profits) in their SME business – itself a sign of weak competition.

These barriers include the high cost of establishing a branch network (it seems that a branch network is necessary if a bank is to be a serious competitor in the SME market) and SME lending being unfeasible for a bank on any significant scale unless current accounts are also held at the bank. All the evidence indicates that it is costly for a new entrant to establish a foothold in this aspect of banking.

Related to this is the strong evidence that the degree of switching between banks by SMEs is exceptionally low. An SME owner is on average four times more likely to change husband or wife than change bank account!

There are also formidable information problems about potential SME customers faced by new entrants. Some potential newcomers have said that access to cash handling facilities and the payments clearing system can be particularly costly while regulatory barriers (such as the requirement that new banks, or banks entering a new line of business, are required to hold more capital than larger incumbents) can be serious.

This lack of effective competition is about more than standard bank loans. There are several additional sources of SME financing including factoring. However, these sources are equally concentrated in the same four dominant banks. Furthermore, there is a market failure in the provision of small-scale risk capital to certain types of SMEs at critical points in their development.

In 2001, the Competition Commission identified only four potential “Challenger Banks” (banks which are large enough to be a threat to incumbents and who have a strong incentive to compete to increase market share). Three of these have since disappeared by being bought by existing banks, and one is a mutual building society which would probably not plan to enter this business. It is true, however, that there are new smaller banks that could enter (Aldermore, Metro Bank, and Shawbrook Bank), and the Swedish Handelsbanken. Whether in practice they could offer serious critical mass competition is, however, open to dispute.

There are several ways in which competition (even with a small number of existing large suppliers of bank funding) could be enhanced: measures to make it easier and at lower cost for SMEs to switch banks (such as full Account Number Portability); greater transparency in what are often opaque and difficult to understand pricing structures for bank services; lowering entry barriers, etc. A particularly fruitful possibility would be mechanisms to make the securitisation of SME loans more feasible.

The recently-ended Merlin scheme will not be repeated. Instead, the government is negotiating with the banks over a national loans guarantee scheme which, hopefully, will increase the flow of bank lending to the SME sector and lower the cost of loans by up to one percent. My judgment, however, is that if this is to be effective it will need to be on a larger scale than the planned £40 billion. The impact, if there is a significant one, is more likely to be on the cost of credit for SMEs than on its availability.

However, what is really needed is more effective competition in the market for SME lending. This has been studied in several official enquiries including the recent report of the Independent Commission on Banking (the Vickers Report). And yet little seems to happen!

This was posted in Bdaily's Members' News section by Jon Duckworth .