THE DEVELOPMENT BANK FOR WALES

The Welsh Government may wish to consider several options as to how to take forward the findings of the access to finance review.

For example, whilst there have been calls for a new state-owned bank, it could be argued that the foundations for such an organisation already exist in the form of Finance Wales.

However, unlike other state-owned financial institutions that have been examined as part of this review, the main focus of Finance Wales has, for the last five years, been on establishing its reputation as a leading fund manager rather than on directly promoting economic development in Wales. In this respect, the Welsh Government could give Finance Wales a more direct remit so that economic development becomes its main priority, especially as questions clearly remain about its commitment to directly supporting SMEs in Wales, despite the presence of new board members. However, it is the conclusion of this review that, in its current form, Finance Wales is no longer fit for purpose in supporting Welsh SMEs and helping to deliver growth to the Welsh economy.

In addition, with the Welsh Government’s own finance programmes, such as the Economic Growth Fund, also being utilised to support SMEs in Wales, there remains confusion amongst businesses as to the different types of support that are available from publicly funded bodies. Given this, the evidence from the review suggests that there is now an opportunity to develop a new approach that can bring together all the different sources of government funding for SMEs in Wales under one umbrella, works with other institutions in the public and private sector to add real value, and puts the Welsh SME at the core of what it does as an organisation.


The Development Bank for Wales

The review therefore concludes that the Welsh Government needs to examine the feasibility of creating a new Development Bank for Wales. This would be achieved not by creating a wholly new entity but by bringing together, under one organisation, all the financial support schemes for SMEs within the Welsh Government (which are estimated to be around £70 million per annum), the funds managed by Finance Wales and elements of Business Wales.

It is also proposed that, by agreement with the UK Government, this new organisation takes responsibility for the export functions of the UK Export Finance within Wales  so as to drive forward internationalisation in the economy and discussion should take place over whether the Business Growth Fund should also be located here for its Welsh operations.

This would create a financial institution that would not only have funding of over £100 million per annum at its disposal but this could, working with banks and other organisations, leverage in considerable amount of further funding for Welsh SMEs. For example, RBS has informed the review that, by working closely with the Regional Growth Fund in England, it has leveraged £300 million of investment from £70 million of public funding. In contrast, the JEREMIE Fund has invested £48 million in loans against which it has recorded £31 million of private sector leverage. In addition, only 45 per cent of these loan deals have attracted other funding from private sources.

A recent review by the National Audit Office (NAO)  into improving access to finance for SMEs found that many of the individual funding schemes run by the UK Government have been delivering against their individual targets. However, BIS and HM Treasury have not managed the range of initiatives sufficiently as a unified programme, and have not clearly articulated what the schemes were intended to achieve as a whole, given the resources available. There is therefore an opportunity for the Welsh Government to achieve a more coherent approach to supporting SMEs in Wales to gain access to finance.


Mission and objectives

The mission of the new Development Bank for Wales will be to “to utilise public and private funds to support and encourage SME growth to help grow the Welsh economy”.

To achieve this, the Development Bank for Wales will:

• Act as a gateway for business and financial support, some of which will be provided by the bank and some through public and private sector partners. 
• Provide loans, guarantees, grants and other financial instruments, all of which will maximise the state aid exemptions available to provide affordable debt finance to Welsh business. Indeed, as one of Welsh Government’s industry panels noted, access to debt funding was the most important area for consideration because most financing needs would be for working capital not for equity or ring-fenced project financing.
• Access the different types of funding that is available from the UK Government. As the first report noted, there were concerns that the UK Government’s financial instruments would be focused on firms in the South East of England. This has been confirmed by the recent NAO report into access to finance, which showed that more than half of the support available under the Enterprise Capital Funds and the Business Angel Co-investment Fund benefits businesses in London and the South East.
• Develop specific consultancy and business support services for Welsh SMEs, as found in exemplar organisations such as the SBA and BDC. This could not only include services currently provided through Business Wales but also elements of skills development currently managed within the Department for Education and Skills.
• Gather, collate and provide detailed information on the SME sector in Wales, as the Sparkassen do in their local area in Germany. This would enable the Welsh Government and the Development Bank to understand the dynamics of the Welsh economy in more detail, especially if it worked alongside other financial institutions to generate the necessary data, and then responded appropriately through its services.
• Establish close relationships with Welsh Government economic bodies, including the sector panels, the enterprise zone boards, city regions and Industry Wales. This will be key in ensuring that the Bank works closely with those organisations that have been established to provide policy guidance for the Welsh Government. 

Funding

It is not the intention of this report to consider in detail how this new organisation will be funded. However, there remain a number of different sources of funding available to the Welsh Government in examining future options.

EST has its own budget for the financial support of businesses that can serve as the foundation for the new body, along with the remaining funds within Finance Wales. In addition, a new bid for further European Structural Funding is possible under the 2014-2020 programme although safeguards must be put into place to ensure that full advantage is taken of the highest level of aid available to SMEs within any such arrangement. Whilst matched funds could be available again from the EIB to support ERDF and Welsh Government finance, the UK Business Bank may also be a potential source of funding, especially as the Welsh Government could make a strong case for a number of new funds to be created to support the development of the poorest region of the UK. It is also worth noting that with the Silk Commission recommending borrowing powers for the Welsh Government, there may be an opportunity for the new Development Bank for Wales to use this new status to borrow money from the financial markets cheaply to support Welsh firms, as currently happens with other state-own funding bodies such as Finnvera and the BDC in Canada.

Organisation

In ensuring that the Development Bank for Wales delivers to its key customers, one of the models that could be followed is that which has been established with considerable success, in Finland where the state-owned financial institution Finnvera has three main markets which its serves. These are: (a) local microenterprises, (b) regional SMEs and (c) SMEs aiming at growth and internationalisation, all of which have been identified as having specific financial and business support needs and none of which are adequately served at the moment (Figure 1). There could also be a specific focus on supporting social enterprises in Wales through the same approach and Welsh Government may wish to discuss the potential models in more detail with the Co-operatives and Mutuals Commission.


Figure 1. The Development Bank for Wales

Local micro-businesses 

The Welsh Government’s Task and Finish Group made a number of recommendations regarding financial and business support to this sector, including facilitating accessible finance of between £1,000 and £20,000 that are simple and reflect the level of investment required; supporting micro-businesses with application processes to access wider appropriate finance options; proactively promoting access and awareness of business support services for micro-businesses; and creating a single well recognised brand for access to business support. Whilst the micro-business fund is being managed by Finance Wales, there is a consensus that most lending to micro-businesses should take place at a local level.

The Welsh Government, through Business Wales, already delivers support programmes to micro-businesses across Wales. More importantly, the Business Wales providers work closely with these businesses to develop their potential and, as such, have a detailed understanding of the firm and their funding needs. An alternative model to the delivery of this type of funding could take place through Community Development Finance Institutions (CDFIs). Whilst these are well developed in Scotland and England, there is one such organisation within Wales (Robert Owen Community Robert Owen Community Banking Fund) .

It is therefore proposed that all micro-business lending is devolved to Business Wales providers, under the Development Bank for Wales brand, to provide funding to those local businesses they support. This would streamline the current process and create an effective and efficient means by which affordable funding is distributed to micro-businesses across Wales. As with other micro-business loan programmes elsewhere, the funding would be fixed at an affordable rate, to be determined by the Development Bank which would oversee the governance of this scheme and be responsible for reviewing the cost of borrowing regularly. This principle has already been adopted with regard to the new Start-Up Loans programme in Wales where a number of providers have been given the authority to approve loans to local start-ups. Such an approach could also be extended to programmes such as the Welsh Government’s Digital Development Fund (DDF), which supports the development of new creative products and services that can be exploited across multiple digital platforms and in international markets.

Regional SMEs

These would be financial and business services oriented towards providing financial and business support for the growth of those larger regional SMEs across Wales that largely serve the Welsh and UK markets, and require largely debt finance to grow their business. Similar to other state-owned funding bodies across the World, it will work in partnership with different providers of funding (including the banks, invoice discounters, leasing companies) to ensure information on, and access to, the right type of support. For example, it could grant associate status to Commercial Finance Brokers as well as asset finance providers to deliver specific finance solutions to Welsh businesses.

In this respect, the role of the Development Bank will be complementary in supporting the banks when there is a situation when they cannot lend to businesses, and acting as a publicly funded gap lender to ensure that SMEs obtain the capital they require. This will be in the form of guarantees but could also take the form of subordinated loans to established lenders. This ensures that the risk is not only borne by the state but in partnership with the private sector, enabling funding mechanisms to be used more effectively. It also ensures that the cost of lending to be substantially reduced as the risk is being supported by the state. As one member of a sector panel noted, “the general theme of the Welsh Government providing a guarantee scheme to enable banks to support smaller businesses would be of enormous benefit. Any such scheme must be simple, transparent and encourage faster decisions”.

It will also deliver specific business support, mainly through external intermediaries and consultants, to help these businesses to grow and develop. As the FSB noted in their response to the review, its members have suggested that there is an inherent benefit in government-supported finance schemes that couples business support with finance. Business Wales therefore needs to be fully engaged with financial support mechanisms to ensure that weaknesses in business management are addressed at the same time as financial concerns. This concept is not new to Wales as, in its original business plan, Finance Wales stated that “money with management” was an important element in improving investment opportunities for businesses in Wales although this approach was quietly discontinued several years ago.

High growth firms

There is also an increasing consensus that there should be more specific and targeted support for the small number of businesses that have potential for growth. A recent study by Demos  concluded that if most SMEs had no immediate ambitions to grow, efforts should be focused on those businesses with the potential to deliver significant growth in the future regardless of size. Similarly, Bain and Co’s review of funding in Europe suggested that the emphasis should be on building stronger SMEs for a more challenging future – export and growth-oriented, globally competitive and highly productive firms – supported by an SME funding structure with a different mix of bank lending and alternative funding sources than is currently available .  Yet as previous research has indicated, smaller, younger, and higher-growth businesses find it harder to access finance than more established firms.

Whilst the Welsh economy is not in the position to focus its efforts solely on growth firms, there could be a more coherent approach in supporting this type of firm that, as NESTA has shown , is a significant job creator across all sectors. Currently, there is no specific support structure that is in place to direct business and financial support towards this type of enterprise. However, many of the individual elements are already present in Wales including a business angel network (xénos), mezzanine and equity funding from Finance Wales, private sector-led sector panels (especially those in life sciences, energy and environment, creative industries and ICT), Business Wales’ high potential start-up programme and Welsh Government funding for innovation. Yet, the evidence suggests that there is little co-ordination between these elements to create a coherent and cohesive support mechanism for high growth firms. In addition, there has been little effort to link in with other entities including venture capitalists, the various equity-funding schemes supported through the UK Government, and new forms of financial support such as crowdfunding.

Therefore, there is a requirement for an increased focus on lending to new innovative high-growth businesses, especially those unable to obtain finance from the commercial banking sector. This could, as in some economies, be a standalone body for growth and innovation or could be integrated as a specialist division of the Development Bank for Wales. Alternatively, it could build upon the successful partnerships currently operating the high growth start-ups programme for the Welsh Government. The structure for this entity will be examined in more detail as the Welsh Government considers the way forward for the creation of a Development Bank for Wales.


Summary

During the last ten months, this review has examined access to finance to SMEs in Wales. It has concluded that whilst the lending from the banks has fallen, alternative sources of finance have yet to fill this funding gap. In addition, it can be shown that public sector financial support in Wales seems to be fragmented and more relevantly, the organisation tasked with providing debt and equity finance to SMEs is not specifically focused on developing the Welsh economy.

Given this, the Welsh Government needs to develop an approach where public funding for SMEs is affordable, is focused on economic development, is supplemented by business support and is oriented towards the needs of the business customer. It is also critical that the public sector does not displace the private sector but works alongside the banks and other stakeholders to address a market failure in the provision of finance to SMEs.

The review believes that the most appropriate way in achieving this is through the creation of a Development Bank for Wales that will draw together the various sources of public sector funding in Wales and utilise these efficiently alongside private sector finance solutions. Therefore, the review recommends that the Welsh Government examines the feasibility of this approach as soon as possible to ensure that a viable and coherent solution that supports SMEs in Wales is put into place as quickly as possible.

THE FIVE PRINCIPLES BEHIND A NEW MODEL FOR FUNDING FOR SMEs IN WALES

During the last ten months, the access to finance review commissioned for the Welsh Government has undertaken an extensive analysis of access to finance to SMEs within Wales.

In June 2013, it made a series of recommendations in the first report that are currently being implemented by the Welsh Government. Some of these - including the development of a commercial finance comparison website, close links between the banks and business support, and the improvement of trade credit via the Welsh Government’s own procurement rules - have the potential to make a significant impact on access to funding for Welsh SMEs.

In addition, the launch of Start-Up Loans programme in Wales could provide a major boost in enabling many potential entrepreneurs to have the in initial funding they require to begin a new venture.

The evidence from the report suggest that major challenges still remain and that the current approach in providing access to finance in Wales is not fit for purpose. For the Welsh Government, it should be extremely worrying that Finance Wales has focused its mission, in recent years, on becoming a viable investment fund rather than on supporting the Welsh economy.

In particular, many will be surprised and disappointed at its failure to not only have lower interest rates as allowed under state aid rules but also to fully utilise the financial instruments available to it – such as GBER and de minimis - to provide affordable loans to Welsh SMEs during the economic downturn. This suggests that, in its current form, the organisation is not fit for purpose in delivering the economic development aims of the current administration in Cardiff Bay. Therefore, there now needs to be change in how the Welsh Government can intervene to ensure that businesses are fully supported to develop the Welsh economy.

One of the potential options is whether the Welsh Government should establish a new publicly owned bank. Both Plaid Cymru and the Welsh Conservatives have put forward considered options for this development whilst Professor Colyn Gardner was also commissioned by the Minister to examine the option for the establishment of a new Community Bank for Wales as a potential way forward. The evidence from these submissions may wish to be considered in greater depth by the Welsh Government, especially in terms of creating a financial institution with a wider remit.

However, the main focus of this review has been on the supply of funding to SMEs although the review has taken on board some of the main points from these alternative solutions as well as examining various models of financial support for SMEs developed elsewhere. Indeed, there needs to be a more pragmatic and immediate response to get funding flowing into Welsh businesses again especially, given the experience of the Business Bank, it is likely that that there would be numerous delays through state aid and procurement issues if a wholly new financial organisation were to be established, leaving Welsh business in limbo.

The review believes that five principles should form the core for any changes to the current way in which Welsh Government supports access to finance for the SME community and each will be discussed in turn before going on to propose an option that could work for the Welsh economy and which the Welsh Government could implement immediately.


1. Every viable business in Wales should get access to funding at an affordable price

This review was established not only to examine whether there was an issue related to access to finance for SMEs but, more relevantly, what the Welsh Government could or should do to intervene if there was a perceived market gap in provision from private sector providers. As the research into lending patterns by the banks has shown, lending to SMEs in Wales remains fragile despite statements from the banking community that it has ‘millions of pounds to lend’, is ‘open for business’ and has one of the lowest rates of lending to businesses has seen in a generation.

A number of reasons are given as to why small firms in particular are not meeting the criteria set by the banks for affordable lending, including under-collateralisation, shorter credit history, lack of an agency credit rating and paucity of verifiable financial information which banks can use to make credit allocation decisions. Given this, it can be argued that the state could, if it so wished, provide specific interventions to alleviate these different types of market failure and provide a greater flow of credit to businesses.

This is the approach currently being undertaken by the UK Government with the creation of the Business Bank and the Funding for Lending scheme. In the context of Wales, the fiscal levers that are at the disposal of the Welsh Government are limited, although the recent announcement regarding borrowing powers from the UK Government suggests that there may be an opportunity to acquire funds from the capital market to support SMEs. There is also the opportunity to use its own economic development function, as well as the highest level of European Structural Funding, to provide solutions to address the lack of funding available to businesses.

Currently, Finance Wales is the main alternative supplier to the banks of debt and equity funding for SMEs in Wales but, as the evidence has shown, the cost of borrowing to Welsh businesses is above the EU reference rate for its loans despite being owned by the Welsh Government. This is different to other countries, with evidence from the European Union showing that there are numerous financial instruments that offer a lower cost of borrowing to SMEs than Finance Wales.

The Bank of North Dakota (BND) stated that it did not charge high interest rates because that would be tantamount to setting up the business to fail and there was no rationale in borrowing costs that amounted to “a dime in every dollar” going back to the state when it could be used within the business to create jobs. An interview with Finnvera, the state owned Finnish Bank, showed that a public fund could offer lower rates of interest generating a healthy surplus through its operations. Currently, and whilst operating under the EU reference rate regulations, Finnish SMEs can gain access to borrowing at a cost of between 1.5 per cent and 6 per cent. Unlike Finance Wales, Finnvera has made a decision not to support businesses which it considers to be a bad risk.


2. The primary role of government-backed funding for SMEs is to drive forward economic development

During the recession, publicly-owned financial institutions played a vital role in supporting SMEs and their financial requirements. For example, the Small Business Administration (SBA) in the USA worked closely with local financial institutions to distribute loans to small businesses whilst in Germany, the Sparkassen (savings banks) have played a vital role in ensuring that funding reaches businesses operating within the local area that each bank serves. Indeed, the dual focus of German regional banks on both their financial position and their wider social role has meant lower rates of return on capital but delivered greater stability and long-term support for small firms.

As a recent review of the German banking system noted, “There has to be part of the financial system in Britain that operates not as an end in itself but to serve society and the real economy. Without this there is little prospect of rebuilding the economy on the basis of real products and real services that produce real wealth for the benefit of the nation” .

In Wales, various funding initiatives promoted directly by the Welsh Government are related to economic development priorities, including job creation. In contrast, the mission of Finance Wales had, until recently, been focused on establishing itself as the leading fund manager in the UK. It has been argued that both can complement each other but during a time of economic hardships experienced during the last five years when access to finance was difficult for SMEs in Wales, the primary and overriding focus should have been on supporting businesses to create jobs and yet Finance Wales’s JEREMIE Fund remains well behind on its targets to create jobs under the ERDF programme.

Contrast this with the situation in Finland where the state owned bank not only saw the number of businesses applying for public financing increase by 12 per cent, but focused its efforts on introducing counter-cyclical loans and guarantees to finance working capital for enterprises whose profitability or liquidity had declined because of the economic crisis. It was estimated that without this funding, the number of job losses in the Finnish economy would have been twice as high as actual job losses (23,700) in 2009 and 2010.

Therefore, the role of any publicly funded programme to support access to finance for SMEs has to focus on economic policy goals as its first priority but can also support the individual goals of SMEs at the same time, shown in Figure 1 which illustrates the public funding philosophy adopted in Germany.


Figure 1. Broad promotional funding landscape in Germany.

3. It is not the role of the public sector to displace the private sector but to address a market failure in the provision of finance to SMEs

At a recent event to discuss access to finance for SMEs, there was consensus that it was not the role of the Government to make direct investments in SME financing, but rather to encourage an atmosphere in which SME lending could occur, as well as to increase the effectiveness of schemes to encourage funding. Others have noted the need to identify well specified market failures to avoid competition with the private finance sector and, where possible, to work with the private sector to the benefit of both the funding scheme and the wider development of the financial community.

Whilst some have argued for the Welsh government to create a publicly owned institution that then competes directly with the banks for SME customers, one could argue that Finance Wales has already evolved into such an entity and is in the Welsh market looking for deals against the high street banks and other providers. As one respondent noted “Offers of funding to clients from our investment fund have been displaced on more than one occasion by competing offers from Finance Wales….we do not feel Finance Wales should be competing with private sector funds – or indeed any other sources of funding. Surely it is not its role to displace other sources of finance. By competing with others it also discourages entrants to these segments of the business finance market”.

Interviews undertaken during the review suggest that one of the strengths of publicly owned institutions such as BND and Finnvera (see case study below) is that neither organisation sees itself as competing with the banking system and is instead a complementary partner in supporting SMEs. For example, the BND was created to partner with other financial institutions and assist them in meeting the needs of the citizens of North Dakota. Well-structured credit guarantee schemes can, if developed in partnership with the Welsh Government, spread some of the risk and thereby enable banks to extend loans to firms that would find it difficult to access credit otherwise.

As discussed in the first stage of this review, the UK Government operates the Enterprise Finance Guarantee scheme although there have been no recent regional loan guarantee systems developed in the UK, which is very different to what is found in other parts of the World. For example, of the 3.9 billion euros disbursed to enterprises by EU financial instruments, 32 per cent were in the form of loan guarantees  with 134 funds offering guarantees as a financial product.

The Welsh Government has already been in discussions with three of the high street banks about the potential of this development which could, if implemented, give Welsh businesses access to funding across Wales. More relevantly, no new expensive branch network would be needed as this could be managed via the current structure of banking participants. In addition to working closely with the banks, it is clear that more can be done by the Welsh Government to attract and encourage greater levels of private sector investment into Wales, especially for high growth businesses, through encouraging informal investment and developing greater links with venture capital organisations.

Finnvera PLC

It is a specialised financing company, owned by the State of Finland, which supplements the financial services offered by the private sector. Finnvera provides financing for various stages in the life of an enterprise: for its start, growth and internationalisation, and for exports (Finnvera has an official Export Credit Agency (ECA) status). In the first six months of 2013, it offered €420 million in financing to SMEs.

The Finnvera Group reinforces the capacity and competitiveness of Finnish enterprises by offering loans, domestic guarantees, venture capital investments, export credit guarantees, as well as interest equalisation and funding for export credits. Finnvera has about 30,000 clients and employs nearly 400 persons including more than 100 business analysts of corporate finance and development. It has a network of 15 regional offices throughout Finland and a representation office in St. Petersburg.

By providing financing, Finnvera strives to promote the internationalisation and exports of Finnish enterprises; the operations of small and medium-sized enterprises, especially in situations of change; and realisation of the government's regional policy goals.

The Ministry of Employment and the Economy monitors and supervises Finnvera and sets annual goals for its operations. When determining these goals, attention is paid to the Finnish Government Programme, the Ministry's corporate strategy, the policy objectives concerning the Ministry's branch of administration, and the goals of EU programmes. In 2012, Finnvera's strategy was adjusted so that the company is increasingly able to respond to new challenges in corporate financing. The focus of operations has now shifted more on speeding up the growth and internationalisation of companies and on improving the financing options available for start-up enterprises.

4. It is critical that business and skills support is offered alongside financial support to businesses in Wales rather than as separate elements 

Research has shown that various public organisations that are involved in supplying financial support to businesses also provide various types of business support to their clients. A recent evaluation of European financial instruments suggested that the provision of business advice is a key element of some financial intervention tools although this can depend on the development stage of business.

For example, the provision of advice and support for entrepreneurs who may have little business expertise is important although as the business grows, the founders and their managers may already have significant experience although they may also wish to buy in specialist support services. There are advantages in having a joined up approach to business and financial support so that a company can evolve as it grows towards different services being provided by such an organisation. There could also be benefits in terms of reduction in costs but also a stronger relationship with the beneficiary, which leads to better access to information (which is a problem for many banks) and a reduction in risk when lending. More importantly, financial and business support needs to be available at different stages of the life cycle of the business.

In the USA, the Small Business Administration provides grants and loans alongside its counselling and training programmes for small business. The Swedish funding agency Almi provides advisory services to customers at all stages of development from ideas to successful companies through both its own internal advisers and external sub-consultants.

Another example of how finance and business support can lead to benefits for business can be found in Canada. The BDC is Canada’s business development bank and promotes entrepreneurship by providing highly tailored financing, venture capital and consulting services to entrepreneurs. A recent review of its services showed that whilst sales growth among BDC financing clients was up to 14 per cent higher than that of non-clients, those firms that used both the financing and consulting services performed better with sales growth of up to 25 per cent greater than that of non-clients.


5. Funding solutions should be customer-oriented

As the first review has shown, there is a plethora of different public funding schemes that are available to businesses in Wales. These range from the ten grant programmes operated by the Welsh Government, the five different funds currently being managed by Finance Wales, UK Government schemes such as export guarantees and the Business Growth Fund, and various European funded initiatives to support innovative firms and high potential start-ups.

Add to this the different types of funding that is available from the private sector, such as loans, asset finance, and invoice discounting, as well as new types of alternative funding – P2P lending, crowdfunding - and the landscape therefore remains confusing to the average SME. According to a member of one the Welsh Government’s sector panels, many SMEs including large successful companies, are either unaware of or confused by the variety of schemes available, deterring some from seeking finance.

In its paper on establishing a new business bank, the British Chambers of Commerce emphasised the need for a single ‘brand’ for Government finance support and the consolidation, at a UK level, of various funding schemes into one organisation. This principle should be adopted for Wales and the Welsh Government should consider whether all funding schemes, including grant support currently operated within the Department for Economy Science and Transport, should be located within the same organisation. Not only would this have considerable efficiency costs and marketing synergies, but would enable the focus to be on the SME’s specific needs.

FINANCE WALES AND THE COST OF LENDING TO WELSH SMEs

The first part of the Access to Finance review noted the role of Finance Wales, which is wholly owned by the Welsh Government, in providing finance to Welsh SMEs since its creation in 2001. It is currently managing over £200m worth of investments in Wales over four live funds, namely:

• The £150 million Wales JEREMIE Fund that aims to encourage effective investment in small and medium-sized businesses. The Fund is backed by the European Regional Development Fund, the Welsh Government and the European Investment Bank; 
• The £40 million Wales SME Investment Fund which is backed by the Welsh Government and Barclays and invests in micro, small and medium-sized firms;
• The £6 million Welsh Government-backed Wales Micro-business Loan Fund;
• The £10 million Wales Property Development Fund, which makes loans to small and medium-sized Welsh construction companies developing small-scale, non-speculative commercial and residential property. 

In addition, Finance Wales also manages three funds in England namely the North East Growth Plus Fund (£20 million), the North West Funds for Loans Plus (£45 million) and the Tees Valley Catalyst Fund (£10 million). The latter was launched in June 2013.

One of the key themes that emerged was that of the cost of debt lending, which a number of respondents had suggested was often higher than the rate offered by the banking sector in Wales. For example, a number of the Welsh Government’s sector panels had concerns about the effectiveness of Finance Wales, stating that interest rates on offer are too high for the market and the security required against loans can be too onerous for small businesses.

Following the first stage of the review, Finance Wales made a formal response to the Minister in which it was suggested that this conclusion was incorrect. The argument used by Finance Wales was that it had to charge higher rates of interest because it had a higher default rate than the banks. As a result, the Minister requested that an examination of the cost of lending and the approach taken by Finance Wales to supporting SMEs should form part of the second stage of the review. This will also help to inform how the Welsh Government’s role could change in delivering finance to businesses in Wales.

Cost of lending to SMEs

Since it was established, Finance Wales has operated a number of funds, all of which have charged different costs of borrowing to Welsh SMEs.

The difference between the average cost of borrowing across all of the funds and the average EU base rate has actually increased from 0.43 per cent in 2001 to 9.69 per cent in 2013 (table 1).

Table 1. Finance Wales – average interest rate for all loans, 2000-2013.

In addition, it is worth noting that the current Bank of England estimated median lending rates for SMEs was 3.55 per cent in August 2013 (Figure 1).


Figure 1: Indicative median interest rates on new SME variable-rate facilities, 2008-2013 

As Figure 2 shows, if the difference between the cost of borrowing on each loan since 2001 (in blue) and the EU base rate at the time (in red) is tracked, the difference between the two begins to increase considerably in 2008.

Figure 2: Cost of borrowing on Finance Wales loans, EU base rates, 2002-2013

As will be discussed later, the rationale which has been adopted by Finance Wales for these higher levels of borrowing costs to SMEs will be discussed later and its veracity will be examined in more detail. This is important historically but in terms of this review, the focus will be on the four main loan funds operated by Finance Wales namely Finance Wales III (the interim fund), JEREMIE Fund for Wales, the Wales Micro-business Loan Fund and the SME Fund (Finance Wales suggested that as it manages various funds that range from straight debt through to mezzanine and quasi-equity products, data would be difficult to provide to the review. Therefore, detailed statistics were requested on loans only which make the majority of the borrowings from Finance Wales).

Since October 2007, there have been 743 loan investments made by Finance Wales across these four funds. As Figure 3 shows, 73 per cent of these loans have attracted a cost of borrowing of 10 per cent or higher and there have been only thirteen investments at a rate lower than 8 per cent.


Figure 3. Number of Finance Wales loans by the cost of borrowing, October 2007-

Therefore, the evidence seems to suggest that Finance Wales’ loans are more expensive than the median for UK banking sector, although this must be mitigated by the fact that, according to EC regulations, state-backed funders must offer standard loans at rates that reflect the credit worthiness of the business and the collateral offered against any possible default so that this reflects market rates.

The cost of borrowing and EU reference rates

Finance Wales is an organisation that is wholly owned by the Welsh Government and, given this, there is an expectation that its primary aim must be to support the Welsh economy, particularly the SME sector. One instrument in achieving that would have been through lower interest rates to businesses, especially at a time when banks were not lending for other reasons such as lack of collateral, affordability and overexposure in some sectors.

As with all financial instruments supported by European and state funding sources, Finance Wales’ loan funds have to comply with EC regulations on reference and discount rates. Simply put, guidelines have been developed as to the minimum cost of borrowing that can be charged so that it reflects market rates, i.e. is similar to what the private sector would offer and therefore does not breach state aid rules. To determine the actual rate, a new methodology has been drawn up by the EC that takes into account both the credit rating of the business and the collateral it will offer for the loan (table 2).

In this case, the credit rating  is obtained from either from a credit agency or a national/government institution)  and collateral should be understood as the level of collateral normally required by financial institutions as a guarantee for their loan i.e. the level of collaterals can be measured as the Loss Given Default (LGD), which is the expected loss in percentage of the debtor's exposure taking into account recoverable amounts from collateral and the bankruptcy assets. Therefore, ‘High’ collateralisation implies an LGD below or equal to 30 per cent; ‘Normal’ collateralisation an LGD between 31 per cent and 59 per cent and ‘Low’ collateralisation an LGD above or equal to 60 per cent.

Table 2. European Commission guidelines on loan margins.




Therefore, for an average SME with a satisfactory credit rating and normal collateral  that is applying for a loan, the financial institution utilising European or state funding to support its loans programme must, to avoid a breach of state aid rules, charge a minimum of 2.2 per cent above the base rate. Currently, that would be 3.19 per cent (as the base rate is 0.99 per cent). Therefore, the interest rates to be offered can, depending on the creditworthiness and security offered by the business, range from 1.59 per cent to 10.99 per cent.

If EU member states apply the calculation method of these reference and discount rates in force at the moment of the grant of the loan and comply with the conditions set out in that communication, the interest rate does, in principle, not contain state aid. As a result, every publicly backed financial institution, to be compliant with state aid rules, applies the above principles to its debt lending and Finance Wales is no exception.

In a response to the review, Finance Wales stated that their

"State aid legal advice has consistently been based on the view that provided we are lending at a rate that is at least at the EC Reference Rate plus the appropriate risk margin, this is strong evidence that the loans do not contain State Aid.  Clearly, the greater the margin over the minimum the stronger such evidence that the loans are at market rates. If we lent money below the minimum margins for the relevant Rating and Collateral indicative margins (most SMEs fall into the BB-CCC or lower categories with low collateral, therefore risk margins are typically 4-10 per cent), this argument of market rates would fall away and a potential state aid challenge become more likely.”

However, the evidence shows that Finance Wales is charging higher margins than that required by the European Commission to satisfy state aid regulations and that there are considerable differences between the cost of borrowing with regard to the reference rates proposed by the European Commission and the different rate categories offered by Finance Wales.

It would have been useful to be able to directly compare the fifteen different rates used by Finance Wales with their equivalent EC rate categories as shown in table 2. However, Finance Wales, despite providing the table below to the review, then withdrew permission to use it within the report. The rationale for this was that the information was commercially sensitive, the pricing guidelines are an internal document and, on their own, do not fully explains how risk is assessed on each investment. This was despite the fact that Finance Wales had already made public their three main categories of risk in the first report; that only thirteen investments in the current fund have been charged at less than eight per cent interest; and that, according to one of their senior executives, Finance Wales is not in competition with other funders as “most applicants to FW have been rejected by the usual sources for funding”.

Table 3. Finance Wales guidelines on loan margins  

Nevertheless, the limited comparison of tables 2 and 3, using the published reference rates for three categories, shows that the difference between the EC reference rate proposed and the minimum cost of lending proposed by Finance Wales is as much as six per cent. It has been difficult to determine the scale of this overcharging, as Finance Wales does not keep detailed records of the collateral and credit rating of businesses on its internal IT system and, as a result, it has not been possible in the time available to determine how many businesses may have been paying above the suggested EC rates.

Therefore, the best proxy for this is to examine the individual rates of interest paid by each business according to the three main categories of risk supplied by Finance Wales. This estimates that if the EC reference rates had been adhered to accurately, up to 10 per cent of the current portfolio could have been paying interest rates as low as 1.99 per cent, and a further 50 per cent could have been paying interest rates as low as 4.99 per cent instead of 10 per cent. This would have been achieved without any breach of state aid rules. With regard to the interest rates for companies in bad financial difficulties with low collateral (which would be paying a minimum of 10.99 per cent), the EC recommended rate for Finance Wales is 12 per cent.

This suggests that Finance Wales could have lent at lower interest rates to Welsh SMEs without breaching state aid regulations if it had chosen to do so. In addition, there are also other costs that it charges to Welsh business on top of interest rates as part of the loan process. For example, average monitoring fees are 0.54 per cent, average arrangement fees are 1.8 per cent on current funds. In addition, Finance Wales also charges legal fees.

In responding to this study, Finance Wales stated that it regularly reviews its interest rates and benchmarks against various market indicators including LIBOR, Bank of England guidance on future rates and general competitor rates. Yet, whilst other state backed funds have kept their interest rates relatively low (e.g. Finnvera’s normal cost of borrowing to Finnish SMEs is in the range of 1.5 per cent to 4 per cent), there have been no substantial reductions in the cost of borrowing from Finance Wales even though the EC base rates have fallen since 2008. 

As table 4 shows, whilst effective interest rates in the EC have declined during the last five years, Finance Wales pricing guidelines have stayed static until January 2013 when they actually were increased for ‘safer’ businesses but decreased for those businesses that can be considered as high risk. With Finance Wales being wholly owned by the Welsh Government, the decision to increase rather than decrease the cost of borrowing to Welsh businesses does not resonate with the current administration’s pledge to “ensure the maximum effectiveness and flexibility of all those Assembly Government departments and other organisations providing support for businesses, especially in these economically uncertain times”.

Table 4: Finance Wales guidelines on interest rates relative to EU guidelines.

 The submission from the FSB noted that its members frequently came into contact with Finance Wales, believing it to be an organisation designed to support SMEs with investment but are then disappointed to find very restrictive and expensive lending conditions. One respondent noted: “My surprise to see that the offer on the table is more expensive in interest rates compared to the existing [High street bank] overdraft in place, the personal securities required are the same if not more stringent as from the bank, and on top Finance Wales is asking for 1.5 per cent lending fee, 0.5 per cent monitoring fee and a £275 security fee for the guarantee. This is a more commercial proposal based on stripping from any SME as much money as possible and in direct competition with the commercial banks and not offering small business any benefits at all.”

Therefore, many SMEs in Wales may find it difficult to understand why Finance Wales has not taken the opportunity to reduce its interest rates on loans, especially as there seems to be sufficient flexibility within the EC reference rate guidelines to do so.

Finance Wales’s strategy

As to all intents and purposes the sole shareholder, Welsh Government will need to determine the future strategic direction of Finance Wales and, more importantly, the role it should play in the future financial landscape for Welsh business alongside other providers. Given the evidence submitted by Finance Wales to this review, it can be argued that during the last few years, Finance Wales has predominantly focused on developing itself as an investment fund rather than as an economic development tool for the Welsh Government. 

When Finance Wales was first established in 2001, its mission was to “assist Welsh businesses to realise their true potential for innovation, growth and economic impact in the region”. In addition, its key objectives were to: 

• Increase the indigenous base of SMEs in Wales;

• Encourage diversification and development of new markets and products;

• Enhance capacity for Wales to grasp new competitive opportunities;

• Improve the growth rates of businesses accessing finance and

• Create new jobs.

So what was the logic behind this change in direction from the original focus on Wales and Welsh SMEs? According to Finance Wales, the organisation adopted a self-funding strategy in 2009 which had two main components - cost savings and efficiencies - and the pursuit of profitable fund management contracts which would both cover the cost of managing the funds and contribute to central costs (finance, IT, marketing), thereby reducing reliance on Welsh Government core funding. 

Options were also considered in 2009 to “spin out” Finance Wales as a solution to a potential funding shortfall in the Welsh Government capital budgets of around £90 million. This followed discussions between Welsh Government and HM Treasury in late 2008 in which it was verbally agreed that Finance Wales’ borrowings from both Barclays and the European Investment Bank (EIB) of £95 million would not count against these budgets. Following a change of UK Government policy in 2008, these borrowings were then considered “on balance sheet” and Finance Wales was asked to consider ways in which it could to take its borrowings off balance sheet, which included becoming an independent commercial body.

During the two years it took to resolve the matter, the evidence suggests that Finance Wales therefore became more focused on developing itself as an independent fund with its role as an arm of the Welsh Government becoming a secondary issue. This is not only reflected in its lending policy, which is more similar to that of a private investment fund than an economic development body, but also its decision to move outside of Wales to manage funds in the North East and North West of England . This would enable it to earn management fees to move towards a self-funding position that would be necessary if the organisation was located outside of the public sector. This issue was resolved in 2010 when it was concluded that it was not financially or logistically viable to spin out Finance Wales and it would remain as part of the Welsh Government. 

Despite this decision, the evidence suggests that it is only recently that Finance Wales has begun to change its focus towards its economic development role. For example, in its 2010-11 annual review, its mission statement pronounced that it wanted “to become the UK’s leading SME Investment Company”. This was further emphasised by its decision to undertake the management of other funds outside of Wales - a direction that many respondents have questioned - and to compete directly with other financial institutions for new business. 

With the appointment of a new Minister responsible for business and the economy in June 2011, a different direction was set out for the relationship between the Welsh Government and Finance Wales. In a letter to the Chairman of Finance Wales on September 20th 2011, the Minister stated that she wanted to see a “clearer alignment between the activities of Finance Wales and the priorities of the Welsh Government”. This included the appointment of a new independent board member to look after the Welsh Government’s interests. 

It could be argued that this change in direction has been partly reflected in the new mission statement of Finance Wales, which is “to maintain our position as the UK’s leading SME fund manager, delivering commercial investments from public and private funds to support and encourage SME growth and create sustainable businesses in Wales, fully aligned with Welsh Government policies”. However, this wording still suggests a reluctance to move away from a primary focus as a private fund manager towards a greater role in supporting SMEs in Wales. That role, as will be discussed later, may include moving towards more affordable lending to businesses rather than focusing on generating surpluses in its funds, as a normal fund manager would do. 

There is also a question regarding Finance Wales’ wider role in supporting SMEs in Wales. According to its own data, 915 business plans have been received from Welsh SMEs since 1st April 2012 of which 317 were declined (a rejection rate of 34 per cent) with the main recorded reason being the underlying viability of the business plan. The evidence to the review suggests that any rejected firms were only then introduced to the wider business support community on an ad hoc basis (although Finance Wales has now stated that it has recently introduced a more formal relationship with Business Wales to ensure reciprocity of introductions and more joined up support for mutual clients).

Therefore, the evidence submitted to this review indicates that there continues to be a reticence within Finance Wales to accept that it could have reduced the cost of borrowing to SMEs across Wales. More relevantly, it should have focused its efforts on developing the Welsh economy as its key mission and not only as a consequence of the management of its funds. If it is to retain the confidence of Welsh business community then it needs to address these issues. 

Four weeks prior to the publication of this review, Finance Wales announced that it was planning to reduce interest rates for borrowings from the JEREMIE Fund, the SME Loan Fund and the Micro-business Loans Fund within the seven Welsh Enterprise Zones. This was a welcome development in that it demonstrated that, contrary to earlier claims during the first stage of this review, interest rates could be reduced by Finance Wales to support SMEs.

It also showed that Finance Wales could use the financial instruments at its disposal to reflect the economic development policies of the Welsh Government.  Despite this, serious questions remain as to why Finance Wales had not previously considered utilising lower interest rates as an effective economic policy tool prior to this announcement and during a period of sustained economic crisis and reduced lending  from the banking sector.

Exemptions for state aid regulations

In developing a policy of interest rate reductions for enterprise zones, Finance Wales has made the case that this decision does not breach state aid. Further research into the state aid issue raises questions as to why Finance Wales has previously not pursued greater flexibility through utilising mechanisms that would minimise the impact of state aid regulations on its ability to offer lower costs of borrowing to SMEs across other parts of Wales. However, the prohibition of state aid is not absolute and current state aid rules do allow public authorities, under certain conditions, to assist SMEs.

General Block Exemption Regulation (GBER)

By using GBER, loans financed under Structural Funds programmes can be rendered compliant by ensuring that the interest rates payable respect the grant equivalent thresholds, taking account of the relevant reference rates discussed earlier.

Advice received from the Welsh Government suggests that “GBER can be used for transparent forms of aid including loans.  The calculation must take account of the reference rate at the time the loan is made.  The aid element is the interest forgone by the public authority.  For example if an interest free loan was made for a capital investment project, then the aid element would be the interest not collected by the public authority.  You would of course need to ensure that all other terms and conditions are met e.g. the ‘free interest’ does not exceed the aid intensity when the eligible costs are taken into account, the company is not in an excluded sector etc.”  Independent expert advice has confirmed this position.

Various policy papers (including these from the University of Strathclyde and the College of Europe) have also discussed how GBER can be used to minimise the impact of state aid regulations. The principles within these documents suggest that GBER could have been used to subsidise the interest rates on loans to SMEs within the two thirds of Wales classified as qualifying for the highest level of aid and been a significant policy tool for Welsh Government.

For example, with the maximum intervention rates for capital investment and employment for a small business operating within West Wales and the Valleys set at 50 per cent, interest rates could have been discounted by Finance Wales without breaching state aid regulations. Even within the non-assisted areas within East Wales, aid of up to 20 per cent on investment could have been provided in the form of cheaper loans for small firms.

De Minimis

It has also been suggested that the cost of borrowing could have been reduced for a high number of small firms through the use of de minimis aid. This describes small amounts of state aid that does not require formal approval i.e. the European Commission considers that public funding which complies with the de minimis regulation has a negligible impact on trade and competition and does not require notification and approval. The total de minimis aid which can be given to a single recipient is €200,000 over a three year fiscal period. This can be granted for most purposes and is not project-related.

Indeed, when it was first established in 2001, Finance Wales operated an interest rate rebate scheme and management support services under the de minimis rules. The de minimis rule is particularly important in terms of the financing of new businesses and micro-businesses, which are usually judged to have the highest risk profile because of limited collateral and credit ratings and therefore attract the highest level of reference rate. If the economic development aim of a government was to promote start-ups and micro-businesses, then a lower interest rate could be charged under the de minimis rules if a business did not breach the €200,000 limit on such aid within three years.

For example, the Start Up Loans programme established by the UK Government to encourage more young people to set up their own firms provides funding to start-ups and therefore should, according to the reference rates, be charged at the highest minimum level. With an average loan of £4,500, the de minimis rule is being used by BIS to lend money at a nominal fixed rate of 6.2 per cent instead of 10.99 per cent. Commercially, such a low interest rate would not normally be approved and there have been estimates that up to two fifths of the loans are unlikely to be repaid. However, this is justified as being a government policy decision to financially support young entrepreneurs in a time of economic difficulty rather than a commercial decision taken by a private organisation. For such a low amount, even lower rates can be charged without any risk of breaching state aid regulations.

Contrast this with the development of the new Micro-business Loan Fund in Wales that is a direct response to the recommendations of the Micro-business Task and Finish Group. Its final report, published in January 2012, identified that access to finance is a key barrier to growth for this size of firm and recommended that the Welsh Government should facilitate accessible finance of between £1,000 and £20,000 that is simple to access and reflects the level of investment required. As a result, the Welsh Government has provided funding of £6 million for a new loan fund that was launched earlier this year. As of the end of September 2013, this fund had invested in sixty-one micro-businesses with an average loan of £15,000 at an average interest rate of 11.2 per cent.

Whilst this rate of borrowing may be commercially sound, there is a question whether the approach taken by Finance Wales is one that reflects the economic development imperatives of the Welsh Government and the conclusions of the Micro-Business Task and Finish Group that “viable micro-businesses need viably-priced debt finance”. With the evidence from this review demonstrating that the lending to small firms continues to be stagnant, the cost of lending to micro-businesses by Finance Wales seems excessively high, especially compared to the Start-Up Loan programme currently operating in Wales and other micro-financing initiatives in other European counties (for example, Microfinance Ireland  offers a fixed rate of 8.8 per cent to those micro-businesses being supported under its remit and Deutsches Mikrofinanz Institut in Germany, 8.9 per cent).

Therefore, it can only be concluded that that there have been no state aid impediment to Finance Wales offering cheaper loans to the vast majority of micro-businesses under de minimis regulations. Similar reductions could have been imposed across the £40 million Wales SME Loan Fund although Finance Wales has decided to apply the same rationale on borrowing to this fund. In fact, according to Finance Wales, no discussion has been undertaken with the Welsh Government over the cost of borrowing to be applied to the SME Loan Fund.

Summary

Following a request from the Minister, this section has undertaken a detailed review of Finance Wales and its approach to debt funding of SMEs. It has concluded, as many interviewees pointed out during the review, that Finance Wales was offering higher rates of interest on borrowing to SMEs within Wales. There may be sound commercial reasons as to why this is the case and arguments have been made that if it had been operating essentially as a commercial fund manager, albeit one owned by the Welsh Government, then the rationale for self-sufficiency as the key part of its corporate strategy explained a number of issues that have arisen in this report. There also remains the question why it has not utilised the full range of financial instruments available to it through both de minimis and GBER, especially for the convergence area of Wales that qualifies for the highest level of structural funding intervention. 

Since the JEREMIE Fund was launched in 2009, the indication is it has operated a universal pricing tariff for JEREMIE-backed loan facilities irrespective of the geographical location of the borrowing entity. A similar approach has subsequently been adopted with the SME Loan Fund and the Micro-business Loan Fund. On the face of it, this appears to be an unusual approach given the existence of ‘match-funding’ in the form of ERDF and the higher intervention rates that are available in the poorest parts of Wales. Given the availability of such a geographically defined financial mechanism, one might therefore expect its operation would have been reflected in a territorially differentiated pricing structure. It has not, although this can be corrected within those financial instruments that will be developed for the next round of European Structural Funding.

That this situation has occurred is unfortunate since it suggests firms have faced a situation where the cost of capital provided by Finance Wales is greater than might otherwise have been the case. Whilst Finance Wales may have provided the finance needed at a time when the banks were not lending, it is reasonable to speculate that this policy may have discouraged viable businesses from applying for financial support and affected the financial management of those in receipt of funding during an economically challenging period. It is equally unfortunate that they have been allowed to persist and, inevitably, it raises questions about the degree and intensity of oversight that Finance Wales was subject to both internally and externally at the time of the launch of the JEREMIE Fund.  

As the first report noted, it is still unclear as to whether Finance Wales is essentially operating as a commercially oriented fund manager in all but name.  Whilst there have been welcome developments such as the appointment of new board members to drive forward the Welsh Government’s interests and the recent enterprise zone reductions, this has to be tempered with evidence of a reluctance by Finance Wales to fully embrace its role in supporting SMEs and economic development in Wales and its apparent confusion over its commercial ambitions with its development responsibilities.  It has constantly used breach of state aid as its defence for its high interest rates and yet expert opinion in this report demonstrates that it could have lowered the cost of borrowing if it had so wished.

And despite the clear remit given to it by the current EST Minister, the most worrying aspect is that there is little indication of any change, as the following statement on the future of the organisation makes clear in its latest annual review: “The Finance Wales Group is a leading UK SME fund manager and we aim to be a sustainable long-term investment company. We raise our funds from a range of commercial and public sources and we need to ensure we achieve effective returns when we invest these funds.”  

Therefore, if the role of Finance Wales is to support economic development and the SME sector in Wales, the evidence suggests that it is currently not fit for purpose in achieving this aim. As a result, the EST Minister may have a view as to how this role could change to achieve this aim, including bringing Finance Wales directly into the Welsh Government to fulfil the economic development role it has not prioritised in recent times. The next section may help to provide guidance on the strategy and structure need to ensure that Welsh SMEs get the best support possible to help develop the economy of Wales.

TRENDS IN BANK LENDING TO WELSH SMEs

In January 2013, the Minister for Economy, Science and Transport announced an independent review into access to finance for SMEs in Wales. Supported by a voluntary advisory panel from academia and business, the aim of the review has been to examine how effectively SMEs in Wales are served by existing sources of funding, identify areas of particular challenge and provide recommendations for action. There are five sections to the report, namely:

• Banks lending patterns to SMEs
• Alternative sources of funding
• The role of Finance Wales
• The principles of public funding for SMEs
• the case for a Development Bank for Wales.

Over the next five days, I will be publishing each of the sections individually so that those wishing to respond to the review can understand each aspect of the issues surrounding access to finance to SMEs that have emerged from the 10 month consultation.

This blogpost will examine the current state of lending by the banks to SMEs in Wales. It will update the data from the first access to finance report published in June 2013 and will examine whether the situation regarding access to finance from the banks to the SME sector in Wales has changed since then.


UK trends in bank lending

At a UK level, the latest available data show that, in terms of gross lending, a total of £308 billion has been lent to all non-financial businesses in the UK since September 2011 (Figure 1).

Of this, only 26 per cent (£80 billion) have been lent to SMEs and net lending, after repayments, for UK SMEs has gone down by £10 billion (for the banking sector, SMEs are those businesses with annual debit account turnover on the main business account less than £25 million; large businesses are those with annual debit account turnover on the main business account over £25 million). This suggests that there continues to be little appetite by firms for bank lending or, as some suggest, a lack of credit being made available to smaller businesses.

As of August 2013, there was a total of £420 billion of fixed term loans outstanding to the banks from non-financial business in the UK, with SMEs accounting for 36.7 per cent (£154 billion) of this amount. Therefore, and contrary to expectation, the Bank of England’s statistics suggest that there has been no substantial increase in the level of lending to SMEs during the last 12 months (September 2012-August 2013). 

In fact, there has been an overall decline of £1.2 billion during this period and the only monthly growth in net lending to SMEs (excluding overdrafts) since September 2011 has been in March 2013 and May 2013, despite claims from the high street banks.

The other main form of debt funding from banks to SMEs is via an overdraft i.e. a short-term loan giving customers the right to overdraw their bank account by an agreed amount and which is normally repayable on demand. According to Bank of England data, there is a total of £34.6 billion of overdrafts with UK businesses, with SMEs accounting for 42 per cent (or £15.5 billion) of this amount. This has fallen by 25 per cent since September 2011, indicating that banks have been put under pressure, through Basel III arrangements, to reduce their risk through such lending to SMEs. 

Various conversations with banks, customers and intermediaries also suggest that there has been acceleration in businesses having their overdrafts withdrawn because of a lack of utilisation and then being encouraged to move into invoice discounting. Whilst it is argued that this may be more effective for managing cashflow, this type of finance is not suited to every business and may cause difficulties over time. 

Therefore, in terms of total loans and overdrafts, SMEs owe a total of £169 billion or 37 per cent of all lending to businesses in the UK. This equates to an overall reduction in debt finance facilities of around £25 billion (or a 13 per cent decline) since September 2011. At this stage, there is no clear evidence that this situation will change soon although hopes of a growing economy may transform the appetites of both the banks and SMEs towards increased lending and borrowing respectively.

Figure 1: Gross lending (excluding overdrafts) to non-financial businesses, 2011-2013.

There are also mixed messages regarding lending emerging from the latest version of the SME Monitor, which reported that in Q2 of 2013, 44 per cent of SMEs using external finance (loans, overdrafts, credit cards), up from 39 per cent in Q1. This was higher than the 36 per cent of SMEs who met the definition of a “permanent non-borrower”, expressing no interest in external finance. However, this growth is in non-core products offered by the banks with the use of core bank products (overdraft, loan or credit card) remaining flat at 33 per cent. Indeed, overdrafts are now only used by 18 per cent of SMEs, the lowest since the SME Monitor was created. Instead, the growth is coming from ‘other’ forms of external finance (such as leasing, invoice discounting, grants and loans from directors), with use increasing to 21 per cent, up from 15 per cent in recent quarters.

Bank lending in Wales

The main source of information on regional lending from the banks can be obtained from the BBA, which publishes limited regional data on a quarterly basis, although this information only dates back to the third quarter of 2011. The updated statistics enable an examination to be made as to how Wales has been performing during the first two quarters of 2013. 

The latest data shows the following:

• Current value of loan balances in Wales in Q2 of 2013 was £4.284 billion, which equates to no substantial change on the position at the end of 2012. The value of overdraft balances had increased, during the previous six months, from £623m to £656m. This represents 4.9 per cent of the total UK lending by banks (loans and overdrafts) to SMEs, with 86.7 per cent of all banking in lending in Wales being in the form of loans, slightly lower than the UK (88.7 per cent).

• During the 12 month period Q3 2012-Q2 2013, the banks approved 11,459 loan facilities for Welsh SMEs with a total value of £862.6 million. The average loan was £76,016, the lowest of any UK region, with an average loan of £58,403 for small firms and £185,359 for medium-sized firms;

• A total of 16,469 overdraft facilities were approved for Welsh SMEs over the same period with a total value of £305.7 million. The average overdraft for SMEs was £20,738, the lowest of any UK region with an average overdraft of £14,610 for small firms and £56,648 for medium-sized firms.

The average loan for businesses with a turnover of less than £1million (i.e. small firms according to banking definitions) remains relatively high (as compared to what would be expected from most micro-businesses) and suggests that micro-enterprises may not be getting access to the smaller loans they require (microcredit is defined by the EC, as a loan or lease under EUR 25,000 to support the development of self-employment and microenterprises (which are defined by the EC as less than 10 employees, and a turnover of less than € 2million).

This supports the finding from the first report namely that whilst bank funding is available to businesses in Wales, many newer and smaller businesses do not get the funding they require, at least relative to the rest of the UK.

To examine this trend over a period of two years, table 1 examines the change in the value of loan balances for Wales over time as compared to the UK.

Table 1: Change in loan book and overdraft balances, Wales UK, Q3 2011 – Q2 2013.

Overall, the comparison shows that the amount of loans and overdrafts to SMEs in Wales has actually increased by £55 million (or 1.3 per cent) between quarter 3 of 2011 and quarter 2 of 2013. In contrast, the amount of lending to SMEs at a UK level has decreased by £4.6 billion, a fall of 4.9 per cent.  More detailed examination of the data shows a considerable difference in the lending profile of small firms and medium-sized firms in Wales. Whilst medium sized firms in the UK are facing difficulties in accessing finance, the loan balance for this size of firm in Wales has increased by 14.2 per cent over this period. In contrast, there has been a decline of £232m in the value of loan balances for small Welsh firms, which is the largest overall decline of any UK region over this period. This decline accounts for 40 per cent of the total UK fall in loan balance for small firms.

This supports the indications from interviews with stakeholders that it is smaller firms that are struggling to get loan funding from the banks. This view is also evidenced by the findings from the most recent Bank of England Agents’ summary of business conditions which suggests that whilst credit availability has continued to improve gradually, “Availability of finance remained polarised between very easy conditions for large companies, both for bank and capital market finance, and tight conditions for smaller companies holding few assets or operating in riskier sectors. For smaller companies, however, access to non-bank financing had increased further, and there were reports of greater activity by some ‘challenger’ banks albeit often in ‘lower-risk’ lending, such as asset finance.“

There has also been an 8.9 per cent fall in overdraft balances for small firms during this period (£33 million) although this is half that of the UK average. To explain this trend, banks have indicated that the reason that small firms’ overdrafts had been withdrawn or converted to invoice discounting was because of a lack of utilisation. For example, data from the BBA regarding overdraft facilities shows that only around 53 per cent is currently utilised by SMEs. Whilst this leaves almost half the agreed borrowing commitments available as ‘headroom funding’ for businesses to draw on, it is reducing year on year.

Whilst examining the decline in loan balances is one way of estimating the amount of funding that is available to Welsh firms, it is also worth examining the loan facilities that have been approved between 2011 and 2013. This data shows that whilst there have been fluctuations in the number of loan facilities approved for SMEs during the last two years, the number of loan facilities approved for medium-sized firms has remained almost flat (Figure 2). 

Figure 2: The value of loan facilities approved for small to medium sized enterprises in Wales, Q3 2011-Q2 2013

Figure 3: The number of loan facilities approved for small to medium sized enterprises in Wales, Q3 2011-Q2 2013.

In terms of the value of loan facilities being offered to SMEs in Wales (Figure 3), this has declined by 58 per cent since Q3 2011 with the value of lending to mid sized firms falling by 140 per cent over this period (from £159 million in Q3 2011 to £66 million in Q2 2013). In fact, it would seem that the main decline occurred between Q3 2011 and Q2 2012, with the number and value of loans to medium sized companies reaching equilibrium and staying there for the last 12 months. A similar pattern has been observed for overdrafts, with the value of such facilities for mid-sized firms in Wales falling by 67 per cent in the last two years. 

Cost of lending

It is not only the supply of lending from the banks that is critical to SMEs but also the cost of lending. This review has found it almost impossible to get any relevant data from the high street banks on the cost of lending to Welsh businesses. In fact, there is an argument made that it remains difficult to get any data on the cost of borrowing as the spread over relevant reference rates that SMEs face on new borrowing can vary widely, taking into account various business-specific risk and credit quality factors. As a result, there is no single definitive measure of loan pricing, though statistical and survey data can provide broad estimates.

The latest report on trends in lending from the Bank of England  (Figure 4) shows that indicative median interest rates and spreads on new variable-rate facilities to all SMEs has fallen slightly in recent months, according to survey data from the Department for Business, Innovation and Skills. This shows that the median interest rates for SMEs stood at 3.55 per cent in August 2013, which equates to a reduction of 1.84 per cent since November 2008. 

For small firms, the median rate was slightly higher at 4.74 per cent - a reduction of only 0.93 per cent that suggests that those with limited negotiating power are paying more.  Another indicator of pricing on loans to smaller businesses (PNFC) - the Bank of England’s measure of effective rates on new corporate lending for advances of £1 million or less - was broadly unchanged over this period. 

Figure 4: Indicative median interest rates on new SME variable-rate facilities, 2008-2013 

This is the median by value of new SME facilities priced at margins over base rates, by four major UK lenders (Barclays, HSBC, Lloyds Banking Group and Royal Bank of Scotland). Data cover lending in both sterling and foreign currency, expressed in sterling; (b) Median by value of SME facilities (new loans, new and renewed overdrafts) priced at margins over base rates, by four major UK lenders (Barclays, HSBC, Lloyds Banking Group and Royal Bank of Scotland). Data cover lending in both sterling and foreign currency, expressed in sterling (c) Smaller SMEs are those with annual debit account turnover on the main business account less than £1 million  (d) Medium SMEs are those with annual debit account turnover on the main business account between £1 million and £25 million (e) Weighted average of new lending to PNFCs of all sizes by UK monetary financial institutions (MFIs) for advances less than or equal to £1 million. Data cover lending in sterling. The Bank’s effective interest rates series are currently compiled using data from 23 UK MFIs.

The reduction in interest rates over time was reflected in a recent survey from the Federation of Small Businesses, which showed that the cost of finance continues to reduce for UK small businesses. 

In Q3 2013, the average interest rate to small firms was estimated at 5.5 per cent, down from 6.3 per cent a year before. Within this average, almost a third of small firms report being offered loans at 4 per cent interest or lower in Q3 2013 – up from the 22.3 per cent of firms at the same time a year ago.

At the other end of the scale, the share of firms being offered interest rates of 6 per cent or higher has fallen back notably, with just 7.2 per cent of businesses being offered rates of 11 per cent or over, down from 9 per cent in Q3 2012. Similar reductions over time in the costs of loans have been found in the latest editions of the SME Monitor. For example, two thirds of the SMEs within the SME Monitor Q2 survey  stated that they were paying 6 per cent or less for fixed rate loans (with 23 per cent paying less than 3 per cent). 

Therefore, this evidence suggests that the cost of borrowing to SMEs remains low although evidence from the first stage review suggests that the main difficulty remains one of getting access to the loans with the banks still applying strict rules with regard to security, affordability and the viability of certain sectors. For example, one of the sector panellists noted that “the high street banks have "black-listed" whole sectors, in which our businesses trade, and have been very risk adverse regardless of the considerable financial strength, and low gearing, of our group.  Without the latter I do not believe we would have been able to finance our investment strategy at reasonable rates.”

Rejection rates

As stated in the first report, if a business is declined lending following a formal application for a loan, it has the right to appeal the decision. This is because the UK banks, through the BBA, have agreed a new set of principles for appeals that are monitored and scrutinised by an independent team of reviewers, ensuring that the banks have implemented a fair, prompt and transparent appeals process. 

According to the latest review, the banks have received almost 5,500 appeals since the inception of the new process in 2011, with 39 per cent overturned in favour of the customer and, as a result, an estimated £30 million in lending was put into the economy in its first two years. 4.6 per cent of the appeals have come from Wales, slightly higher than its share of the UK business population.

Detailed case data on a regional basis are only collected on those appeals which have been reviewed and the case selection is predominantly skewed towards reviewing those cases overturned in favour of the customer so that there is a better understanding of the reasons for overturns and whether any process improvements may be appropriate. In those cases, 46 per cent of the appeals were overturned in favour of the customer in Wales and it is worth noting that the main reason given the author of the review, Professor Russell Griggs, for the relatively high number of successful appeals was that banks rejected applications “too early” without giving them thorough consideration. This suggests that a considerable number of businesses that are, of sufficient quality to attract bank lending, are being turned down because of internal processes within the banks themselves.

Whilst banks are obligated to inform those declined for lending of the appeals process, the latest edition of the SME Monitor  suggests that amongst those initially declined, awareness of the appeals process remained low (only 15 per cent of those initially declined for an overdraft in the last 18 months and 7 per cent for those initially declined for a loan). It is also worth noting that most of the firms declined rated the subsequent advice given by the bank as to issues such as other sources of potential funding as poor (70 per cent for declined overdrafts and 62 per cent for declined loans).

As the first report noted, both the banks and Government could do more to ensure that those that are turned down for lending are not only given the opportunity to appeal but to look for alternative sources of funding. In the case of Wales, such action could be a major step in increasing lending to businesses. 

For example, if the banks’ approval rates for lending are 70 per cent, as the BBA suggests, then this would indicate that, extrapolating the data from the regional data discussed earlier in this section on bank lending to SMEs in Wales, that there are nearly 5,000 Welsh firms that have been turned down for loan funding during the last 12 months and a further 7,000 for overdrafts. The total is probably higher given that a number of businesses are actively discouraged from applying formally to the banks for support. In fact, as the review into RBS lending practices by Sir Andrew Large recently pointed out, the bank discouraged a disproportionate amount of businesses from making formal applications and its staff were risk averse.

Therefore, the report estimates, by utilising this data, that there is a minimum of half a billion pounds lending ‘gap’ within the Welsh economy.  A similar estimate can be made from the recent NAO report on access to finance for SMEs, which indicated that the ‘funding’ gap (the difference between the funding required by SMEs and the funding available) for the UK as a whole is £10 billion to £11 billion.

Whilst it is likely that a significant proportion of those turned down may not be ready for funding, if SMEs that do not receive finance from the banks could be supported with their application or to get access to other sources of funding, then this would have a significant effect on supporting business within the Welsh economy. There are a number of implications from this finding including ensuring that more Welsh businesses are ‘investment ready’ and there is more effective signposting to alternative sources of funding.

Summary of key findings

The first report highlighted some of the main issues regarding lending by the banks to SMEs in Wales.

Whilst the banks are stating that they are ready to lend, the data shows a very different picture, with the value of borrowing approved facilities to SMEs in Wales actually falling by 30 per cent since Q3 2011. Differentiating by size of firm, then the data shows that the borrowing levels of small firms have fallen during the last two years whilst the number and value of lending approvals to medium-sized businesses have flatlined during the last 12 months. This is a conundrum as the evidence is clear that the cost of borrowing is at its lowest levels ever with evidence that the Funding for Lending scheme is starting to have an impact on the interest rates charged by some banks.

Nevertheless, in recovering from previous recessions, banks have not had to contend with changes in the regulatory landscape that have changed the cost and balance sheet dynamics of providing credit.  The funding drought that then affected the SME market, especially in the period 2008-2010, has also eroded confidence amongst the business community. Whereas there have been efforts by the UK Government to introduce cheaper lending with rates reducing as a result, this has not been translated into increases in the number of loans from the banks. 

This has left a total funding ‘gap’ of around £500 million per annum for those businesses who want to get access to funding but were refused support by the banks in Wales. This is clearly an upper limit as a proportion of those applying for funding may not be a position to receive it from any source although it does exclude those that are reluctant to go to the bank for funding because of the current uncertain economic conditions or have been actively discouraged from doing so. Nevertheless, it gives an estimate, albeit a crude one given the lack of statistics from the banks themselves, of the finance required by the Welsh SME sector that is currently not served by the high street banks. 

As suggested in the first stage of the review, a large part of this problem may be attributed to the way that banks are currently assessing risk, valuing collateral and whether to invest in certain sectors. In that respect, the question is whether a new challenger bank is needed within Wales - either in the public or the private sector – especially as it will face many of the same issues that are affecting the current set of high street banks? Alternatively, is there a more effective way for the Welsh Government of working alongside current providers whilst, at the same time, encouraging access to other types of alternative finance?

It is important that banks and the Welsh Government do not operate in isolation in terms of the provision of finance to SMEs. Following the first stage review, there have already been negotiations between the Welsh Government and one of the high street banks to develop a referral system for those turned down for bank lending although closer links between business support and access to finance could also sustain this process. In addition, another bank has stated its intention to work closely in developing the potential of growth businesses in Wales. Given this, regular formal meetings could take place every six months between senior officers at the banks and the Welsh Government to discuss the challenges facing the Welsh economy and the way to address these challenges together.