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.

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.

NEW BUSINESS BANK MUST SUPPORT LENDING TO SMEs IN WALES

One of the most disappointing aspects of my recent review on access to finance for the Welsh Government was the absence of any detailed information on lending from the banks to small to medium enterprises (SMEs), despite numerous requests to the British Bankers Association (BBA).

It is not surprising that given the lack of information on the lending practices of banks, considerable political pressure has been placed on the banking community to publish relevant data on a quarterly basis by post code, including the total amount of lending to small and medium sized enterprises.

This pressure has finally paid off, and this week saw the publication of detailed statistics from the BBA that details the lending by the banks to SMEs within 120 postcode areas in the UK.

So what this data tell us?

First of all, total borrowing by small and medium-sized businesses in Britain, in terms of loans and overdrafts, stood at £100.3bn at the end of 2012. However, overall lending had contracted from £104 billion in 2011 to £100 billion in 2012, a decline of 4.3 per cent. This was at a time when the high street banks were keen to emphasise that they were open for business.

Of course, throughout this debate on lending to SMES, the BBA and the banks have been at pains to emphasise that the lack of take-up of loans has not been down to their own approach to lending. Instead, they have suggested that this is not a supply issue but a demand issue from small firms and the current data does partly support their case.

For example, the SME sector in the majority of UK regions is currently sitting on £125 billion in cash, a sum that is actually higher than the total amount of debt outstanding to the banks. In fact, the amount of deposits held by SMEs has actually increased by £7.2 billion overall between 2011 and 2012.

However, that argument does not hold any water in the context of the Welsh economy. Whilst the SME sector in nearly all of the UK regions have a cash surplus with the banks, Welsh SMEs had £3.6 billion of cash available within their accounts as compared to £4.8 billion owing to the banks.

And if we dig down deeper, we find that there are more localised problems regarding borrowing within Wales. For example, the three main postcode areas covering North Wales, Mid-Wales and Swansea show businesses in those areas have amongst the lowest proportion of deposits to loans in the UK.

Certainly, this goes against the BBA’s arguments on loan funding i.e. that many businesses have been building up their cash reserves and are using this to fund activity rather than take on additional borrowing. Indeed, it simply fails to explain the fact that borrowing to SMEs in Wales declined by £172m between 2011 and 2012.

This could suggest that UK Government’s current approach to stimulating bank lending may not be working across all regions.

Take, for example, the case of Business Bank that was announced in the Autumn Statement of 2012 by the Chancellor of the Exchequer. It is a fantastic idea that aims to increase the amount of lending to businesses and provide more diverse sources of finance.

With £10 billion earmarked to help get funding to businesses, the Business Bank will not directly lend to businesses but will instead work with the private sector to support and increase the capacity of current channels of finance.

Encouragingly, the Business Bank’s programmes have already started operating with £300m of funding allocated in April 2013 to encourage the growth of smaller lenders in the market. The bank itself aims to become fully operational as a new institution in the Autumn of 2014.

Many bankers, intermediaries and small firms I have spoken to about this development have welcomed the creation of the Business Bank. However, concerns have been raised that it will not take into account the real regional differences that exist across the UK in terms of funding for business.

For example, BBA data has shown that whilst the amount of lending to small firms (with less than a £1million turnover) decreased by £175m in Wales, it actually increased in Scotland by £246m over the same period. Yet, the same financial instruments will be used by the Business Bank to support small businesses in both devolved regions.

With the recovery from the recession starting within the more prosperous regions of the UK such as the South East of England, it would only be natural that the Business Bank and its private sector partners would focus on companies in these regions to the detriment of good businesses in less wealthy regions such as Wales. In fact, my research has shown that Welsh firms are already in a position where they not getting as much access to current UK Government finance programmes as they should.

Similar concerns have recently been raised by the Institute for Public Policy Research.  In their recent examination of strategies for local authorities to promote investment in the North of England, they suggested that any national business or investment bank must respond to the different regional economic contexts of parts of the UK.

If SMEs are to be supported by the UK Government, then consideration must be taken of the different regional differences that exist across the economy and conscious effort must be made to develop specific interventions to boost prosperity within poorer areas.

In this respect, the Business Bank must take this into account when developing financial instruments to support smaller firms. In addition, the Welsh Government must also lobby for this to happen, either through requesting a proportional allocation of funding from the Business Bank or by getting it to support specific programmes for Welsh SMEs.

Therefore, with the data showing that bank lending continues to fall in Wales, it is critical is that Welsh businesses get their fair share of funding available from the new Business Bank so that they can develop their markets, create jobs and grow the Welsh economy.

ACCESS TO FINANCE REVIEW - REFLECTIONS ON THE RESULTS TO DATE

Last week, I completed the first report of the access to finance review for the Welsh Government.

This part of the work was to ascertain the current situation with regard to the provision of finance to small to medium sized enterprises (SMEs) in Wales, especially in relation to the role of the banks.

So what did we find out after over ninety interviews with stakeholders, countless submissions by small firms and a veritable mountain of data and reports?

First of all, we now know that the total lending from banks to SMEs is approximately £5 billion, with overdrafts now accounting for only 13 per cent of this total. This places the role of the Welsh Government into context, with Finance Wales having invested only £250 million into Welsh businesses since it began, which is equivalent to around 5 per cent of the banks’ current loan book to SMEs.

We also found that there is now a divergence in funding to different sizes of businesses. Whilst loans to medium sized firms had increased by 11 per cent between 2011 and 2012, there has been a decline of £175m in the value of bank loan balances to small Welsh firms, which is the largest overall decline of any UK region. In contrast, lending to small firms in Scotland increased by £246m over this period.

We also found that contrary to popular belief, the vast majority of businesses in Wales are not lending money from the banks with 69 per cent being classed as “happy non-seekers” i.e. those SMEs that had not had a borrowing event with a bank and also said that they had not wanted to apply for any loan or overdraft funding in the previous twelve months.

Therefore, only 31 per cent of SMEs in Wales have had a borrowing event from the bank or would have liked to have a loan or overdraft during the previous twelve months and of these, we estimate that the number of those unable to obtain funding from banks is around 20,000 businesses, which equates to around 11 per cent of the Welsh business population.

Therefore, those are some of the facts about the role of the banks in supporting SMEs in Wales but what are the conclusions from the report?

First of all, it is clear that there is no ‘one size fits all” solution with regard to the issue of finance for SMEs. For example, we have found that localised community-based solutions – such as microfinancing or mutual investment bodies – may be required to address the major issue of the lack of funding to micro-enterprises in Wales.

Secondly, the banking community and the Welsh Government need to work more closely to support the SME sector. The research has shown that there is a clear disconnectivity between a Welsh Government that supplies most of the business support in Wales and the banks that supply most of the finance.

For example, very few of the businesses that are rejected by the banks for loans are referred to business support for help. If we could create a system where this happens, then this could help solve a large part of the problems faced by small firms in getting their proposals ‘investment ready for banks’ and therefore getting access to finance.

Thirdly, the Welsh Government can play a major role in supporting SMEs in partnership with other financial institutions, either by acting as a guarantor or through co-funding loans with the banks. Indeed, there needs to be a move away from a dependency solely on government funding by some SMEs towards an approach where there is greater partnership between the public and private sectors in supporting businesses.

However, we must not forget that the Welsh Government itself can help with small firms, especially in terms of issues such as late payment. We have therefore proposed that it should look to use its contracts with large suppliers to ensure that they pay smaller subcontractors within a thirty-day period. We believe this would be the first time any government has done this anywhere in the World and, if successful, could ease cashflow difficulties for thousands of small businesses in Wales.

Finally, SMEs need to appreciate that it is not only banks that are the source of funding for survival and growth. The role of the Welsh Government should be to signpost businesses to a range of other suppliers of finance as there are various funding opportunities out there already. However, the vast majority of firms tend to go to only one source – the banks – and we need better information for businesses on various sources of funding so that they can make an informed choice. The Welsh Government also needs to provide support and encouragement for new forms of finance, such as peer to peer lending and crowdsourcing, which are currently underutilised in Wales.

Therefore, we now have a better idea of what the current position is with regard to access to finance for SMEs in Wales but the real challenge lies ahead of us with the second part of the review, which will report in November.

This will hopefully take this process forward and not only examine the types of financial support that is needed to deliver the funding that is sorely needed by businesses in Wales to flourish, but the role that Welsh Government should take in delivering this.