Lending to SMEs: An incentive structure is needed for banks to lend to the most profitable businesses
21 February 2012
In October last year, the Chancellor had announced that the Government would begin a policy of credit easing to improve small businesses' access to finance. Subsequently, in the Autumn Statement the Chancellor announced the launch of a £20bn National Loan Guarantee Scheme and a host of other measures to improve the flow of credit to business in 2012. The idea was to get small companies, under £50m of turnover, access to cut price bank loans in the coming months. Recent reports have suggested that this scheme, under its current proposed structure, will be insufficient to get banks lending again as it does not provide the correct incentives for banks to lend. However, the Treasury is hopeful that negotiations with the banks are still on going, and that they will be able to reach a workable structure for the scheme.
The Treasury’s proposals will withdraw £40bn of indemnity from the Bank of England’s Asset Purchase Facility to finance a loan guarantee to banks to facilitate lending. High street banks will then be allowed to raise funds in the wholesale money markets over the next two years using the Government’s AAA-credit rating, which will lower the cost. They will then pass on the savings to businesses with up to £50m in turnover. The scheme purported to save a company looking to borrow £5m up to £50m, by reducing the typical rate charged by 1 percentage point.
Banks will be charged a fee of 1 percentage point on top of the governments borrowing costs to mitigate the risk of moral hazard from a full loan guarantee – that is, to ensure that banks bear share some of the risk of lending, so as to provide them with the right incentives to lend to the right firms. However, banks have argued that these measures make this scheme more expensive compared to other funding sources available to them. In addition to this, the European Central Bank has also made available an alternative liquidity scheme which may give banks access to cheaper funds than those provided by the Treasury. Thus, it appears that under its proposed structure the scheme will fail to increase lending by banks.
In this context, it is useful to revise the arguments for and against this loan scheme. The purpose of ‘credit easing’, in contrast to ‘quantitative easing’, is to reduce interest rates to ease lending to businesses, where as quantitative easing specifically aims to expand the money supply.
The key purpose of quantitative easing was to offset the contraction in the money supply induced by problems in the banking sector. Specifically, the goal is to increase the volume of bank deposits — if bank deposits were to contract faster resulting in a further contraction of money supply, prices might fall and falling prices would mean that the burdens of household debts would rise, leading to defaults, further problems with the banks (as would they suffer bad debts) creating a vicious spiral.
Credit easing on the other hand specifically targets reducing interest rates to companies, and in this case to small and medium sized companies, in an effort to increase business lending. The argument for intervening in specific markets would need to be that those markets were suffering from some particular market failure, which intervention could offset. Indeed, this was the explicitly stated rationale offered for the form that the first round of quantitative easing took in the US (which can be considered a form of credit easing), where the Fed used a large part of its new money creation to buy private securities (corporate bonds, mortgage-backed securities etc.) driving down interest rates in these markets.
Last week, Mervyn King argued that market failure in lending to businesses meant that firms are being starved of the funds they need to grow, create jobs and drive the economic recovery. The figures in the recently released inflation report show that net lending fell by £10.7bn in 2011 – in other words, the banks received £10.7bn more in loan repayments than they gave out in new loans, bringing the total fall in lending since the end of 2008 is £82.7bn. The loan guarantee scheme was designed to ensure that profitable, innovative and growing firms would be able to access finance at lower rates, increasing the amount of lending and reducing the cost of borrowing for the most innovative firms. Furthermore, to ensure that the government would not be engaged in ‘picking winners’ and creating distorted incentives, the lending would be routed through the banks as they are much better placed than the government to assess the credit risk of firms.
Therefore, it is absolutely essential that banks are behind this initiative and a proper incentive structure is in place for banks to lend to the most profitable businesses. We at the Big Innovation Centre have argued that the key to making any such scheme a success, is to ensure that a structure exists that properly incentivises the institutions that are best placed to assess the credit risk of firms to lend, and that this structure creates a conduit for the new money created by QE by giving banks access to the cheapest finance on the market. If the proposed scheme fails to meet these criteria then it will be wholly ineffective in increasing lending to businesses.
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