The Bank of England and U.K. Treasury announced this week they are offering lending institutions incentives for small business loans. But if the U.S. experience is an example, incentives won’t do the trick.
U.K. Incentives for Small Business Loans
British small businesses say they are starved for credit Britain continues its struggle to recover from the financial crisis and just entered its third recession in the last five years. According to a Reuters report, the next phase of the “Funding for Lending Scheme” (FLS) would give banks incentives for granting loans to small businesses.
The original FLS was introduced back in August of 2012. The intention was to offer banks incentives to increase loans to consumers and businesses. But it didn’t work out that way. The benefits were seen by banks and homebuyers, not small businesses / SMEs.
Under the latest iteration, for every additional one pound that banks lend to small businesses in 2013, banks will be able to draw on 10 pounds of discounted FLS funding (it’s a 1:1 ratio for other types of lending in the FLS). In 2014 that formula drops to five pounds of discounted funding for every one additional pound loaned to small businesses.
The U.K. Finance Minister George Osborne said in a statement, “This innovative extension will now do even more for small and medium-sized businesses ….”
Not everyone agrees. In an article in the Guardian, economics correspondent Phillip Inman says it won’t much matter as long as the Royal Bank of Scotland is under restrictions to reduce its lending. He writes:
“When the Royal Bank of Scotland is under pressure to conserve its cash and shrink its lending, what, you might ask, is the point of officials inside the Bank of England extending and upgrading the funding for lending scheme (FLS) to encourage the small business loan market?
The Edinburgh-based bank can already lay claim to more than 40% of small and medium-sized business lending. With Lloyds, the other state-owned bank, it dominates the scene and, according to many business leaders, sets the benchmark for the industry. Loan criteria, charges and penalties are all set by RBS, they say.
RBS wants to make money and can only do so by lending, but it is under instruction from the Treasury and a welter of new banking rules to be risk averse. A risk averse strategy turns away pleas from risky SMEs in favour of safer borrowers – which in this case are big business and high loan-to-value homeowners.
He calls for more action. He quotes John Longworth, head of the British Chambers of Commerce, as calling for backing of an embryonic Bank of Business in order to bring more options to the small business loan market. Longworth, in his New Year’s message at the beginning of 2013, noted:
“Britain’s business finance system is dysfunctional and restrains growth and there is an urgent need for a patient business lender to give innovative, new and growing businesses, as well as those businesses in recovery, access to the levels of finance they need to grow and evolve.”
Lessons From the U.S. Experience
For many of us here in the United States, to think of one bank being responsible for 40% of the nation’s small business loans is mind-boggling. True, the banking industry has been consolidating here in the United States for decades. Yet we still see a different bank on every corner. We’re lucky to have so many choices.
Even so, U.S. banks appear to be making fewer small business loans, based on FDIC data between 1995 and 2012. As Professor Scott Shane points out, one reason is that big business loans are more profitable than small business loans.
Loans to small businesses are riskier, making small business loan portfolios less profitable. Small business loans are harder to underwrite due to a dearth of public credit histories and solid financial statements by small businesses. Assets to secure such loans are slim. And small business failure rates don’t help lenders sleep better at night.
Some small business owners simply don’t bother applying for business loans. Or they take one look at the paperwork and assume (rightly or wrongly) they will be turned down. So they run up their credit cards or tap into their home equity loans instead, and don’t get enough funding that way.
But why wouldn’t government incentives help, you ask?
Here in the United States, we’ve had a recent experience with government incentives to increase small business lending — and it wasn’t pretty. Just this month, an Inspector General report disclosed that many banks receiving money from a special government Small Business Loan Fund used that money to repay bailout debt, instead of increasing small business lending. According to the report, there was no penalty if they didn’t lend.
There was no regulatory oversight to determine if recipient-banks’ plans to increase small-business loans were even achievable. Some of the banks just weren’t in a position to increase their small business lending much.
If the U.S. experience is any indication, the Guardian correspondent and the British Chambers chief have a point. To increase small business lending calls for a larger and different vision. Incentives alone won’t do it, because they don’t fix the fundamental underlying issues with small business lending.
Innovative New Approaches Needed
What’s needed are new approaches that directly address the challenges of lending to small businesses. Small businesses everywhere need more innovative funding programs that still balance responsible underwriting.
Extended loan repayment terms for small businesses, more focus on microloans (and redefining microloans as being up to $200,000, because after all, $10,000 or even $50,000 doesn’t go far today), loosening of crowdfunding restrictions, more programs backed by successful businesses and entrepreneurs (such as Samuel Adams “Brewing the American Dream” program and Amazon’s Capital program for Amazon merchants) that combine mentoring oversight with funding, and expansion of programs like Accion microloans — here in the United States these and other innovative approaches need to be encouraged.
Another help would be more educational programs aimed at small businesses to help them understand business credit scoring. Many U.S. small business owners are in the dark about how to build a credit history for their businesses (versus themselves personally).
Change the paradigm, and you can open up small business access to operating and expansion funding. Keep it the same and the state of small business lending will be more of the same, too.
Mel @ Capiota
Your article was really interesting to read as somebody UK, reading your opinions and what the UK can learn from the US when it comes to lending to small businesses. I agree that the FLS isn’t working and new approaches are necessary in order to kick start our small businesses and get out of recession.
I confess I don’t know that much about small business lending in the UK. But having been a banker in my past, I know a bit about U.S. lending. And I know that we keep circling the problem here in the Untied States yet haven’t done much to solve it, despite a lot of talk.
The real reason nothing ever changes is that we approach small business lending too much like big business lending. When you look at it that way, it’s costly to make small business loans and so the lending volume numbers don’t change dramatically.
And microloan programs that do address small business lending differently have little impact because the amounts are too small to make much of a difference except for tiny home-based businesses. For me to go out and get a $10,000 loan would do next to nothing for my business, and wouldn’t even get us through one month. It’s not worth my time and effort.
Here’s hoping more can be done in the UK and in the US. 🙂