Credit where it’s due: The SME lending puzzle

The Competition and Markets Authority has announced its intention to conduct investigation into SME banking.

Lending to businesses increased in the three months to May, according to data released by the Bank of England this morning. For the first time since Q2 2009 total net finance raised by UK businesses was positive, as businesses took on new lending and reduced the amount of debt being paid back. Net bank lending to non-financial businesses rose by £3.5 billion in May, after stumbling earlier in the year.

Lending to small and medium enterprises (SMEs), however, continues to fall. These businesses saw a £200 million reduction in loans in May, despite an increase in demand for credit. Cost may be one factor limiting access to credit for the UK’s smaller businesses – the Bank of England data shows that while spreads on interest rates fell for large and medium enterprises through Q2, making finance cheaper, smaller businesses continue to pay a premium.

Credit for SMEs is, in some ways, bound to be more expensive: start-up enterprises lack a track record and so will have to pay a risk premium to borrow. But a lack of competition, highlighted by the Competition and Markets Authority’s proposal to launch a full-scale inquiry into the banking sector, may be stifling access to credit for many SMEs.

The report published by the CMA and FCA today paints a sorry picture of the SME banking landscape in which businesses are not satisfied with the service they receive from banks, but are also not sufficiently engaged to drive competition which could force banks to improve. The vast majority of business current accounts used by SMEs are provided by one of the “big four” banks, who also provide 90% of bank loans. Despite efforts to encourage competition in the banking sector over the last six years, only one new entrant offers business current accounts.
SMEs persistently report that they are dissatisfied with the level of service provided by their bank. Despite this, almost 60% of SMEs spend less than an hour researching providers of lending, and around 70% only approach one provider, and 90% end up taking a loan with their main bank. It’s clear that SMEs are not shopping around to get the best deals. But why?

Most SMEs take the view that all banks are the same, with more than 70% arguing that alternatives are no better or only marginally better than their existing provider. This dampens appetite for new banks, and together with regulatory barriers to entry, makes it very difficult for new providers to get a hold in the marketplace. The inertia also means there is relatively little incentive for existing banks to improve the services they offer, and in turn reinforces the SMEs’ view that the alternative options available are strictly limited.

These problems in SME credit markets deserve to be taken serious: SME’s are a vital part of the economy, stimulating competition, innovating and creating jobs. Failures of SME lending – particularly a failure to direct capital to high-growth organisations – could be one factor holding back improvements in the UK’s productivity, by preventing redistribution of resources to where they can be used most effectively. This, in turn, should set alarm bells ringing over the UK’s future growth prospects.

An inquiry is thus clearly in the public interest. However given the self-reinforcing nature of the situation, policies to stimulate demand-side competition should also be taken seriously. The difficulties outlined in the CMA report highlight the relative lack of financial knowledge among small businesses, suggesting there may be room for a free, non-commercial financial advisory service for SMEs – similar to the consumer Money Advice Service. As many business owners report feeling they are not “bank ready” (see our report Venturing Forth: Increasing high value entrepreneurship), information for entrepreneurs could help to cut through some of the problems in these markets and provide a first step towards adequate competition.


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