The penalty for being small

Britain’s Coalition Government has made it clear that it believes the health of the private sector is key to the recovery of the UK economy. The Business Secretary, Vince Cable, stated “the public sector is having to contract. Private investment has to grow, where the public sector contracts. A lot of that growth is going to come from the small-scale sector. Most of the employment growth will come from micro-companies”.

There are approximately 4.8 million small and medium enterprises (SME’s) in the UK, accounting for 99.9% of all UK businesses. They create over half of private sector employment and economic turnover. It is plain to see that if SME’s are struggling, the UK economy will too.

Bank lending is the predominant form of financing for SME’s. Unlike larger businesses, access to finance through equity markets or other means is limited, at best. Recent Bank of England figures showing that for the fifth month in succession, lending to small companies has contracted, is of concern. The effect of this credit starvation on small businesses is highlighted by figures from Britain’s Federation of Small Businesses which show that 300-400 of its members collapse each week.

Reduction in bank lending

Over the past year, net lending to British businesses has fallen by £46 billion. A reduction in the availability of bank finance has created a significant refinancing challenge for businesses, as older loan deals expire and new deals need to be negotiated. Figures from Reuters indicate that levels of refinancing are expected to peak in 2012 (as a result of large amounts of 5 year debt issued in 2007 and 3 year debt issued in 2009). If banks’ purse strings are not relaxed, many SME’s may struggle to refinance existing debts, let alone obtain new loans for expansion.

There appears to be a rare political consensus that, having been kept alive by the taxpayer, the banks are failing to hold up their end of the bargain. Vince Cable goes further and accuses the banks of not acting in the national interest. Mr Cable has warned banks that if they continue to hand out large bonuses and dividends (while not lending to businesses), new tax measures will be introduced.

Drop in demand

The banks themselves have suggested another possible explanation for the reduction in lending. Banks argue that lending to businesses has reduced because of a fall in demand for loans. They say that they are still approving 85-90% of loan applications. It is true that a number of companies have been prioritising the repayment of their debt, so that they are less vulnerable to future “credit crunches”. However demand may have dropped for another reason.

The price is not right

Demand for new loans has been reduced due to the banks’ pricing structures. The banks argue that they have to take account of the increased costs which they are suffering. Although interest rates are at record lows, banks are having to pay more for capital than they did during the credit boom years.

However, bank margins are currently at record levels. For example, the average margin between authorised overdraft rates and the Bank of England base rate is a whopping 13.74%. This figure gets even higher for interest charged on credit cards.

Government intervention

In 2009, the Government introduced an ‘Emergency Package’ to help SMEs during the economic downturn. The two most relevant schemes for SME’s are the Enterprise Finance Guarantee Scheme (“EFG“) and the Capital for Enterprise Fund (“CEF“).

Businesses with a turnover of up to £25 million can apply, through the EFG scheme, for a bank loan of up to £1 million (and the government will guarantee 75% of the loan). Through the scheme, the Government is providing £1 billion of guarantees to support £1.3 billion of bank lending. However, lending under this scheme fell from £472 million (April – September 2009) to £365 million (September 2009 – March 2010).

The CEF provides capital of £200,000 to £2 million to high growth businesses (with a turnover of up to £50 million) by allowing them to sell debt in exchange for equity.

In June 2010, the Coalition Government presented its first Budget with the focus being on getting public finances back under control and providing a springboard for a private sector led recovery. The Budget provided that the EFG facility for 2010 be increased by £200 million to support additional lending for small businesses until 31 March 2011. A processing target for applications of 20 business days was also introduced.

The Budget also provided for the creation of the Growth Capital Fund to address the problems highlighted by ‘Rowlands Growth Capital Review’, namely that capital for growth was not being provided by the market for fast growing SME’s. The fund will form part of the existing CEF and will provide an extra £37.5 million in equity finance. This is to be funded through a £25 million contribution from the Coalition Government and £12.5 million in private co-investment.

Another stated aim of the coalition government is to encourage more ‘business angels’ to put venture capital into start up companies.

State controlled banks

Lloyds Banking Group (currently 41% government owned) and Royal Bank of Scotland (68% government owned) have made an agreement with the government that they will lend £94 billion between them to businesses in the year to February 2011.

To manage the Government’s shareholdings in Royal Bank of Scotland and Lloyds Banking Group and other financial institutions, UK Financial Investments Limited has been set up. One of its aims is to manage state investments in the financial sector commercially with a view to achieving an exit. This represents a problem. On the one hand the Government is telling banks that they must lend more to businesses. On the other hand, it wants the share price of the banks to rise so that the government can exit at a profit or certainly not at a loss. For the share price of the banks to rise, conservative lending policies are required with existing loans being reviewed and re-priced. Obviously the two cannot go hand in hand.

USA Government action

Let’s compare the UK government’s actions with that of the USA government. The Small Business Administration’s America’s Recovery Capital Loan programme was introduced in June 2009. It provided interest free loans, fully guaranteed by the government of up to $35,000 to struggling but still ‘viable’ businesses. There was initial protest because only 10,000 business stabilisation loans were being made available. Less than 8,500 stabilisation loans have been approved. There appears to be two problems; (a) few businesses fall within the definition of struggling but viable and (b) it was not commercially attractive to banks to underwrite the loans.

The Small Business Administration also provides full guarantees for a qualifying loans by banks and financial institutions to small businesses. One part of the Small Business Jobs Bill recently introduced allows banks to make larger loans to bigger businesses. The maximum loan size of most popular loan, the 7(a) loan, has been increased from $2 million to $5 million.


It is clear that SME’s in the UK are finding it hard to raise debt finance in the current market. One of the cures to this problem is improving bank confidence. Another may be tax/bonus sanctions if they don’t loosen the lending strings.

However, due to the losses sustained by banks since the start of the economic downturn, it is no surprise that banks are unwilling to lend to small businesses who may not be able to repay. The schemes introduced by the Labour Government in 2009, and extended by the Coalition Government, have sought to get credit moving by reducing the risks involved in lending to SME’s.

Despite the introduction of such schemes, bank lending to SME’s is still low. This may be because the cost for a business of taking out a loan may be too great. If this is the case, capitalist principles should dictate that the market will adjust to fee/margin levels where the banks are happy to lend at and businesses are happy to borrow. However, the rule book as to what is normal, remains thrown out of the window! Expect a great deal of uncertainty for a good time to come.

Paul Taylor is a partner at City law firm Fox Williams LLP ( Paul can be contacted by telephone on 020 7614 2512 or by email at Duncan Jones is a trainee solicitor at Fox Williams LLP ( Duncan can be contacted by telephone on 020 7614 2647 or by email at


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