Manos Schizas, Senior SME Policy Adviser, ACCA
Will the NLGS encourage any lenders that were previously put off by the high cost of capital?
Probably not in the short term, unless the UK banks come to be seen as undercapitalised – in which case, however, the beneficial impact of the guarantee will probably be drowned out by deleveraging.
According to the Bank of England (BoE), changes to the cost of capital have had very little impact on bank lending over the last year, and there appears to be no correlation between those and either the volume or cost of lending to SMEs during this period. That said, the banks have benefited from reasonably good liquidity conditions; during the financial crisis of 2008-9 the correlation between the cost of funds and lending to SMEs was much more significant.
However, if the guarantee is maintained in the long term there is a good case that it will help SMEs. As ACCA has repeatedly warned (see here, here and here), due to their miscalculation of the systemic risk posed by lending to SMEs, the new capital and liquidity requirements under Basel III / CRD IV would put pressure on banks’ current business models, leading to a further marginalisation of small business lending in the long run. A permanent, large-scale guarantee scheme (very common elsewhere in Europe) could help address this problem.
Figure 1: The impact of banks’ access to funding on lending to the real economy
Q. Will the NLGS encourage any would-be borrowers that were previously put off by the high cost of credit?
Possibly, although the cost of credit is not the most important disincentive for discouraged borrowers.
More specifically, the independent SME Finance Monitor, the definitive account of SMEs’ access to finance, offers us an estimate of the share of SMEs that would have liked to apply for a loan but have been put off partly by the cost of borrowing.
We know that 12% of SMEs did not apply for loans or overdrafts over the past year but would have liked to. We will assume that one third of those would have applied for loans, based on the share of applicants for loans or overdrafts in the past year who sought loans. This ratio has remained remarkably constant.
Of this 4%, 22% claimed to have been put off by the price of credit among other factors. This distinction is important as we don’t really know how influential different discouraging factors are; only how common.
Anyway, at this rate a maximum of 0.88% of businesses – around 40,000 – could potentially be encouraged to apply for loans by the promise of cheaper loans each year. Assuming success rates remain constant, 63% of these should end up with a loan – that’s 25,000 businesses. In fairness, since discouraged borrowers tend to be higher-risk, the approval rate for these might be lower. For SMEs with worse than average risk rating, approval rates are 53%, which would return an estimate of just over 21,000 successful applicants.
To this number we should also add the 2.2% of loan applicants who ended up with no loan after being offered unfavourable interest rates by their bank. Our best estimate based on the Monitor data it that that would at best add another 3,000 to 5,000 successful borrowers (although the margin of error here is very substantial) for a total of 24,000 to 26,000 new borrowers.
This may not sound like much in a business population of 4.5 million, but it’s important to note that borrowing activity is not evenly distributed among businesses. When ACCA last modelled the borrower population in our submission to the Rowlands Review of Growth Capital, we found that about 12% of the stock of businesses, or just under 500,000 firms, accounted for 57.5% of the SME sector’s total demand for external finance.
Q. And how many SMEs would normally take out loans over a year?
The SME Finance Monitor found that 3% of SMEs applied for new or renewed loans over the 12 months to Q4 2011 – that’s about 135,000 businesses, and ca. 85,000 successful applicants. Thus the additional 24,000 to 26,000 would increase the number of borrowers by 28-31%. Even if the latest percentage is just a seasonal fluke (5% applied in the year to Q1-2 2011), the number of borrowers could increase by 17%-19%.
Q. Won’t all of this be mostly renewals though?
The inclusion of renewals to the guarantee scheme complicates things a little but most renewed facilities are overdrafts, not loans. According to the SME Finance Monitor, the ratio of new facilities to renewals is about three to one in the case of loans. Importantly, this ratio has been rising (from 2:1 to 3:1) over the last year. So our best guess is that about a quarter of the 24,000 to 26,000 businesses encouraged to apply will be renewing facilities.
Q. How much new lending would this trigger?
This is where it really becomes difficult to make any estimates. The beneficiaries are not typical businesses so their financing needs are also not typical. According to the SME Finance Monitor, the average loan application in the past year was for £135,000 – although this will tend to be skewed by the largest applications. Using this figure, we would estimate an additional £3.24bn-£3.51bn of loans per year, a quarter of which will be renewals. By using this figure, however, we’re making a lot of silent assumptions – since discouraged borrowers tend to be smaller, and they will tend to account for the bulk of new lending, we could be overestimating substantially.
Then there is the benefit to all applicants of a lower interest rate. If we estimate 110,000 new loans and renewals to SMEs in the coming year (based on the discussion above) at £135,000 each, the saving in interest will be £148.5m per year. The more significant effect, of course, could be the possible additional investment and job creation, but here analysis is limited. We would have to wait and see the impact here.
Q. How much of a difference can 1 percentage point make?
A substantial one. For reference, the typical (median) loan taken out in the past year had an interest rate of 5.3% for fixed rate loans and 3% over the base rate for variable rate loans.
Judging from the above, the 1% reduction could make a significant difference to the interest burden – 19% off the typical loan. That said, interest is only part of the cost involved in taking out loans. According to the SME Business Finance Monitor, 66% of SMEs that took out or renewed a loan in the past year paid some kind of fee and more SMEs objected to the fees they were offered by their banks than the actual interest rates.
Q. But that’s only the best-case scenario, right?
Correct. The reality is likely to be much more modest. Our estimates depend on a lot of very strong assumptions:
- One assumption is that all banks will sign up to the guarantees and take every opportunity to use them: it is not clear how coercive the roll-out of the guarantee will be. In previous cases, awareness has not cascaded perfectly down bank hierarchies and individual lenders have tended to dominate individual schemes: Lloyds TSB, for instance provided a disproportionate share of loans under European Investment Bank (EIB) guarantees, while Barclays has at one time boasted of providing 40% of all Enterprise Finance Guarantee (EFG) loans. Then there’s also the case of the failed Working Capital Guarantee, which most banks simply refused to sign up to as they saw it as too restrictive and expensive.
- All new loans and renewals to SMEs will be eligible: but we know this is not true as state aid rules restrict how much government assistance can be provided to any one business.
- All would-be borrowers will be made aware of the guarantees: this is unlikely as awareness of government schemes is sometimes low. Larger and finance-hungry SMEs tend to be more knowledgeable, but even among medium-sized businesses (those with 50-250 employees), fewer than half of the owners and managers who responded to the SME Finance Monitor knew about the Enterprise Finance Guarantee Scheme (EFG) – and that was the best known of the host of programmes the survey asked them about. In fairness, the government have learned the lessons of the EFG roll-out and made sure to make more information available in a timely fashion. ACCA is working with the government on this as our membership provides a valuable channel for reaching the SME sector.
Q. But if that’s the case, isn’t the Guarantee a lot of hot air?
No it isn’t. Any amount of additional lending the government can enable without undue costs or risk to the public purse is to be welcomed, and a permanent, European-style guarantee scheme would be even more welcome. But the Government could succumb to the temptation of spinning this good scheme into something it is not, which would risk discrediting it when it inevitably fails to deliver to inflated expectations. If the Guarantee is spun as a tool to steer Britain’s SMEs away from a double dip recession, it will not live up to the hype. If instead it is established as part of a long-term framework for industrial policy, it will eventually come into its own and SMEs will be better off for it.