Competition in UK SME banking has been weak for some time, well before the financial crisis. There is a staggering fact that only one new bank has opened on the High St in 100 years. Competition has been the subject of a major review by Don Cruickshank in 2000 and various other OFT and Competition Commission reviews since.
In the run-up to the global financial crisis, relatively easy credit masked these structural problems in access to finance for SMEs, and perhaps made it easy to ignore the consistent conclusions of these reviews that the market was uncompetitive. Arguably the easy credit actually worsened competition problems further by allowing banks to supplant non-bank sources of finance.
The impact of the financial crisis has been to increase the relative cost, decrease the availability, and at least initially worsen the terms and conditions associated with credit for SMEs. Although these impacts were to some degree inevitable given the unsustainable easy credit and occurred in many other countries - they were exacerbated in the UK by our (un)competitive context.
This matters because of the impact on investment and growth. Our own manufacturing surveys and economy-wide surveys like the SME Finance Monitor indicate viable investments are going unfunded and companies with growth intentions are citing access to finance as a barrier. ONS estimates of investment remain well below pre-crisis peaks in contrast to investment intentions.
Our view is that we need a much more diverse and competitive access to finance landscape. This will mean encouraging the development and growth of new sources of both debt and equity beyond banks. But given the overwhelming dominance of banks in SME finance it must also mean a more diverse and competitive banking sector.
Current goverment efforts to improve access to finance have three main strands:
Funding for Lending, which offers banks access to cheaper wholesale funding but links this to how much they increase their net lending, with a recent new emphasis on SMEs;
- Diversifying the access to finance landscape for SMEs for example by coinvesting with the private sector in funds offering non-bank products like mezzanine finance; and
The Independent Commission on Banking, which as well as making recommendations for how to make banking in the UK safer, also had thoughts on how to increase competition.
Funding for Lending is lowering costs fundraising costs for banks with an explicit incentive to grow net lending - and especially net lending to SMEs. To grow this net lending, banks are expected to lower costs for SMEs (and households). However, this is a temporary intervention, largely introduced because of the strained fundraising environment faced by banks.
Diversifying the finance landscape for SMEs has proceeded under a range of schemes that bring together government and private money to invest in new types of finance, often addressing particular gaps or market failures. While welcome, some perspective is needed. In 2012, bank overdrafts were used by 22%; credit cards by 18%; bank loans by 10%.
No other form of external finance had more than 6% of SMEs reporting usage. Banks are the most important source of external finance for SMEs by some distance.
With the importance of banks in mind the third strand of government action would seem arguably the most important for delivering change over the medium term. And that's why it's concerning that this strand appears to be the poor relation.
Last month we had the news that the Co-Op deal to purchase 632 branches from Lloyds has fallen through. Yet this divestiture was the central part of the Independent Commission on Banking's competition-focused recommendations. While there are success stories of smaller banks in the UK - an effective divestiture was essential to create a true 'challenger'.
With the Co-Op deal a new challenger with a 7-8% market share would have been created. Without it, an IPO, as planned by Lloyds, is likely to leave it with a share closer to 5%. The ICB said that a minimum of 6% market share was necessary for the new entity to be an effective challenger to the dominant incumbents.
At the same time we have had a NIESR paper looking at bank lending to SMEs in the UK from 2001-12. This analysis controls for risk characteristics (worsened by the financial crisis) to look at the cost and availability of finance for SMEs.
As expected, controlling for risk characteristics, conditions have tightened relative to the 2004-07 period - during which there was undoubtedly an unsustainable boom. But worryingly conditions have also tightened relative to the 2001-04 period, suggesting a potential overcorrection on the supply side.
The clock is ticking until 2015 when the ICB recommended the government look at whether there's a case for making a referral to the Competition Commission. With a key plank in the government's strategy for increasing competition looking wobbly, I would suggest the government needs to be thinking now about what more can be done to boost competition.