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The problem with banks lending to small businesses is that it is not often a good idea. Business loans are risky, of course they are. Mortgages are less risky because for one thing there is the property they are secured against, and for another thing there is the fact that to the people who own the homes keeping up mortgage payments is just about the number one priority. But there is a third far more important point. Businesses create wealth; mortgages don’t. And the creation of wealth is incredibly important, but also by its very nature risky. Banks have become the bogey men of the 21st century. The public hate them. The truth is, however, that small businesses, the type run by entrepreneurs and that create wealth don’t really need banks at all, not banks as they are these days anyway. They need something far more. And curiously enough the venture capital industry has just been spelling out what it is.

Barclays is on a fund raising spree. It needs to find £12 billion or so to ensure it can meet the 3 per cent capital ratio that the regulators have decided is essential. So it is raising money, selling shares, and trying to get existing shareholders on board. Of course, in an ideal world its better paid staff, the ones with big bonuses, would contribute to the fundraising by receiving their bonuses in shares rather than hard cash.

But just imagine if more than 3 per cent of its loans went bad. Imagine if the 3 per cent of the people it lent to went bust, and were unable to repay a single penny. The bank would be in rather a lot of trouble. That is why banks prefer providing mortgages, over loans to businesses. Think about that. Businesses fail; it happens all the time, so is a 3 per cent safety margin really enough?

We keep reading about how banks are providing mortgages again, but are not lending to businesses. But is that really a surprise? Banks are not geared to truly understand entrepreneurs; their business model doesn’t fit.

It wasn’t always that way and it doesn’t always have to be that way. But for as long as the principal way in which banks provide money is by charging a fixed rate of interest, which provides the same return regardless of the company being lent to (whether it turns out to be the next Google, a business growing at about 0.0001 per cent year, or a company that fails outright), the most a bank can make for backing such a business is always the same and is actually quite small. The most it can lose is… well it is everything it lent.

If banks were remunerated in the form of share of profits, so that they benefitted from the upside as well as losing out from the downside, it would be a different matter.

It was not always thus, of course. There was a time when local bank mangers understood local businesses, and even if they couldn’t provide funding they might have known someone who could.

Back in November 2008, Edmund Phelps, a former winner of the Nobel Memorial Prize in Economics, said in an interview with ‘Spiegel Online’: “A fundamental issue that regulatory discussions must confront… is what function society needs the banking industry to perform. Increasingly over the past two decades, the banks have tried to make money with mortgages, residential and commercial. As this has proved difficult, the banks will either have to shrink their supply of credit to the economy as a whole or else redirect some [of] their credit to the business sector.”

But now the venture capital industry has spoken up.

For some companies even getting an extension on an overdraft can feel like “pulling teeth”, or so said David Hughes, chief investment officer of Foresight Group, managers of Foresight VCTs. He added: “In our experience banks seem interested only in funding mature, profitable businesses with proven management and clear growth plans… We have heard numerous accounts of banks dragging their heels on seemingly straightforward requests, where for example the request for an extension to a facility took over eighteen months for the approval to come through. … From where we are sitting, the outlook for banks stepping up to the plate remains bleak.”

Alex Macpherson, head of the Ventures team at Octopus Investments, proffered a similar opinion saying: “The banks have rarely been interested in providing debt finance to high growth entrepreneurial businesses where an equity investment is typically more appropriate.”

So what does that mean? Businesses need to court the VC and business angel market and now peer to peer lending.
As for the government, well frankly so far its efforts don’t add up. The UK badly needs a more entrepreneurial minded psychology amongst the funding community in the UK. And the government needs to put its money where its mouth is. It is extraordinary that the last Labour government cut VAT in a scheme that cost the UK government tens of billions of pounds of revenue, while it provided a few million pounds here and there for SMEs mostly in the form of training, and quite often training was not what was required. The current government spends billions on trying to get house prices up, but Vince Cable’s business bank will have one million pounds of new money. The Bank of England creates £375 billion in new money via QE, but still entrepreneurs , the people who can create wealth and make the retirement of the baby boomers affordable, are left to fight over scraps.

© Investment & Business News 2013

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