David Davis writes about diversifying the sources of lending for the UK’s small businesses

As reported in the Financial Times:

“Financing smaller enterprises is not just for venture capitalists, say David Davis and John McFall
I would rather see finance less proud and industry more content.” Those words were spoken by Winston Churchill almost 90 years ago, but should serve as a mission statement for our financial industry and parliamentarians today.

From money laundering to mis-selling, Britain’s banking industry has failed its customers. The parliamentary commission on banking standards, set up to examine how the industry behaved, found that standards were low and the culture rotten. This reinforced the comments of Adair Turner, the former Financial Services Authority chairman, who branded much City activity as “socially useless”.

With assets worth 492 per cent of Britain’s annual gross domestic product, the banking sector is still too large to be stable. Worse still, its failure to lend threatens economic recovery. We need innovative ideas to get businesses moving without having to rely on the banks.

Over the past four years we have seen a series of futile attempts to increase lending to business and stimulate the economy. Project Merlin and the Funding for Lending Scheme have had limited impact.
These failures are costly. British businesses currently get 80 per cent of their finance from banks; their US counterparts raise 80 per cent of their finance through capital markets. It is no coincidence that the US economy is growing and creating new jobs while the UK lags behind.

For British business to catch up we need a growth agenda that creates jobs and a diverse financing system that breaks the banks’ stranglehold on lending. New research shows how to do so.

A survey by The New City Network, a think-tank, reveals that of the companies refused loans, 93 per cent only approached banks in their search for funding. By contrast, those that sought more diverse financing – from invoice discounting and mezzanine loans to venture capital and private equity – were more successful. The lesson is clear: when it comes to borrowing, British business needs more options.

Diversifying the financing of small and medium-sized enterprises is not just a job for experienced venture capitalists. The first and most obvious opportunity to do so lies in the £750bn of deposits idling on the balance sheets of big UK businesses.

If these companies took even a fraction of this money and invested it in partnerships with SMEs and start-ups, the benefits for both sides – and the economy – could be huge. For large companies, it would bring new ideas and products to their business. For small ones, it would provide the funds required for them to grow rapidly and create jobs.

There are 4.8m SMEs in the UK, employing 60 per cent of the workforce and representing 50 per cent of GDP. It is these companies, not the FTSE 100 giants, that create the most new jobs. With better access to finance they could create another 2m jobs across the UK.

For small businesses, the financial crisis has made access to bank finance much more difficult. With banks facing consolidation and deleveraging, there is simply not enough money available to allow SMEs to fulfil their potential. One government review estimated that, in the next three years alone, there would be a funding shortfall of between £84bn and £191bn. This is a massive wasted opportunity.

Reliance on bank finance also creates a mismatch between the risk that entrepreneurs take and that shouldered by the banks, whose incentive is not growth but a fixed return. Small, high-growth businesses often need loans before they start generating revenue, and may not be able to make regular loan repayments straight away. Partnerships between large companies and SMEs could provide the flexible funding they need.

Debt can be used very successfully, and access to the bond market for more mature SMEs should not be overlooked, but we have become too focused on one type of funding and we are, as a result, in danger of failing our entrepreneurs.

We urgently need to develop new, sustainable and secure sources of finance. It is time to make the financial industry less proud and our SMEs more content. Our message to policy makers is simple: diversify lending or be damned.

The writers – Sir David Davis for Haltemprice and Howden and Lord John McFall – are board members of the New City Network “