Traditional bank finance just isn't working.
Quantitative Easing - the government's injection of 'cash' into the system - has resulted in it being squirreled away in the banks' balance sheets as regulation requires them to hold more 'cash' and to boost the property market - one of the causes of the current problems. Paul Tucker, Deputy Governor of the Bank of England recently stated that "... successive schemes designed to boost lending to small businesses had failed to reach their target after the majority of loans offered as part of the central bank's £80bn funding for lending scheme went to homebuyers". He continued, "I am worried, and this is a personal opinion, that the current battery of credit policies are not reaching small and medium-sized businesses at the moment".
According to the Federation of Small Business, at the start of 2012:
So, what is the answer?
We brought together three speakers at the House of Lords to present and discuss 'different' ideas: Xavier Rolet, Chief Executive of the London Stock Exchange Group; Richard Williams, Chairman of the UK Islamic Finance Secretariat and Finance Director at Bank of London and the Middle East; and Simon Dixon, CEO of BankToTheFuture.
The EU has around 26 million unemployed people and as some 50% of UK businesses export, this has relevance to us all. "We hear anecdotes in the press telling us that entrepreneurs are unable to get bank finance, often even very minor loans. This puts in focus the shape of the financial industry as a whole."
Comparing the EU / UK with the US, Xavier expressed the view that we are very close to being able to create a lot of new jobs and kick-start the economy and release 'energies' - particularly in the SME sector. "What is clear is that we will not see an economic recovery powered by the banking industry. Compared with the US which has a $15 trillion economy, the EU, including the UK, has an $18 trillion economy. The aggregated balance sheets of the banks in the US is $12 trillion (compared with a $15 trillion economy) - in the EU, the aggregated balance sheets of the banks come to $68 trillion - and that's compared with an $18 trillion economy. Banks remain hugely leveraged in the EU. Whilst the UK banks are a bit better, they are still over-leveraged and however much QE we pump into the economy, we cannot expect the banks to further leverage their balance sheets to lend, as they are already over leveraged. In the EU, 70% of corporate funding has come from the banks - this compares with 18% in the US."
Historically, there are three sources of job creation: the government (with such as the Civil Service); the 'blue chips' which continue to be the vast reservoir of jobs; and the third category is the SMEs. The current economic problems mean that the government does not have any money to create jobs - on the contrary, we have seen a shrinking of the public sector. During the most recent economic boom, the 'blue chip' sector (the FTSE here in the UK, the DAX in Germany, etc) actually saw a decrease in the number of jobs (by 0.4%). So, even during outstanding economic growth, the best we can expect from the blue chips is for them to maintain their job pool.
So, that leaves the SME sector. "This is our only salvation to create new jobs. It is also the solution to creating the value we need to maintain our social welfare system that society wants to preserve. There are 23 million small and mid-sized enterprises in the EU and the largest contingent - 4.5 million - is found here in the UK. Think of the power of these SMEs. If each were able to create just one extra job, think of the result on the unemployment statistics alone."
"SMEs are generally based on one thing - innovation - whether it is in the service industry, new science, someone coming out of university, SMEs are based on innovation. This gives them pricing power, particularly if underpinned by scientific research. We have almost 2000 SMEs listed on the Stock Exchange group here in London. They tell us that they don't have a pricing problem; they don't have a demand problem; they can create good, highly-paid, high value-added jobs. Their only issue is access to appropriately-priced capital."
By definition, SMEs are looking for affordable finance at relatively low levels. This will not come from banks - non-bank finance is the answer. "Fundamentally, particularly for start-ups, bank finance is not suitable. Debt needs to be serviced and the banks demand security - often a mortgage on the entrepreneur's house or other asset. Furthermore, every crisis in our capital-based economy for the last 200 years has been caused by one thing - and one thing only: excessive leverage on the balance sheets of financial intermediaries which is fuelled by debt and subsidised by the fiscal code."
SMEs need investors that are aligned with the objectives of the company and that can realise the long-term potential of the idea. They have to take the risk that the company will go bust - one in three do in the first few years - but they can expect good returns if the company is successful.
"Such funding is called equity and it was invented right here in the UK. It is the oldest foundation of the capital-based economy, but we have now regulated and taxed it to death. A third of the wealth created in the UK (National Growth Value Added - NGVA) is accounted for by 197,000 companies that employ between 10 and 200 employees. This is the core: this is where the wealth is. The leaders of these companies tell us that all they need is to secure an extra half-a-million or a million pounds of appropriately-priced finance. We have been working with the government (and hope that the forthcoming budget will contain some good news) to help secure a package of measures that will transform the ease by which SMEs can secure capital in the UK. The high-growth sector in the London Stock Exchange is where we need to focus."
"The UK is missing out most today in the high-quality growth jobs, often funded by science, which, in turn, is funded by the investment of tax payers in the universities. It is not so much at the start-up level, but when they succeed after 4 to 6 years. At that time, many leave the UK as the conditions for securing the required growth finance are far, far more attractive in one particular country - the US. The cost of capital in the US compared with the UK is a magnet, but, if we can get it right, the UK is best placed to benefit from the 4.5 million SMEs that will provide our route to success in the future."
"There is a lot of hype about the growth of Islamic finance, but it is growing extremely quickly and it is currently available in 61 countries around the world. There are 716 banks offering Islamic services with assets of just over $1.1 trillion and they made $13 billion profit in the past year. The total assets are set to exceed $1.8 trillion by the end of 2013."
"London has the largest value of sukuk (Islamic 'warrants' or 'bonds') listed - some £27 billion are listed on the London Stock Exchange and they are always over-subscribed. They are sought by investors globally. The market is small - only 0.5% of the total conventional market, but it is growing very fast. As an aside, sukuk is the plural - the singular being sakk, the origin of our word for cheque."
"So, what is Islamic finance? It is a method of finance that seeks to generate a fair and equitable profit from transactions and funds that are backed by real assets. And where does that lead us? To bricks-and-mortar lending - we lend on commercial property, individual properties, we do a lot of leasing - real assets like ships, trucks - very fundamental aspects of the economy. We do a lot of trade financing - goods on the high seas - and we do invoice financing to enable companies to have access to the funds for things they have sold more quickly."
"Islamic finance institutions operate under the principles of fairness, integrity and transparency, avoiding short-selling, speculation and excessive credit creation, whilst encouraging sound risk-management procedures. Sounds good, doesn't it? In other words, the moral compass that some commentators say should be rediscovered in banking is already embedded in the objective of Islamic finance."
"It means that we cannot over-gear our balance sheets. We cannot go in for 'casino banking' - we concentrate on credit risk and so we are a bit like the banks of the past. I believe that we are actually re-creating the equivalent of the UK's merchant bank of the past. We were actually rather good at merchant banking. These principles are also very like what others call 'ethical finance', so we appeal to that market too."
"Oddly, the government schemes available to other banks are not available to Islamic banks. It would be useful if they were, particularly given what we have achieved in the past year. We would like to be able to deposit with the Bank of England, for example."
"We therefore need to know our clients well - their business, their strategy. Most other banks are far-removed from the business and a true relationship with their clients. We have liquidity and we are lending. My bank, BLME, is a big supporter of the UK mid-market - we have provided £600m of finance over the past five years. This is the market Xavier was talking about. Islamic finance really is 'fit for the future'."
"For the last couple of decades, silicon valley has been paying the bills for any small company to start up in the UK. The cost of the 'factory' to start the business has shrunk to the need for an internet connection, smart phone and a laptop. Most people have these already so, because Silicon Valley is paying for our worldwide distribution network (such as Twitter and Facebook), the cost has shrunk to about £1000. The government has also introduced extremely attractive incentives for investors in start-ups - like the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS). These give high-earners the opportunity to invest in early-stage businesses with the Chancellor paying 78% of the bill that you can claim back off your tax."
"This will potentially bring a redistribution of wealth from high-earners to SMEs that are looking to find equity finance. If you invest £100,000 in a company, then the real risk to you is about £28,000 that you pay in tax. The government has therefore effectively de-risked the investment in early-stage businesses."
"So, access to funding is the key for the entrepreneurs - enter crowd funding. All this has done is take the same processes that I used to use to raise finance for large companies, strip out all the costs, and make it accessible to small businesses looking to raise relatively small sums of money. This means that everyone can be an angel investor and venture capitalist - with just a few pounds if the want."
"So, we have three simultaneous benefits. The cost of business has never been lower; the cost of finance has been democratised - taking it from institutions to people, thanks to products like crowd funding - and the government is de-risking the investment process. That has to be the making of something truly special and it is 100% unique to the UK. It is not available anywhere else - not even the US - so this offers us the opportunity to do something really good."
"What's stopping us? If you are a high-growth company, investors will seek you out. If you are in that early stage, looking to raise less than a million pounds, crowd-funding is the answer. There are three products - so far we have only raised about "1.8 billion, but it is growing fast. The first is what we call crowd-investing. It is effectively a mini-IPO (Initial Public Offering) for small businesses looking to raise between about £150,000 and half-a-million. At the moment, there is no heavy regulation in this sector (unlike the AIM - Alternative Investment Market), but the challenge is that this might change. The other product is crowd-lending (also known as peer-to-peer lending) where you effectively become the bank and lend money to the start-up. You put your money into a crowd-lending platform where the risk is diversified and you get about an 8% return. Effectively, you bid on loans to credit-worthy SMEs that are looking for finance. The final route is micro-finance. An SME uploads its 'pitch' to something like a social media platform and you ask your followers to invest in return for a non-financial benefit."
"These crowd-financing options are the most exciting things in the market. The UK is the leader - this has to be 'finance for the future'. Let's see what happens in the next few years."
The conclusion? SMEs are the key to the future of the UK economy. The government and business should focus on this really exciting engine for growth and recovery. The UK is uniquely positioned to benefit from an entrepreneurial culture, an existing reliance on SMEs and the country's talent pool. Some relatively simple actions and well-placed investments would see the economy grow, unemployment levels slashed and the UK regain its world pre-eminence.