Why UK Bank Lending to Small Firms is Unlikely to Revive Soon

Posted on 12/08/2010


From the Scotsman, 27th July 2010: “Launching a consultation document to set out options for improving the flow of cash to firms, Business Secretary Vince Cable said small and medium-sized firms were facing a “very serious problem” in raising finance. If bonuses and dividend payments are too big, the government has the option of looking at taxation of their profits. There is a choice between giving out cash in bonuses, or re-investing. There are potential sanctions available which we hope are not necessary.”

However, various government policies have had a much greater impact on bank lending than either bonuses or dividends, and these policies are seemingly here to stay.

1.  Higher Capital Requirements. Integral to the banking bail-out was the concept that banks would be required to operate with higher levels of equity capital than they had in the past, with the FSA now viewing 4% as “a minimum” and 8% as what would be expected in normal circumstances. In June 2008 RBS had a tier 1 capital ratio of 5.7%, by March 2010, this had increased to 10.6%. To put into context the impact of this, if a bank has £10bn of equity capital, an increase in its capital ratio from 5.7% to 10.6% would mean reducing lending from £175bn to £94bn. Changes of this magnitude are certain to have a significant impact upon the economy.

2.  Requirements to Hold Larger Amounts of Gilts. Following the bank bail-outs of 2008, one of the policy solutions that has been implemented by the UK Government and the FSA was to mandate higher level of Gilt (UK Government bond) holdings by the UK banks.  While it is convenient for the Government to have captive buyers for its bonds at a time when its is borrowing record amounts of money, every pound lent by the banks to the UK Government is one pound that cannot be lent to the private sector, a clear demonstration of the concept of crowding-out in action.

The recent RBS investor presentation quantifies the impact of these two factors by stating: “Total balance sheet [ie lending to individuals, firms and governments] decreased by £636bn since FY08 despite £75bn increase in the liquidity portfolio [ie. holdings of government bonds] to £165bn at Q110.” This means lending to individuals and firms by RBS has declined by £711bn over the period. Note that RBS is an international banks, so not all of this impact would have been felt in the UK.

3.  Expiry of the Special Liquidity Scheme. As part of the bank bail-out, the Bank of England organised a “Special Liquidity Scheme” whereby it would also the banks to swap up to £200bn of high-quality mortgage-backed securities for hard cash. This scheme is due to expire in January 2011 and Bank of England Governor Mervyn King has explicitly ruled-out its extension. Therefore, in aggregate, UK banks will be required to pay £200bn to the Bank of England in January, and they need to be certain they have the cash available to do this, depressing current – and expected – levels of lending. HBOS, now part of Lloyds, is thought to be the biggest user of the scheme.

With requirements to hold high levels of capital and gilts seemingly here to stay, and the Bank of England unlikely to perform a u-turn regarding the expiry of the Special Liquidity Scheme, all the key factors that have caused a decline in bank lending to UK SMEs appear to be here to stay.  Harsh words from Vince Cable are unlikely to have an impact on their own.

Posted in: Economy