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Britain Needs a State-Backed Investment Bank to End Lending Freeze

Neither America nor Germany rely solely on commercial banks

As George Osborne’s next Budget approaches and the UK teeters on the edge of recession, a new Civitas report reveals that the Government is failing to tackle the key barrier to growth. A lending freeze affecting small and medium-sized (SME) businesses is preventing economic recovery.

Extending Lending, by David Merlin-Jones, shows how state-backed investment schemes in the US and Germany have created better lending opportunities for SMEs, allowing them to expand and replace jobs lost during the financial crisis. Both the US and Germany have seen quicker recoveries than the UK since the crash.

By contrast, Britain has relied too much on the big commercial banks, which are failing in their public function as investors in business. Britain risks being left behind by its economic peers which are willing to use pragmatic state-banking schemes to help employers when the commercial market alone is not enough.

Mind the lending gap

SMEs are the backbone of the British economy and the source of 60 per cent of private sector employment. They frequently require loans to grow the business, particularly when venturing into exporting. This often leads to employers taking on more staff as well. Without access to finance, these businesses are paralysed and the growth the UK badly needs in jobs and exports will be stunted.

Extending Lending shows how the lending situation for SMEs has deteriorated since the financial crisis:

  • Successful SME loan finance applications to banks fell from around 90 per cent in 2007 to 65 per cent in 2010.
  • The proportion of SME businesses seeking finance rose from 35 per cent in 2007 to 42 per cent in 2010 [p.xv].

SMEs usually require funding of between £250,000 and £2m and this is the range provided by banks. They are stuck in a “no man’s land” because this range is beyond the capability of informal financing, such as family support networks, but too little to attract the interest of major institutional investors.

The US’s and Germany’s pragmatic response

While Britain is still languishing, it has been outpaced by rivals who used state-run organisations to maximum advantage during the recession, to provide loans when commercials lenders would not. Both Germany and the United States are now well on the road to recovery. Extending Lending draws on the best features of these examples for an Enterprise Bank model for Britain:

  • In America, the Small Business Administration (SBA) works alongside commercial lenders and provides guarantees for loans to business that would otherwise be rejected. SBA loans are longer, cheaper and require less collateral than normal loans. The SBA’s funding was increased through the recession, allowing it to increase loan approvals by 20 per cent since 2009-10. In 2010 alone, through the main two loan schemes on offer, over 550,000 American jobs were protected and in total, $680m of taxpayer funds supported $21.5bn in loans [pp.41-2].
  • In Germany, KfW provides cheap loans to SMEs while using the commercial banks as intermediaries. In 2010, KfW financed loans worth a record €28.5 billion for SMEs, creating 66,000 jobs in addition to the 1.3m jobs it helped maintain [p.62]. Those sectors hit hardest by the recession received the most lending from KfW. In addition, KfW helped seed new businesses, financing 7,100 start-ups in 2010 [p.63].

The solution – the Enterprise Bank

Merlin-Jones argues that the UK needs its own state-backed bank, perhaps to be called the Enterprise Bank. This will be a permanent solution to the lending gap and would lend to any company, regardless of sector or size, provided it can demonstrate its creditworthiness. Because it is state-backed, it could use the UK’s AAA rating to increase private finance at the lowest cost and pass this saving on to businesses. The Enterprise Bank (EB) should have the following features:

  • It should focus on lending between £250,000 and £3m. It would lend only after companies have been rejected by commercial lenders (so as not to crowd them out). Borrowers would first apply to the EB through their commercial bank.
  • It would pay a fee to commercial banks for acting as intermediaries to incentivise their cooperation but if commercial banks are uninterested, borrowers could apply directly to the EB.
  • Funding decisions should be taken by industrial experts based on future prospects of the company, not the sector.
  • It should provide expert advice to borrowers, reducing risk to itself while benefiting the economy.

No cost to the taxpayer

Although a state-backed entity, the Enterprise Bank can be established and run without burdening the taxpayer. Instead of buying gilts from commercial banks, the Bank of England could allocate part of the latest tranche of QE to purchasing shares in the Enterprise Bank. After this, the EB could raise further funds on the capital markets as other state-backed banks currently do. For every £1, it is possible that the EB could attract a further £8 this way [p.100]. The Government already owns RBS, which could form the basis of the Enterprise Bank.

Giving the invisible hand a helping hand

The report argues that concern about state-backed investment banks is too often based on ideological opposition, rather than practical problems. British policymakers, unlike their more pragmatic counterparts in Germany and the US, are unwilling to adopt flexible policies in the face of cataclysmic economic challenges. David Green, in a foreword to the report, explains:

…the government must be bold and not find itself embroiled in a distracting argument about the value of the free market versus state intervention. The EB is about supplementing the free market and filling in holes, not displacing it. It is a pragmatic institution which will resonate across the political spectrum [p. xvi].

David Merlin-Jones concludes:

Whatever the banks say, the truth is that they are lending less and this hurts the overall British economy. Unless the Chancellor is content to let banks’ self-interest impede growth, we need a new state bank, motivated by serving the public good, to be at the frontline to avoid another recession.

For more information contact:

David Merlin-Jones, Director of the Wealth of Nations Project, 07949 811 032 anddavid.merlin-jones@civitas.org.uk

Civitas 020 7799 6677

Notes for Editors

i. David Merlin-Jones is Director of the Wealth of Nations Project at Civitas and a Research Fellow in economics, energy and industrial policy.

ii. Extending Lending: The case for a state-backed investment bank is available from the Civitas shop (RRP: £9.50) and by calling 020 7799 6677.

iii. Civitas is an independent social policy think tank. It has no links to any political party and its research programme receives no state funding.

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