By Emmanouil Schizas, senior policy adviser, ACCA
Upon returning from annual leave, I was not overly surprised to find that the UK government was in a spot of trouble with its latest initiative in support of small and medium-sized enterprises (SMEs).
The initiative in question is named 'Project Merlin', although 'Loans for Bonuses' might be more appropriate. The deal is that banks will be allowed to set aside slightly more funds for their bonus pots or avoid further windfall taxes if they also commit to lend more to SMEs. This is of course mostly conjecture as no one is very happy to discuss what the banks are getting in return in this deal.
This isn't the first time since the Lehman collapse that small business lending targets have been discussed, or even imposed, in the UK. Invariably, previous attempts have failed (see here, here and here). It should come as no surprise then that Project Merlin has now stalled, although enough political capital has gone into it to animate it for a while.
Why the banks and the government will never strike a credible deal…
One problem with lending commitments is that neither side has a real incentive to honour their obligations. No government can fully commit to a soft(er) touch on banks, whether in words or deeds, unless the opposition and media also sign up to the deal; such a commitment would be political suicide. As the past three years have shown, governments will always reserve the options of windfall taxes, regulation and even nationalisation.
Meanwhile, no bank with shareholders to answer to can commit publicly to either lending on non-commercial terms, lending at a loss, or lending without regard to risk.
If you do hear of a deal to save Project Merlin, take the news with a pinch of salt - the wiggle room involved for both sides will be enormous.
… and why they shouldn't anyway.
But planning commitments aren't just unreliable, they are completed misguided. If bonuses really do encourage reckless risk-taking on a systemic level (and they have in some cases), extra lending to SMEs will not offset this; in fact, if the extra lending is performed on less than commercial terms it will make bonuses even riskier as banks' capital will be depleted.
More to the point, central planning doesn't magically become workable when the private sector jumps on board. Banks (whether individually or collectively) cannot guess the demand for loans in the current environment any better than the government or anyone else with an econometric software licence (evidence here); nor do they understand the strength (or otherwise) of the aggregate small business balance sheet.
Who is to say that £70bn (the amount supposedly pledged by banks for small business in the latest round of negotiations) is a sustainable amount to lend to UK small businesses at this moment? It is, after all, 31% more than the current amount of credit outstanding. Or is it, as one can't help but suspect, a figure plucked out of the air, like Homer Simpson's Tomacco valuation?
These are substantial risks and UK taxpayers - who own a good deal of the UK banking sector and of whom 60% work for SMEs - need to be very mindful of what is signed on their behalf; they will be exposed to SME default risk on both sides.
To their credit, the technically-minded people in both banking and the government admit that they don't have a proper birds'-eye view of the SME sector's finances, which is why the banks are about to spend millions per year on the biggest-ever series of regular surveys on SMEs' access to finance (a Banking Taskforce recommendation) in order to find out more. ACCA is represented at the meetings of the technical group working on the study's specifications and we understand it will be some time before this produces any actionable information.
Now suppose the plan goes ahead and SMEs fail to develop an appetite for the credit bonanza bestowed on them. Maybe they're afraid of a double-dip, they want to be debt-free, or they no longer trust banks. Perhaps banks will then be forced to honour their obligations by lending to anyone so desperate for cash right now that they don't care whether they'll be able to pay it back. Is this a real risk? Yes it is.
As our joint research with the Confederation of British Industry (CBI) found last year, the chances of an SME with poor cash flow applying for short-term credit are roughly twice those of an SME with strong cash flow.
More realistically, banks will return to business as usual but try to increase lending where it is easiest and safest to do so. We know from our international research with Forbes that lenders hate it when their loans are used to finance SMEs' customers (essentially they avoid borrowers with poor cashflow, a finding confirmed by the CBI research) and international research shows that they are increasingly cautious of unsecured lending. So this extra lending will go to the largest and safest businesses, and particularly those with very reliable customers, such as the government.
Arguably, these are the businesses that least need the government's help.
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