4 Competition for SME business
Finance for SMEs
122. A more competitive banking sector could benefit
small and medium sized enterprises (SMEs). Financing a private
sector recovery, published by the Department for Business,
Innovation and Skills and HM Treasury pointed out that:
There are around 4.8 million SME businesses (99.9
per cent of all UK businesses), accounting for over half of private
sector employment and turnover.
SMEs have generally experienced greater difficulties
than their larger counterparts in accessing finance primarily
due to the higher risk they represent, especially those without
a significant credit history or track record.
Around a third of SMEs do not use formal sources
of external finance at all, relying instead on retained earnings
or personal finance to fund investment and growth. Those SMEs
that do seek external finance are almost entirely reliant on banks.[186]
123. The Governor of the Bank of England, when giving
evidence to the Committee on Monetary Policy last year, felt that
there had been a particular problem in getting finance to SMEs
following the banking crisis.[187]
He argued that "we should try to encourage new entrants into
the banking system because they will not have the same problems
of legacy balance sheet difficulties."[188]
He also believed that competitive pressure could come from other
sources telling us "we have to make sure there are other
sources to which those SMEs can turn for finance."[189]
124. The Financial Secretary to the Treasury agreed
that competition for the business of providing finance and services
to SMEs from new entrants in the banking sector was important.
He told us that he "would like to see more challenger banks.
I would like to see more new entrants into the banking sector
to offer better deals and different products to SMEs."[190]
He also agreed with the Governor of the Bank of England that there
should be greater flexibility and a more diverse range of funding
sources such as "equity or direct access to debt markets"
than at present.[191]
125. Some banks considered that the supply of finance
was not the major problem. Antony Jenkins told us that "demand
for credit, particularly in the SME sector, has contracted because
customers are less confident about the future." Barclays
Chief Executive Bob Diamond emphasised the willingness of Barclays
to lend to SMEs as lending to their customers was the "core
business" of Barclays.[192]
HSBC Chairman Douglas Flint also pointed out that most SMEs were
able to get finance:
There was a report at the end of 2010 from the
Department of Business Innovation and Skills that recorded that
SMEs were able to get finance—the vast majority—from
the first port of call and those who couldn't from the first port
of call got it from the second, and that the cost of finance had
not gone up between 2009 and 2010.[193]
Mr Flint conceded that in 2008/2009 the cost of banking
did rise but as he explained "I think history would show,
with hindsight, that risk had been mispriced."[194]
126. On the other hand Neville Richardson, of The
Co-operative Financial Services, told us that funding for SMEs
had been reduced by the financial crisis and the regulatory response
to it.
[...] to lend money out to SMEs we have to take
money in. Over recent times, the wholesale markets have become
very expensive, so to borrow money is becoming expensive as banks
are having to repay the Special Liquidity Scheme and the other
government schemes. So, to lend out to them we have to borrow
in. I think the second is regulation, where the regulators are
increasingly asking organisations such as ourselves and across
the financial services sector to hold more capital and more liquidity.
The more capital that you hold, the more liquidity that you hold,
the less you can lend out.[195]
127. This Government like the previous administration
has intervened to encourage bank lending. As part of the 'Merlin'
agreement between the banks and the Government, announced on 9
February 2011, the Chancellor announced that there was "a
commitment from the four major banks, as well as Santander, to
make much more money available for lending to small and medium-sized
business." He explained that "the banks commit to lend
£76 billion this year. That is £10 billion more gross
new lending to small and medium-sized businesses."[196]
128. We asked the Governor of the Bank of England
about the Merlin agreement. He was keen to clarify that the Bank
of England had not been involved in the negotiations. He said:
"Let me make it clear we were not involved in the discussions
on Project Merlin at all."[197]
He also pointed out important differences between the promised
increases in 'lending' and the Bank's own definition of bank lending
As I understand it, the Project Merlin definition
includes facilities. That is money that companies could borrow
but have not yet borrowed, and our definition would include only
loans that had been made—facilities versus actual lending.
There is the difference between the two measures of gross lending,
and of course then there is net lending, which at present to the
corporate sector as a whole from the Banking sector is negative.[198]
129. He felt that SMEs were still under great pressure:
I think there is no doubt that anyone who goes
round the country and meets small to medium-sized businesses meets
a lot of people who feel that they have been denied access to
credit. I just find it very, very hard not to go round the country
and get that impression.
[...] credit conditions have improved for bigger
companies, but there's no real sign that they've improved for
small to medium-sized companies. I can understand why people running
those companies still feel under great pressure.[199]
He explained that the Bank would be publishing figures
on lending according to the Project Merlin definition and also
the Bank of England's own definition.[200]
130. The Merlin Agreement is welcome. We hope
that it does deliver the amount of SME lending that it promises,
and given that there remains scepticism about this we shall examine
the Bank of England's reports carefully. We are also concerned
that the FSA's requirements on capital may inhibit the lending
that is needed.
Customer service
131. The Office of Fair Trading commissioned a survey
of SME banking in 2006. This found that only a minority of SME
customers chose their bank due to them 'offering the best prices'(13%).
Far more customers chose the bank due to other reasons such as
convenience, service or due to a recommendation.[201]
The importance of the customer service provided to small businesses
and the improvement that needed to be made was recognised in the
'Merlin' agreement. The Chancellor said "the banks have committed
to greatly to improve their customer service to small businesses."[202]
132. Some of our witnesses felt that at the moment
SMEs were not being well served. Since starting Metro Bank, Vernon
Hill and Anthony Thomson said that he had underestimated the demand
for their services from SMEs and that they had originally been
understaffed to serve the SME response. They put this down to
poor customer service on the part of the other banks:
It is interesting to observe that of the SMEs
that have approached us, by far the majority are approaching us
because they want service, and they want a human being to talk
to. Very few are actually seeking credit.[203]
Adam Philips, Chairman of the Financial Services
Consumer Panel, also felt that rather than focusing on what customers
wanted banks were focused on pushing products onto customers,
and this was particularly a problem for SMEs.
What they want to do is move the product they
want to do. This is why the SMEs have a problem, because they're
not thinking about building the business in their community. They're
thinking about what their lending requirements are and whether
they want to suck in money or push it out again. There is a lack
of engagement with their customers.[204]
The ICAEW report of 2009 on SMEs found that many
of them were very dissatisfied with their banks:
Before September 2008, the relationships between
SMEs and their banks were felt to be fairly healthy. Since then,
they have become increasingly strained. This is largely believed
to be the fault of the banks being less supportive and existing
direct relationships weakening, for example as branch managers'
decisions on funding are countermanded by head office.[205]
133. Vernon Hill, Chief Executive of Metro Bank said
that in his experience customers were more concerned with service
and building a relationship with the bank than price. He also
felt that local, smaller banks, were best able to serve customers
well:
For the SME segment—and in fact the middle
market segment—their first concern is not about the price.
What they care about is—and we have a phrase—"local
lenders making local loans". They want an old-fashioned banker
who handles their £1 million credit, their house mortgage
and their kid's car loan.[...] That is a completely different
model from the one you see in large banks—whether large
banks in America and Britain—and it's why the American small
banks end up serving the majority SME segment, because the customer
wants a banker and not a phone number.[206]
Ana Botin, Chief Executive of Santander, agreed that
big banks may find it harder to serve SME customers well:
I think size makes it harder when you're very
big, but we're not at that point yet in the UK. You're right:
at some point, having systems might mean having automated systems
that are faster, but more rigid.[207]
134. The debate on SME banking has often only
been focused on the availability and cost of credit. Good customer
service for SMEs can be as, or even more, important to SMEs. Competition
and the ability to switch, is the most important spur to better
service.
Concentration
135. Although there may be wider reasons for the
decline in lending and problems with customer service than competition,
a more competitive market could have reduced problems. Professor
Llewellyn told us that there were deficiencies in the competitiveness
of the SME market:
It is evidently the case that the degree of contestability
varies between sub-markets. While new entrants have entered some
banking sub-markets, other markets have been untouched.
[...] there are few suppliers, and high entry
barriers, in the markets of general-purpose business loans for
SMEs[208]
He also considered that concentration was higher
in the SME banking market than in other markets:
[...] aggregate concentration in the UK banking
sector is comparatively low but is high in some sub-markets such
as SME banking products and services.[209]
Market concentration was raised by other witnesses.
Jayne-Anne Gadhia the Chief Executive of Virgin Money considered
there was an "effective oligopoly of the five big banks"
and that the "five big banks together operate [...] more
than 90% of the SME market."[210]
Such concentration has been considered an issue for many years.
In 2002 the Competition Commission reported on the supply of banking
services by clearing banks to small and medium-sized enterprises.
It found "the market for SME banking to be highly concentrated
especially with regard to the four largest clearing groups (Barclays,
HSBC, Lloyds TSB and Royal Bank of Scotland Group) that accounted
for over 90% of liquidity management services in each geographic
region."[211]
In 2007 the OFT considered that competition in the market had
increased. They pointed out that "several of the smaller
banks have increased their market share in England and Wales (HBOS,
Alliance & Leicester and Abbey have moved from around three
per cent to nine per cent collectively)". In particular they
pointed to HBOS and Alliance & Leicester as the strongest
challengers.[212] Since
then HBOS has become part of Lloyds Banking Group and Alliance
& Leicester has joined with Abbey which is now branded as
Santander. There are still very high levels of market concentration
for SME banking even though the sale of some of the RBS branches
to Santander means the 'Big 4' in the SME sector could in future
become the 'Big 5'. Two 'challenger' banks which were cited in
2007 as a sign of improving competition have since been subsumed
into larger banks.
Barriers to entry
136. Even in a market which is highly concentrated
the threat of new entrants can result in good outcomes for customers.
However there are significant barriers to entry in the SME market.
Virgin Money told us:
[...] organic entry to SME banking is very difficult.
To enter SME banking, a new entrant would have to offer current
accounts and other SME banking products, recruit experienced customer-facing
and credit personnel, and invest in appropriate infrastructure—and
would probably have to open branches, since many SMEs visit branches
frequently for advice and to make payments. Credit management
is also challenging for a new entrant, without historic customer
information. Even if these could all somehow be resolved, there
would remain the difficulty of demonstrating a reputation for
good service in SME banking. SME banking is different from many
other businesses in that both the customer and the bank expect
a long term relationship in which the unquantifiable aspect of
service is as important as the quantifiable aspect of price. A
reputation for delivering the required quality of service can
only be achieved through being in the business. So, in a perverse
sense, an SME bank "has to be in the business to enter the
business."[213]
Research commissioned in 2006 by the OFT showed that
the majority of small businesses also had personal accounts with
the same bank and that this was the most popular reason given
for opening a small business account with the bank.[214]
137. The need for a branch network is a further significant
barrier to entry. The importance of this was highlighted in a
report on SME banking by the OFT in 2007:
In terms of servicing existing customers, some
SMEs continue to make relatively heavy use of branches. The OFT
customer survey found that 79 per cent of SMEs were still conducting
some or all of their business in person through a branch, with
42 per cent conducting over half their banking by this method.
Most obviously, cash handling businesses require convenient local
facilities for making transactions. In addition 78 per cent of
respondents to the FSB's membership survey in 2006 felt that access
to local banking facilities was 'important'.[215]
138. The Campaign for Community Banking Services
(CCBS) also raised the importance of a branch for small businesses.
It considered that branch-dependent small businesses in over 1,000
urban and rural communities "effectively have no choice of
banking provider". The organisation provided two suggestions
for resolving the problem:
- An improved and better promoted Inter-Bank Agency
Agreement (IBAA) service. to provide a convenient service to business
customers who find the accessibility of their own bank's branches
difficult.
- Neutral shared branching to provide a basic counter
and related services delivered by a third party provider on behalf
of participating bank. on behalf of participating banks.[216]
A report commissioned by the OFT in 2006 revealed
that very few SMEs knew about the current Inter bank agency agreements:
Inter bank agency agreements offer a facility
where SMEs are able to deposit and withdraw money at another banks
branches (as well as conduct a prescribed range of other services).
The 2006 survey included a question to examine awareness of these
agreements amongst SMEs.
Awareness of inter bank agency agreements was
low. Only a quarter (25%) of businesses definitely knew agreements
existed. A further 11% felt their bank might well offer it but
were not sure, whilst the remaining two thirds either thought
their bank did not have such an arrangement (32%) or did not know
of their existence (32%). Smaller businesses, (with a turnover
of up to £500K) were more likely to say their bank did not
offer such an arrangement (37%).[217]
139. The importance of branches to many SME customers
presents a significant barrier to new entrants and therefore to
competition. We recommend that the Independent Commission on Banking
considers solutions such as an improved Inter Bank Agency Agreement
and neutral shared branches as part of its remit to promote competition
in banking.
140. Neither Virgin Money or Tesco Bank currently
provide a full range of banking services for SMEs and although
Virgin Money expressed an interest in entering the SME market
in the future it is not currently involved in the market. One
of the reasons for this may be the difficulty and risk involved
in serving SME customers. Ana Botin, the Chief Executive of Santander
told us that "SME lending is the most difficult business
for any bank"[218]
and also it's a higher risk business.[219]
Stephen Hester, Chief Executive of RBS considered that some of
the new entrants were only interested in certain customers and
products:
[...] some of the competition expressed itself
in people cherry-picking with specialist business models in specialist
areas. The lists of people that want to come into the UK in a
mainstream banking full service way—which is what we are
offering—is short to negligible.[220]
In their written evidence Metro Bank told us that
in their opinion the SME sector were "the most under-served"
customers of British banks.[221]
Metro Bank plans for its customer base, "over time, should
be "half-consumer and half-SME",[222]
however they currently only have branches in Greater London.
141. The Enterprise Finance Guarantee scheme provides
a limited government guarantee for certain loans to SMEs. In their
written evidence Metro Bank argued that this scheme should be
improved and extended and felt it could learn from a similar scheme
in the United States which they felt had "been extremely
successful." They also pointed out that the scheme, which
commenced in 2009, was not open to new entrants and suggested
that the Government should consider "allowing new banks to
enter as lenders."[223]
142. Potential entrants to the SME market are
faced with the same problems of customer inertia and fear of the
switching process as face those entering the personal current
account market. SMEs need access to a branch network and staff
who understand their circumstances. It is unsurprising that the
growth of new entrants in this market is slow. It is all the more
important that Government policies positively encourage them and
are designed in ways that recognise the challenges they face.
Alternatives for SMEs
143. Competition may not simply be a matter between
banks but between banks and other forms of finance. The Governor
of the Bank of England told us to "make sure that we find
ways of encouraging new banks and new sources of finance that
will pose a competitive threat to those banks" explaining
that:
If people want to jeopardise client relationships
they will just lose business. We have to make sure there are other
sources to which those SMEs can turn for finance.[224]
The importance of other forms of finance was also
highlighted by the Financial Secretary to the Treasury, who noted
that the European Commission was doing work on encouraging equity
investment into SMEs:
[...] we do need to see a broader range of finance.
That means more players in the lending market, but also, crucially,
it means businesses not just being reliant on debt and looking
for equity from business angels, VCs, direct access to capital
markets.[225]
144. In the paper Financing business growth
the Government notes.
The serious under-capitalisation of British small
businesses, especially compared to their counterparts in the US,
both in the start-up stages and subsequently, needs to be addressed.[226]
Financing business growth details
initiatives designed to increase equity investment which include:
- Over £300 million over the next four years
through Enterprise Capital Funds.
- A £1.5 billion Business Growth Fund set
up by a number of banks working through the BBA (British Bankers
Association)[227]
145. The internet is also providing new possibilities
in terms of finance for businesses. Individuals can now lend their
money to businesses on exchanges such as Funding Circle,[228]
a website which acts as an exchange helping to match lenders with
businesses who need to borrow. While the market for lending is
currently very small this is a growth area which is a viable alternative
to bank finance for some small companies. However the lending
through such exchanges is more like investing in a company bond
rather than having a deposit at a bank; it is not covered by the
deposit protection scheme.
146. While we welcome the Government initiatives
to increase equity investments, they are very small in comparison
to the £10 billion extra lending pledged from large banks
as part of the 'Merlin' agreement. Non-bank funding such as equity
or web based lending may increase the competitive pressures on
banks but there may be limits to their attractiveness. SME owners
may not wish to dilute their equity or may find debt financing
more tax effective; lenders may consider direct lending to small
businesses unduly risky. We recommend that the Independent Commission
on Banking consider the extent to which non-bank lending can offer
competition for banks and whether there are ways to increase the
attractiveness of other sources of financing. In particular they
should consider the effects of the regulatory and fiscal framework—such
as the different tax treatment for debt and equity.
186 Department for Business, Innovation and Skills,
Financing a private sector recovery, July 2010, p 14 Back
187
HC 429, 28 July 2010, Q31 Back
188
Ibid., Q 38 Back
189
Ibid., Q 41 Back
190
Q 1145 Back
191
Q 1144 Back
192
Q 605 Back
193
Q 864 Back
194
Q 864 Back
195
Q 958 Back
196
HC Deb, 9 February 2010, col 312 [Commons Chamber] Back
197
HC 798, Q 30 Back
198
HC 798, Q 31 Back
199
HC 798, Q 33 Back
200
HC 798, 1 March 2011, Q 30 Back
201
Office of Fair Trading/IFF Research Ltd, Survey of SME Banking,
July 2006, Figure 4.2, p23 Back
202
HC Deb, 9 February 2010, col 312 [Commons Chamber] Back
203
Q 437 Back
204
Q 16 Back
205
ICAEW, SME Access to Finance, July 2009, 2 Back
206
Q 463 Back
207
Q 744 Back
208
Ev w39 Back
209
Ev w39 Back
210
Q 628 Back
211
Ev w51 Back
212
Office of Fair Trading, SME Banking: Review of the undertakings
given by banks following the 2002 Competition Commission report,
August 2007 Back
213
Ev 182 Back
214
Office of Fair Trading/IFF Research Ltd, Survey of SME Banking,
July 2006, Figure 4.2, p23 Back
215
Office of Fair Trading, SME Banking: Review of the undertakings
given by banks following the 2002 Competition Commission report,
August 2007, p70, para 4.107 Back
216
Ev w1-w3 Back
217
Office of Fair Trading/IFF Research Ltd, Survey of SME Banking,
July 2006, p107, para 8.17-818 Back
218
Q 707 Back
219
Q 709 Back
220
Q 312 Back
221
Ev 248 Back
222
Q 460 Back
223
Ev 248 Back
224
HC 429, 28 July 2010, Q 41 Back
225
Q 1145 Back
226
HM Treasury and Department for Business Innovation and Skills,
Financing business growth: The government's response to Financing
a private sector recovery, October 2010, p5 Back
227
Ibid., p4 Back
228
www.fundingcircle.com Back
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