Competition and choice in retail banking - Treasury Contents

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.


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  Back

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