Published on 3 June 2011 by Tony Groom

Recently Business Secretary Vince Cable called for significant improvement in lending to Small and Medium Sized businesses (SMEs) through Project Merlin.

The figures for January to March showed a shortfall of 12% against the £19bn that represents a quarter of the annual £76bn target agreed with the government for lending to smaller businesses.  The Federation of Small Businesses also reported that only 16% of its members had approached banks for credit and 44% of those had been refused. This includes those businesses seeking credit to fulfill firm orders.

Businesses that are growing need working capital to fund the purchase of goods, materials, marketing and staff for new growth and although some of that can be obtained by borrowing against the sales ledger (through factoring and invoice discounting) when they turn to the banks they are being seen as too high risk.

This is actually a reasonable response by the banks where businesses have been clinging on by their fingernails since the 2008 recession by using up most of their working capital and therefore according to the bank models are seen as high risk and facing the prospect of insolvency.

Because businesses are continuing to deleverage by paying down old loans they are in a vicious circle of decline. The reduction in working capital used to pay off loans means they no longer have funds to buy materials to fulfil orders nor are they adequately capitalised to justify new loans.  This explains why it is very common for businesses to go bust when growth returns to the market after a downturn.

A second problem is that once a bank realises that a company with outstanding debt is in difficulty, it is providing for the bad debt by adjusting its own capital ratio to cushion against increased risk. While the new Basel 111 rules requiring banks to increase their Tier 1 capital holdings (equity + retained earnings) from 2% to 7% have yet to be introduced, they are repairing their balance sheets in preparation for phasing in the new rules between 2015 to 2018.

Inevitably the banks are passing these costs onto businesses in the form of higher fees and higher interest rates and it is therefore no surprise that some companies cannot borrow money, even when orders are rising, when they are already seen as a bad risk.

The third factor in the mix is businesses that own their own premises trying to borrow against their property.  Loans that might have seemed good when a commercial property was worth a lot are no longer the security they once were because, like the domestic housing market following the sub prime crisis that sparked the recession, the commercial property market is in desperate straits.  A look at the boarded up properties on the High Streets and on industrial estates across the UK makes this abundantly clear.

Those businesses that own their land and buildings but have used them to secure loans or mortgages can become subject to huge risk related costs due to the exposure of the bank. This is because banks have so much commercial property as security already that cannot be either leased or sold. The bank will therefore impose penal fees in a bid to recover the provisioning costs.

It is no wonder that Bank of England Chief Economist (and member of the MPC) Spencer Dale recently warned of at least another two bleak years and a high risk of feeble growth and high inflation.

However, there is at least something businesses can do to mitigate this catch 22 and survive and that is to call on expert help to look at fundamental solutions recognising they will not be able to borrow money to limp along as they have been for the last two years and to thoroughly revamp their business models.