Is Global Financial Regulation Putting a Stop to SME Growth in the UK?

It’s long been known that small businesses are one of the cornerstones of a healthy economy, and in the UK, SMEs account for a staggering 99.8% of incorporated companies. Without getting into a discussion on that classification (if 99.8% are small- and medium-sized, what counts as large?) it’s important to note how SMEs are defined. This figure shows that the term ‘SMEs’ refers to a much larger and more diverse pool of companies than is often realised — and they’re not just small firms and startups.

Interestingly, although these enterprises make up the overwhelming majority of the UK’s incorporated companies, they only account for 30% of the revenue. We’ve repeatedly seen that access to lending is a key growth factor for SMEs, and in turn how they’ve suffered disproportionately in the post-recession landscape. This is normally chalked up to the recession — times are still tough, and amongst talk of a ‘double dip’ we should be glad that the state of SME lending isn’t even worse. But what we perhaps haven’t considered is that this situation could have been avoided — and good intentions aside, it could be a direct result of Basel III.

What is Basel III?

Basel III is the most recent set of guidelines issued by the Basel Committee on Banking Supervision (BCBS) whose mandate is to “strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability”. This stated aim became increasingly important after the global recession of 2007-8, especially in light of the widely discredited Basel II.

In layman’s terms, Basel III aimed to make banks more stable and less vulnerable, by requiring them to hold more capital in proportion to their risk. Theoretically, this is a perfectly logical position to take, but it came with unfortunate (and predictable) results.

Where Basel II was lax, Basel III has potentially overcorrected — particularly when it comes to liquidity and capital requirements. While appearing sensible on a macroeconomic scale, the new capital requirements disproportionately affected SMEs. Indeed, contemporary commentators pointed out this risk, with the consensus at the time saying that Basel III traded macroeconomic stability for SME prosperity.

This has held true, and years later it’s clear that SMEs are still suffering terribly because of Basel III’s collateral damage.

Unintended consequences

Basel III’s requirements for the banks to hold more capital in proportion to their risk effectively presented banks with two choices — increase held capital in absolute terms to sustain the same risk, or hold the same amount of capital and reduce risk exposure.

Unfortunately, the latter has overwhelmingly been the preferred course of action for the major institutions. What’s worse, SME lending is an obvious area to decrease for banks looking to reduce their exposure, because it’s riskier, and has a lower rate of return than lending to larger, more established businesses. That’s exactly what has happened — the major banks are much less able or willing to lend to SMEs, regardless of how credible their applications are.

Another example of this phenomenon is the reduction of overdraft facilities for smaller businesses. Basel III redefined how overdrafts are categorised in terms of risk, meaning that banks have to hold capital against the full overdraft capacity even if only a small proportion is ever actually drawn.

This is a good example of Basel III’s overcorrection of the mistakes of Basel II — because even if the bank’s total value of overdrafts are only ever drawn at 20%, they have to hold capital as if 100% were loaned. The sadly predictable result is that Funding Options research shows that business overdrafts in the UK have been reduced or removed at a rate of £5 million per day, as banks focus their limited capital requirements on more profitable types of lending. Again, while appearing superficially sensible, Basel III’s policy seems detached from reality, and indirectly encourages banks to turn their backs on SMEs.

But what does all this mean for the SMEs who can no longer be helped by their business bank?

Put simply, they’ve been struggling since the credit crunch, and continue to do so even as the wider economy shows positive signs of recovery. Access to lending is a crucial growth factor for small businesses, so the reduction of bank lending — a direct result of Basel III — is starving them of the opportunity to expand, and in some cases leading to their closure.

What are the alternatives?

But all is not lost for SMEs in the UK. The alternative finance industry has — perhaps unsurprisingly — grown and diversified immensely since the credit crunch, and now lends 45% of the amount that the banks do. This proportion is growing all the time, and we expect it to continue.

Moreover, alternative lenders aren’t restricted in the same way as the mainstream institutions. As well as having the appetite to lend to higher-risk propositions — and the freedom to do so — alternative finance providers have such a wide range of products between them that there are more and more solutions for a huge number of businesses in specific situations.

For example, the retail and hospitality sectors have always been difficult to lend to; merchant cash advances have emerged as a flexible and accessible alternative way to fund such businesses.

Invoice finance is hugely useful for firms that trade on credit; trade and supply chain finance give many SMEs the platform they need to start doing business internationally; and of course, crowdfunding has been very useful for new businesses looking to get things off the ground.

These are just a few examples — there’s a lot more alternative finance besides that can help hard- hit SMEs access the funding they need to survive and thrive. And while it’s clear now that Basel III has had serious consequences for SMEs, it remains to be seen whether bank lending to SMEs will recover, or whether alternative finance will continue growing to fill the funding gap, and gradually replace the banks.

With alternative finance already accounting for 45% of bank lending to SMEs, the latter future is closer than you might think.

Conrad Ford is Chief Executive of Funding Options, recently described by the Telegraph as “the matchmaking website for small businesses and lenders”. With the free Funding Options service, you can quickly search dozens of alternative business finance providers.