Beyond the Banks: The case for a British Industry and Enterprise Bond

8/3/2019 Beyond the Banks: The case for a British Industry and Enterprise Bond

1/23

Research summary: November 2011

Beyond the BanksThe case for a British Industry and Enterprise Bond

Stian Westlake, Sam Gyimah MP and Marco Zappalorto


2/23

NESTA is the UKs foremost independent expert on how innovation cansolve some of the countrys major economic and social challenges. Its work isenabled by an endowment, funded by the National Lottery, and it operatesat no cost to the government or taxpayer.

NESTA is a world leader in its eld and carries out its work through a blendof experimental programmes, analytical research and investment in early-stage companies. www.nesta.org.uk

Contents

Beyond the Banks

The case for a British Industry and Enterprise Bond

Executive summary 3

Part 1: Business credit: The nature of the problem 5

Part 2: Options to increase business lending 10

Part 3: Recommendations 18

Appendix: International examples of credit easing institutions 19

Acknowledgements 22


3/23

Economic recovery and growth relies oninvestment by UK businesses. But levels of

bank lending remain stubbornly low, and mayfall further as the Eurozone crisis deepens. InOctober 2011, the Chancellor of the Exchequerannounced that the Government would begina policy of credit easing to improve smallbusinesses access to nance.

The issue of credit easing has been widelydiscussed by macroeconomists and large banks.This report offers a different perspective,drawing on the insights of the entrepreneurialbusinesses that rely on nance to grow and the

new providers of credit who are attempting toimprove the system.

Our central recommendation is that the rightkind of credit easing measures can bring newsources of capital to invest in small businesses.

We propose that the government buy upbanks loan portfolios and nance these byissuing securities a British Industry andEnterprise Bond to investors. Our researchamong institutional and retail investorssuggests there is considerable investor appetitefor these bonds, with around 70 per cent ofboth groups saying they would be likely orfairly likely to invest.

This would address the immediate problem ofa shortage of lending to small businesses, byfreeing up banks balance sheets for furtherlending. Just as importantly, it would helpaddress a more structural problem of the UKnancial system: its dependence on a relativelysmall number of banks and the relatively smallsize of non-bank lending options.

By accessing new pools of capital to investin UK companies, the British Industry and

Enterprise Bond would increase the diversityof the UK lending market, and would provide a

basis for new providers to enter the market.

The development of this market could bestimulated by the Bank of England buying aportion of the highest-rated bonds as part of afuture round of quantitative easing.

Any such investment of course has risks,However, there is good cause to believe thatthe risks associated with the British Industryand Enterprise Bond would be manageable andacceptable to investors. Good quality analysis

exists of the risks of small business lending.And during the credit crisis, it was banks largercorporate and real estate portfolios ratherthan their small business loans that causedembarrassment. This risk can be mitigatedfurther by requiring banks to maintain aproportion of the securities sold to reducemoral hazard, and would retain responsibility formonitoring and managing the underlying loans.

At the same time as launching the bond, thegovernment should also commit to concertedplans to increase the diversity of nanceavailable to small business. The UK should levelthe playing eld for start-ups that provide smallbusiness credit: these are currently unable toavail themselves of much of the governmentsupport open to other start-ups. Financialregulation should include an explicit aim ofincreasing diversity of business models (somespecic proposals are included in this report),and swift resolution should be sought to theregulatory limbo that some innovative nancialproviders, such as peer-to-peer lenders,frequently face. And the government should

set in motion a review of the taxation of debtnance, which articially tips the scales infavour of debt rather than equity.

Executive summary


4/23

4

These proposals offer a way both to increasethe amount of lending available to Britainssmall and medium-sized businesses, and toincrease the diversity, quality and resilience ofthe UKs business lending sector.


5/23

The quest for economic growth has becomethe dening challenge of the remainder of

this Parliament. Having taken steps to stabilisethe UKs decit and protect its credit rating,the government is undertaking a range ofpolicies to encourage economic growth,including a series of supply-side growthreviews on subjects ranging from infrastructureto university tech transfer and from corporategovernance to intellectual property.

In October 2011, the Chancellor of theExchequer announced that he had asked theTreasury to work on ways to inject money

directly into parts of the economy that need itsuch as small businessesand to help solve[the] age old problem in Britain: not enough

long-term investment in small business and

enterprise.

The question of how to make credit easinga reality has attracted the attention ofmacroeconomists and the UKs leading banks.This report attempts to provide a differentperspective: that of growing UK businesses,and of those seeking to provide businessnance in new ways.

There have been widespread debates amongmacroeconomists and in the nancial press onthe technical merits of credit easing. So it isperhaps helpful to set out at the outside somebroad principles that any policy in this areashould seek to achieve.

1. Availability of nance. In order forthe economy to recover, we need to seebusiness growth. We know that high-growth businesses play a disproportionate

role in economic growth.1 As thesebusinesses grow and others shrink,

economic output increases as resources capital, manpower, know-how are shifted

from less productive opportunities to moreproductive ones. One prerequisite for this isnance: the nance to back entrepreneurs,and the nance to allow successfulbusinesses to grow. Increasing access tonance is the governments stated objectivebehind credit easing.

2. Mix of nance. The type of nanceavailable matters too. Risky, early-stageventures are best nanced with equity.Our nancial system discourages equity

investment by providing tax deductionsfor debt interest payments, but not for thedividends paid to shareholders. Competitionamong providers of nance is benecialfor borrowers, encouraging innovationand better offers. Debt nance in the UKis dominated by a relatively small numberof banks, with bonds being relevant onlyfor the largest borrowers and non-bank,non-bond debt being rare. Mitigating theseproblems is a worthwhile objective forpolicy.

3. Limiting government exposure. At thesame time, any policy that involves thegovernment lending money or guaranteeingborrowing involves the risk that loans willgo bad. Policies should keep to a minimumthe risks that government takes on, andencourages that others are incentivised toreduce and manage them.

4. Avoiding moral hazard. The other dangerof government loans or guarantees is thatit will reduce the incentive on others to do

their homework: why assess prospectiveborrowers carefully if the government will

Part 1: Business credit: The nature of the problem

1. NESTA (2009) The Vital 6 PerCent. London: NESTA.


6/23

pick up the tab if they default? Effectivepolicy needs to minimise these perverseincentives.

The analysis that follows looks at the questionof credit easing through these four lters.

The short-term problem: An ongoinglending malaise

The past three years have seen a dramaticfall in lending. During an economic recession,nancial intermediaries and markets allocatecredit less well with a bias against small rmswho need to be carefully assessed and againstnew rms who have no track record.2

The BoEs Trends in Lending report, published

in October 2011, shows that growth in thestock of lending to SMEs began to slow inearly 2008 and turned negative in about July2009.3 The stock of lending to larger smallbusinesses (turnover of 1 million-25 million)was contracting at about 4 per cent a year,

according to the October 2011 report. Theeffect is more pronounced still among smallbusinesses. British Bankers Association guresshow that at the end of April, banks lending tosmall businesses stood at 39.9 billion, some2.3 billion less than two months earlier, whileoverdraft borrowing had shrunk from 7.6

billion to 7.3 billion.

Behind these gures lies a story of frustrationat banking relationships, inducing someSMEs to refrain from using bank nance.This withdrawal from loan nance is reectedin data from the Department for Business,Innovation and Skills (BIS) showing that thevalue of applications by SMEs for new termloan and overdraft facilities in the six monthsto February 2011 fell 19 per cent comparedwith the same period a year earlier.

The cost of debt is one explanation of thisretreat. Corporate loans are priced in terms ofa spread, or interest rate premium, added toa reference rate such as the Bank of Englandbase rate. Recent data show that the averageinterest rate that the smallest businesses (up

2. How to do more. AdamPosen, Bank of England,speech delivered 13September 2011. Posenreferences a range of recentempirical research on thisquestion.

3. Bank of England (2011)Trends in Lending. October2011. London: Bank ofEngland.

Figure 1: Lending to UK small businesses

Source: Bank of England, British Bankers Association, UK Department for Business, Innovation and Skills in Lending to UKbusinesses and individuals, Bank of England, October 2011.

Rate of growth in stock of lending to SMEs

0

-5

20

15

10

5

-10

Mar2008

May2008

Jul2008

Sep2008

Nov2008

Jan2009

Mar2009

May2009

Jul2009

Sep2009

Nov2009

Jan2010

Mar2010

May2010

Jul2010

Sep2010

Nov2010

Jan2011

Mar2011

May2011

Jul2011


7/23

to 1 million turnover) have to pay has risenfrom less than 4 percentage points over baserate (0.5 per cent) in mid-2009 to about 4.7percentage points by May 2011.

This claim has been disputed by banks, andit is difcult to show for sure to what extent

a shortfall in nance is the result of lack ofsupply or lack of demand. However, researchsupports the idea that access to bank nancebecomes more difcult in recessions, especiallythose following banking crises. In the wordsone economist,

tighter credit conditions among fewer

banks are not leading to better lending

decisions... years of accumulated

economic research are consistent with

this... assessment of what happens in a

credit crunch. Financial intermediaries

and markets allocate credit less well underconditions of stress, with a bias against

small rms who need to be carefully

assessed and against new rms who have

no track record.4

Evidence continues to emerge supporting thisnding. A recent paper by Becker and Ivashinaprovided evidence that those companies thatcould switched from bank loans to bonds whenthe economy was performing poorly and bank

shares were low, implying that bank creditwas harder to get or less attractive.5 Lookedat in the round, there has been both a generalwithdrawal from lending/borrowing by banksand small businesses, and a repricing of riskby lenders in the years since the credit crunch,with the smallest businesses the worst affected.

Two longer-term problems

The effects of the global nancial crisis aresignicant and severe. But they are not theonly issue that needs to be resolved when itcomes to debt nance for UK businesses.

UK credit markets are curiously homogeneous.First of all, the UKs banking sector is relativelyconcentrated, as shown in Figure 2.6 One senior

regulator we spoke to observed that the UKwas particularly lacking in medium-sized banks,which have a particular afnity for mid-sizedbusiness clients and unlike large banks areunlikely to retrench to large business customersfollowing a crisis.

Moreover, the main debt alternative to bankloans, the corporate bond market, is unusuallysmall in the UK, as demonstrated by Figures 3and 4.7 Part of the shortfall between the UK


5. Becker, B. and Ivashina, V.(2011) Cyclicality of creditsupply: rm level evidence.Harvard Business School

Working Paper No. 10-107.Boston MA: Harvard BusinessSchool.

6. Posen, A. (2009) Gettingcredit owing: a non-monetarist approach toquantitative easing. DeansLecture Series, Cass BusinessSchool, London 26 October2009.

7. Ibid.

Figure 2: Banking Sector Concentration

0.2

0.8

0.6

0.4

0

Canada France Germany Italy Japan UK US Average


8/23

Figure 3: Private Sector Bond Market Capitalisation

Figure 4: Short term Private Sector Securities

0.2

1.4

1

0.6

1.2

0.8

0.4

0

As a ratio

of GDP


0.3

0.2

0.1

0.25

0.15

0.05

0

As a ratio

of GDP



9/23

and other European countries may be explainedby the greater ability of UK businesses toobtain equity nance; but the fact remains thatwhen it comes to debt nance, UK banks aremore dominant than their equivalents in mostother countries.

It was not always like this. Private, illiquiddebt used to be bought and held by a numberof institutional sources: in particular, denedbenet pension schemes, insurance companiesand with-prots funds. Demographic changeand stock market performance has drasticallyreduced the number and size of dened-benet pension schemes, and the dened-contribution schemes that have replacedthem have less appetite for illiquid securities;while increasing regulation and transparencyrequirements are reducing the number and sizeof with-prots schemes and the appetite of

insurance rms for untraded debt.

For some time, this shortfall was concealedby an inow of bank lending, especially fromthe foreign banks that established themselvesin London over the course of the 1990s and2000s. But the nancial crisis has caused thistide to retreat and the relative barrenness ofUK debt markets becomes more apparent.

This lack of funding options can also be linkedto the fragility of the nancial system. The

exposure of large UK banks to large commercialloans that in some cases performed disastrouslypoorly, created shocks that were felt by largeand small business loan applicants alike. Theconcentration of the sector also saw balancesheet and management systems becomingincreasingly homogeneous. As banks aimedto pursue diversication on an individualbasis, diversity decreased across the systemas a whole. Greater levels of homogeneity areunderstood to increase systemic fragility.8

A second issue is likely to compound theproblem of slow lending. The need todeleverage, combined with the possible chillingeffect of future capital adequacy regimes andthe gathering storm of the Eurozone crisis (andin particular its chilling effect on the interbanklending market) will make it at least a littleharder and maybe very much harder for banksto increase SME lending. Xavier Rolet, CEOof the London Stock Exchange argued thatbanks are being forced out of nancing smallbusinesses because of regulatory pressure onthem to improve their balance sheets following

Basel III; even those who are less pessimisticappreciate that making up for the decreases in

lending during the credit crunch will be difcultin this climate.

Towards a solution

In October 2011, the Chancellor of theExchequer announced that he had asked theTreasury to work on ways to inject moneydirectly into parts of the economy that need it,

such as small businessesand to help solve[the] age old problem in Britain: not enough

long-term investment in small business and

enterprise.

The remainder of this paper considers howthese kinds of measures can help address thetwin problems of a lack of credit and relativelyhomogeneous debt markets. In doing so, we

strive to avoid a number of possible unintendedconsequences, in particular increasing risk byencouraging moral hazard, incurring excessivecosts or liabilities on the part of governmentand signicantly increasing systemic risk.

8. Haldane, A. and May, R.M. (2011) Systemic risk inbanking ecosystems. Nature.469, 351-355 (20 January2011).


10/23

Part 2: Options to increase business lending

0

Although the UK banking sector isconcentrated and its bond markets relatively

immature, it is not short of innovative newideas. This section surveys the landscape ofearly-stage proposals and ventures aimed atproviding debt nance to small and mediumbusinesses. It is based on a series of interviewswith nancial institutions, professional advisers,journalists, economists and central bankersconducted over the course of autumn 2011.These interviews were supplemented withquantitative research, in particular looking atdemand for various types of SME bond amongretail and institutional investors.

The proposals that follow are divided intotwo broad categories: a set of new regulatoryand structural solutions, which involve usingsystemic change to increase the ow of creditto SMEs, and new or niche providers whoserole could potentially both provide credit andincrease market diversity.

In each case, we provide an overview of theproposal or venture in question, and briefoutline of its advantages in addressing thetwo problems we have identied (the lack ofnance for SMEs and the lack of diversity inthe lending system), and the risks and costsassociated with it.

A. New regulatory and structuralsolutions

The most immediate way to address the creditproblems faced by SMEs involves working inone form or another with existing banks and

with the regulations that govern the system.

Before we look at these proposals, it is worthconsidering how banks business lending

operations work. As is well known, retail banksare in a very general sense businesses that takedeposits from savers that are short term (thatis, the customer can ask for them back at will)and make loans that are long term (that is, thebank cannot ask for its money at will, and oftendoes not expect it back for years or decades).Banks make money because they pay peopleless interest on their deposits than they chargeon their loans. In a banks balance sheet, loansare of course assets and deposits are liabilities.The time inconsistency between assets and

liabilities is one reason why a bank run (whentoo many deposits want their money at once)is so damaging. Two factors protect againstthe risk that too many assets will turn out tobe worthless or that too many liabilities will becalled in at once by depositors. The rst is theexistence of the interbank lending market fromwhich banks can meet short-term obligations.The second is the protective capital thatbanks are expected to hold by regulators. Theamount of capital that must be held dependson the type of assets that are held (i.e., thetypes of loans the bank has made). Riskierassets require more capital. The more moneythe bank has to hold as regulatory capital, theless capital it can put to work as loans, to thedetriment of its shareholders.

Most structural solutions look at ways ofpersuading banks to lend more, by relaxingsome aspect of this model, generally by freeingup parts of the banks balance sheets throughthe use of regulatory changes or public money(either in the form of money printed by theBank of England as part of quantitative easing

plans, or government guarantees).


11/23

1

Securitisation of existing bank business

loans

A direct way to bring to bring new money intothe business lending eld is for the governmentto establish and organisation to buy, packageup and securitise loans made by banks to smallbusinesses,9 resulting in bonds that could be

thought of as British Industry and EnterpriseBonds which other investors could buy.By buying portfolios of loans, the proposalwould free up banks balance sheets to acquiremore assets that is, to make more loans. Bytaking banks small business loans, which areessentially illiquid (banks rarely sell them, butrather wait for them to be repaid) and turningthem into bonds, which are tradable, theproposal would allow other investors to investin small business debt. These securities maywell be attractive to investors at a time wheninterest rates and equity returns are low.

Another nancing possibility, given thelikelihood of further quantitative easing,is for the Bank of England to buy some ofthe higher-quality bonds generated by sucha proposal, while others could be sold toinstitutional or even retail investors, who mightvery well be interested in assets offering abetter return than many of the underwhelminginvestment opportunities currently available.Adam Posen, a member of the Bank ofEnglands Monetary Policy Committee, has

been a vocal supporter of this option.10

The proposal is an attractive way of bringingnew capital into the SME loans space andfreeing banks relatively quickly to loan moreand bringing new private money into thebusiness lending market. But there are anumber of concerns that it has to overcome.The implication that the Bank of Englandwould undertake to buy the bonds of agovernment-organised scheme could beseen compromising the Banks hard-wonindependence. There is the question of howto measure the riskiness of the debt issued bythe entity, and how to ensure that enough ofit is of a high enough quality for the Bank ofEngland to buy (the equivalent of AAA or AArated) should this become an option. Wouldprivate investors really be interested in buyingthe new securities? And there are questionsof moral hazard and asymmetric information:would banks provide the securitisation vehiclewith a group of dodgy loans, or neglect theirrole in managing the loans once they had beenparceled up and sold? There is also a question

of diversity: by buying loans from banks, do weencourage rather than mitigate a monocultureof bank lending? Finally, there is the hygiene

factor: securitisation has a bad name after therole that securitised mortgages played in theglobal nancial crisis, and government-backedentities engaging in securitisation may remindthe public of the ill-fated US agencies FannieMae and Freddie Mac.

These concerns are important ones, but allseem to have plausible answers.

Posens speech itself makes a strong casethat neither this proposal specically nor thegeneral idea of coordinated Bank-governmentaction, compromise Bank independence andnotes previous comments by Sir Mervyn Kingsupporting the idea that in times of crisis,the Bank should play its role as an agent for

government.11

The question of measuring the riskiness of

securitised SME loans is a controversial one,not least because inaccurate measurement ofthe risk of securitised loans played a role in thenancial crisis, and some distressed businessloans were a cause of the travails of RBS.However, there is some cause for optimism.Firms like Experian, the UKs largest creditreference agency with an extensive corporatebusiness, argue that they have the capability tomeasure SME lending risk that could be usefulin assessing the portfolios, based on databasesof company loan defaults that have very

wide coverage (~80-90 per cent of UK rms).Defenders of the proposal argue that thedefault risk of large portfolios of small businessloans is both less signicant and easier topredict than that of the kind of large, oftenproperty-backed loans that caused so muchtrouble to RBS. The proposal in Box 1 givesone example of how similar schemes have beenimplemented in the past.

The question of how to ensure the debt ofthe new entity is of high enough quality tobe purchased by the Bank of England is amore signicant one. Posens suggestion isthat this would require a partial governmentguarantee in the event of widespread defaultof the loans. Providing such a guaranteewould be in keeping with the Chancellorsremarks in the October 2011 speech in whichhe proposed credit easing, where he used aloan guarantee scheme as a model, and couldallow a signicant investment-grade trancheof bonds to be created without requiringthe UK government to put its full faith andcredit behind the entire bond a costly and

risky suggestion. For state aid reasons, anyguarantee would most likely have to be paid forby the new entity.


10. Ibid.

11. Ibid.


12/23

2

Any government guarantee of course raisesquestions of moral hazard (e.g., will theentity care about how its loans are managedif a guarantee is in place?), alongside issuesof asymmetric information that would existeven without a guarantee (e.g., how do we

know banks will not unload bad loans onthe new entity?). One way of mitigating themoral hazard is to require banks to retain aproportion of the securities issued by the newentity. Rather than making the banks retainingthe most risky securities (which would requirethe banks to hold relatively large capitalreserves, thus defeating the object of theproposal, and if some losses were sustained onthe portfolio of loans might quickly wipe outthe banks incentives anyway, since the riskiestsecurities would take rst loss), an alternativeis to require banks to hold a small proportionof each type of securities, from the safest tothe riskiest. Our interviews suggested that thisstructure was used in similar private sectorstructures undertaken by banks before thenancial crisis, with the result that retail bankmanagers were on the whole not aware whichloans of the loans they managed were ownedby their bank and which by other investors.The issue of asymmetric information and thepossible passing off of bad loans would beone of the main tasks of the managers of thenew entity. However, proposals like the AgFe

one discussed above suggest that at leastsome organisations currently believe theyhave the skills to do this, and were planning

to do so even in the absence of governmentintervention.

The question of what other markets mightexist for these securities other than the Bankof England is an interesting one. If it can be

argued that these would genuinely be BritishIndustry and Enterprise Bonds, with appealto institutional investors and perhaps also toretail investors, the political argument for theintervention appears stronger. To this end,NESTA conducted two pieces of research: aquantitative survey of mass afuent investorsconducted by Ipsos-MORI, and an interview-based evaluation of the views of a groupof institutional investors, carried out byEvolution Securities. These results (which arealso relevant to a number of other proposalsset out here) are included in Box 2, and showwidespread interest in investing in theseproducts.

The issue of securitisation risking creatinga monoculture is an important one, and hasnot been widely addressed in discussions ofloan securitisation so far. It would certainlybe unfortunate if non-bank investors wereeffectively left out of credit easing because themethod used to deliver it did not factor themin. One solution for this would be to establishone securitisation vehicle that looked beyond

the banks to funds such as M&Gs UKCompanies Financing Fund and even to CDFIsand start-ups.

Box 1: Deepening the pools of capital

In the early 2000s, one of the major UK clearing banks looked into the question of howto access new sources of capital to nance its small business loan book. Working withspecialised data and risk advisors, the pH Group (now part of Experian) and InterRisk,bundled their business loan portfolio into a number of tranches of different risk levels,

with a view to offering them to non-bank providers of nance. At the time, the reinsurancemarket provided a good value source of nance. By providing a clear view of thecreditworthiness of the portfolio, the bank made the insurers comfortable with the risk theywere undertaking; for their part, they freed up economic capital, improving the efciency oftheir lending operations.

The insurance market is now considerably tighter than it was in the early part of the 2000s,but other attractive sources of capital exist, not least pension funds and other institutionalinvestors, who are keen to identify new investment opportunities in a world of low interestrates and poor equity performance. These investors would nd the opportunity to beexposed to generalised SME credit risk attractive. Firms like AgFe (whose members includesome of the leaders of the bank reinsurance transactions in the early 2000s) have beendeveloping this model and believe there is signicant market interest.


13/23

3

The nal concern relates to what has beencalled Fannie/Freddie risk the worrythat a securitised solution may fall prey tothe excesses that nished off the US non-governmental mortgage securitisers. On thispoint, there is some cause to be condent.Adam Posens original proposal notes thatFannie Mae and Freddie Mac ran into troublenot because securitising loans is a bad plan,but because they were explicitly allowed

in recent years to keep mortgages on theirown books, rather than quickly bundling andsecuritising them.

Assessment: Buying and then securitisingbank business loan portfolios offers a way ofbringing signicant amounts of capital into thebanking sector relatively quickly, and the majorobjections to it are remediable. Such a solutionwould of course require some governmentguarantees and the purchase of bonds by theBank of England.

New lending entities

Since early in the nancial crisis, a range ofcommentators have suggested that a newinstitution be established to make loans

Box 2: Investor appetite for small business bonds

Two exercises were undertaken to assess investor interest in a British Industry and EnterpriseBond, a tradable xed income product with some risk, a maturity date of ve to ten years,and a return of around 7 per cent, that might be issued either as part of a securitisation ofexisting bank loans or by a new bank.

Ipsos-MORI undertook a survey of 200 investors with investment portfolios ranging from 100kto 1 million, asking about their interest in a proposed British Industry and Enterprise Bond.

The British Industry and Enterprise Bond as presented to interviewees was well-understoodwith 97 per cent nding it at least fairly easy to understand. Seventy-six per cent found itat least fairly appealing and 70 per cent are at least fairly likely to make an investment in it.Seventy-seven per cent of the investors who found the product appealing would be willingto allocate up to 10 per cent of their portfolio to this product.

Investors felt that the most credible providers of such a product would be either companieswith a track record of investing in small businesses or new government-backed institutionscreated to support small businesses. (Over 70 per cent of investors identied each of these

types of issuers as credible providers of the product.)

Qualitative interviews also suggest that there is signicant interest from institutionalinvestors in getting exposure to SME credit risk. Low interest rates and poor equityperformance has increased investors willingness to look at new asset classes. To the extentthat these products can deliver relatively pure exposure to the credits of UK small businesses(rather than bank-specic exposure), our interviews suggested institutional investors wouldbe keen to participate, either through private placements or by buying bonds.

The same survey has been carried out by Evolution Securities across 17 UK wealth managers.Seventy-six per cent of the interviewees are very likely or fairly likely to invest in the BritishIndustry and Enterprise Bond.

Forty-four per cent of the wealth managers stated that the most credible providers of theproduct would be a new government-backed institution created to support small businesses;30 per cent of them felt that the product should be issued directly by the SME who willbenet from the investment.

A government guarantee to cover 50 per cent of any loss in value of the initial investment isbelieved to make the product more appealing to 82 per cent of the wealth managers.


14/23

4

to small businesses. Under the previousgovernment, BIS spent some time looking atGermanys Kreditanstalt fuer Wiederaufbauto see if it offered a role model for a newgovernment-backed institution in the UK.Anthony Hilton recently argued in the Evening

Standard12 that the Government should

establish a new bank, perhaps carving it outfrom one of the nationalised banks, while WillHutton has in the past been a vocal supporterof the establishment of several state banks.Indeed, it is occasionally remarked upon thatwhile the US, Germany, France and Italy allhave quasi-public banks or bank guarantorinstitutions (see Appendix A), the closestequivalent in the UK is the relatively recent,small-scale and non-institutional EnterpriseFinance Guarantee scheme.

One suggestion is that a public bank be

established to lend to SMEs, with a size-limit forloan applicants and a willingness to make loansand discount trade credits and invoices; becausethe bank does not have a legacy portfolio of(in some cases bad) loans, it is likely to be amore active lender, and will help address theissue of diversity of provision. Indeed, given theremit of the bank, it is possible that it will beable to develop a more SME-tailored offering,delivering extra value to its customers.

A few concerns have been expressed over the

idea of a new, in-practice state-backed bank.One risk is that a state bank risks handingtoo much funding discretion to if not politicalappointees, then those who can be inuencedby government. Although this could bemitigated by the way the bank is structured,while the bank remains in the public sectorthere will always be the accusation either thatthe bank is a distant unaccountable quango orthat it is too politically controlled. On the otherhand, it is worth noting that such institutionsare not rare. As Appendix A shows, most richcountries, including the US, Germany, Franceand Italy, have their equivalent.

A more pragmatic concern is the time it wouldtake to establish a new bank. The experienceof Metro Bank and the Business Growth Fundare cautionary in this respect: both have takenmonths to set up and more months to bed in,and have both been criticised for it. Whetheror not this criticism is fair, a state bank is not ashort-term solution.

Assessment: An interesting solution both

from a credit easing point of view and from thepoint of view of competition. The question oftime to impact is important to resolve though.

Macroprudential easing

Championed by the Bank of Englands AndyHaldane, macroprudential easing takes adifferent approach to the problem. Ratherthan buying bank assets so they can lendmore without breaking capital adequacy rules,macroprudential easing involves changing the

rules, at least temporarily while the economy isstriving to recover.

By relaxing the capital reserves that need tobe held against business loans, banks can befreed up to lend more to businesses. There issome precedent for this kind of policy: banks(equity) investments in the Business GrowthFund were deemed by the FSA to be less riskyfor regulatory purposes than a normal privateequity investment given the nature of itsinvestments. It also has the advantage of beingquick, requiring little more than a regulatory

decision.

One important question to address when itcomes to macroprudential easing is the politicalacceptability of the proposal, which conjoinstwo worlds that policymakers often seekto keep separate: capital adequacy and thepromotion of growth, leading to nervousnessabout precendents.

Assessment: A fast-acting idea, if politicallyfeasible. Probably does little to affect the

diversity of the sector, but could be combinedwith other measures.

Competition regulation

Perhaps the most long-term proposal forencouraging new money into the SME lendingmarket is to change the basis on whichbanks compete for customers. One issue thatentrepreneurs report is the difculty of seekingloan quotes from banks other than their mainbank. This is unsurprising, as the credit scoringmetrics used by banks to evaluate the bulkof loan requests rely on cashow data that iseasily accessible for a banks own customersbut not for others.

Businesses like Funding Options, a London-based start-up and winner of the TSBs TechCity Launchpad, argue that their IT-basedsystems can help improve companies ability toseek out loans from a variety of banks. Theyhave also argued that regulatory measurescould be taken to assist this, such as increasedstandardisation of SME loan features (as iscommonplace in retail nancial services).

(If implemented, this would also make iteasier to securitise portfolios of SME loans).Another useful step would be if it were easier

12. See: http://www.thisislondon.co.uk/markets/article-24002556-smes-need-help-not-a-new-bond-market.do


15/23

5

for SMEs to access and use positive nancialdata held about them (such as their historicloan repayment track records, or evidence oftheir sound bank account management) todemonstrate their credit-worthiness (whilstalso providing new structured and reliabledata sources to support securitisation and/or

underwriting); government may have a role toplay here, for example in encouraging banksto open their programming interfaces to makeit easier for third-party vendors to designsoftware allowing this to happen.

B. Niche and emerging debt providers

The other set of options involves looking atexisting but smaller players in the businessdebt market and looking at the potential role

they can play. In the context of a market thatcould benet from more diversity, this angle isimportant.

New banks

Although the nancial crisis saw many foreignbanks scale back their presence in London,across the UK we are seeing a range of growingstart-up banks, the most famous of which arethe UK operation of Swedens Handelsbanken,the UK-owned Metro Bank, and Virgin Money,which recently acquired Northern Rock from

the Government. Handelsbanken for one has adistinctive attitude to business banking, basedon empowered branch managers, church spirelending and a relatively high-touch service.This is a trend that many larger banks aretrying to follow for their best medium-sizedcustomers, but the inertia of large banks makethis harder to achieve, especially while cuttingcosts. What is clear is that new banks areunlikely to scale quickly enough to offer a realchallenge to the Big Four.

Assesssment: It would seem anticompetitive ifany measure taken with relation to large banks,such as securitisation and bond purchase, wasnot also on offer to new providers. At the sametime, growth of new providers is unlikely to befast enough to address the credit needs of UKSMEs.

Investment funds

Although the UKs business lending marketrelies on banks heavily, a small number offunds either invest in business debt or havean appetite to. The UK Companies Financing

Fund established in 2009 by M&G, one of theUKs leading xed income fund managementexperts, is a prominent example: this is a 1.5

billion fund established to provide debt nanceto medium-sized businesses, set up to ll thegap left by international banks going back todomestic lending. Similarly, organisations thatcurrently invest equity, such as the BusinessGrowth Fund (BGF) and the government-backed VC fund-of-funds operator Capital

for Enterprise have also expressed interest inthe question of how to expand debt nance.In the case of the BGF, it has argued that itsexisting due diligence network and the kindof businesses in which it invests would enableit to triple the sums it invests by being a debtprovider (for example by raising bonds). Theseorganisations also bring expertise with them in M&Gs case a track record of analyzing andvaluing a wide range of private debt, and in theBGFs case the possibility of combining debtand equity products to offer a suite of nancepotentially very relevant for the fast-growing

companies on which the economy relies.

Peer-to-peer lending

Peer-to-peer lending involves can get fundingdirectly from a community of lenders, generallythrough an online platform without referenceto banks. The development of this marketniche was boosted by the banking crisis whenperson-to-person lending platforms promisedto provide credit at the time when banks andother traditional nancial institutions arehaving scal difculties. A pioneer in this area

is Funding Circle. The company is an onlinemarketplace where small businesses can borrowfrom a pool of individuals and organisationswith money to lend, eliminating the hightransaction cost and complexity of banks.Lenders can be private individuals, limitedcompanies or public bodies. Funding Circlecurrently facilitates 2.2 million of businessloans in the UK each month. Although loansmay be more costly than other sources ofnance, the speed of decision-making andexible repayment terms are offsetting factors.Borrowers are usually companies that wish toborrow to nance their expansion or seekingworking capital but they had been rejected bybanks or they are frustrated with the length oftime they had to wait for a loan decision fromtheir bank.

CDFIs and mutuals

CDFIs lend money to businesses, socialenterprises and individuals who struggle toget nance from high street banks and loancompanies. CDFIs are funded in different

ways. Many are part-funded by Governmentdepartments and agencies. For example, anumber of business-lending CDFIs in England


16/23

6

have funding from the Regional DevelopmentAgencies, while many personal-lending CDFIshave funding from the Department for Workand Pensions Growth Fund. Other fundingsources include European grants, donationsfrom charitable trusts, social investments, andgrants and loans from high street banks.

Direct bond issuance, including loan notes

and shaving bonds

Despite the relatively small size of themarket for small and medium-sized corporatebonds in the UK, it does exist. The LondonStock Exchanges ORB electronic market isincreasingly dealing with smaller bond issues (arecent issue for the Places for People housingassociation raised 140 million). The CBI hasrecently argued that more medium-sizedcompanies should consider issuing bonds, andthe existence of a high-quality trading platform

is an important prerequisite.

A number of companies too small to make thecost of issuing bonds worthwhile have takenadvantage of loan notes, occasionally calledshaving bonds after an early bond designedand issued by King of Shaves in 2009. Thebuyer hands over cash for a xed period whilethe company issuing the bond agrees to paya set rate of interest for the duration. As theissuer asks investors to take a stake in thefuture growth of their businesses, they are

particularly suitable for companies with existingbrand loyalty or a following by its customersor clients. Some UK businesses spurned bybanks are increasingly turning to this source ofcash to nance their expansion. The King ofShaves bond has a three-year term and carriesan interest rate of 6 per cent per annum. Theirfundraising raised 627,000, a sum that wouldbe difcult to raise through any other sortof offering because of the high overheads.Hotel Chocolat offered to their 100,000members of the testing club the possibilityto choose between a bond of 2,000 with agross annual return of 6.72 per cent or 4,000at 7.29 per cent. They raised 3.7 million andthey expanded their business taking on morestaff and opening new stores.13Caxton FXis a 400 million-turnover foreign exchangebusiness. The CEO, Rupert Lee Browne, afterhaving been offered less than he required bya bank, decided to raise the working capitalneeded himself. Caxton is now issuing retailbonds, and so far they have raised 4 millionof working capital with an investment of60-100k in marketing and legal costs. Caxton

FX allows investors to invest between 2,000and 50,000 for a 7.25 per cent gross annualrate of return.14 Other similar products have

been offered by John Lewis Partnership andEcotricity.

Assessment: the wealth of potential newproviders in the UK is encouraging, giventhe lack of diversity among the big players.There are several options for using credit

easing in a way that encourages their growth.One potential option is to establish a set ofprinciples for quantitative easing funds to beapplied to existing non-bank channels in thesame way that the securitisation proposal givesbanks access to it. This may be less relevantto the smallest new providers, but it couldprovide a valuable boost to new banks andother institutions like M&G and BGF, and couldbring new expertise (such as the use of equityalongside debt for growth companies) to themarket. Of course, the disadvantage of such anapproach is that, to the extent that these are

not deposit-taking organisations, there will beno money-multiplier effect from this.

Whether or not a formal credit easing policy isimplemented, new providers have an importantrole to play in the UKs debt markets in thelonger term. The proposals cited above toincrease businesses ability to shop around fortheir business loans will benet new providers,by decreasing the advantage of incumbentbanks. In addition, there is a wider question tobe asked over the goals of nancial regulation

when it comes to new providers. Currently,nancial regulators are rightly concerned toprotect customers from risks arising fromunproven new models. However, given thebenets of greater diversity of provision, itwould make sense for regulation to have regardto the question of diversity of provision ofdebt nance. This would mean that in respectof new providers with new business models,such as peer-to-peer lenders, regulators wouldconsider the development of more limitedregulatory frameworks that could be quicklyput in place to allow new ventures to go tomarket faster. Critics might argue that thisis a foolish move in light of the deleteriouseffects of nancial instability on the worldseconomy over the last three years. However,this view is mistaken: nancial stability is notbest served by a monocultural industry, anddiversity brings a strength of its own. It isbetter to have a few small innovative nancialservices businesses fail than to encourage thepersistence of a system overly dominated bylarge banks, which as we have seen are notimmune to failure either, but who fail far more

dramatically. The UKs willingness to allowpeer-to-peer equity investment when the USdid not gave it a lead in this useful and growing

13. See: http://www.thisismoney.co.uk/money/investing/article-1726430/How-invest-direct-retail-corporate-bonds.html

14. See: http://www.ft.com/cms/s/0/4babaa20-d8a6-11e0-9089-00144feabdc0.html#axzz1d6vx9CMU


17/23

7

sector the opportunity exists to do the samefor debt nance, and we should not be putoff by a false dichotomy between safety andinnovation.

Finally, there is a case for levelling the playingeld between nancial services start-ups

and other start-ups. Currently, a number ofincentives exist to encourage entrepreneursto proceed with the risky business of startinginnovation new rms. These include theavailability of government risk capital throughthe Enterprise Capital Fund scheme, tax reliefthrough the Enterprise Investment Scheme,the ability to pay share options at a reducedrate of tax through the Enterprise ManagementInitiative, and others. Financial servicescompanies are for the most part explicitlyexcluded from these incentives. The intentionbehind this appears to be to exclude the likes

of hedge funds or large leasing businesses,which arguably do not generate the samelevel of positive externalities as other start-ups, and which due to their ability to scalequickly might be able to take advantage ofunduly large tax breaks. But it creates the oddsituation that a company like Wonga, recentlyvoted Europes most successful tech company,was ineligible for any of the support generallyavailable to tech start-ups in the UK. Draftingan exemption for nancial services businessesof an appropriate scale that are providing new

models of nancing businesses, like FundingCircle, seems a fair step to take and one thatwould help encourage diversity of provision.


18/23

8

Part 3: Recommendations

Regardless of the nal decision on formal crediteasing, the long-term goals of governmentpolicy should be clear: to encourage a diverse

and competitive market for debt nance thatincludes but extends beyond the banks.

There are some no-regrets moves that shouldform part of any plan: creating a level playingeld for innovative start-ups involved in thenancing of small and medium businesses,ensuring nancial regulation has diversity ofprovision as one of its goals as well as simplystability, and encouraging banks to adoptstandards that help business shop around forthe best lending rates. The government should

also encourage moves by individual businessesto seek independent debt nance, whetherthis is medium-sized businesses tapping bondmarkets like the London Stock ExchangesORB, or smaller businesses raising loan notesfrom their customer base.

If the Treasury and the Bank of England seekto have more short-term inuence on theow of credit to small businesses, the mostpromising option is to set up a vehicle to buybusiness loans from banks and securitise them,supported by a partial government guarantee.Our research suggests that the UK IndustryInvestment Bonds created by such a processwould be of interest to institutional and retailinvestors. This would signicantly increase thediversity of nance available to UK businesses.The securitisation process could also be carriedout in such a way that the bonds can bepurchased by the Bank of England, should itchoose to buy corporate securities in a futureround of quantitative easing. In order notto entrench the dominance of banks in thenancial landscape, this scheme should also

be available to non-bank institutions thatissue and hold SME debt, such as M&Gs UKCompanies Financing Fund.

Finally, in the medium term, the combinationof bond purchases through quantitative easingand a partial credit guarantee by the Treasury

could also be used to support the growth ofnew or expanded entities to lend to businesses.A number of existing entities may be wellplaced to take up this challenge (includingpublic entities such as Capital for Enterpriseand private organisation such as the BusinessGrowth Fund, demerged parts of currentlynationalised banks, and investment managers)allowing new loans to be made rapidly.


19/23

9

The report notes the relatively concentrated nature of the UKs credit markets. It is also worthnoting that most other rich countries also have publicly-backed institutions whose role is to

increase supplies of nance to small and medium businesses.

Appendix: International examples of credit easing

institutions

15. See: http://www.sba.gov/content/what-sba-offers-help-small-businesses-grow

16. Ibid

17. See: http://www.sba.gov/content/tax-exempt-bonds

18. See: http://www.sba.gov/content/what-sba-offers-help-small-businesses-grow

United States

Small Business Administration (SBA)

SBA is a US government agency that has been providing support to entrepreneurs andsmall businesses since its creation in 1953. SBA supports $27billion in loan guarantees forbusinesses.

SBA provides a number of nancial assistance programmes for small businesses coveringdebt nancing, bonds, and equity nancing:15

Guaranteed Loan Programmes16

SBA does not lend directly to small businesses, but guarantees that banks loans to SMEsare repaid, thus eliminating some of the risk to the lending partners. When a businessapplies for an SBA loan, it is actually applying for a commercial loan, structured accordingto SBA guidelines with an SBA guaranty.

Tax-exempt, industrial revenue bonds (IRB)17are attractive nancing options for smallmanufacturers looking to expand operations and upgrade facilities. These bonds aredebt securities issued by a state or local government development agency on behalf of aprivate business. Once issued, tax-exempt bonds are sold in the open market or purchasedby investors or nancial institutions. Interest income earned by the bond purchaser isexempt from state and local taxes, which allows the lender to pass savings to the borrowerin the form of a lower interest rate.

Applicants have to demonstrate a strong business plan and project proposal,creditworthiness and strong nancial statements. In addition, borrowers have todemonstrate how proposed projects will create jobs and positively impact the localeconomy.

SBAs Small Business Investment Companies (SBIC)18are privately owned investmentfunds, regulated by SBA. With the private capital they raise with funds borrowed atfavorable interest rates through SBA, SBIC provide nancing in the form of debt or equity

to small businesses.


20/23

0

Italy

Germany

Despite the critical economic situation of the country, in the past few years the Italiangovernment has put in place numerous initiatives to increase the stock of lending to thefour million plus Italian small businesses. Signicant for this report are the two following

intermediaries:

Cassa Depositi e Prestiti (CDP)19 is a joint-stock company under public control, with theItalian government holding 70 per cent and a broad group of bank foundations holdingthe remaining 30 per cent. The institution manages a major share of the postal savings ofItalian citizens which it uses to contribute to the growth of the national economic systemby supporting the wide variety of needs of Italian small businesses. In 2009 the CDP hadbeen endowed with 8 billion for the support of small businesses. Since then, 6.5 billionhas already been used to spur the expansion of ca. 36,000 companies.

CDP funding to SMEs is not granted directly to the businesses but issued via the Italianbanking system, provided that the banks are insured or guaranteed by SACE, thecredit and investment insurance company. CDP can only directly fund a company if the

transaction amount is more than 25 million, if the banking system is not willing to beinvolved to the same amount of credit. This process is, however, guaranteed by SACE.

Bank of the South Banca del Mezzogiorno is a new project that was launched in2009 by the Italian Ministry of Finance with specic focus of providing long-term credit tosmall businesses in the South of Italy. The project aims to create new businesses, supportyoung entrepreneurs, increase the internationalisation of southern companies, supportinnovation and reduce unemployment in the region. Banca del Mezzogiorno acts as asecond level nancial institution: it operates by networks of banks and institutions joiningthe initiative. Due to the fact that the bank has not started operating yet, the Italiangovernment has not yet indicated how much money will be set aside for the project.

Kreditanstalt fuer Wiederaufbau (KfW)

KfW is a German government bank formed in 1948 as part of the Marshall Plan. Thecore activity of KfW has always been nancing SMEs. Innovative instruments have beencontinuously developed to create a more conducive environment for SME nancing.Examples of the new approaches pursued include the extension of global loans, promotionof the capital market and the securitisation of SME loans.

KfW Mittelstandsbank is the segment of the bank in charge of nancing the expansionof small and medium-sized businesses. Financing is available for small and medium-sizedbusinesses that have run into nancial difculties. The KfW-Unternehmerkreditis the specicprogramme for small and medium-sized companies from Germany that have been active inthe market for more than three years, to nance their investments and working capital.

The loan has a term of up to 20 years and a maximum sum of 10 million. KfWs loans toSMEs are not granted directly to the SMEs but channeled via the German banking systems,therefore the SME can apply for a KfW loan with a bank of its choice. After a positivecredit appraisal the application is forwarded to KfW by the bank. KfW checks whether theeligibility criteria for the promotional programme are met. The SMEs bank bears only 50 percent of the credit risk and KfW bears the other 50 per cent. Leaving 50 per cent of the risk

with the bank, KfW ensures that the bank has an adequate incentive to conduct the creditappraisal as carefully as it would do if it was fully liable for the loan.20

In 2009 KfW Mittelstandsbank achieved a record volume of commitments of 23.8 billion.21

19. See: http://www.cassaddpp.it/cdp/Areagenerale/English/index.htm

20. See: http://www.KfW.de/KfW/en/Domestic_Promotion/Our_offers/Business_expansion_and_consolidation.jsp

21. See: http://www.KfW.de/KfW/en/KfW_Group/Press/Latest_News/News/2010/KfW_achieves_record_nancing_volume_in_Germany.jsp


21/23

1

France

Caisse des Dpts22

The Caisse des Dpts (CD) is the French public institution responsible for the economicdevelopment of the country. Last year, CD spent 18 billion to nance SMEs through three

main programmes:

CDC Enterprises is a subsidiary of the CD Group. It is dedicated to nancing SMEs withgrowth potential and not listed on the stock market, using equity capital.

It invests in capital investment mechanisms which themselves invest in companies anddirectly in SMEs. On average, it accounts for 35 per cent of the seed capital funds inFrance and 20 per cent of venture capital funds. CDC Enterprises nances around 2,500companies.

The Strategic Investment Fund (FSI) is also a subsidiary of the CD Group, created in2008. CD has a 51 per cent holding, while the State has a 49 per cent stake. FSI investsequity capital in French companies mainly in the manufacturing and service sectors with

industrial projects which add value and competitiveness to the economy.

CD approves funding to the OSEO. OSEO is a public institution whose mission is tonance and support SMEs, to ensure better continuity in the chain of nancing for theirprojects, through three complement areas of work: innovation support, bank nancingand guarantees. CD annual budget for OSEO is 6 billion. In addition CD and OSEOhave created shared regional platforms to provide an even better support for companiesseeking funds.

22. See: http://www.caissedesdepots.fr/


22/23

2

This research forms part of a joint project undertaken with Sam Gyimah MP for Surrey East,with the support of James Hurley, Editor of the Telegraph Business Club. It would not have beenpossible without the generosity of the wide range of entrepreneurs, nanciers, economists andpolicymakers who have provided input, advice and challenge. We are especially grateful to our

advisory committee, Sir John Gieve and Andrew Lilico, and extend our thanks to all those we spoketo, including:

Ipsos Mori Evolution SecuritiesAdrian John BellMichael DysonCharles DaviesManoelle Lefevre

Panellists at discussion events:Xavier Rolet,CEO of London Stock Exchange

Will King,CEO of King of Shaves

Samir Desai,CEO of Funding Circle

William Reeve,Founder of LoveFilm

Malcolm Small,

Director of Policy, TISA

Acknowledgements

Andy Haldane,Bank of England

Adam Posen,Bank of England

Stephen Welton,Business Growth Fund

Jon Rhodes,Business Growth Fund

Mark Hutchinson,M&G

William Nicoll,M&G

Stephen Hughes,British Chambers of Commerce

Andy Tonkin,Lloyds TSB

Shaun Beaney,ICAEW Chartered Accountants

David Petrie,ICAEW Chartered Accountants

Katerina Joannou,ICAEW Chartered Accountants

Colin Ellis,BVCA

Rupert Lee-Browne,Caxton FX

John Jenkins,CEO of GE Capital UK

Ian Collier,Solstice Capital

Nasir Zubairi,EuroTRX

Rolf Hickmann,Experian pH

Mike Cherry,Federation of Small Businesses

Carly Brookeld,Fidelitas Capital

Peter Cunliffe,Flex FD Ltd

Samir Desai,Funding Circle

Conrad Ford,Funding Options

Simon Cook,DfJ Esprit

Richard Marsh,DfJ Esprit

Simon Fraser,InterRisk

Andrea Montanino,Italian Ministero del Tesoro

Pietro Poletto,London Stock Exchange

Gillian Walmsley,London Stock Exchange

Allen Simpson,London Stock Exchange

Marcus Stuttard,London Stock Exchange

David Walker,Memery Crystal

Jeffrey Sirr,Munich Re

Mario Berti,Octopus Investments

Matthew Margetts,Telegraph Media Group

Grant Peggie,UK Department for Business

Innovation and SkillsSimon Lodge,Handelsbanken

Luke Webster,Ofce of Sam Gyimah MP


23/23

NESTA

1 Plough Place

London EC4A 1DE

[email protected]

www.twitter.com/nesta_uk

www.facebook.com/nesta.uk

www.nesta.org.uk

Documents

Beyond the Banks: The case for a British Industry and Enterprise Bond