by David Butler
The case for banking reform is one that, on the centre-left, does not require extensive repeating. The banks were central to the crash and have not been seen to have redeemed themselves. In particular, lending to small and medium enterprises has fallen substantially in the post-crash environment and was not particularly healthy pre-crash. It is into this sea which the good ship One Nation Labour (formerly known as Responsible Capitalism), under her captain Ed Miliband, sailed.
Small and medium-sized enterprises suffer from an inadequate supply of finance. The impact of this was captured in IPPR’s Investing for the Future report. SMEs are usually reliant on loan-funding and are unable to sell bonds or access other sources of capital available to bigger businesses. The report contends that banks have gradually been switching their activities towards loans and investment that offer bigger yields and more immediate profits, which has squeezed loan-funding to SMEs. Due to information asymmetry, banks have used a ‘tick box’ approach for making decisions on loan funding, which has result in a further structural shortage as many potentially good SMEs are shut up of the one-size-fits-all criteria.
Current government schemes to encourage SME lending do not appear to be successful. In the footnotes of the IPPR report, the authors quote an article in the Financial Times which claims that of the £100 billion in low-cost capital created by the government, banks plan to use up to £80 billion to replace existing loans backed by market-price capital. It is clear that simply giving cheap capital to private sector banks will not help. This has been matched by the continue fall in lending to SMEs captured by recent Bank of England figures. This lending problem is a constraint on future prosperity and do nothing to relieve the cost of living crisis. A new approach is needed. Ed Miliband believes that more competition will provide the answer.
Reform of the banking market under a Miliband administration would come in two parts: a market share cap and a referral of banks to the Competition and Markets Authority. The hope is to create a level of competition which: improves the price and quantity of small business lending; improves service to all customers; creates at least two new challenger banks with significant market shares. These are all worthy policy aims and any government that achieved these would be deserving of praise.
The cap, inspired by policy in the US, will create a threshold of market share that any one bank may have in terms of personal accounts and small business lending. However, the use of a cap will have short term costs. There are potential risks to both the flow of credit, as the market adjusts, and to tax revenue as bank profits may be diminished as they shed branches and staff. However, these issues may be mitigated by the five year time frame built in. Alongside this, existing banks could use their market power to shed the least valuable customers and business, leaving start-ups with an inherited disadvantage. However, if challenger banks compete on service quality, as Metrobank do, then they may be able to overcome having an initial poor pool of customers. This will, of course, be reliant on easy of switching.
The cap will have to be supplemented with other reductions to entry barriers in order to really encourage greater competition. The switching of bank accounts remains a serious problem, meaning customers are far less likely to move their money. The government has a program aimed at seven day switching but more needs to be done. Account portability needs to be explored as possibility and better education is require over the nature of switching. Technology cost remain a problem; a robust IT infrastructure is crucial to giving customers a good quality service and the confidence that their money is protected. Initial capital access is another issue for start-up banks; a scheme to provide support, via state guarantees for loans and favourable liquidity arrangements, for the first five years of a challenger’s life could reduce this barrier.
However, there is a wider issue; if challenger banks use similar risk models and similar ‘tick box’ approaches to the existing banks, they will chase the same customer pool. Although access to the pool will probably widen if the price falls but this is probably insufficient to overcome the structural issues over capital access. In addition, the implications of Basel III for banks will see them reduce their exposure to SMEs as these loans are subject to higher-risk premiums. These two concerns mean that it is Labour’s proposed British investment bank to they must turn to ensure that SMEs get the capital they need. A British investment bank, with local or regional branches, could build up local knowledge to enable a more flexible lending criteria when it comes to SME financing. With access to capital and the security of state-backing, the bank could employ a looser risk model in order to overcome the risk premiums traditionally attached to SME lending.
Increasing competition is a desirable medium-term objective. However, Labour should not pretend their plan of a market cap is without short-term costs. Moreover, only a new British investment bank can offer the sort of capital that SMEs can’t currently access. It is in this area, that Captain Miliband should focus his ship’s biggest guns.
David Butler is a Labour party activist