UK: New Sources Of Credit For Business

Last Updated: 1 November 2015
Article by Ian Stewart

The financial crisis and the ensuing, deep recession demonstrate what happens when risk taking gets out of hand. This is an old pattern. From the tulip mania of seventeenth century Netherlands to the DotCom bubble of the late 1990s economic history is littered with boom bust cycles fuelled by reckless optimism and easy credit.

So why not put an end to boom bust cycles by clamping down on excessive lending and risk taking? The snag here is that an entirely risk free financial system would be one in which companies and individuals found it virtually impossible to borrow. Just as excessive risk taking caused the financial crisis, so extreme risk aversion and credit shortages have held back the recovery.

So, when it comes to risk taking and credit, policymakers are aiming for the Goldilocks outcome: neither too much nor too little.

To avoid too much risk taking regulators have required banks to build huge capital reserves and reduce their exposure to risk. Central Banks, meanwhile, have their sights set on fighting deflation and getting growth going. Their aim has been to make credit cheaper and more available and to bolster risk taking with very easy monetary policy. So while regulators want to reduce risk in the banking system central banks aim to encourage risk taking.

Easy money has helped bolster bank lending, especially for larger businesses. Lending to larger firms is relatively low risk and enables banks to benefit from low interest rates and a recovering economy. The latest Deloitte survey of UK Chief Financial Officers reports that the cost of credit for larger businesses is near an eight year low while availability is better than at than at any time in eight-years.

Conditions are less favourable for smaller and medium sized enterprises (SMEs). They lack the scale and resources to be able to issue corporate bonds, so have missed out on the super-cheap bond finance available to large businesses. SMEs are dependent on bank lending where, while conditions have improved, problems remain. The latest Federation of Small Businesses' survey show that a large number of member firms rating bank credit as being 'unaffordable'.  

This is where the story becomes interesting. Tougher regulation has constrained the capacity of banks to take risk and made it harder for some borrowers to access bank credit. At the same investors are eager to find ways of earning a better interest rate than they would get from putting their money in a bank.  The obvious solution is to put the borrowers in search of credit with the lenders in search of yield together. Three markets are doing just that.

The corporate bond market allows larger businesses to raise debt finance from investors such as pension funds, insurance companies and institutional fund managers. Quantitative easing has lowered interest rates on corporate debt and made it highly attractive to investors. The result has been a boom in debt issuance.  Bank of England data show debt issuance by UK businesses running at twice the levels seen before the crisis. Many corporates have restructured their balance sheets, repaying bank borrowing and financing themselves with cheaper, long paid corporate debt. In this respect the UK corporate sector, which has long been largely dependent on banks for finance, is becoming more like its US counterpart, where corporate bonds play a bigger role.

As banks have retrenched, alternative lenders, including private equity firms and asset managers, have moved in as providers of debt finance to medium and larger businesses. Mid-cap private businesses, which do not have access to equity funding, are increasingly turning to alternative lenders to diversify their sources of finance. Deloitte's Alternative Finance Deal Tracker shows a 67% rise in the number of deals involving alternative lenders in the UK and Europe over the last twelve months.

Finally, rapid growth in peer-to-peer lending or 'crowdfunding' is allowing small businesses to raise funds directly from savers. Near zero interest rates mean savers get next to nothing for their deposits. Small and medium sized businesses often face near double-digit interest rates on debt. This has led to the rapid growth in the number of 'platforms', such as Funding Circle and Thin Cats which match businesses in search of funds to those looking for a better return on their savings. The response has been enthusiastic. In the first half of this year peer to peer lending accounted for almost a fifth of the flow of credit to small and medium sized businesses in the UK.

The financial crisis has ushered in a new era of more regulated banking.  As businesses seek credit and investors search for returns new forms of lending are seeing strong growth. Policymakers have long wanted to see greater variety in the types of finance available to UK business. The irony is that it took a financial crisis of epic scale to make it happen.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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