A weakened economy and regulatory changes are posing challenges for small business borrowers, but there are ample financing sources available even with tighter bank standards applied, Jeremy Weltman writes.

The UK’s economic predicament is a huge concern for SMEs seeking to borrow, especially with rising interest rates to quell inflation affecting firms with floating rate debt, and question marks hanging over the health of the banking system.

As 2022 drew to a close, small business confidence was slipping alarmingly, close to a level last seen during the second Covid lockdown, according to the Federation of Small Businesses (FSB) Voice of Small Business Index.

The worst signs were evinced for accommodation and food services, finance and insurance, and wholesale and retail trade, with 51% of the respondents rating the overall availability and affordability of new credit as poor.

Borrowing rates have increased since. At its latest monetary policy meeting in March, the Bank of England raised its Base Rate further, to 4.25%, as annual inflation measured by the consumer price index re-accelerated in February to 10.4% from 10.1% in January.

Consequently, in its newly released World Economic Outlook update, the IMF depicts a decline of 0.3% for the UK’s real GDP this year. This is an improvement on the 0.6% contraction it forecast previously, but it will still be the worst performance among the G7.

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By GlobalData

Neither the IMF has a financial meltdown as its base case scenario, nor the Bank of England Governor Andrew Bailey. In a recent speech at the Institute of International Finance, Bailey stated that he did not believe we are facing a systemic banking crisis, with UK banks “well capitalised, liquid and able to serve their customers and support the economy.”

The IMF nevertheless acknowledges that the problems incurred in the banking sector – including the recent failures of Silicon Valley Bank, Signature Bank and crypto-lender Silvergate Bank, not to mention the funding issues causing Credit Suisse to be taken over by UBS – highlight the risks as tighter financing conditions exacerbate debt concerns.

Cautious climate

Uncertainty about the economic outlook is inevitably “feeding into businesses being on the whole more cautious,” says Daniel Cichocki, director of commercial finance at UK Finance, the trade association for the banking and finance industry, “further depressing their appetite for finance and investment, with similar trends playing out across all regions and sectors.”

The demand for SME finance has stabilised though, he says, following an end to the government’s loan schemes, and repayments beginning to fall due, and there is also a burgeoning desire for lending products to manage cashflow in an environment of sharply rising costs.

Simon Goldie, director of business finance at the UK’s Finance & Leasing Association (FLA) adds that the asset finance industry is “doing everything it can to support businesses of all sizes to invest and grow in a challenging economic environment.”

Many borrowing options are available to support investment, with asset finance new business to SMEs increasing in the first months of 2023, notably leasing and hire purchase from challenger or specialist lenders, supporting cashflow flexibility.

Some £35.5 billion of loans from challenger and specialist banks were made to SMEs last year, a record high and more than traditional lenders. As an alternative to bank loans, the success rate for asset finance applications tends to be high among SMEs.

Data captured in a survey by Time Finance in November revealed the scale of business resilience in the face of mounting economic uncertainty and rising costs, as investment for growth remained a top priority for UK businesses.

The survey set out to gauge any shift in business confidence in the prior 12 months, aiming to uncover appetite for investment and how optimistic SMEs were feeling about the future. It revealed that, despite the financial challenges businesses were facing at the time, 74% believed it to be a good time to invest in their future, up from 69% the year before.

When asked what the priority areas of investment were, over half of businesses put operations and technology at the top of that list, a considerable increase from the previous survey’s findings which saw just 21% consider this a priority.

However, Phil Chesham, managing director of invoice finance at Time Finance, notes that pandemic funding was injected directly into businesses to cover their losses, thus keeping insolvencies at an all-time low.

Now, more businesses are suffering from legacy debt and are unable to repay their existing loans on top of the everyday pressures of running a business, making long-term business plans more unachievable.

“Not all SMEs are struggling,” he counters. “Those that adapted quickly, leveraged technology and managed their debt well continue to thrive. They have been able to take advantage of commercial lending options available to them to stay viable in the long-term and without the burden of legacy debt over them.”

Chesham acknowledges that the banks are becoming more risk-averse, but he also notes “the independent market continues to support SMEs and increases their appetite.”

“We typically see more businesses having the perception that they may get access to funding without needing to provide any form of guarantee because that’s what was available through the government lending schemes,” he says.

Lack of support

Government policy is not currently helping matters. The fact that leasing was not included in the government’s super-deduction has been a significant source of frustration, according to Goldie, who says that “as that programme is now being replaced by full expensing (as mentioned in the government’s recent Spring Budget), we are discussing with HM Treasury how leasing can be included.”

Martin McTague, national chair of the Federation of Small Businesses (FSB), also bemoans the lack of support for SMEs in the Budget, arguing that investment incentives were mostly targeted at larger corporations.

On top of that he points out the replacement of the Energy Bill Relief Scheme this April with the far less supportive Energy Bills Discount Scheme is “another point of high danger for thousands of small firms.”

Consequently, he adds that almost any small business can tell you that finance is getting harder to source, and more expensive.

“Our research has found that the success rate in the final quarter of last year for small businesses’ finance applications is, at 44%, the lowest it has been since the end of 2013. FSB’s Small Business Index shows that small businesses’ perception of the availability and affordability of credit has been on a downward trend since Q3 2020, when COVID-era funding was widely available.”

He goes on to say that interest rates for successful finance applications among small businesses have risen sharply, with the proportion of applicants being offered a rate of 11% or more having quadrupled over the course of 2022, from 7% in Q1 to 28% in Q4.

Staying positive

Still, the majority of SMEs continue to show resilience and are managing their COVID-19 debt obligations, says Cichocki, and he has yet to see any evidence of banks becoming more risk averse towards SME borrowers.

“Naturally, banks’ assessments of affordability have to take into account the existing debt level of the business and ability to cope with the level of interest rates forecast, as well as increasing energy and other bills. These factors are relatively high compared to recent norms. 

“We are observing more challenges around affordability and amounts available to borrow might be lower than initially requested, rather than risk aversion,” says Cichocki.

“For some sectors, this is more acute. The diversity of the SME profile and sector variety provides some level of a natural risk diversification to banks, and this is seen in the continued flow of credit to SMEs as a whole.”

He remains positive and expects the economic gloom to lift later in the year. This should see confidence return and investment plans rejuvenated, with an associated increase in demand for finance to support this. There is also an important role for the Recovery Loan Scheme to provide some level of government guarantee in the market to support SMEs that might not otherwise be able to access the same level of credit.

UK Finance, meanwhile, recognises some evidence of affordability issues in parts of the SME markets, but the overall message relates more to issues around tax changes, poor payment practice, trade and supply chain issues, and skills/personnel, rather than banking sector risk aversion.

According to a survey of intermediaries released in March by Ipsos UK for the state-owned British Business Bank, the demand for finance is constrained as 70% of SMEs lack awareness of their available financing options, while 80% say there are gaps in the supply of finance to SMEs regardless of their development stage.

The relative stabilisation of performance in the government’s Covid loan schemes is encouraging, however, says UK Finance, and SME credit is flowing, but with some evidence of reduced demand and affordability issues, it is keeping an eye on any deterioration. 

Strong base

In 2022, £34 billion was provided in the form of asset finance to businesses, says the FLA. Of that total, £22 billion went to SMEs to fund new equipment, plant and machinery, or software. This was a record level of annual asset finance new business to SMEs.

According to UK Finance, gross lending by the main high street banks totalled £18.4 billion in 2022, although loan applications and new lending slowed in the second half of the year. Overall net lending was negative due to significant repayments of debt accumulated during the pandemic.

However, new lending of approximately £65 billion across the market in 2022 was higher than in 2021 and most pre-COVID years, with 2020 exceptionally high due to the role of the pandemic-support lending schemes providing over £100 billion of new SME lending.

“Overdraft applications and utilization were higher compared with 2021, which is typical of a more uncertain environment. SMEs started drawing on accumulated cash with deposits declining 5% year-on-year,” according to Cichocki.

“The latest statistics on government loan schemes suggest that, while claims and settlement of guarantees have been increasing, arrears and defaults are no longer increasing at the same pace. Use of the new Recovery Loan Scheme is now at the more modest level expected in normal conditions.”

While overall demand is subdued, Cichocki says there is significant evidence of increasing diversity in the provision of finance across the market, with specialist lenders and products such as invoice finance taking a greater share.

Regulatory risk

The underlying health of the banks and specialist lenders is only one part of the equation, however.

Echoing the views of other industry experts, UK Finance has concerns that the removal of the SME Support Factor under the UK’s implementation of Basel 3.1 prudential standards could be a risk, which it has urged the Bank of England to look at delaying and mitigating.

Others have similar concerns. The FLA states that the proposal suggested in the recent Basel consultation would result in capital requirements that are out of proportion to the risk presented by SME lending.

“There is also the risk that smaller banks and independent lenders would face higher securitisation and compliance costs, and the impact on SME customers would be a reduction in access to finance for some, and increased cost of such finance where it is able to be offered at all.”

An impact study undertaken by Oxera Consulting for the Federation of Small Businesses (FSB), published in March, notes that on a volume-weighted basis, the impact for standardised approach banks would be an increase of approximately 32% in the risk weighting that must be assigned to loans made to SMEs.

For banks using their own internal ratings-based models, the impact is less clear, but estimates suggest that the increase could be around 39%.

 “The overall effect of the increase in risk weighting, assuming no change in either the level of capital held by banks or the capital-risk weighted asset ratio with which they operate, would be a reduction in SME lending of up to £44bn from the banking sector,” according to the report.

It goes on to say that SMEs may find reduced bank lending more problematic than larger firms because they do not have access to wholesale debt markets.

The FSB’s McTague says, “We’re really concerned that the loss of the SME supporting factor in the Prudential Regulation Authority’s (PRA’s) Basel 3.1 proposals will make this situation even worse.

“This is not a detail that the UK can afford to get wrong. Requiring banks and finance providers to hold more capital than they have to at present to counterbalance loans to SMEs will tip the scales in underwriting decisions that bit more against small businesses, suppressing their growth and holding back their investments.”

Following the previous recession, triggered by the credit crunch, small firms were the main source of economic recovery and job creation, he says, “so cutting them off at the knee by putting a squeeze on sources of funding just when we need them to pick up the growth baton once more would be a needless own goal.”

This is why the FSB is calling on the PRA to change course and retain the SME supporting factor.

“We are not yet at a new 2008-style credit crunch – but this is one unwanted sequel that would have horrifying real-world consequences for small firms and entrepreneurs,” says McTague.

Comfortingly, he adds that if things worsen and the economy slows down then the British Business Bank could upscale its lending operations and sustain the small business economy.

“The BBB’s Recovery Loan Scheme could easily be expanded in a credit crunch redux scenario, to keep funding lines open to small businesses,” he says.

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