Corporate finance and daft ideas

On 16th March, an Independent Taskforce instigated by the Department for Business, Innovation and Skills produced a report into non-bank lending. The BIS press release regarding this report can be found here and the entire report (pdf) can be downloaded from this link.

The purpose of the Taskforce and its summary findings are as follows:
The Taskforce, chaired by Tim Breedon, CEO of Legal & General plc, was commissioned by the Government to examine a range of alternative and sustainable finance sources, particularly for small and medium-sized enterprises (SMEs).
Bank lending is by far the largest source of external finance currently used by businesses, but the Taskforce believes there is significant potential to develop both the demand and supply of non-bank lending to match the financial landscape of countries like the US. 
The main recommendations from the Taskforce’s report to Business Secretary Vince Cable are:
  • Increase awareness of alternative financing by creating a single brand and a single business support agency to deliver the Government's range of SME finance programmes, drawing on international examples such as Germany's KfW.
  • Industry to establish a Business Finance Advice network, comprising the main accountancy bodies.
  • Open up access to capital markets financing for smaller companies through the creation of a body to bundle and securitise SME loans.
  • Consider the potential for the Government's Business Finance Partnership to invest in innovative products such as mezzanine loan funds and peer to peer lending.
  • Encourage large businesses to support smaller companies by reinforcing prompt payment practices, supporting greater use of invoice discounting and utilising supply chain financing to invest in smaller suppliers.
  • Government and industry to review the impact of international prudential regulation such as bank and insurance capital rules on the supply of SME finance.
  • Increase the UK retail investor appetite for corporate bonds.

So this report is all about financing small and medium size enterprises (SMEs) by means other than traditional bank loans. Well, this certainly seems to be an area that needs expansion. Bank lending to SMEs is pitiful and expensive, and although the Government has managed to enforce Project Merlin lending targets, just about, it is nowhere near enough to enable the UK's smaller businesses to develop domestic and export markets, employ lots of people and get the economy growing again. Which, most people agree, is what they should be doing.

There are some sensible proposals here which would be relatively simple to implement and probably quite effective in the short term.
  • Integrating the various Government finance schemes under a single brand name and delivering them through a single agency would certainly help to target finance where it is needed and reduce the (considerable) confusion that exists around what financing is available and to whom it applies.
  • Creating a Business Finance Advice network sounds like a good idea and could work well in practice if it is delivered through the professional bodies ICAEW, ACCA and ICAS. The network should cascade effectively down not only through the big accountancy firms but through much smaller accountancy suppliers, which would mean that for the first time businesses would be able to rely on their accountants to provide much-needed business advice. But there is a big hole in this proposal. Your average high street accountant has no more idea than his clients regarding some of the fancier forms of financing discussed in this report, and the report doesn't come up with any other ideas whatsoever for helping SME directors navigate the complex and difficult seas of corporate finance.
  • It is manifestly sensible to apply Government pressure to large companies to get them to treat their smaller suppliers better, and to set a good example by treating small suppliers to the public sector better (personal gripe here - state schools please note, that includes you). Squeezing of small suppliers is a reprehensible practice which should have been stamped on long ago. Personally I'd do a lot more than "encourage" large companies to behave better. Legislation and enforcement is the right way to go, in my view. 
All good so far. But from here on, sanity disappears from this report. I should have known, really. The moment anyone says they want our financial system to look more like the US my heart sinks and I wonder what planet they are on. 

Here's daft idea no. 1:

"Open up access to capital markets financing for smaller companies through the creation of a body to bundle and securitise SME loans".

Translation: The Government should create a State agency which will buy from banks the loans they have made to SMEs, bundle these loans up into packages of larger value and create from them asset-backed securities for sale to capital markets investors.

What this means is that the Government should create an American-style "Government-Sponsored Enterprise" (GSE) for SME loans. The purpose of GSEs is to enhance availability and reduce cost of credit to targeted sectors. America has GSEs in three sectors - home finance (mortgages), agricultural finance and education. Of these home finance is by far the largest and the most controversial. The two giant GSEs, "Fannie Mae" and "Freddie Mac", bailed out in the 2008 financial crisis at a cost to the US Treasury of $200 billion, are currently in "conservatorship", which is nationalisation under another name. The jury is still out on what contribution these enterprises made to the failure of the American mortgage market and the consequent near-collapse of international investment banking and capital markets. Note that the US does not have an SME GSE. This would be a UK innovation.

Anyway, ignoring the chequered history of GSEs in the US, just suppose that the UK were to create a Government agency to buy up SME loans, bundle them together and create asset-backed securities. Who would buy these securities? By any standard they are high risk. Unlike mortgages, which are secured on property, SME loans are at best secured on the assets of the company. If an SME goes bust, these assets will be sold at firesale prices - or they may be worthless. And SME failure rate is much higher than the default rate on residential mortgages, especially for startups. So given that the capital markets are still wary of mortgage-backed securities after the thrashing they received in 2008, why on earth would anyone invest in bundles of much higher-risk SME loans? Well, actually, someone would - if the price was right. But because of the risk, the right price would likely to be low, and the yield, high - rather pointless if the intention is to reduce the cost of borrowing for SMEs. They could tranche the securities, of course (structure them like CDOs). That way, even though the default risk would still be high, the most senior tranches might make it to investment grade. But I can't see that there would be much of a market for these securities.

In fact the report completely undermines the whole idea anyway in section 8.1, where it notes that the present direction of financial regulation (Basel III, Solvency II and UCITS) will actually make it more difficult for institutional investors to participate in SME loan securitisations and that there is currently little international appetite for relaxing regulations to accommodate the higher-risk financing needs of smaller businesses. The best it can do by way of constructive suggestions to solve this problem is to recommend that "UK authorities and business representative bodies should produce an evidence-based perspective of the impact of international regulatory measures on the provision of bank and non-bank finance to UK SME's and to update their findings on an annual basis". In other words, produce a report which will get filed.

The regulatory problem is a showstopper. There is no way a liquid market for SME loan securitisations can be created from nothing in the teeth of regulation that is designed to reduce the risk in investor portfolios, unless the risk of the underlying loans can be significantly reduced and the pump primed by Government intervention. This implies that the Government will have to guarantee SME loans directly (rather than the bank funding for those loans), and probably purchase the securities as well, perhaps through the Bank of England's corporate asset purchase scheme. Without such direct action by the Government I see little prospect of SME loan securitisation getting off the ground at all in the present financial climate. But if the Government has to intervene so directly to create such a market, why bother with it at all - why not just create a State Investment Bank and lend to SME's directly?

And now for daft idea no. 2.

"Improving access for mid-size businesses to the Private Placement market".

At first sight, this doesn't seem to be too bad an idea. For institutional investors to buy bonds directly from medium-size corporates, bypassing the capital markets, seems eminently sensible. Except when you start looking at the difficulties. The report identifies several major stumbling blocks:

- lack of tools to establish credit worthiness
- maturity mismatches (investors want to lend for 10-15 years, corporates want to borrow for 3-10 years)
- regulatory barriers, notably liquidity requirements
- price: illiquidity premium may make this an expensive way of raising finance.
- issuance costs

As with the SME loan securitisations, I really wonder whether the Government intervention that would be required to get round this lot would be justified. Yes, pressure could be applied to the industry to lower barriers and reduce costs. But how do you deal with the fact that the maturity needs of institutional investors and corporates are fundamentally different? And what appetite is there to reduce regulatory requirements to allow institutional investors to accept more private placements? The world is going in the opposite direction at the moment. And unless there is significant investment in tools to assess credit worthiness, investors would have to do full due diligence for every placement, which would be expensive, time-consuming and invasive. Would they really want to do this - or would they prefer to buy rated bonds in the open market?

Moving swiftly on, here's daft idea no. 3.

"Increasing UK retail investor appetite for corporate bonds"

To start with I thought this was quite a good idea. Retail investors can already invest in corporate bonds and equities, but it is fair to say that most people are a bit nervous about investing in these things and prefer to put their money in building society accounts and National Savings. Encouraging people to invest directly in companies is a good way of raising corporate finance.

But then they suggested this: "Launching electronic retail-dedicated gilt products available through registered stock exchanges". GILTS? Gilts are government bonds. The idea seems to be that if everyone's grannies got used to buying gilts instead of putting their money in National Savings, they would become more willing to invest in corporate bonds. Now, I can quite imagine that a naive granny might be happy to buy some gilts instead of National Savings certificates - as the report implicitly notes, they're the same thing really - but to assume that therefore she would be equally happy to buy corporate bonds, especially in smaller companies that she's never heard of and with no Government guarantee, seems to me to be stretching credibility to its limits. Why on earth would familiarity with gilt purchases motivate grannies to move from "safe" Government investments to much riskier corporate investments?

And it gets better. Even stupider is the suggestion that the ISA scheme should be expanded to encourage investment in riskier SMEs. I have no problem with explicit tax breaks to encourage SME investment by people who know what they're doing, but ISAs are intended as a safe tax-efficient investment for your average naive granny. No way should grannies be investing in risky SMEs. They'd lose their chemises and we'd never hear the last of it.

And finally - daft idea no. 4. This is probably the silliest of the lot.

"Government should explore the potential for the Business Finance Partnership to make commercially attractive investments in the following:
- Online Receivables Exchanges;
- Mezzanine Loan Funds; and
- Peer-to-peer lending platforms"

Wonderful. The shadow bank network in the US was created not by Government, but by the private sector seeking to avoid Government regulation that raised costs and restricted commercial activities. Here we have the same sort of thing developing: non-bank, technologically sophisticated commercial platforms facilitating trade flows; loan funds made up of complex financial instruments that have characteristics of both debt and equity; non-bank financial intermediaries for higher-risk forms of lending . So what do they recommend? The Government should take this over and CREATE a shadow bank network in the UK. You really couldn't make it up, could you?

I don't have a problem with any of these innovations, although I think the lack of financial understanding in SME's generally limits their use - though this could be addressed through the business advice network that the report also advocates. But why on earth does Government need to get involved? They are developing quite nicely on their own. Government involvement would simply raise the costs, restrict the activities and annoy the independent commercial players who are already developing these innovative products. It's like bringing up children - they have to be allowed to take risks and do things on their own. The best thing Government could do in my opinion is to provide a supportive regulatory environment (which the report notes it already does), then turn a blind eye and be ready with sticking-plasters.

So a good half of the report is taken up with daft ideas - plus section 8.1, of course, which is entirely dedicated to moaning about the fact that changes to regulatory requirements designed to make financial institutions safer places for grannies to put their money have the unfortunate effect of making it harder for SMEs to borrow money, especially for trade finance. And then there's section 8.2, which suggests that bank should provide credit information to non-bank suppliers of finance (i.e. their competitors) and that HMRC should provide additional information to assist finance suppliers in the assessment of credit worthiness. Yup, that's really going to encourage SME directors to be open about their financial affairs, isn't it?

But what the report DOESN'T address is the lack of equity financing for SMEs, and the preferential tax treatment of debt financing that ensures that companies will always prefer to borrow money rather than issue shares. The Executive Summary (paragraph 4) notes that equity is significantly under-used by smaller companies and that in the early stages of company development equity is often a more appropriate form of financing than debt. Then it de-scopes equity from the review and it is never mentioned again.

The Treasury has already responded to this report. Apart from slapping down the report's ridiculous suggestion that the ISA scheme should be extended to riskier SME investments, and giving a distinctly lukewarm response to ideas for enhancing gilt sales to retail investors and watering down regulatory changes, the Treasury's response is noncommittal. The word "welcome" these days generally seems to mean "more work needed", and it was possibly the most frequently used word in the document. So, the Treasury thinks more work is needed. Can it PLEASE include equity financing and improvements to corporate taxation - and get rid of daft ideas?


  1. Maybe a limit on debt : equity ratios should be imposed? Like twitter where you can't follow more than follow you :-)

  2. Tim,

    Personally I think levelling the playing field between debt and equity would help considerably. At present interest payments on debt are made from pre-tax income whereas dividend payments on equity come from after-tax income. This amounts to a preferential treatment of debt finance which (ceteris paribus) skews the financing decision in favour of debt over equity.

  3. Agreed. How about a tax on debt beyond 1:1 debt/equity ratio too? Maybe recoverable as tranches of debt are converted to equity? Excellent analysis BTW.

  4. I think the big problem is that everyone knows that some variant of a State Investment Bank or other direct intervention is required if we actually want to make a difference to SME funding in the next 5 years.

    Every other scheme relies on behaviour change which may or may not be desirable but the behaviour change will be slow. The fastest one would likely be debt/equity balancing, because there would be a real incentive and people who understood it on hand. Yet, at the same time, there isn't that much equity financing going around for SME's and I can't see the psychology changing quickly.

  5. This is an interesting analysis on issues such as connecting private direct investment with the companies in need of capital injections.
    I agree with all your statements and it is really a foolish thing by governments to attempt to simplify such a complicated subject. They just make things worse. Recent experience has shown that too much deregulation of the financial markets has led to a global economic crisis.
    On the other hand, SME are in a dire need of more flexible and less expensive funding.
    The solution: Get experts with proven expertise and hands-on experience in corporate lending, listen to their advice and let them prepare sound and rational plans which are at least tangentially related with the financial reality of small businesses and lending institutions. Then try to adopt those plans to the already existing legislation and, if necessary, make the final adjustments, always trying to provide effective solutions and not make more harm than good.

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