British Business Banking : The Failure of Finance Provision for SMEs [1 ed.] 9781788213028, 9781788213011

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Finance Matters Series Editors: Kathryn Lavelle, Case Western Reserve University, Cleveland, Ohio and Timothy J. Sinclair, University of Warwick This series of books provides advanced introductions to the processes, relationships and institutions that make up the global financial system. Suitable for upper-level undergraduate and taught graduate courses in financial economics and the political economy of finance and banking, the series explores all aspects of the workings of the financial markets within the context of the broader global economy. Published Banking on the State: The Political Economy of Public Savings Banks Mark K. Cassell British Business Banking: The Failure of Finance Provision for SMEs Michael Lloyd The European Central Bank Michael Heine and Hansjörg Herr Quantitative Easing: The Great Central Bank Experiment Jonathan Ashworth

BRITISH BUSINESS BANKING The Failure of Finance Provision for SMEs MICHAEL LLOYD

© Michael Lloyd 2021 This book is copyright under the Berne Convention. No reproduction without permission. All rights reserved. First published in 2021 by Agenda Publishing Agenda Publishing Limited The Core Bath Lane Newcastle Helix Newcastle upon Tyne NE4 5TF www.agendapub.com ISBN 978-1-78821-301-1 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Typeset by JS Typesetting Ltd, Porthcawl, Mid Glamorgan Printed and bound in the UK by TJ Books

CONTENTS

Acknowledgements

vii

Introduction

1

1. British banks and the industrial revolution

7

2. Modern British banking since 1900

33

3. From the other side: the culture of British SMEs

53

4. Banking problems for SMEs and alternative financial provision

71

5. UK financial and political economic culture

97

6. Optimum financial institutional structures and SME performance

119

7. Implementing reform

141

Notes References Index

155 159 167

v

ACKNOWLEDGEMENTS

My thanks go to a number of individuals and organizations, including representatives of banks and of SMEs, who have provided me with valuable insights and information during the course of writing this book; one person, I especially wish to mention is my friend, colleague, and ex-banker Craig Iley. However, any errors in conceptualization or of fact are entirely my responsibility.

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INTRODUCTION

Within the European Union the dominance of bank lending in the financing of small and medium sized enterprises (SMEs) is well-observed. Indeed, so much so that one main aim of the 2014 launch of the Capital Markets Union (CMU) programme was to change what was viewed as an over-reliance by European Union companies on bank lending for investment (Pesendorfer 2015). In the EU, 86 per cent of new funding in 2017 came from banks, principally investment loans, and only 14 per cent from capital markets. The intention of the CMU was to encourage SME access across a more integrated capital market across the EU. But this preponderance of bank investment loans to SMEs across the EU conceals the startling fact that in one country, the United Kingdom, exactly the opposite is the case. In the UK, most SME funding is not via standard bank investment loans, but instead short-term bank overdrafts and credit cards (83 per cent; Ernst & Young 2018). This puzzling outlier position of the UK, in relation to the relative absence of long-term investment finance provision to SMEs, requires an explanation. Currently, in the UK, SMEs are defined as having a turnover of less than £25 million and less than 250 employees and represent 99 per cent of all private businesses. A considerable variety of sectors are represented within this overall SME universe. Note that the EU SME definition has a higher turnover level, up to €50 million/£45 million and this is the definition employed in this book. This book, therefore, addresses an important, and persistent, problem in British political economy: namely, why British banking has not adequately invested in British SMEs, and especially manufacturing. The position in the UK has its roots in the culture and historical and institutional structure of the British banking system, alongside explanatory factors among the UK SME population. However, banking systems and industrial companies do not exist in a vacuum. The political economic environment of the country and its culture play an important role in influencing institutional, cultural, and business behaviour, both historically and today. It is the case that, during principally the eighteenth and nineteenth centuries, business banking structures evolved differently in the UK than in other European countries (and

1

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in the US). The position of the UK as “first mover” and the distinctive entrepreneurial nature of its industrial revolution were both contributing factors to the development of a British business banking system during this period, which was not constructively engaged with the UK industrial revolution. The real mystery, however, is why, since the early twentieth century, there appears to have been no significant change in British banks’ attitude towards providing long-term investment loan finance to SMEs, particularly given the importance of middle-sized companies in growing national gross value-added and in developing a strong national export performance. This apparent “risk aversion” of British banks might have been expected to alter, especially during the post-Second World War period, with the substantial expansion of consumer demand and expanded commodity production; but it did not. One contributory factor, which will also be explored in relation to this latter period will be the adherence of the UK state to a specific form of “liberal market economy”. It will be argued that whatever “first mover”-related explanations may be offered for banking structures and entrepreneurial SME culture during the 1870 to 1850 period, that subsequent to 1850, the specific form of liberal market economy which developed in the UK has inhibited the development of a productive relationship between British business banking and industry, especially SMEs. The form of liberal market economics which has developed in the UK may be contrasted with the liberal market economy of the US and, more relevantly, it will be suggested, with the development of “coordinated market economies” in Germany (corporatist in form) and France (dirigiste in form). In the nineteenth century, until the outbreak of the First World War, and in the economic reconstruction period following the Second World War, Germany has demonstrated a successful economic record, which might have been emulated by the UK. Indeed, as will be shown, an unsuccessful attempt at replicating elements of the German and French approaches to economic policy was made during the late 1960s and early 1970s. One historical factor of considerable influence after 1850, although its development had started earlier, was the enhancement of the role of the British Empire. The UK’s dominance of global trade and the substantial overseas investment by City of London banks, assisted by the gold standard, drew attention away from the need to sustain Britain’s early manufacturing superiority. These investments permitted a repatriation of profits to achieve a balance of payments, but this masked the decline in manufacturing performance on the trade account from the late 1870s. This approach led to the significant “financialization” of the British economy, still evident in 2020. This book will explore how the initial conditions forming the British banking structures in relation to its industrial revolution produced a relatively 2

INTRODUCTION

non-integrated bank–business structure in the UK, compared to other European countries and to the US. But it will also discuss why this lack of constructive engagement of British business banking, especially with SMEs, has persisted to the present day. Four linked explanations are advanced in the book. First, it will be suggested that the specific nature of the evolution of the industrial revolution in the UK – in both the initial phase and the second industrialization phase from around 1850 – and the circumstances surrounding the elaboration of the early banking structure, the absence of any extensive integration of banks and industry, and its subsequent intensive concentration phase around 1900 to 1920, may have had a lasting impact on the attitudes of UK banks to providing investment loan funding to SMEs, and indeed on the cultural attitudes of SMEs themselves. Second, it will be argued that the embedded characteristics of the UK financial institutional and business environment, including banking, and the prevalent liberal market economic approach developed in the UK, has thus far inhibited the introduction of the necessary improvements in supportive, state institutional structures, to drive forward the business culture in the British banking system in relation to the provision of investment finance to SMEs. Third, I maintain that a cultural shift will also be required in the approach of UK SMEs, including improving their financial management, and replacing short-term profit orientation with a focus on long-term growth objectives. This shift would emphasize their need, at appropriate times in their individual life-cycle, for external finance to be provided by integrated bank financial support via various forms of long-term investment provision. Finally, it will be suggested that substantial change is urgently required in the institutional structure and functioning of British business banking – essentially reversing its embedded centralized, bureaucratized direction of travel – with support from the state and appropriate regulatory reform, to ensure a better-balanced provision of funding to UK SMEs. These recommendations form the final chapter. It should be noted that, although the book attempts to draw conclusions about the historical industrial development of the UK in the late eighteenth and nineteenth century, it is not a work of detailed historical scholarship about the industrial revolution. Its perspective is analytical rather than descriptive in its approach; aimed at identifying the key factors involved in the development of the banking sector, the SME sector, and the role of the British state, over the period concerned. The early analysis focuses on the specific role of banks in financing (or not) the early industrial revolution in the UK (broadly 1750–1820). It appears that their role was not substantial, and the analysis will attempt to identify various reasons why this was the case. This is achieved partly by contrasting the UK 3

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experience with the strong historic role played by banks in funding SMEs in two other European countries and in the United States. It is argued that in the UK – even in the later “industrialization” phase of the industrial revolution – the banking sector did not become involved with industrial companies in the manner which it did in these other counties during their own “industrializations”. Other political economic and global factors were also at play in explaining the separate development of the UK during this period from the 1850s and into the early twentieth century, as already suggested above. An assumption is made – based partly on evidence from the success of the German Mittelstand (medium-sized companies) manufacturing export sector – that long-term bank–company relationships (structural engagement) will provide sustained investment and other relevant support to SMEs. The Mittelstand sector has been successfully supported by long-term banking relationships and bank lending since 1945. There is also evidence that the decline of “relationship banking” in the UK has damaged the ability for a constructive engagement, including the provision of investment finance to SMEs. Some evidence for this lack of constructive engagement is suggested by the fact that around one-tenth of British SMEs are discouraged from applying for loans,1 and the relative success in the UK of the Swedish bank Handelsbanken since 2003, which does provide “relationship banking” to SMEs. This assumption, which does not exclude the availability of capital market provision of investment capital, will be explored in the book and the arguments in favour of the position elaborated. It will be suggested that too great an apportionment of blame to the banking sector in failing to provide investment capital to SMEs is not wholly fair. There is nineteenth-century evidence of the “separate development” of banking and business in the UK, accompanied by a lack of understanding and of trust. However, in the modern era, since 1900, and certainly since 1945, this situation has persisted. An explanation of its persistence is required. The view – that there is a “deficiency” in the financial relationship and integration between the British banking sector and industry, particularly the SME enterprise sector – has been a recurring theme in official reports from the Macmillan Report in 1929, through to the Radcliffe Report in 1959, the Bolton Report in 1971, the Wilson Report in 1980, the Breedon Committee Report in 2012, the Young Report in 2015, and the Vickers Report in 2011. Not surprisingly trade and industrial organizations representing the SME sector have reiterated the criticisms made, as have various UK Parliamentary reports, in recent years. Academic and other studies have also documented the “funding gap”, initially noted by the Macmillan Committee. In this book an attempt is made to examine and analyse the complex of factors that have led to this long-standing lacuna and suggest also what remedial action could now be taken. Ironically, in March 2020, the initial frustrated efforts of the UK government to provide bank loans to 4

INTRODUCTION

SMEs2 – in an attempt to mitigate the business impact of the coronavirus – provide a backdrop to the problems faced by SMEs attempting to access bank loans. The first two chapters examine the evolution of British business banking during its early emergence and interaction with the country’s industrial revolution, up to its development as expressed in modern banking in 2020. The parallel evolution of business banking in Germany, France, and the United States will be used in these two chapters as a comparator, illustrating the differing developments in those countries. The next three chapters (Chapters 3–5) will provide detailed analyses of: (1) the culture of British SMEs as it affects their business behaviour, including seeking finance; (2) the embedded and failing structure of British business banking; and (3) the wider political economic failings of the British state which contribute to the problems identified in relation to inadequate investment funding of SMEs. Again, comparisons with Germany and the US will be used to indicate alternative approaches to the issues involved. The penultimate chapter will discuss – again using a comparative approach involving Germany and the US – the extent of the cultural, institutional, structural, and political economic changes required. The discussion will cover the British business banking sector; the SME sector, and the actions required of the British state. The final chapter will draw some conclusions from the book’s analysis and indicate a potential reform agenda which might allow development of an integrated investment relationship between British business banking and UK SMEs. The aim will be to suggest how best to facilitate the provision of long-term investment finance and other banking services to ensure the innovative development of the key SME business sector of the British economy going forward.

5

1

BRITISH BANKS AND THE INDUSTRIAL REVOLUTION

This chapter begins by indicating that in the UK the early industrial revolution was principally driven by entrepreneurs whose desire was for short-term risk capital to test their new technology, affecting industrial processes as well as products. Their need was for working capital, or as it was also known “circulating capital”. The entrepreneurs’ requirement appeared to be better served by relying on their own capital or on merchant capital rather than attempting to persuade existing banks to provide finance. Indeed, in some cases entrepreneurs founded their own banks, specializing in specific industries. The involvement of Quakers, both as entrepreneurs and as bankers, was notable – today’s Barclays and Lloyds banks both originated in nineteenth-century Quaker families. An analysis is presented of the comparable situations in Germany, France, and the United States. It will be shown that these industrial revolutions post-dated that of the UK, indicating the need for the banks in these countries – dealing with the more developed industrialization phase of the revolutions – to provide long-term capital to install and implement already tested technologies. This situation enabled a different structure of industrial banking to develop, with a willingness to adopt a risk profile suited to achieving long-term investment returns. The US developed initially by following the UK entrepreneurial funding model in the early 1800s, but its subsequent, if delayed, industrialization phase developed in a different manner, in relation to its banking system and structure. There is a need, therefore, to explore the reasons why, in the second industrialization phase in the UK, from 1830 to 1900, British banks did not participate in the same fashion as in say, Germany, or by following the alternative path taken in the US. One significant factor that will be discussed, in these other European countries, is the existence of agricultural credit banks serving initially the farming communities and subsequently agricultural equipment manufacturers and merchants. In the US, the story was similar, and its wider geography led to a large variety of “unit” banks, initially serving the agricultural sector, although here there was a considerable turnover of these independent banks.

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The provision of appropriate and adequate finance to support the development of the industrialization phase was an important enabling factor in driving forward the industrial revolutions. However, it was not the only factor. The nature of the accepted political economy, culture, and the availability of human capital, also played important roles in the process of accelerating and deepening industrial development, as did the process of urbanization. The chapter will explore these other explanatory factors in the timing, pace, and character of the process in the UK and in the other countries. The chapter will conclude by reviewing the evidence available to compare the UK experience of the early historical involvement of banks, and particularly business banking, with that of Germany, France and the United States. Specific attention will be paid to comparing their differing experiences in the phase of subsequent phase of intensive industrialization in the second half of the nineteenth century. The first industrial nation In the UK not only did the industrial revolution come earlier than elsewhere, but agriculture had also seen substantial change and reductions in land holdings. Effectively, it overlapped the continuing agricultural revolution. However, the later, intensive industrialization phase did nor occur until after the turn of the nineteenth century and the advent of the railways, supplementing waterborne transport. Employment in agriculture fell substantially following the 1773 Enclosure Act, which consolidated land holdings and motivated peasant farmers and labourers to move to urban areas. The consequential significant expansion of the populations of cities like London, Manchester and Birmingham, after 1750, drove both further technological improvements in agricultural production and introduced a shift from wood to coal-burning for domestic heating in the cities, which led to further innovation in mining techniques. New technologies, were initially concentrated on the textile industry in the North-West of England, close by rivers. A combination of the new technologies, Whitney’s cotton gin and workers’ skills (Mokyr 2009) saw a steady and long superior development of the textile industry. Later development, stimulated by the entrepreneurial drive for advances in machinery and other technology areas, led to industrial development in the West Midlands. The technologies were those which drove factory textile production, the shift to coal and coke in the iron industry, and the continual improvement of the steam engine. The economic history of the causes of why the UK was the first into an industrial revolution provides various explanations. However, there are some common themes and it is useful, therefore, first to consider the initial entrepreneurial 8

BRITISH BANKS AND THE INDUSTRIAL REVOLUTION

phase of the country’s industrial revolution in more detail, including the various socio-economic factors involved. If we look at the technologies involved, as Allen (2006, 2009) observes, “these technologies eventually revolutionized the world, but at the outset they were barely profitable in Britain, and their commercial success depended on increasing the use of inputs that were relatively cheap in Britain. In other countries, where wages were lower and energy more expensive, it did not pay to use technology that reduced employment and increased the consumption of fuel”. In the UK, the impetus behind the inventions and innovations came from two main factors; high wages relative to the price of energy and the price of capital. It is interesting to observe that this relative price ratio – indeed the obverse of the above – contributes to the low investment and low productivity currently affecting the UK. This conjunction of the input prices of manufacturing being low and the relative cost of labour being high meant that it was profitable to invent and to innovate. But although these factors provided the economic motivation for entrepreneurs, particularly in an era of interest and curiosity in scientific literature, they required research and development to fully engineer the products and to bring them and industrial processes to market, and, hopefully, to ensure adequate commercial returns. However, in the short term, the net profitability was unlikely to be high, with no immediate guarantee of long-term returns. Even to engage in these ventures required risk capital. Patents could provide some greater certainty, but it is not clear that these were widely used. The emphasis in this period was on rapid development of innovative processes and products in order to get them into the market as soon as possible. This entailed high risks for which suitable risk capital was required; fixed capital requirements were not required at this stage of industrial development. UK entrepreneurs had to find ways to circumvent the funding gap. They could not rely on the private banks that existed at the time to provide working capital. Few at the time, the banks were unable to provide such venture capital, not having an ability to assess long-term revenue generation, and hence not suited to providing the requisite risk funding for entrepreneurial inventors and businesses, eager to progress their businesses. It is perhaps useful to define at this stage what banks are (Gobat 2012). Essentially, banks are institutions that match savers with borrowers. Their primary role is to take in funds – called deposits – from those with money, pool them, and lend them to those who need funds. Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money). In this endeavour banks use shorter-term deposits to make longer-term loans. The process involves maturity transformation – converting short-term liabilities (deposits) to long-term assets (loans). This is their crucial 9

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function in the business economy. Banks do have other functions and in a modern monetary economy their function is more complex, but for the purposes of our discussion throughout the book, the above definition is sufficient. For the entrepreneurs in the first phase of the industrial revolution in the UK it was easier to recruit their own capital from their own families, notably Quaker families – or even set up their own collective banks to fund themselves: eager to develop their innovations; to bring them to market, and to retain control over their enterprises, rather than wait for bankers to fund their technological enterprise. For example, the Goldney and Darby families who worked together to develop the iron works business at Coalbrookdale throughout the eighteenth century – in 1752, Thomas Goldney III set up a bank with five other partners. Other economic factors were at work during this historical period. Following earlier declines, in the period 1750 to 1800, the population expanded rapidly. Substantial population movements into cities took place on an increasing scale during the second half of the eighteenth century. By 1800 London had 1 million inhabitants and the cities of Manchester, Birmingham, Bristol and Liverpool each had populations of around 75,000. These populations provided the workforces for the growth of manufacturing and, with increasing literacy, numeracy, teaching, and instruction in trade skills, an increasing pool of technicians to work in workshops, and later, factories. Also important in terms of developing the British factory system was the role of indentured apprentices. This system provided a malleable and disciplined labour force. There is also significance in the fact that the cities mentioned above, including London, were ports. The eighteenth century saw the early expansion of international trade, offering new markets abroad and bringing in migrants. This was accompanied by the expanding British Empire, defended on the high seas by the Royal Navy and protected by the Navigation Acts to establish and maintain colonial preference. The significant development of the East India Company was a case in point; not only trading, but also recruiting and expanding a private army to protect its burgeoning economic interests in East Asia, and particularly India. The growth of cities in the latter part of the eighteenth century, and the relative, high real wage economy, increased urban demand for various food products, including meat, and led also to technological improvements in agriculture itself. Agriculture was being increasingly transformed by the concentration of land holdings into large farms. Agriculture required less people; fuelling emigration from the countryside, and further driving the expansion of urban areas. This catalogue of factors that enabled technology and industrial production to thrive in the UK was not unique in all respects, but in combination these factors provided a period, measured in many decades, which confined the industrial revolution to the UK. Allen (2000) gives the example of a French government scheme in Burgundy in the 1780s which involved construction of an 10

BRITISH BANKS AND THE INDUSTRIAL REVOLUTION

English style iron works. Despite being well-capitalized and employing English engineers the project failed, probably because of the high price of coal in France, compared to England. The industrial revolution was also a fundamental resource revolution. It is perhaps best regarded as a transfer from an “organic-based” land economy to an “energy-based” economy, extracting the sun’s energy stored in the form of carbon deposits (see Wrigley 2002). It was the easier extraction and transport of coal in the UK – via the sea routes from the Northumberland and Durham coalfields to London, and subsequently the construction of canals in the period from 1760 to 1800 (150 constructed), with 90 used for coal carriage – which enabled the UK to be the first European country to achieve the transformation to an energy-based economy. But technological development is a continuous process. The subsequent innovations also reduced the need for the inexpensive inputs, for example, energy. These later innovations occurred during the second half of the nineteenth century, electricity and communications technology among them, meant that, although having a substantial early technological lead, by the end of the nineteenth century the British lead would be substantially reduced. Other countries, notably Germany and the United States exploited and further developed them. In addition, important factors, including the failure of banks to provide adequate long-term investment in manufacturing industry, and specifically SMEs, inhibited British industrialization. Further competitive factors, extant in other countries, such as the Prussian technical education system and US entrepreneurial drive, were not matched sufficiently by the UK. These factors would culminate, in the last quarter of the nineteenth century and into the early twentieth century, in Britain being overtaken by Germany and America. Different trajectories As the industrial revolution gradually transferred to other European countries, each offered a different historical, cultural and economic environment in which industrialization subsequently developed. The banking sector also played a different role in each country compared to the negligible one in financing the early British industrial revolution. By contrast there continued to be significant proportions of the economies in other European countries, and in the United States, devoted to agricultural production. In Germany and France in 1800, agriculture represented (using rural populations engaged in agriculture as a surrogate) 68 per cent of their economies, compared to just 50 per cent of the UK (Allen 2000). In the US the comparable figure for 1800 is 75 per cent (Lebergott 1966). 11

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It is illuminating to compare the trajectories of these three countries as they moved, on differing timescales and with differing economic resource endowments to the UK, from substantial agricultural dominance to the accelerating increase in industrial production stimulated by technological development. We will start by exploring the development of the industrial revolution in Germany, followed by France and the United States. Germany Germany possessed the natural resource endowment required to start an industrial revolution. Large coal reserves were to be found in the areas of Saar, Ruhr, Upper Silesia and Saxony. Iron deposits were also located in Upper Silesia. So why did Germany not start its industrial revolution at the same time as the UK? As in the case of the UK, although the access to plentiful coal and iron resources and beneficial coastal transport sea routes, were necessary conditions for starting an industrial revolution, they were not sufficient conditions. There were a variety of other essential conditions for entrepreneurial development and expanding markets which were not met in late-eighteenth century and early-nineteenth century Germany. Perhaps the most obvious problem for Germany at the time was that it did not exist as a cohesive nation. Instead it was a loose confederation of German states. Indeed, not until 1871 were the various German states unified, dominated by Prussia as by far the largest state. This earlier fragmentation hindered the expansion of trade and prevented the development of effective land and river transport routes, enabling raw materials to reach factories in different parts of the confederation. This situation, however, did not entirely prevent technological advancement or the development of, for instance, the textile industry. Indeed, the textile industry did introduce mechanization much earlier. In 1782, in Chemnitz the first German spinning machine was built. This event was followed in 1784 by a textile factory near Dusseldorf being established using the factory system developed by Richard Arkwright in Lancashire. British skills also contributed more widely to the development of the German textile industry, including building power looms for the Maschinen-Wollen-Weberei in Silesia around the 1790s. The growth of the textile industry led to the rise of renowned textile centres such as Krefeld (famous for its silk). Meanwhile by the early1800s the iron casting industry was developing in Silesia. Despite these developments, their dates indicate that the start of the first entrepreneurial phase of the industrial revolution, described above in the UK, was delayed by perhaps some 50 years in Germany. However, although there was a postponement in Germany, it enabled the second, industrialization phase, to be successfully financed and intensified, as will be indicated below. 12

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There were other constraints applying in the area we now call Germany, delaying its industrial revolution, compared to the UK. Feudalism returned in the early nineteenth century and with it the serfdom of many and their obligation to provide a share of their harvest and labour to their landlords. In industry the prevalence of the strong guild structure of craftsmen worked against replicating the British factory system, which had a weaker guild system and relied on indentured apprentices. And imports from the UK were damaging the prospects of internal industrial development. In 1818, Prussia moved to counter trade problems by imposing a new tariff system targeted on imposing tariffs on all imported manufactures into the Prussian state. The Prussian tariff acted to stimulate industrial growth within Prussia across the various provinces. This Prussian/Northern German customs union (or Zollverein) enlarged its home consumer market and allowed free trade between provinces. Subsequently the Prussian administration moved to establish a system of technology and skills institutes (Technische Hochschule); a system which still serves twenty-first-century Germany. On the other hand, the factor which still inhibited the ability to stimulate a full-blown industrial revolution in Germany, despite the success of the Prussian tariff imposition, was the need for an even larger market than Prussia alone could provide. In the 1820s, other German states had decided to form their own customs union to compete with Prussia. In 1820 Wurttemberg, Baden, Bavaria, HesseDarmstadt, and some Thuringian states attempted to form a customs union but negotiations failed. But the idea of a separate customs union remained alive and Wurttemberg and Bavaria proceeded with the negotiations for the formation of the Southern German Zollverein in 1828. In the central region of Germany, another Central German customs union was formed in the same year, covering the German states of Hanover, Brunswick, Nassau, and Hesse-Darmstadt. In 1834 Prussia proposed an amalgamation of the three customs unions. The merger took place in that year, save for the states of Hanover, Brunswick and Oldenburg who ceded from the Central German Union in order to form their separate customs union – the Steuerverein. However, in 1854 these three states also joined the original Prussian Zollverein. After the establishment of the initial enlarged German customs union in 1834, Silesia suffered competition from the Ruhr region, which had seen strong growth in its iron industry based on its natural deposits. In 1849, the first coke-smelting facility began operation in the Friedrich Wilhelm Ironworks in Mulheim, in the Ruhr. Foreign investment further accelerated development of the Ruhr. William Thomas Mulvany, Irish by birth, along with other investors, opened mines in the region using the latest mining technology. In 1866, these mines and iron works became the Prussian Mining and Ironworks Company. In the 1850s the regions of Westphalia, Rhineland, and Saar also experienced 13

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growth in their iron production. From a total of 46,000 tons of iron produced in these regions in 1810, it rose to 529,000 tons by 1850. Steam engines contributed to the industrial development of Germany. Steam engine powered textile mills. It also pumped out water in iron mines making the extraction of the ore easier. It allowed the increase in the number of factories operating, most especially in Prussia. From only 419 in 1837 it grew to 1,444 in 1849. Besides factories and source of power, steam also changed trade. It allowed riverine tugs to carry more load and transport goods faster. It also allowed German ships access to the Atlantic trade. Steam powered the industrial revolution in Germany, as in the UK. The rail revolution in the 1840s transformed the transport structure and the railroads served Germany well in its industrialization phase. The first railroad opened on December 1835 and ran between Nuremberg and Fürth. In 1839, another line opened that connected Dresden and Leipzig. Initially, the private sector took the initiative in constructing railroads. In Prussia, however, the government supported private railroad companies. In 1842, the Prussian government created the “Railway Fund” to finance railroad construction projects. At first, Germany imported locomotives from Britain and Belgium, but later it began to produce its own. During the 1840s, major cities across the German states were all connected by railroads. In Prussia, Berlin became a centre of the railroad network. In 1871 Prussia finally united the various German states. This event launched an accelerating phase of industrialization of Germany’s industrial revolution. Companies like Krupp began the mass production of steel and weapons manufacturing and ship building followed the steel boom. Industrial cartels provided protection and stability for individual companies. In other countries, like Britain and the United States, cartels were negatively viewed for their anti-competitive and unfair business practices. In Germany, cartels were seen as providers of stability for the growth of infant industries. It spared them from sometimes unprofitable and self-destructive price wars. It also provided protection in cases of price fluctuations and the entry of foreign competition. In this manner industrial development proceeded with adequate financial support from banks and stable markets via cartels (the role of German banks in this industrialization phase is discussed below). This “coordinated market economy” approach developed strongly under Bismarck. The approach integrated all principal actors: aristocrats, landowners, bankers, merchants, and industrialists and the dominance of Germany as an industrial power by the turn of the century was based on this cooperative, integrated approach. This “corporatist” approach to industrialization was accompanied by a continuation of a “mercantilist”, protectionist approach to trade. Both strands of which may be seen in contemporary Germany. This approach stands 14

BRITISH BANKS AND THE INDUSTRIAL REVOLUTION

in contrast to the competitive market and free trade economic approach which the UK adopted from 1850. France There were some limitations imposed on France in its path towards becoming an industrialized country. It did not have the quantity of natural resources needed to pursue early industrial development. Much of its iron and coal lay in the northern and eastern parts of the country and wasn’t easily transportable. And much of its coal initially came from Belgium. Nevertheless, it did not prevent France from attempting its own industrial revolution. Although, by the late nineteenth century and even the early twentieth century, France, although it had industrialized, remained a substantially agricultural economy. In 1806, agriculture employed 65.1 per cent, it then decreased to 42.5 per cent in 1896. Meanwhile, industry grew in its share of employment; from 20.4 per cent in 1806, to 31.4 per cent by 1896. The French government was extremely active in trying to promote advanced British technology, even in the eighteenth century, but its efforts failed since the new British techniques were not cost effective at French high raw material prices. In the late 1760s in the UK, James Hargreaves perfected the spinning jenny, the first machine to successfully spin cotton. In 1771 John Holker, an English Jacobite, who held the post of Inspector General of Foreign Manufactures in France, brought a spinning jenny into France. Demonstration models were made, but the jenny was only installed in a few large, state supported workshops. During 1789–93 the French Revolution and its aftermath slowed France’s industrial development. Despite some positive elements, such as the abolition of the guild systems and internal domestic customs duties, which allowed many products to move from one region to another without paying tariffs, the overall disruption was considerable. Many entrepreneurs sought refuge abroad. Moreover, the land reform that followed the fall of the aristocracy led small farmers to prosper, peasants to continue farming and not move to the cities for factory labour The Napoleonic Wars (1803–15) stimulated an economic recovery. Internal trade became even easier and efficient as Napoleon invested in infrastructure. Road and canals expanded across France. Canals connected major rivers that  served  as highways for goods. Roads also improved travelling. Napoleon ordered improvements to French ports. War also brought an increase in the demand for textile for uniforms and iron for weapons. In the textile industry, Joseph Jacquard developed a new loom in 1805 which significantly increased textile production. 15

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Many of those French businessmen who had sought refuge in Britain during the revolutionary period returned to France and applied British technology in their business. For example, steam engines from Britain arrived in France and proliferated to about 6,800 engines by the mid-nineteenth century, the largest number in Europe. The proliferation of steam engines led to the rise of textile and coal production. From 1830 to 1860, the use of multi-spindle spinning frames, adopted from Britain, substantially increased textile production. The town of Mulhouse in the province of Alsace rose to prominence for its dyes that brought many designers to it. From this foundation, Mulhouse diversified into the growing heavy industry of the region and became also prominent as a maker of machines. Thus began the industrialisation phase ofb industrial development in France. Iron output increased further during the 1860s. With the introduction of the hot blast method, production increased from 125,300 in 1826 to 1,250,000 by 1865. A decade later it supplied the iron needed for the Freycinet Plan in 1878, an amibitious public works programme which called for the expansion of France’s railroad system and the iron industry. The further development of industrialization and of improved transport links continued up to 1900. Hence, although France did not become as fully developed an industrial nation as Germany and the UK, it was, by the end of the nineteenth century, able to be competitive with its more industrialized neighbours. United States There is clear evidence of early-nineteenth-century industrial development in the North-East of the United States, in New England. In 1814, Francis C. Lowell, a Boston merchant and early industrialist had enlisted the support of his three brothers-in-law and obtained the financial backing of two merchants to establish the Boston Manufacturing at Waltham Massachusetts, using the power of the Charles River. The BMC was the first “integrated” textile mill in America in which all operations for converting raw cotton into finished cloth could be performed in one mill building. Lowell hired the machinist Paul Moody to assist him in designing efficient cotton spinning and weaving machines, based on British models, but with many technological improvements suited to the conditions of New England. Lowell and Moody were awarded the patent for their power loom in 1815. This led to the development of the textile industry throughout New England.  However, more widely industrialisation was slow to start. Poor transportation and the impact of the war with Britain 1812–15 meant extensive industrialization in the US did not commence in earnest until 1830. In the US, the 16

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technologies made available by the earlier development of industries in Britain were not restricted to the textile industry, but were used and further developed across a range of sectors, including, subsequently, other consumer goods, for example, food-processing, furniture, shoes and glass manufacture. The US had substantial key natural resources of timber, water, coal, iron, but the vast scale of the country meant that production was confined to the NorthEast during the 1800 to 1830 period. The British blockade of ports between 1812 and 1815, during the war with Britain, stimulated domestic production in the North-East. Because of inadequate transport links, the supply of raw materials and manufactures from the North-East to other areas was restricted, and wider industrial development was hampered. Following the construction of the Erie canal in 1825 and the concurrent construction of the first railroad connections with the Mid-West, other regional areas developed industries. As a result, the mid-Western industries of coal, iron, food processing, lumber, furniture, and glass-manufacture increased sharply. At the same time new industries in the North-East such as clocks, textiles, and shoes grew massively. It is important to recognize that, as with France, in the nineteenth century the US was principally an agricultural country, notwithstanding the industrialization which was taking place in the North-East and subsequently the Mid-West. Moreover, the early application of technology in agriculture moved the sector towards mechanized and commercial farming, unlike in France. Between 1860 and 1910 the number of farms in the US tripled from 2 million to 6 million. New machines – reapers, automatic wire binders, the threshing machine, combined reapers and threshers, mechanical planters, cutters, huskers and shellers, manure spreaders – increased productivity during this intensive period of technological advancement in agriculture. The application of technology to agriculture was essential to economic growth. The population movement into cities and into industry, and the doubling of the US between population in the 30 years between 1860 and 1890, necessitated substantial increases in agricultural productivity. Nonetheless, during the two decades before the Civil War the manufacturing sector of the economy grew more rapidly than agriculture or construction. Statistics, admittedly not always reliable, suggest that manufacturing production represented approximately one-third of US GDP in 1860, having doubled in the previous 20 years. The substantial expansion of railroads between 1830 and 1880, when rail gauges were standardized, enabled the industrialization of the Mid-West and eventually beyond to the Eastern seaboard. Railroads were accompanied by the development of the telegraph and newspaper photography which revolutionized communications. The Civil War (1861–65) also accelerated industrial development. By 1870 America’s intensive period of industrialization had begun. 17

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Other new technologies fed the push for industrial growth. By the early 1890s, alternating current (AC) had become the standard means of power transmission. As with railroads, this industry standardization allowed electrical networks to spread rapidly, first among urban areas and later into less populated regions.  Electric light of course enabled factories to keep working for longer each day. By 1900, manufacturing would account for more than 50 per cent of the value of goods. Correspondingly, the number of people living in cities and towns accounted for some 40 per cent of the total population. This pattern of accelerating urban-industrial growth, typical of the nature of the industrial revolution, and particularly the second phase of industrialization in all countries, would continue in the US well into the early twentieth century. The momentum generated between 1870 and 1900 meant that – given the larger scale of US industrialization across space and sector, and the ample availability of manpower – by 1900, the US had overtaken the UK in terms of manufacturing production. The expansion of US manufacturing production continued into the early twentieth century. Despite starting later than the UK, the substantial availability of natural resources of coal and iron, cheap labour, supplemented by migration from Europe, and the expansion of transportation networks stimulated the rapid industrialization of the US in the last quarter of the nineteenth century. Even disruptions caused by wars, civil wars, and economic crises, did not significantly slow the progress of industrialization in the US. The role of banking systems during the industrial revolution In France, Germany and the United States, unlike in the UK, the involvement of the banking sectorsin supporting farming and agriculture was considerable. The very name of the most important bank in this context, and still a major French bank – Credit Agricole – clearly indicates the link between the banking sector and agriculture. Although Credit Agricole did not emerge until 1884, France, as already shown, was still a predominantly agricultural country at that time. These strong links with agriculture, goes some way to explaining how banking in these countries became involved with the industrialization process. Once the industrial revolution, “copied” from the UK, was underway there was a requirement for long-term finance for companies, using already extant, tested technologies, to invest in factories, etc. There were, of course, differences across the various countries in the way the banking and capital markets worked. In Germany, notably, not only was there a stable banking structure – enabling the farming sector to thrive, and to increase its productivity – but these banks were 18

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focused on the sustainable development of agricultural enterprises. They were thus in a good position to provide the necessary longer-term finance for the burgeoning new industrial companies as well as in agriculture. The role of the banking sector in the second period of industrialization will now be examined in more detail, first in the UK and then in the other three countries. United Kingdom The UK’s early development of banking emanated from the creation of the Bank of England in 1694 as the largest private bank (i.e. not the public central bank of today), over 100 years before the Banque de France. Beyond the Bank of England, by around 1750/60, a second tier of around 30 private banks (sometimes referred to as “merchant banks”) served merchants and some industrialists. A third tier was provided by 12 country banks which operated during this period in local areas. Prior to the setting-up of the Bank of England, the system of Bills of Exchange1 had developed and was used extensively. This system enabled credit transfer to take place remotely, but also created a financial system as the bills were exchanged numerous times before eventually being redeemed. The system relied on trust in the eventual redemption of the bills. The core of any monetary system is trust between creditor and debtor. This is true whether the system is primitive and embryonic or as sophisticated as our modern twenty-first century systems. When trust breaks down any financial system suffers major problems, as in the global financial crisis of 2008. The development of banking in the UK was slow. One obstacle to development was the illegality of joint stock banking, implemented following the collapse of the South Sea Bubble2 investment “scam” in 1720 and the near bankruptcy of the country. This experience appeared both to have led to suspicion of banks on the one hand and reluctance from the banks to lend to risky entrepreneurial ventures, unless they were closely connected, like the Quaker families on the other. As already mentioned, British entrepreneurs tended to use their own family capital, or indeed set up their own banks, and Quaker families were to the fore here, including funding inventors like the Darbys (i.e. the Goldneys) and their innovations connected to iron production. Merchants and landowners were other sources of short-term finance, usually in the form of working capital. By 1800 there were 70 private banks and the number of local country banks had almost doubled. These banks were mainly established by successful businessmen anxious to add banking to their portfolios as the industrial revolution accelerated in the early to middle nineteenth century. The monopoly of the Bank of England covered London and a substantial area beyond. 19

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Several events affected the development of the banks. The Napoleonic Wars created pressure on banks, leading to substantial withdrawals, prompting the government to restrict withdrawals to bank notes, rather than gold whose withdrawal was blocked. However, some protection was provided for the banks in 1826 by the restoration of joint stock banking, albeit with unlimited liability, via the 1826 Banking Act. Later, by 1858, limited liability was made available by legislation for the joint stock banks ostensibly providing protection for banks, but it was not until a further Act in 1879 that a substantial majority of banks registered for limited liability. An 1844 Act had earlier banned the issuance of notes less than £5 in value. This stopped the practice of issuing extremely small denomination notes (strictly promissory notes, which are small enough for anyone to be, in effect, a “banker”). This practice had led to bankruptcies and even capital punishment for forging such notes. In England, but not Scotland, notes to the value of £1 were gradually replaced by gold sovereigns during the nineteenth century. The 1826 Act had not revoked the existing monopoly of the Bank of England on joint stock banking practiced within a 65-mile radius of London, but it did end its monopoly on note issuing. To counter this loss the Bank opened branches in other major cities. However, in subsequent Banking Acts, in 1833 and in 1844, the Bank of England’s notes were made legal tender and note-issuing once again became concentrated in the hands of the Bank of England. However, by the time the banking system had caught up with the pace of change and established a viable structure by 1850, business had been used to self-funding. Moreover, the development of joint stock limited liability companies, together with the establishment of stock markets in London and other cities, enabled companies to fund expansion via the issue of preference shares and low interest-rate debentures, although these were not traded. Hence, companies remained principally in private hands. The demand to be beholden to banks for funding was negligible. Even in 1914, 75 per cent of companies were still in private hands and, aside from overdraft facilities, did not use bank-lending as a source of finance (Watson 1996). This experience, particularly from 1850 onwards, of businesses ignoring banks, suggests, to be fair to the banks at the time, a demand-side rather than a supply-side phenomenon, as far as investment loans were concerned. But, of course, supply and demand do not move independently of one another. There is an interactive, symbiotic relationship between them. Gaining an insight into the motivations of the actors involved at the time is obviously problematic, we can only observe the external manifestations of the behaviour or, occasionally, rely on anecdotal evidence. There are two separate issues to be considered in assessing the role of British banks in financing the country’s industrial revolution in its second industrialising 20

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phase from 1830 to 1900. During this second phase, other European countries and the US moved to support companies in the industrialization phase with bank finance. The two issues relate to the nature of the development of the banking sector, the capital market, and the role of the state. All these factors varied in significant ways in the UK in comparison to the other countries. The first issue concerns the national integration of regional city capital markets, including London, which coincided with the second industrialization phase and the demand for fixed capital as well as working capital. The increasing use by companies of the issuance of preference shares and debentures, and thus retaining private control over their companies, was a significant factor in banks’ relationship with business. The second issue concerns how much the development of the integrated capital market, plus the apparent cultural reluctance of entrepreneurs to use banks, prevented banks from playing a role in the second industrialization phase. Faced with this measure of reluctance could the banks have provided an alternative, and perhaps more durable and sustainable investment source of funds, as in Germany? This lack of integration between banks and business may also be related to the competitive, free market (liberal market economy, LME) positioning of the UK as against the coordinated market economy (CME) approach of the larger continental European countries, which included favouring cartelization.3 As already observed, there was a strong preference for entrepreneurial companies in the first phase of industrial development to require only short-term risk capital, essentially working capital, sourced in imaginative ways. For instance, Hudson (1986) describes the existence of a “credit matrix” in the West Yorkshire wool textile industry linking individuals and families supplying goods for sale with those financing the production process. Banks were not the chosen vehicle. From the banks’ perspective it was impossible to judge whether there was a likelihood of the technological innovations involved producing long-term revenue. This situation carried forward into the early nineteenth century, notwithstanding the significant increase in the number of banks operating. It is this period between 1800 and 1830, during which one might have expected a rapprochement of sorts to have taken place between the banks and their prospective company customers for fixed capital, prior to the challenge after 1830 from developing UK capital markets. However, the evidence suggests that, during this period, the finance of fixed capital (e.g. for factories), was predominantly sought and received from within industry, including the development of trade credit and the utilization of bills of exchange. It is here that the regional country banks did perform a valuable capital mobilization function by taking in local savings deposits which were then recycled to discount bills of exchange. In this way short-term loans or overdraft facilities were provided. This also enabled 21

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relationships to be established between these banks and London as the issuer of the bills of exchange. A number of these country banks were founded and owned by industrialists, who were then able to support other business owners. Banks owned by brewers for instance were probably able to anticipate revenues from surplus profits which then could be loaned to other businesses. By the 1880s and 1890s a significant number of companies were starting to issue preference shares and debentures to raise capital. Nonetheless, the desire of the original owners to retain control meant that shares were not traded on a public stock exchange. There were some exceptions. The brewing industry was an example. In 1886, Guinness converted to a public limited company, floating capital worth a substantial £46 million. But this was the exception rather than the rule. The strong and enduring preference of companies, even in the second phase of industrialization, appears to have inhibited the use of banks except for shortterm finance, working capital. The preference of small and medium sized companies, in this era, appears principally to be down to a strong desire to remain in control of their companies and not to relinquish equity to outside investors. It is also the case that banks were reluctant to provide long-term finance. One reason may have been their not taking up limited liability status until the 1879 Companies Act (Turner 2017). During the latter period of industrialization phase and into the twentieth century, another feature of today’s British business banking system emerged. It may be represented as the mirror image of the German and American attention to the investment needs of its industry surfacing at the time. British banks became increasingly “outward-facing”; content to invest heavily in overseas markets, like the US and South America and use the repatriated profits to make up for the weakness of British exports on the trading balance. This feature was the embryonic emergence of the “financialization” of the UK economy; still seen as a contemporary problem by some economists (Blakeley 2019). Discussion of this issue will be covered in later chapters. Germany The ability to access long-term investment funds from banks was not the only factor which enabled Germany gradually, during the nineteenth century, to overtake the UK in terms of industrialization. Other factors such as the creation of the Zollverein, which established a customs union among various Prussian states, was another key distinguishing feature of Germany’s industrial development. This protectionist mode of industrial development accompanied by the widely practiced cartelization of industrial companies, and of the banks, 22

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contrasted with the British adherence, from 1850, to the practice of free trade and competitive markets. Nonetheless, the ability to access long-term finance from their banks and to take a long-term view of company development, based on substantial investment aimed at long-term growth, was an important feature of the early small and medium sized industrial enterprises in Germany during the nineteenth century. Indeed, this structure has survived into the twenty-first century. The banking structure in Germany developed from the early nineteenth century in a different manner from that of the UK. As in France there was a mixture of private banks and joint-stock credit banks; the latter subsuming the former and becoming large in terms of assets and varied in terms of financial activities. However, in Germany a third sector comprising savings banks and cooperative banks existed. The small regional and locally organized and supported savings banks (Sparkassen), are unique to Germany. They are credit institutions, governed under public law, and are widespread across Germany. Although the first German savings bank was set up in 1778, the launch of the movement began only after the end of the Napoleonic Wars in 1815. By 1836 there were 281 such small banks. As the saving banks grew, most, around 90 per cent, were established under the aegis of a city or a county. In contemporary Germany in 2020, there are 385 Sparkassen, operating 13,016 branches. They are credit institutions set up under public law, which means that local or regional authorities act, not as owners, but as trustees to make sure that the banks operate to serve their local communities. The banks may pay a dividend to the public authorities, but rarely do.4 To encourage small savers – the target customer base – the liabilities were underwritten by the local authorities involved. This meant that savers would not have to lose their savings. The savings bank did play a substantial part in financing the construction of public infrastructure, which was an enabling factor in permitting industrial growth. They also facilitated urbanization by providing the finance for the housing of factory workers. They also acted as banks for SMEs within their locality. One incidental benefit, to other banking institutions, particularly the joint-stock credit/banking companies, was proof that domestic retail deposits could act as a source of capital for banks. Credit cooperatives, or mutual credit banks also grew strongly after 1848. By 1861 there were 364 Schulze-Delitzsch credit cooperatives with nearly 49,000 members (Herrick & Ingalls 1914). These cooperatives were mostly established in urban areas. Two other groups of cooperative banks, operating mainly in rural areas, were the Raiffeisen cooperatives, which specialized in purchasing agricultural inputs and marketing agricultural products, and the much larger Haas group, which specialized in creamery purchasing and marketing cooperatives. Haas rapidly overtook the Raiffeisen group. One key difference between the two lay in the fact that the urban cooperatives generally restricted lending to 23

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short-term (2–3 year) loans, whereas the rural cooperatives provided long-term loans, on the basis that agricultural businesses required longer loans to cover investment needs, for example, for farm machinery. The mismatch between long-term lending and short-term borrowing on the part of the rural cooperatives – and hence what may be viewed as having insufficient liquidity – was not a problem. In rural communities, there was not the same informational asymmetry between depositors and borrowers as in urban areas. This position enabled rural cooperatives to have lower liquid portfolios. An accompanying difference existed in terms of rural cooperatives, via their enhanced ability to enforce credit terms in an area where everyone tended to know each other. Both the savings banks and the credit cooperatives were locally restricted, albeit by choice. Indeedm this was generally their strength. However, if economic conditions affecting their geographical area worsened then this would negatively impact borrowers and depositors alike. The answer came in the form of the establishment, by the German state governments, of regional banks. These Landesbanken and Provinzialbanken had been established by German governments to provide several kinds of loans to defined entities, including to Sparkassen. These regional banks provided a central banking function for the savings banks which they were able to use in times of financial stress. Similar regional cooperative banks were set up to cover the needs of the local cooperative credit banks. The regional cooperative banks – sometimes known as Centrals – took deposits from the local cooperatives and, in return, provided loans to them. Private banks had existed from the early nineteenth century and operated on the lending side by issuing securities and bonds for their industrial clients much as private banks in other European countries and the US did. The only difference appears to have been a non-reliance on taking deposits as the means of raising capital. Some of their issues on the investment side were substantial and required collaboration. For example, the incorporation of the Rhenish Railroad Company in 1837 required the participation of four Cologne private banks as well as the assistance of both the Frankfurt and Paris branches of the Rothschild family (Donaubauer 1988). However, the returns would have been substantial, consonant with the risk entailed. The credit banks offered their customers a broader array of services than did most private banks, and their size and range of services was crucial to their role in German economic development. But it is important to see the credit banks as developments of the private banks, and to understand how credit banks and private banks interacted in the first few decades of the credit banks’ existence. Although some were created earlier, it was the 1870s that saw the rise of the massive joint-stock credit banks. Deutsche Bank in Berlin and Dresdner Bank were two which grew to be extremely large, particularly Deutsche Bank. Private banks eventually ceded their position to these large credit banks which, unlike 24

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the private banks, did solicit retail deposits. Regional banks also needed access to the Berlin money market, to employ funds they could not profitably invest at home, and to carry out large transactions for themselves and their customers. The Berlin banks needed the regional institutions to be able diversify and to extend across Germany their ties to borrowers and investors. In their mature form, with increasing concentration, at the end of the nineteenth century, the credit banks could offer a wide array of services. They lent on current account and they discounted bills. They also ran securities operations, helping firms to develop and sell both equity and bond issues, offering the service internally to industrial clients. A major reason for increased concentration in banking, serving large enterprises, was the increased concentration and outright cartelization of large sectors in Germany industry. German law allowed firms to write binding cartel agreements, and in many sectors these agreements were in force among firms accounting for much of that industry’s market share (Feldenkirchen 1988). Banks themselves would then also establish cartel arrangements in order to be able to service their now larger industrial clients. Despite this, and that many of the largest industrial firms were joint-stock enterprises, joint-stock firms accounted for only a small minority of firms and a small fraction of industrial capital in Germany. The institutional connection between the large credit banks and business, sometimes stressed in the literature, was absent for most firms, including many large firms. It was certainly absent for small and medium sized enterprises. However, as has been shown, these SMEs were well served by the extensive country-wide network of local savings banks and the cooperative banks, providing them with the required financial support. France The dirigiste political culture of France meant that like Germany, but in a different manner, the British free trade, competitive market structure of political economy was not adopted. Here, although banks were involved in financing business, the direct role of the state was also a key factor. The Banque de France was established in 1800, but it was not until the end of the Napoleonic Wars that it was able to develop a central banking role. The creation of the central bank was accompanied by the existence of around 20 large independent banks, essentially the creation of men and families of extreme wealth, for instance James Mayer de Rothchild. Alongside the powerful bankers, a network of local banks grew up which by 1870 numbered around 2,000. There were close links between these banks and the private Banque de France having the sole right to issue currency. In 1857 25

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the Banque de France was able to open one branch in each of the départements (regions). The role of these local banks was important given their close funding relationships with agriculture and industry in their localities. After 1930 these local banks were closed, unlike in Germany. The pyramidal structure with credit issuing from the Banque de France nonetheless represented what was a coherent and effective credit system (Plessis 2003). There were earlier attempts to create credit institutions to support industrial development, such as the Caisse Générale du Commerce et de l’Industrie, founded in 1837 and involved in financing iron production and early railroads. But in the political and economic crisis in 1847/48 this bank and others, principally based in Paris, collapsed. After 1860 a new system was established to support industrialization, involving two banks that are still operating today: Crédit Lyonnais and the Société Générale, founded in 1863/4, and Crédit Industriel et Commercial, founded earlier in 1859. These deposit-taking banks supported industry with long-term loans to finance investment by industrial and linked commercial enterprises, aside from also providing retail banking services. Unfortunately, the Franco-Prussian war of 1870, and the severe and prolonged economic depression which followed for over a decade afterwards, damaged the willingness of these banks to lend, except short-term (2–3 year) loans. In this manner the banks were able to protect their deposit bases. They reverted to discounting of bills of exchange as a traditional and safe form of risk-taking in support of short-term loans.5 In this re-discounting they were joined by the local banking sector and Banque de France, who as the central bank also engaged in direct discounting. There were also a small number of large investment banks who offered loans and other services to large companies. One lacuna was that this available credit was not supporting agriculture, which, given the still substantial proportion of GDP given over to agriculture in France, was a problem. To redress this neglect, in 1894 a banking act authorized the creation of agricultural credit companies. Notable, and first among these banks, was Société de Crédit Agricole, created on 23 February 1885, and better known later and to the present day, simply as Credit Agricole. This led rapidly to the formation of local banks under its umbrella. Initially, the finance provided was in the form of short-term (1–2 year) loans, but later longer-term loans were made to enable investments to be made in breeding stock and new farm machinery. Towards the end of the century further support to agricultural banks came from substantial funding (40 million gold francs) from the Banque de France and the establishment of a regional banking structure, also supported by the government, which acted as a clearing house for the local banks. Meanwhile industrialization was supported by both the state and banks operating in the various regions. The leading banks were the Crédit Lyonnais and the Société Générale. Following the Crédit Industriel et Commercial, they embraced 26

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a major innovation which would allow them to tap into national savings. They began to advertise for deposits across a wide network of branches, emulating the British approach. These credit institutions provided long-term loans to finance industrial investment. However, with the costs of war with Prussia in 1870–71, ensuing reparations and the long global economic recession that lasted until the 1890s the French commercial banks moved to offering only short-term loans. Nonetheless bills of exchange circulated widely and afforded an available source of commercial credit. Despite the revolutions, wars and difficult economic circumstances which beset France throughout the late-eighteenth and nineteenth century – and with the high proportion of agricultural production in France, even at the end of the nineteenth century – a varied banking and credit structure had developed in France to support industrialization. Hence, banking credit was eventually provided to both industry and agriculture. The French state was also much involved in providing financial support, throughout the credit structure, to enable industrial and agricultural enterprises to be funded adequately. United States In the United States, the first major banking initiative was that of Robert Morris, who in 1782 established the Bank of North America, conceived as a national bank. This initiative partly derived from the debts incurred during the Revolutionary War with Britain from 1775 to 1783. However, it was rapidly converted into a commercial bank, the Bank of Philadelphia, then the capital of the US. Subsequently, the first genuine national bank – it was not a central bank and centralized monetary control did not occur until the twentieth century – was established at the urging of Alexander Hamilton. In 1791, the Bank of the United States, with a 20-year charter was inaugurated. Following this event some 18 new commercial banks, adding to the seven previously existing banks, were created by 1796. By 1800 there were 28 state banks, set up in the individual US states. The next phase of banking development was assisted by two Supreme Court decisions. The first was the Dartmouth College case (1819), which established the constitutional legal personhood of the corporation. The second provided constitutional legal patent protection for innovation in the Charles River Bridge decision (1836). Much of the recorded historical debate about banking in the US has tended to revolve around the issue of whether there should be a central bank. This technical debate was caught up in the political struggle between those advocating a powerful central role for the presidency, and those proclaiming the need for the decentralized powers to be in the hands of the states, and for the protection of individual rights. 27

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Private banks and state chartered banks grew across the US states, but by virtue of the early concentration of industrial development in the North-East, and to a lesser extent in the Mid-West, it was mainly in these areas where state and private national banks were established. Industrialization during the period from 1830 until around 1860 progressed, but principally in New England and the Mid-West, and even there at a modest pace. The most important impact on the development of the banking system – the main driver of manufacturing growth in the US after 1860 – appears to have been, ironically, the Civil War (1861–65). National legislative action, taken before the end of the Civil War, namely the Banking Acts of 1863/64, appears to have had a significant and substantial impact on the banking system, and in turn on the massive expansion of industrialization from 1870 to 1900. Manufacturing output in the three areas of New England, the Mid-West, and the Mid-Atlantic (sometimes called the “manufacturing belt”) rose by almost 800 per cent in this period and manufacturing capital by 1,200 per cent. The Banking Acts introduced two key innovations. The first restricted the individual state chartered banks from issuing bank notes, and allowed the newly federal government chartered national banks to do so across the country. The second, by instituting the Federal chartered national banks, created a national structure of private banks, strongly competing with state chartered banks. Matthew Jaremski (2013) establishes a clear connection between the introduction of the Banking Acts and the increase and distribution of private national banks and state banks during the following decades. He goes on, via a regression analysis, to produce results showing how the impact of the new banks and the recapitalization of existing banks accelerated manufacturing production and business capital intensity during the decades succeeding the Banking Acts. Hence, this impact in part explains the massive expansion of US manufacturing and agriculture during the period from 1860 to 1900. Ironically, as Jaremski suggests, the high capital and reserve requirements of the Acts, originally intended to restrict the number of banks, had the perverse, but positive, effect of both increasing the number of banks, and in substantially improving their quality. The impact of the provision of strongly performing loans by these banks stimulated economic growth and thereby the demand for more loans. This virtuous circle was particularly the case with the national banks (chartered nationally), compared to the state banks (chartered by the individual states). There was a strong impact on the existing “manufacturing belt”, perhaps at the expense of a lesser impact outside this geographical concentration of manufacturing industry. What was also remarkable was that this period of substantial industrialization took place during a period of global economic depression6 affecting both the US and Europe. This period was inaugurated in the US by the collapse of Jay Cooke’s 28

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Philadelphian investment bank which had invested in the massive expansion of railroads. Unfortunately, the firm was unable to market $300 million worth of bonds invested in the transcontinental Northern Pacific Railway. In September 1873, the company was declared bankrupt. This event triggered a substantial collapse on the New York and other stock markets. Despite the collapse of many railroad and real estate businesses and substantial unemployment during the long recession, and the occurrence of various banking stock market panics, the underlying health of the banking system, as indicated above, was maintained. In an era of falling prices of goods and services, real wages and overall real income rose significantly. This factor drove economic growth, stimulated also by investment in new technology, and enabled industrialization to be maintained, and indeed accelerated. Conclusion Examination of the availability of financial provision to entrepreneurs and companies participating in the second “industrialization” phase, from 1830 to 1910, suggests that the provision was uniquely different in the UK from that experienced in France and Germany and in the United States. There appear to be three main factors lying behind the differences. The first factor relates to the fact that the industrial revolution was initiated in the UK some 50 or more years earlier than in other European countries and in the US. The second causal factor relates to the differing structures of the British banking sector and the other countries’ banking sectors; extant at the time of the industrialization phase of their industrial revolutions. The third factor is the underlying choice of political economy made by each country, including the role of the state, its impact on the capital market and banking structures and operations, and on industrial corporate structures. Unlike the UK, in Germany and France, and in the US, there was a banking structure which was already supporting an agricultural sector, and which developed to support the small and medium-sized enterprise industrial sector, as well as larger companies. The continuing existence of the French bank Credit Agricole indicates a strong banking facility supporting French agriculture. However, the postponed agricultural revolution in France, and the other tribulations of France during the nineteenth century, meant that the supportive bank credit structure in France did not arrive until the final quarter of the nineteenth century. In the US, like France, there was a substantial agricultural sector throughout the nineteenth century, particularly by the end of the century. However, US agriculture was by then, unlike in France, substantially mechanized and its output enough, not only to feed the massive increase in urban populations working in new industries, but also to export food. 29

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The US banking sector was not as deeply embedded in industry as were the German banks, although local banks were involved in agricultural communities and areas. Nonetheless, particularly after the Banking Acts of 1863/64 and the end of the Civil War, US banks supported small and medium sized enterprises despite a series of banking panics and the long depression. This apparently ready acceptance of the vicissitudes of capitalism in the US, possibly inuring US businesses to frequent booms and busts, assisted industrialization to continue. A more stable banking structure and the protection afforded by imperial preference in the UK appears to have led, by contrast, to a more stable, but slower pattern of industrial growth, and a lower overall take-up of the later technologies, in the second industrialization phase. We may advance the following propositions, with a reasonable degree of confidence, in relation to the role of the banking sectors of the four countries in supporting their respective industrial revolutions, and the role of the wider political economic models adopted in the respective countries. In the UK, the early industrial revolution was driven by innovative entrepreneurs frequently providing their own high-risk, short-term funding. In effect this was funding which the banks at the time appeared unwilling to countenance. Certainly, the small-scale private banks were not interested, or capable, of offering this type of risk capital in an absence of solid collateral. Instead owners’ capital, sometimes via banks set up by entrepreneurs themselves, was the principal source of finance for British companies in the early days of the industrial revolution. However, the demand for finance during the industrialization phase was not high-risk, short-term provision. Rather it was geared towards the need for investment in fixed capital, for example, for factories or for new technological equipment. Banks, in general, were not structured to provide the required investment finance, but were also not held in high regard by company owners, who preferred to finance development through the burgeoning national and regional capital markets. In Germany, the existence of community-linked small savings banks and cooperative banks, with close links to the farming sector, provided analogous support for industry. Support, for instance, to introduce new technology in relation to agricultural machinery could readily be appreciated by banks as increasing productivity and hence future farming revenue. This business model was easily adapted to supporting small and medium-sized industrial businesses which was extremely valuable during the industrialization phase when fixed capital was required. The savings and cooperative banks, although operating at local level, were able to develop close links with larger regional banks, and the regional banks to national banks, to provide a stable pyramidal national banking structure. In France, throughout the late-eighteenth and nineteenth century, with a high proportion of agricultural production in France, even at the end of the 30

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nineteenth century, a varied banking and credit structure had developed in France. Hence, banking credit eventually was provided to both industry and agriculture in the final quarter of the century. The French state was very much involved in providing financial support throughout the pyramidal credit structure to enable industrial and agricultural enterprises to be funded adequately. However, for external reasons perhaps beyond its control, the French banking system did not achieve the same success in terms of its industrialization by the end of the nineteenth century as had Germany. In the United States, the country was also in the process of wars of conquest and expansion and the resolution of constitutional struggles. Ironically, this ferment appears to have accelerated, not hindered, the industrialization process in the second half of the nineteenth century. Significantly, after the end of the Civil War, and promoted by the Banking Acts of 1863/64, industrialization developed incredibly rapidly throughout the wide “Manufacturing Belt”. The nationally chartered banks, more than the state banks, were the engines of this industrial growth acceleration, notwithstanding serious “banking panics” up to, and indeed beyond 1900. Nonetheless, despite the fragility of the overall banking system – resolved eventually by the creation of the Federal Reserve System in 1913 – the commitment of business (including banks) to an acceptance of a Schumpeterian7 process of creative destruction, allowed US industrialization to continue, despite specific setbacks. Finally, we should factor into our explanatory model the preferred varieties of capitalist development; that is the models of political economy adopted in each of the counties considered, and the cultural and social environments in place in those countries. Hence, in the German states, and particularly Prussia, throughout the nineteenth century there was an adoption of cartelization and of protectionism. Eventually this led to the modern Germanic coordinated market capitalism, although with an idiosyncratic role for the state guaranteeing the market. A similar position, albeit with a stronger dirigiste state model could be seen in France. In the United States, an aggressive liberal market capitalism prevailed, with an acceptance of a Schumpeterian disruptive capitalist model. By contrast, the UK also adopted a liberal market capitalist model, dissimilar to its European neighbours, but not pursued as aggressively as in the US. Its adoption was characterized by an apparent embracing, after 1850, of a political economy emphasizing market competition and free trade. However, underlying this stance was its protection of imperial preference, enforced by its mercantile power, its exploitation of its colonial possessions, and by substantial overseas investment. This position was predicated on its dominant global position in the mid-nineteenth century. Echoes of these historical choices may readily be observed in the current twenty-first century positions adopted by the four countries examined here. As 31

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will be argued, particularly in relation to the UK, in subsequent chapters these political economic factors are relevant in explanations of the apparent unique position of British banks in providing long-term investment loans to SMEs. In the next chapter it will be argued that the characteristics of the UK in the nineteenth century, outlined in this chapter, are still manifest in the modern British business banking sector, and in the attitudes of British SMEs. It will be suggested that there has been a persistence of apparently “risk-averse” attitudes to long-term financing, and a lack of “constructive engagement” towards SMEs. This situation has continued notwithstanding long periods of high bank liquidity, enabling the fulfilment of their economic role of financial intermediation in respect of SMEs. This failure has tended to reinforce a short-term profit-oriented vision among these companies, to the overall detriment of the sector’s international competitivity. Any resolution of the issues involved will require, as later chapters will argue, a complex mix of changes, involving banks, SMEs, and state actors – in short, a systemic change.

32

2

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Notwithstanding the historical and cultural context which defined the British business banking functionality in the nineteenth century, an explanation is required as to the persistence of the poor record of British banks in providing sufficient investment loan capital to SMEs in the twentieth century, and to the present day. This chapter will seek explanations for the persistence of the apparent unwillingness of British banks to provide long-term loan finance to SMEs. Contrasting experiences will be described in relation to Germany and to the United States. The contemporary structure of UK banking demonstrates the dominance of the sector by the five major, centralized banks, surrounded by a penumbra of “challenger” banks. It will be argued that even these new challenger banks, whatever their prospectuses may say, have, for a variety of reasons, failed to significantly alter the lack of provision of long-term investment finance to the British SME sector. The analysis will uncover the historical pattern of apparently risk-averse British banks failing to accept the risks of business lending to SMEs over a 120year period. One aim will be to attempt to understand how far the attitudes of both the major banks and SMEs, as modern economic conditions emerged in the twentieth century, may have been conditioned by the historical relationships built up during the late-eighteenth and nineteenth centuries. On the other hand, it may also be the case that other more recent factors have compounded these earlier attitudes. The discussion will proceed chronologically and can be usefully divided into four periods: (1) from the start of the century to the end of the Second World War; (2) the postwar period until 1970; (3) 1970 to the mid-1990s; and (4) the period since 1995.

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1900 to 1945 By 1920, a long process of consolidation in the preceding century of small private country banks into larger banks had produced an oligopolistic structure with a handful of dominant banks. Size clearly mattered in terms of the stability of the larger banks and their ability to recruit deposits and to make well-performing loans to individual and to business clients, at least to large companies. In 1920, the government concerned at this concentration, introduced legislation preventing further takeovers without Treasury approval. In the period between 1900 and 1945, five large banks – Lloyds, Barclays, Midland, National Provincial and Westminster – dominated the banking sector. These five banks developed into large‐scale, centralized, and bureaucratic organizations, focused on London head offices. Indeed, much of the structural organization and operational practice which exists today was settled during this period. Characteristically, there was a strong emphasis on maintaining a high level of liquidity, particularly in connection with any industrial loan portfolios; bad debts were minimized by avoiding risky loans. There was, and still is today, a low likelihood that loans (whether short- or longterm) to SMEs would be granted. Perhaps even more crucially, the traditional British banker’s dictum of “borrow long and lend short” became established: turning on its head the banks’ financial intermediation role to recycle bank liquidity into long-term credit to businesses in the economy. The general mode of lending to SMEs became, and remains, the provision of overdraft funding for working capital and cash-flow purposes; quintessential short-term funding which could be withdrawn with little notice. Nonetheless, overdrafts can be rolled over, if the company can provide evidence of continuing customer contracts or provide personal collateral. However, this revolving short-term funding still impedes long-term business planning and investment. Indeed, SMEs are sometimes challenged by banks as to why they are using rolling overdraft funding to finance investment. This operational practice and the centralized structure of decision-making did have some variation across the “Big Five”. Barclays and, to some extent Lloyds, for example , were less centralized during this period than the other three. In criticizing British banks it is worth being mindful of the tendency, observed in the nineteenth century, and reported in the previous chapter, of British enterprises themselves to prefer self-funding or the issuing of preference shares and debentures, rather than allowing banks to become too closely involved in their businesses. However, in the late 1920s concerns were beginning to be raised about the problems created for small businesses by what was viewed as the excessive centralization of decision-making by banks. A quotation from H. E. Levitt of the Institute of Bankers following a visit to the Bradford and Manchester chambers of commerce provides an illustration: 34

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There is undoubtedly a general feeling of dissatisfaction with the Banks … Many people stated that Foreign Banks in London were far more enterprising than English Banks and were anxious to help even the small businessman. There were also many complaints against the policy of centralization. It was said that not only was the banking system being mechanized, but that local managers were being turned into machines for the transmission of requests to Head Office. (Newton 2009) These concerns were eventually considered by the Macmillan Committee, established in 1929. The Committee, whose report in 1931 appears to have been substantially written by committee member and Cambridge economist John Maynard Keynes, had a wide remit covering domestic and international financial issues. Nonetheless, one of its areas of concern was the apparent deficiency in the long-term funding of businesses, including SMEs, later termed the “Macmillan Gap”. The report was, however, largely concerned with the lack of close involvement with industry of the UK banking sector and the capital market. It drew attention to the close relationships between banks and business in Germany, France and the United States, although the banking to business links were mediated in different ways in each of the countries. Interestingly in respect of Germany, the Macmillan Report suggested that “Scarcity of capital and of independent investors compelled the banks to supply industry with long-period as well as short-period capital. These responsibilities obliged them to keep in intimate touch with the industries themselves” (Macmillan Report: 10). Shortage of capital is not the principal reason advanced in Chapter 1 for the close banking/ industry relationship in Germany, although it could have been a factor. Rather, it was because of the specific banking structure and the prevailing political economic choices made in Germany (Prussia) in the nineteenth century. What is undeniable, as the Macmillan Report confirms, was that the UK, alone of the four countries examined, lacked a close relationship between banks and industry. Their recommendation, for the UK, was that “progress necessitates closer association through appropriate organisation of the financial and industrial worlds” (Ibid.: 10). The Macmillan Report, as further chapters will indicate, was the start of successive government attempts to bridge the “Macmillan Gap”. Since 1931, various mechanisms have attempted to remedy banks’ failure to adequately fund SMEs. Most of the attempts have avoided ways of effectively “purposing” banks to provide investment funding via long-term loans for SMEs, in addition to the shortterm overdraft finance already available to firms. Effectively, all of the attempts have failed. One attempt was made during the 1930s to bridge the gap indirectly. Credit for Industry Ltd (CFI) was established in 1931, with finance from United 35

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Dominions Trust (UDT) (the hire purchase firm) with the aim of assisting established concerns whose capital requirements were too small to be served via the ordinary equity capital market. But resistance from the major banks to such direct competition rendered the efforts of the CFI nugatory and it was eventually wound up. Subsequent government attempts to fill the gap during the ensuing years have also failed to achieve any major break-through, despite some limited success in the post-1945 period. 1945 to 1970 The postwar period witnessed a period of tight control over bank lending, instituted during the Second World War, which was only gradually relaxed over the following 25-years. It was not until July 1958 that official restrictions on bank lending were lifted for the first time since 1939. Even then constraints remained, albeit successively relaxed, until 1970/71.1 During this period, some hire purchase companies (e.g. UDT), competed with banks and were able to offer credit to purchasers. However, this credit avenue was still subject to government control, for example, on the level of initial deposits to be paid, which could be increased if inflation fears prompted the government to tighten credit. This postwar period could have facilitated rapid industrial development, via the intensification of investment in industry, and specially in SMEs. Ironically, this re-industrialization is precisely what was happening in Germany where the establishment of a state investment bank, the Kreditanstalt für Wiederaufbau (KfW) – 80 per cent owned by the German government and  20 per cent by the German Lander (regional states) – provided support to SMEs by sharing risk with the local banks providing the loans, i.e. in effect subsidizing those loans. This was not the only role for KfW; its focus was on the reconstruction of Germany and its infrastructure after the Second World War. However, KfW Mittelstand supported SMEs, via the local Sparkassen and cooperative banks, as a key part of the reconstruction task. The constraints on lending in the UK did affect further consolidation in the sector. This consolidation involved the merger in 1968 of two of the dominant banks, Westminster and National Provincial, and takeovers of smaller banks. The Big Five became the Big Four: Barclays, National Westminster, Lloyds and Midland. As far as relations between the banks and industry was concerned the situation remained as before the war. Large businesses were provided with overdrafts and occasionally medium-term loans, but SMEs were restricted to overdrafts. Large companies were able to access funding via share issues on the stock market, aided by the City-based merchant banks, who would also advise on mergers 36

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and takeovers. The commercial banks were interested in having safe, low-risk business customers and a steady flow of income. Deposits were not a constraint as they showed a steady growth in this period. But SMEs continued to be neglected as a sector requiring on-going investment support, save for overdraft funding to provide working capital. In 1945 the government did revisit the idea of how the Macmillan Gap might be addressed, in order to provide funding support for SMEs. The Industrial and Commercial Finance Corporation (ICFC) was established in 1945 by the Bank of England, with subscriptions from the major clearing banks, as a new vehicle for bridging the gap. The ICFC established a regional branch network, countering the centralization of the major banks. It invested in acquiring industrial and market expertise to be able to assess better the risks of an investment, as well as assessing the credit worthiness of the company and its principals involved. After a first three years of losses it became profitable. As well as direct participation in SMEs, ICFC was able to provide a brokerage function for the major banks, providing them with a detailed credit-worthiness assessment of SMEs, if requested (Mayer 2017). In the 1970s ICFC went on to become an independent institution, as “Investment for Industry”, and later became the “3i Group”. Typically, it provided venture capital to SMEs, rather than attempting to provide loan finance and from the 1980s, now privatized, it shifted its focus to supporting management buy-outs. During this postwar period, savings banks, building societies, insurance companies, and hire purchase organizations encroached upon the traditional market of the clearing banks. These institutions competed with the banks by offering lower interest rates for borrowing and adopting a much stronger customer focus than the banks, and, notably, paying interest on retail customer deposits. As an example of the effectiveness of this competition for the major banks, the percentage contribution of building society assets to total assets of UK financial institutions had increased from 1.9 per cent in 1920 to 11.7 per cent by 1962 and that of banks and discount companies had decreased from 59.5 per cent of the total assets to 33.1 per cent during the same period. In 1968, a new state competitor for the major banks, the Post Office’s National Giro, a policy initiative of the Labour government, opened for “personal” customers. The Giro’s prospective customers were a customer cohort which would not, at the time, have considered having a “standard” bank account. The UK National Giro was the first financial institution in Europe (even though Giro banks existed in various other European countries) to be fully computerized. It adopted optical character recognition for its payment transfer transaction documents, which enabled utility companies and other businesses to automate part of the complex accounting process involved in establishing regular remittances from customers. 37

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The major clearing banks did not respond aggressively to the competition from other financial institutions, although they did, as far as government constraints allowed, develop a variety of new products and services, such as personal loans (Midland) and a credit card (the Barclaycard). However, from the viewpoint of SMEs, aside from the ICFC, the British banking sector failed to attempt any shift from short-term overdraft lending towards the provision of loans for investment purposes. Large companies had adequate means to use the capital market to support their long-term investment plans and innovation. For SMEs, this inherent conservatism of the large mainstream banks, admittedly inhibited by government rules on lending, represented a potential loss of innovation and UK supply chain development. To stimulate and to sustain investment and innovation requires the certainty of long-term funding; precisely the opposite of what was on offer from the major banks. For British industry, this postwar period was critical in terms of developing an SME base to take the UK forward into a new competitive global economic environment. The relative weakness of this sector of the British economy to the present-day may be partly attributed to this failure of vision, notwithstanding some attempts to improve the situation in the early 1970s. 1970 to 1995 If the previous 25-year period represented quiescence and missed opportunities for the British banking sector then a similar time period from 1970 offered both considerable challenges and new opportunities. In 1973 the UK had become, together with Ireland and Denmark, a member of the European Communities, colloquially known as the Common Market. This would present new business opportunities for banks themselves, but perhaps also for British business banking to observe more closely the links between business and banks in continental Europe. In 1971 banking regulation was relaxed. Quantitative constraints on bank lending were removed and hence the allocation of credit to bank customers became primarily dependent upon interest rates and the credit worthiness of its customers. The new regime also eased the liquidity requirements of banks and thus provided more latitude to lend. Moreover, the major clearing banks were able borrow funds on both the wholesale inter-bank market and on the growing eurodollar market.2 This new-found freedom might have prompted a change in attitudes towards business lending to SMEs, but there is no evidence that it did. The banks were of course faced with substantial changes in financial markets and with developing trends already noted in terms of competition for deposits and retail business from other financial institutions, particularly building 38

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societies. The latter expanded their branch network during the ten years from 1970 to 1980, reaching a figure of around 6,000. The developing housing market led to demand for personal mortgages which was met by the building societies. Only later did banks begin to offer personal mortgages for house purchase. In the same period, personal savings as a percentage of GDP had doubled, reaching over 10 per cent in 1980. The outcome of these two factors: the increase in personal savings and the fierce competition from building societies on interest rates on deposits led to a fall in the share of total deposits of the major clearing banks. Between 1963 and 1973 the share had fallen from 50 per cent to 28 per cent. In contrast to the building societies, savings banks, for instance the trustee savings banks, also saw their share of total deposits fall – from 8 per cent in the 1960s to only 5 per cent in 1978. In an attempt to redress this fall, and facilitated by government legislation, the trustee savings banks eventually merged into a single corporate entity, the Trustee Savings Bank (TSB). This enabled the TSB to offer similar services to the major clearing banks in the form of checking accounts, credit cards, and personal loans. This relative success led – perhaps inevitably given the historically demonstrated proclivity of the major clearing banks when faced with competition – to a merger/takeover in 1995 with the Lloyds Group, which became Lloyds TSB. (Ironically, as will be indicated subsequently, TSB was demerged from Lloyds in the years following the Global Financial Crisis in 2008). In 1978, National Giro renamed itself National Girobank and became the first bank to offer free banking to UK personal customers (provided the account was in credit). Later the bank dropped the word National from its title, simply being known as Girobank Plc. By the late 1980s, Girobank was Britain’s sixth largest bank. Girobank continued to provide innovative competition for the major clearing banks until it was “absorbed” into the Alliance & Leicester Building Society in 1990 (subsequently in 2003 the name Girobank was dropped). Despite its relative success as a retail bank, and its attraction of some small businesses, for example, retail shops, the Girobank never attempted to be a business bank or to provide business loans. However, further competition for the Big Four banks in the 1980s now came from the two main Scottish banks, Bank of Scotland and Royal Bank of Scotland who moved into England, and in the north of England competed for both retail and business customers. However, as far as SMEs were concerned the provision offered was the same as the Big Four, i.e. overdraft facilities, not loans. An exception was often made for property companies.3 Larger businesses were in the fortunate position of being wooed by another set of banking competitors. American and other foreign banks, which had moved into London to be better able to trade in the developing eurodollar markets, began to offer services to businesses. The US banks also began to take 39

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over the traditional British merchant banks (now known as “investment banks”) which had close advisory relationships with the major UK businesses. By 1980 around one-third of loans to these major businesses came from overseas banks. This aggressive competition was also seen in retail banking where HSBC took over Midland Bank in 1992, moving its head offices from Hong Kong to London. However, if SMEs thought that this invasion of foreign banks might presage innovation in terms of the provision of long-term investment funding then, as with the Scottish banks, they were mistaken. Notwithstanding the traditional banking precept of borrowing short and lending long the reverse was true of the Big Four and the newcomers did not buck that trend as far as funding SMEs were concerned. Given the oligopolistic situation into which newcomer banks were entering, it was hardly likely that there would have been any “bucking of the trend”. In later chapters these structural (and cultural) reasons will be explored further. Why the banks, old and new, in the UK adhered to the use of short-term overdraft funding of SMEs – so out of line with the close relationships between banks and businesses in other countries – will be analysed in more detail. The 1980s was a particularly interesting period given the increase in the number of small and medium-sized firms, partly as a result of the encouragement provided by the “Thatcher revolution”, with its emphasis on individualism and entrepreneurship. Moreover, the Wilson Report in 1980 had, like the Macmillan Committee and the Radcliffe Report before it, criticized the provision of credit and financial services to SMEs. The major banks responded accordingly by expanding their portfolio of SMEs, but still providing finance via overdrafts, usually secured on owners’ collateral in the form of property. It may be argued that the introduction in 1987/88 of the first Basel Agreement reinforced the UK Big Four’s preference for shortterm lending practices. This international agreement, under the aegis of the Bank of International Settlements, mandated banks to increase the amount of share capital they held (equity reserves) in proportion to their exposure to the levels of risk of loans made to businesses (risk-weighted loan capital). Effectively, the agreement made long-term lending to SMEs riskier as perceived by the banks. Recessionary economic forces hit the UK and interest rates climbed: 1988 (12.875%), 1989 (14.875%), 1990 (13.875%) and 1991 (10.375%). There appeared to be little serious attempt to maintain lending to allow businesses to ride out temporary financial difficulties, although lending to businesses did fall by 5.5 per cent between 1990 and 1992, according to Bank of England figures. Further evidence indicates that Company liquidations rose by 154 per cent from their mid-cycle trough in 1988 to their 1992 peak (PwC 2010). There is also evidence (Keasey & Watson 1992, 1995) that, prior to this relatively abrupt withdrawal of credit, there were signs of impending problems for various SMEs. The insistence 40

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by banks of using security (usually property) to assess risk, ignored other relevant variables such as profitability, investment, and directors’ fees. Banks were exposed to risks in the event of an economic downturn and a consequential sharp decline in property values. Average SME profitability was high over the six-year period up to 1991. However, directors’ fees, i.e. earnings withdrawn from the business and not available to creditors’ claims, represented around 70 per cent of total operating profits. A closer relationship between banks and small businesses might have enabled a better assessment of the risk profiles of individual firms. As far as large businesses and corporations were concerned the lifting of restrictions on bank lending in 1971 did lead to increased lending, not only to manufacturing companies, but also to companies in the emerging service sectors of the economy. But areas such as property investment, domestic and commercial, also increased in the 1970s and the 1980s, in common with elsewhere in Europe and the United States. One benefit from the increased recourse by the major banks to the inter-bank wholesale market for liquidity, in lieu of the of reduced deposits, was that for the larger companies fixed, medium-term lending replaced rolling overdraft funding; a change not extended to SMEs. However, the highly variable macroeconomic situation in the UK during the 1970s, culminating in the recessions of 1979–81 and in 1989–93, meant greater exposure to liquidations and an increase in bad debts. Banks’ loss provisions rose as a proportion of assets. Large corporate customers’ cash flow and balance sheet problems in that period were covered by banks providing short-term support, at a cost. They refrained from any involvement in the management of companies. However, they did advise bringing in management consultants, a boon for the larger consultancy companies such as McKinsey and Price Waterhouse. From time to time this disavowal of involvement was breached in relation to high-profile corporate restructuring. For instance, Barclays replaced the board of the manufacturer Dunlop in 1984. But these cases merely reinforced a greater centralization of decision-making by the banks. For instance, Midland in 1974, took away from branches all corporate lending decisions. In the period 1970 to 1995, deregulation and a more competitive market-orientated system emerged, with the development of a variety of financial services and providers. The aim of the 1971 Competition and Credit Control measure of the Bank of England was to free the major banks from restrictions on lending; aiming to provide room for them to support industrial growth. As with previous and subsequent expectations this support did not materialize, at least not for SMEs. The property booms of the early 1970s, led to secondary financial institutions – operating as banks, and securing deposits in the developing, and unregulated, 41

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wholesale money market – becoming heavily engaged in the domestic and office property market. The subsequent property crash in 1973 led to a number of these insufficiently regulated institutions being either on the point of collapse or in liquidation, for example, the London and County Securities bank. These developments and the increasing exposure to the international financial system and the impacts of global economic trends created a less stable financial environment in the UK, both in internal and external financial markets. A “lifeboat” fund for threatened institutions was launched by the Bank of England in 1973, and financially supported by the main clearing banks, in an attempt to stem the financial crisis, which, although not initially, threatened to spread to some of the major clearing banks. The initiative was successful – at its peak support of shared risk reached just short of £1.2 billion falling by 1978 to just over half that figure. The experience of these events initiated substantial improvements in the Bank of England supervisory arrangements. Domestically, the Bank extended the scope and intensity of their supervisory arrangements. Internationally, comparable advances were made in various countries, and machinery for close international cooperation between supervisory agencies was established and put into operation. Legislation in 1979 relating to deposit-taking institutions, brought all such institutions under the control of a single agency, with specific arrangements designed to provide a substantial degree of protection to the smaller depositors. The 1979 Banking Act, for the first time, defined banking in the UK and provided insurance for depositors. The Bank of England remained responsible for the capital adequacy of financial institutions, a role that was formalized at an international level with the Basel Accord of 1987/88. Subsequent legislation, via the Financial Services Act of 1986, protected investors and depositors. Under this Act the Securities and Investment Board (SIB) was established as the regulatory authority for investment business. Banking supervision and investment services regulation were eventually merged later in 1997 and the SIB formally changed its name to the Financial Services Authority (FSA). The FSA took over the traditional regulation of banks and other financial institutions from the Bank of England, as it has continued to do, currently as the FCA. The 1980s and 1990s witnessed a significant movement away from banking self‐regulation towards supervision by outside regulatory institutions. However, a further demonstration of the risks inherent in the new, less regulated financial market structure arose with the collapse in 1991 of the Bank of Credit and Commerce International (BCCI). Clearing banks had to cover the losses of depositors in BCCI through an insurance fund. The period from 1970 to 1995 witnessed a set of changes which opened the UK financial market and its banking sector to competition, domestically and internationally, but also inaugurated a stronger, independent regulatory environment. 42

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A reasonable balance appeared to have been struck, although little of the tortuous history of the events of the period provided any significant improvement in the support provided to SMEs. Moreover, during the next 25 years, the balance between financial market innovative freedom, domestically and internationally, and prudent regulation was to be tested, almost to destruction. Post-1995 The years before the end of the century, some prior to 1995, presented new domestic and international opportunities for growth and profitability in financial markets. However, in the early 1990s macroeconomic problems afflicted the UK. Rising inflation and a deteriorating balance of payment position had persuaded the Conservative government to become a member of the EU exchange rate mechanism (ERM) in 1990. A failed attempt to stay within the permitted range of sterling’s valuation prompted massive hikes in interest rates, briefly to 15 per cent, and the inevitable, summary depreciation of the currency occurred on “Black Wednesday” (16 September 1992). Monetary policy then reverted to inflation targeting. A modest recovery ensued, assisted by an increasingly stable global economic situation, although not without banking panics (see below). A Labour government took over in 1997 and promptly conferred independence from the government on to the Bank of England. This transfer was in line with a prevailing view among macroeconomists at the time that too many political factors entered governments’ decisions on monetary policy and interest movements. Reference to the European Union context, in which the UK’s industrial and export performance was compared unfavourably with that of Germany, might have afforded some reflection in the UK as to the reasons why? This would have been apposite in that the UK-driven initiative in the EU from 1992 of the establishment of the “Single Market”, within which the many non-tariff barriers to internal EU trade, based on differing regulations in each of the EU countries, would be progressively eliminated. Their elimination would provide an additional challenge to the under-invested British SMEs compared to their, especially German, competitors in other EU countries. No such awakening of interest in the problem of investment funding of SMEs manifested itself. In the banking sector itself further consolidation took place with NatWest (National Westminster) acquired by the Royal Bank of Scotland in 2000, and in 2001 Halifax (the former building society) and the Bank of Scotland merged to form HBOS. At the start of the twenty‐first century the largest UK retail banks (by assets) were HSBC, Royal Bank of Scotland, HBOS, Barclays, and Lloyds TSB Group. This new “Big Five” dominated the current account market with 43

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over two‐thirds of the UK’s 71 million personal accounts in 2003 and over half of all credit cards and personal loans. In this period the British banking sector was entering a time of innovative international financial market growth, accompanied by stable global economic growth and lowered inflation. The so-called “Great Moderation”, had been identified by some economists, suggesting an end to “boom and bust” economic cycles. It was purported to have started in 1987 in the United States, but perhaps later elsewhere, and continued to 2007/8. Paradoxically, even during the “Great Moderation”, a variety of banking crises occurred: the stock market crash of 1987; the Asian financial crisis in 1997; the collapse of hedge fund Long-Term Capital Management in 1998, and the dot-com crash in 2000. However, these events did not appear to have significant impacts on macroeconomic growth, particularly in the US, with wider global economy benefits. Whether or not one accepts the idea of the “Great Moderation”, statistical analysis (Gadea et al. 2015) seems to suggest that it was characterized in macroeconomic terms mainly by the upturns being limited in terms of peaks, i.e. the norm is modest growth and low investment – from the perspective of the thesis of this book its relevance is related to its impacts on financial markets and the response of the UK banking sector. Also relevant is the response of the Labour governments during the 13 years from 1997 to 2010. This period witnessed a relaxed attitude to regulation of the financial market sector, including banks; the phrase used at the time was “light touch regulation”. Banking, not only in the UK, but in other countries, such as the US, suffered increases in loss provisions on non-performing loans to large companies, and reductions in banks’ overall profitability, measured as the net interest ratio (i.e. interest income minus interest expenses, divided by total assets). However, it was clear that other non-bank financial organizations, particularly those in the unregulated sector known as “shadow banking”, were returning substantial profits. It was inevitable that banks, particularly those having investment banks within their groups, faced with declining profitability, should start looking at the opportunities to enter the securitized derivatives markets, including the non-regulated, over-the-counter (OTC) market. The banking sector’s move to seek this financial market activity to restore and to grow profitability began in the United States. By 1994 US banks held derivatives4 contracts amounting to more than $16 trillion in notional value. The profitability of derivatives activities had clearly encouraged banks to step up their involvement: in 1994, derivatives accounted for between 15 per cent and 65 per cent of the total trading income of four of the largest bank dealers in the US. Gradually British banks became involved. From 1995, until the Global Financial Crisis (GFC) in 2008, the search for overall market growth and profitability, via aggressive and unregulated profit-seeking in derivatives markets, 44

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accelerated. This occurred via derivatives trading in the banks’ investment arms, and via growth by acquisition internationally. The policy came to be typified by the activity of the Royal Bank of Scotland – run by a “driven” accountant, Fred Goodwin, whose final attempted acquisition of ABN AMRO brought down RBS as a private bank. The major clearing banks’ foray into the global financial market minefield in search of higher retail profit was a key contributory factor leading to the GFC, and its impact on the UK. Not all the British major clearing banks followed this route, Lloyds with a far smaller investment banking arm, avoided most of the pitfalls. Ironically, given the severity of the bank collapses in 2008 and the aftermath, concern about the growing participation of banks in derivatives markets was already signalled in the early 1990s. This is exemplified by the prophetic remarks made by Henry Gonzalez, Chairman of the Banking Committee of the House of Representatives on 18 June 1993: I have long believed that growing bank involvement in derivative products is, as I say and repeat, like a tinderbox waiting to explode. In the case of many market innovations, regulation lags behind until the crisis comes, as it has happened in our case with S&Ls and banks … We must work to avoid a crisis related to derivative products before, once again … the taxpayer is left holding the bag. (Congressional Record, 13393, House of Representatives) In June 2010 in the aftermath of the GFC, the Independent Banking Com­ mission, better known as the Vickers Commission, was set up and reported in September 2011. The Commission’s report provides a valuable survey of the 10year period between 2000 and 2010 and the development of the size, structure, and operation of the British banking sector during that time, encompassing the GFC. The Commission’s remit also covered issues of competition and the supply of finance to businesses, including SME financing. One initial, and startling, fact emerging from the report was that by 2008 the UK banking sector by turnover had grown to be five times larger than the UK economy. This potential over-reliance of the UK economy on the financial services sector might not be considered troublesome were it not for its distorting influence on the UK economy. In practice, it has led to the virtual neglect of the banking sector’s key role in financing an important segment of the UK economy, namely SMEs in UK manufacturing and services. The report noted that “the financial system has three broad functions: to facilitate payments; to intermediate funds between savers and borrowers; and to help manage financial risks. Banks are central to all three functions” (ICB Final Report, Annex 3.7: 270). In this book it is being suggested that there is a serial deficiency in the intermediation function with respect to SMEs. 45

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The Vickers Report also pointed out the banking services to SMEs show the highest level of concentration among the major clearing banks. Some “96% of SMEs with a BCA (business current account) obtain it from their main bank and there is little multi-banking among SMEs”. Other products, the report found, were similarly concentrated across the major clearing banks, these included corporate credit cards, deposit accounts, business loans, and commercial mortgages. At least 80 per cent of SMEs that used the products obtained them from their main bank. The report quoted a 2010 Office of Fair Trading (OFT) report which found that new entrants into retail banking faced “significant challenges in attracting customers”, including particularly SMEs, given the desire for an extensive branch network, strong brand loyalty, and an aversion to “switching”. According to the OFT survey: For 27% of SMEs, one of the main reasons for choosing a bank was that its branch location was closest to their business. Around 35% of SMEs said that already holding a personal current account with that bank was one of the main reasons for choosing it as their business bank, showing that banks without a presence in personal banking face an additional barrier in attracting SME customers. (OFT 2010: 202) In a response to criticisms of support for SMEs in the Interim Report of the IBC, Lloyds Bank Group quoted a Charterhouse Research UK Business Banking Survey of 2010. The report was based on more than 16,000 interviews with businesses conducted between January and December 2010, covering businesses with turnover up to £1 billion, and reported that “51% of SMEs rated their main bank as excellent or very good for the previous year, and 77% rated their main bank as good, very good or excellent”. The Vickers Commission was unimpressed. Moreover, it should be borne in mind that such satisfaction surveys only cover the limited services provided, and cannot ask whether services not provided, for example, access to long-term loans, might have been required. The research literature on the subject of competition in retail banking tends to be based on either traditional microeconomic reasoning, or on a variety of abstruse models and statistical analyses which can be challenged. An exception to this general rule is the Netherlands Bureau for Economic Policy Analysis (CPB) report on “Tight Oligopolies” (Cannoy & Onderstal 2003). This report deals with various so-called tight oligopolies, including retail banking (in the Netherlands), via a discursive, policy-oriented approach. Although the Netherlands is small compared to the UK, the retail banking sector is proportionately similar in structure to the UK sector and has banks with a global profile. The five main banks in the Netherlands have an estimated market share of 93 per cent for payment services and high percentages for other market segments. The report 46

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indicates that on a static efficiency measure the Dutch banks’ behaviour suggests prices are above competitive levels, and in dynamic terms differentiated financial innovations are scarce. However, the report’s conclusions also suggest that intervention to remedy the market failure by adding more “challenger” banks will not necessarily improve the situation. There is no evidence, for instance, that the competition from European entrants into the retail banking sector in the UK has improved the position for SMEs, nor is there evidence of any differences in lending practices (Berry et al. 2004). The Dutch report suggests that longer-term dynamic changes affecting the financial market may offer a better way forward, including consideration of both institutional and technological trends. The continuing evolution of internet banking is a clear example of the latter, but, as is indicated below when considering smaller challenger banks, there are still potential problems. The Dutch authors also argue that the UK regulatory model provides a good mechanism for an on-going pressure for improvement in banking performance. However, regulatory action alone does not seem capable of resolving the long-standing problems of the relative absence of investment loans for UK SMEs. Neither does increased competition, favoured by the Vickers Commission, seem to be working in this regard. Competition is a means to an end, not the end itself. Its benefit lies in the potential for emulation across the sector of a successful initial innovation. There are in the UK a good number of banks, large and small, already existing. The relatively recent entry and expansion of sizeable foreign banks into the UK (e.g. Santander, ING and Handelsbanken) offers proof of competition being possible, despite high entry costs, in terms of the establishment of competing banks. However, it is not clear that new or more competition is likely, of itself, to remedy the long-identified SME funding problem. Before discussing the advent of smaller challenger banks, it is worth mentioning the relatively recent establishment of the sixth largest UK bank, trading as Virgin Money UK Limited. Despite its ranking it is far smaller than any of the five major clearing banks. Notwithstanding the brand name, the bank was formed in 2018 via a takeover of Virgin Money Bank (itself created by an acquisition of the former Northern Rock Bank) by the Clydesdale and Yorkshire Bank Group (itself formed from an earlier merger of the Clydesdale Bank and Yorkshire Bank, which both have their roots in the mid-nineteenth century). The new bank has an SME portfolio and, in the past, claims to have been more flexible in its treatment of SME demands for finance, with 90 per cent of its SME lending focused on the UK regions outside of London. The establishment of smaller UK-based challenger banks – given the 2014 change5 in the amount of capital required and the regulatory procedures to set up a bank in the UK – has seen a large number of such banks set up around the 47

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UK, and particularly in London. In 2017, there were more than 35 such banks in existence or in the process of being set up; the current number is over 50. It is estimated that up to 20 more are awaiting regulatory approval. The regulatory process to set up a new bank is complex and can take up to four years to be finalized. In addition, there are the substantial capital sums to be provided during the process, initially £5 million and later £21 million, to establish the credibility and security of the bank. Two of the better known of these challenger banks are Metro Bank and Atom Bank. A number of these “newcomers” were only offering personal retail accounts, but some, Atom Bank being one, were formed with the intention of attracting business customers and providing a tailored service to these clients, including potentially the provision of business loans. In the event two serious problems manifested themselves. First, the amount of capital required to back up a business loan was effectively assessed by these smaller banks as being two to three times that required for a domestic housing mortgage. Faced with this choice the bank will clearly choose the latter. The Vickers Report looked at this issue of assessing the capital required to match the risk-weighted capital involved for a business loan and concluded that, Small and new banks typically use the standardized approach to riskweighting, which can produce higher risk weightings than the advanced methods used by large banks. New banks do not have the back history of data nor the experience of managing their assets required for the transition to the advanced approaches. And small banks tend not to have the scale to justify the investment in the transition to the advanced approaches. It is also the case that the regulator will not allow these new banks to conduct their own independent assessment of risk-weighting, and, for several years, have been restricted to using the standard assessment model. The second problem facing the challenger banks arose out of the necessity today of providing internet banking. The retail IT systems available are designed for personal account customers. Whereas the internet software requirements for business customers are quite different; in banking jargon the “customer journeys” vary. Investing in two different sets of software is expensive. A further problem arises with collateral. Business assets have no real value outside the business use involved. This may be less of a problem with standard commercial property, but in manufacturing it can be a major barrier. For these reasons, the majority of the existing challenger banks, to date, have “defaulted” to operating with personal retail customers only, although there are on-going attempts to try to establish challenger banks which will serve solely business customers, or at 48

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least that will be their primary focus. The problems of and opportunities presented by the challenger banks will be discussed in more detail in Chapter 4.. A recent discussion of the problem of how to provide investment finance to SMEs in the UK was contained in a Treasury Select Committee, produced in 2018. The committee took evidence from a variety of sources, but its conclusions, which will be analysed in more detail in Chapters 3 and 4, did not appear to offer much comfort to SMEs. Conclusion It appears that the British banking system, whatever may be its strengths in delivering banking services to its personal retail customers, seems never to have adequately developed its business banking services to SMEs. This neglect manifests itself in the virtual absence of the provision of long-term investment finance which its small and medium-sized business customers require. In turn this deprives the UK economy of the type of dynamic SME manufacturing sector which exists for example in Germany. Perhaps the most puzzling period is the period from 1900 to 1939 when the overall strong liquidity position of the banks permitted financial intermediation to be discharged by “borrowing short and lending long”, resulting in lending to large companies. This period would have provided an opportunity for the major clearing banks also to support SMEs with longer-term loan finance. There was, after all, little competition for the major banks from other financial institutions, both during the pre-First World War period and during the postwar period. Unfortunately, over the same time period, demand for loans from small businesses was constrained by the economic problems of the 1920s and the depression of the 1930s. Combined with the predilection of British SMEs, noted in the nineteenth century, to wish to avoid entanglement with banks in relation to long-term relationships this economic context may offer some explanation. Notwithstanding this suggestion, the concerns, raised in the Macmillan Report in 1931, had highlighted the lack of a close relationship between banks and industry in the UK, particularly SMEs, which was an issue recognized as needing to be addressed. During the 1945–70 period, despite the constraints placed on banks during the immediate postwar reconstruction phase, the liquidity of the major clearing banks remained substantial because of the non-payment of interest on current accounts. This being the case then the dictum of borrowing short and lending long could have been applied by furnishing SMEs with long-term loans rather than short-term overdraft facilities. In this manner the UK banks could have supported a key element of postwar reindustrialization. 49

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In the 1960s and into the 1970s, strong competition from building societies, paying interest on their customers’ deposits, led to a consequential halving of bank deposits as a share of GDP by 1973. Nonetheless, from the 1970s, other ample means of accessing significant liquidity, via the wholesale interbank market, developed, and could still have led to investment loan provision to SMEs. From 1970 to 1995 the banking sector entered this new era, freed in 1971 from government constraints. Utilizing the developing interbank money market to provide liquidity, in practice, the banks concentrated solely on matching directly their building society and savings bank rivals. This refocusing led to the development of a variety of mortgage products for the burgeoning housing market; introducing a reward culture for managers to sell endowment and other insurance products; and, finally, if all else failed, then banks took over their rivals in these consumer markets. This innovation in personal retail banking markets by the major clearing banks was not emulated in the business banking market, at least not for SME funding. Searching for higher profitability via product innovation in an expanding retail consumer banking market was the primary objective of the major clearing banks in the UK. The notion that banks have an economic purpose beyond simply making money – and that their raison d’etre, at least in part, should be to provide investment support for British business, including SMEs – did not appear to be part of the discussion in the boardrooms of the banks. However, one aspect of this focus on profit-seeking was subsequently to prove to be a substantial longer-term problem for their profitability, namely the PPI scandal. The widespread selling of Payment Protection Insurance to customers when taking out personal loans or other consumer products (e.g. endowment insurance products) emerged in the 1980s. In a vast number of cases customers were not advised that they may not actually need PPI. Banks have, over recent years, had to compensate millions of customers for the mis-selling of PPI. The problem was only “put to bed” in late 2019. Another existential problem for UK banks, from 2000, resulted from their forays into global securities markets, in search of higher profitability. In the GFC, a number of UK banks, who had retained the collapsing value of securities products on their balance sheets found themselves insolvent and requiring substantial and costly bail-outs from public funds. Following these self-inflicted injuries, from 1995 to the present day in 2020, it is perhaps not surprising that once again the provision of SME long-term funding has continued to be neglected. In manufacturing certainly, with its need for fixed capital investment, the reluctance of the major clearing banks to support SMEs with investment finance has weakened this sector of the economy. Comparisons with the strong, long-term role of German manufacturing SMEs in facilitating export success is an indication of this lacuna. 50

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The relaxation of capital requirements in 2011, leading to the establishment of new “challenger” banks, might have been hoped to fill the long-standing gap in the funding of SMEs. Earlier challenger banks had come from overseas, for example the Spanish major bank Santander, which took over the Alliance & Leicester Building Society, and the Belgian bank ING. But these large banking groups, with the notable exception of the decentralized Handelsbanken that had arrived from Sweden in 2003, entered the existing oligopolistic, centralized structure of British banking and followed the same lending practices. The later advent of the smaller challenger banks promised change, but whatever their initial prospectuses, most have defaulted to becoming retail banks serving only personal customers. Their small size and resource limitations is a disincentive to being able to overcome the barriers placed in their way. Nonetheless, there are some signs that a new low-cost technology solutions and brokerage may be emerging to enable their business banking to take off. In the meantime, until the Global Financial Crisis in 2008, the large banks’ search for retail market growth and profitability accelerated, via aggressive and unregulated profit-seeking in the securities market and growth by acquisition. Perhaps inevitably, the major clearing banks’ foray into the global financial market minefield in search of higher retail profit became a key factor leading to the GFC. The various economic and financial dislocations associated with the GFC, despite UK government and international action to ameliorate the situation, created further problems for large numbers of SMEs. The tightening of regulation, especially with regard to the amount of equity capital to be held by the banks, after 2008, contrasting with the lax regulation prior to the GFC, reduced the willingness of banks even to provide overdraft funding for distressed SMEs during the first part of the following decade. The development of British banking culture during the nineteenth century, the twentieth century, and the twenty-first century thus far, has demonstrated a continuing “parallel development” of the banking sector to that of the wider business fraternity, especially the SME manufacturing sector. Indeed, banks in their desire to become profitable businesses have neglected what may be viewed as their key national economic role; namely their intermediation role to provide adequate investment finance for industrial and commercial enterprises. The linkage and integration between the banking sector and business evident in other countries has simply not developed in the UK. The reasons behind this apparent unique lack of integration will be explored in the remaining chapters, together with potential developments and remedies. The next chapter examines one factor beyond the remit of banks: the seeming reluctance on the part of British business, and specifically SMEs, to seek a close relationship with banks.

51

3

FROM THE OTHER SIDE: THE CULTURE OF BRITISH SMEs

British banks, so far, have failed SMEs by not providing essential long-term finance. However, the relationship is two-way and SMEs’ behaviour is also worthy of examination. The discussion in this chapter seeks to establish whether factors emanating from the culture, perspective, and business behaviour of British SMEs may themselves make a significant contribution to explaining the lack of long-term investment funding. This chapter will attempt, therefore, to determine how far the culture of British SMEs may, in part, explain the alleged failure of British banking to provide long-term investment for SMEs in the UK over the past almost 90 years, since the Macmillan Committee Report. It will be useful to compare the British SME sector with the German SME sector, and how the success of the Mittelstand in Germany appears to have been based on their ready access to, and involvement with, the German banking system. Although there are some similarities between the UK and the United States, such as both countries subscribe to a political economy which may be described as a form of liberal market economy with a strong emphasis on competitive markets, there, however, the similarity ends. The UK does not subscribe to what has been previously termed, in connection with the period of rapid industrialization in the US, the Schumpeterian notion of “creative destruction”, and the acceptance of potentially short-lived firm survival. The British SME sector Before proceeding it will be worth recalling, briefly, the cultural attitudes of UK SMEs to seeking finance in the early years of the industrial revolution. The entrepreneurs’ requirement then was for short-term risk capital. Their intentions were to test new technologies, processes as well as products, to see whether and how they would work, usually in a small workshop setting. For this activity they did not need long-lived, fixed capital, and could manage with working

53

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capital. The early entrepreneurs were able to source risk capital from personal and family sources or from friendly merchants and landowners, in an age that was becoming interested in science and technology. It is possible that this habit of not looking for outside bank financing became ingrained and transferred as a cultural norm into the subsequent era of “industrialization”, which required investment in fixed capital and a longer-term corporate perspective among owners and managers. Indeed, this cultural preference to avoid seeking longerterm bank finance, reinforced by a desire to maintain ownership and control by owners of companies, may have slowed the UK’s industrialization phase of the industrial revolution, compared with Germany and the US, in the second half of the nineteenth century. According to the Department for Business, Innovation & Skills (BIS), in 2019, there were 5.82 million SMEs (0–249 employees) in the UK, representing 99.9 per cent of all UK businesses: it is worth noting that 4.49 million of the total were accounted for by sole traders and partnerships with no employees. By contrast, there were 1.33 million small companies (0–49 employees); 36,000 medium-sized companies (50–249 employees), and only 7,700 large businesses. The SME total comprised 16.6 million employees (60 per cent of total UK employment), with an estimated turnover of £2.2 trillion (52 per cent of total UK business turnover). Of the UK total turnover of £4.58 trillion, 36.8 per cent (£1.5 trillion) was accounted for by small SMEs (0–49 employees), 15.4 per cent (£0.6 trillion) by medium-sized companies (50–249 employees), and 1 per cent (£0.046 trillion) by non-employing sole traders and partnerships. This last group has been the one whose population has been growing fastest since 2000, at +89 per cent, and having contributed 88 per cent of the total SME population growth over the same period. In terms of the spread of sector representation of SMEs, the 2019 BIS figures indicated that: • • • •

18 per cent of SMEs were in the construction industry; 14 per cent of SMEs were in professional, scientific, and technical services; 9 per cent of SMEs were in wholesale, retail, and auto-repair services; 7 per cent of SMEs were in information and communication services.

In terms of SME turnover in 2019, almost a third was spread across three sectors: construction (12%), professional, scientific, and technical services (10%), and manufacturing (9%). As a percentage of total SME employment and turnover, manufacturing accounted for 9 per cent in each case. The business and economic performance of British SMEs has been of concern for many decades and has merited much attention from governments, think tanks, and academics. The first report to identify the lack of integration between the banking sector and business and the funding gap for SMEs was, as we’ve 54

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seen, in 1931 with the Macmillan Committee Report. The first comprehensive UK government report on SMEs themselves was the Bolton Committee in 1970. This report was followed by the Wilson Report in 1980 and the Young Report in 2015. None of the reports appear to have brought about much improvement in the position of SMEs regarding investment funding, although there has, since Bolton, been an explosion of academic interest in issues surrounding SMEs. The main themes in the research have related to the role of entrepreneurship, financial management (and its weakness in SMEs), and the lack of access to funding. One area where less empirical research has been conducted, and where evidence is more often anecdotal, points to UK SMEs tending to be more shortterm profit orientated, with a more limited concept of a “social purpose”, than, for example, German SMEs. The SME “social network business model” established in Germany, with interlocking directorships and shareholdings, is not evident in the UK. Overall, the short-term ethos and outlook of UK SME owners and shareholders, appears both to reflect, and to be reinforced by, the lack of tax incentives for retained earnings and the limited access to long-term external investment funds. A situation that is shown to be reflected in low levels of investment in innovation, staff training, productivity, and in long-term growth (Jindrichovska 2013; Mazzarol 2014). The combinations of the greater ease (and lower cost) of setting up companies in the UK compared to other EU countries, and poor financial practice and knowledge, may make for more vulnerable UK-based SMEs. Inadequate financial management is reflected in the many reported difficulties in completing the paperwork required by UK banks when applying for loans. The tendency is for many businesses to resort to overdrafts or credit cards not only to fund their working capital needs, but to use these sources to finance investment. Given this, it is perhaps not surprising that there are higher levels of SME insolvency in the UK than Germany: 1 in 249 SME compared to 1 in 168 in Germany, in 2018.1 The following figures from the Enterprise Research Centre (Aston University) 2018 report confirm the high launch figures for new SMEs, but also indicate a somewhat stagnant position in relation to growth and investment. .

In terms of early-stage enterprise, data from the Global Entrepreneur­ ship Monitor (GEM) indicated that in 2017 (the most recent data available) the proportion of the adult population in the UK engaged in early-stage enterprise (the GEM Total Early-Stage Entrepreneurial Activity or TEA rate) was 8.7 per cent. This was markedly higher than the long-run rate of around 6 per cent observed before 2010, notably higher than France or Germany, but lower than the US. SMEs’ willingness to invest has also softened. In 2017, the LSBS – Longitudinal 55

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Business Structure Database (itself based on VAT and PAYE data) – suggests that 49 per cent of SME employers had arranged or funded training in the previous year. This was a fall of 6 percentage points on 2016 and the lowest level since 2010.  […]   The LSBS also suggests some underlying concerns, however, about future levels of ambition and SMEs’ willingness to borrow and invest for future growth. In the 2017 survey, 62 per cent of SME employers indicated that they planned to grow the turnover of their business over the next three years, the lowest figure since the survey began in 2007/8. At the same time SME’s willingness to seek external finance has also fallen consistently since 2010. How far these apparent weaknesses may be used as an explanation of the inadequate supply of long-term investment loans is, however, the subject of our discussion. Lifecycle characteristics It needs to be appreciated that the requirements for finance for SMEs, whether by the SMEs themselves or by potential investors, will vary throughout the lifetime of the SME. That lifecycle will also be related to the type of SME and its size. Most common, and supported by most research on SMEs, is the importance of managing working capital at all stages of the lifecycle. Start-up and early-life firms typically lack working capital and cash flow may be meagre, and highgrowth firms also tend to “consume” working capital at a high rate. However, there is not a linear curve in terms of demand for cash or investment finance. Growth in any individual firm is not only non-linear, but also episodic. The lifecycle issue, and other related issues, were considered in an OECD report in 2015. The report suggested that the inherent characteristics of SMEs explain the relatively small absolute number of SMEs who seek capital market financing. Moreover, it also points out that it will be principally during the more mature phases of SME lifecycles when they may attempt to access capital market sources of funds. The report argued for recognizing the important role of typical SME lifecycles in assessing the potential for capital market finance. Certainly at the outset of their establishment, the vast majority of small firms are highly unlikely to be able or willing to require such access, and are highly likely instead to be reliant on owners’ capital, and some form of bank lending, overdraft or possibly a credit card. However, in the UK the business culture, aside from early SME development funded by owners’ capital, tends to create a focus on rapid revenue and profits 56

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growth. In some companies, this approach may be targeted on being boughtout by a larger company, for example, micro-breweries being acquired by large brewing interests. Although a quintessential short-term approach its “evolutionary” potential for the SMEs involved should not be ignored. The “survival rate” for SMEs after 5 years, for whatever reason, is, on average, around 50 per cent. Hence, a substantial proportion of SMEs may never reach the position of requiring long-term finance. Of course, it may be that the survival rate would be higher if long-term loan finance from banks was available, together with a closer working relationship with the banks. One recent attempt made to quantify the nature of the behaviour and performance of UK SMEs was by merchant banking group Close Brothers. The range of statistics deployed in their 2016 report Banking on Growth: Closing the SME Funding Gap was insightful, including their focus on lifecycle and size of SMEs. As already suggested SMEs are likely to use differing forms of finance to grow their business at different stages of their lifecycle. The report’s findings illustrate these variations along the lifecycle of a hypothetical SME from micro-business (less than 10 employees) to a medium-sized business employing 100 to 249 people. The typical micro-business will be likely to fund its growth by a combination of 25 per cent personal savings, 23 per cent overdraft, 25 per cent short-term bank loan, with the balance likely to be funded from credit card and/or profit. The typical medium-sized business will be likely to fund its growth by a combination of 13 per cent personal savings, 30 per cent overdraft, 51 per cent shortterm structured bank loans, with the balance of 6 per cent likely to be funded by profit, credit card or trade credit (Close Brothers 2016). Figures from 2017 from Ernst & Young (2018), however, indicate that 44 per cent of all SMEs used credit cards and 39 per cent used overdrafts, with only 23 per cent using structured-term loans2 or mortgages. The continued use of overdrafts and credit cards to fund cash flow and growth is concerning in relation to the typical larger company, given the insecure nature of overdrafts or the basis of structured-term loans on receivables. The continued use of personal savings at this size of business development is another concerning feature as it represents a continuation of a pattern of behaviour from the start-up phase. The widespread use of personal credit cards (of the 44 per cent who have used a credit card, 19 per cent use credit cards regularly), already indicated as a feature of UK SMEs, is a further concern, notwithstanding that the British Business Bank’s Small Business Finance Markets (2019/20) report indicates that 80 per cent of the credit card debit balance is cleared each month. It seems clear that most SMEs suffer from regular cash flow needs, that are not being met from business revenue. Perhaps even more worrying is the lack of confidence of the typical larger SME about being able to access additional finance for development: when business revenues reach over £5 million some 90 per cent of SMEs lose confidence in 57

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their being able to recruit the necessary additional funding. Partly this problem may be linked to the lack of long-term financial planning and strategic business planning. The Close Brothers research suggested that only 28 per cent of SMEs plan their financial requirements more than one year ahead; only 64 per cent plan up to one year in advance; with 8 per cent not planning at all. Their report indicates that: Micro businesses are planning further ahead than small SMEs; small SMEs’ average planning period is just seven weeks to six months compared to micro businesses.   Only one in nine SMEs look beyond the next year and a half. Planning far enough ahead in advance is vital for SMEs, in order to build financial plans which should include investment in new equipment, staff and training and any other elements which support long-term growth.   The planning timeframe does not vary significantly by sector of operation. SMEs across all industries tend to plan at an average of seven months to a year ahead. However, when you delve further there are differences by industry; while just one in nine engineering SMEs plan only a month to six weeks ahead, the same is true of 20% of construction SMEs. It is the deep knowledge of the differences between their sectors, as well as size of company, that is valuable to SMEs and will help them to access the right financial products. The report’s confirmation of the short-termism of British SMEs indicates the measure of the cultural and behavioural change that will be required from these businesses, for them to be better able to articulate clear demands for long-term financial support from banks. The securing of this finance is essential from a UK economic perspective, both in domestic and in terms of international trade. The report notes that it is sometimes suggested that UK SMEs are not involved in trade beyond the UK. This is misleading. Half of British SMEs trade within the European Union. Of these firms 40 per cent are also involved in importing and exporting more widely, either directly or via the supply chains in which they participate. One major, and recalcitrant, problem lies in the extreme variation in the activities covered by the complete range of SMEs, even excluding sole traders. This variation, which was alluded to at the outset of this chapter, leads to considerable frustration on the part of SMEs when approaching banks. The SME may well understand the complexities of the markets it operates in, but banks do not. These complexities will cover the differing needs of its customers; how well its product range is able to accommodate these requirements, and the abilities or otherwise of its processes to deliver the products on time and within budgets. 58

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All of this information needs to be communicated to the bank in relation to its request for financial support and will be a key factor in securing finance. On occasions the director(s) of the firm may be listened to sympathetically and with understanding, but even then, the likely response may well be that all the bank can offer is an extended and increased overdraft, often with a requirement for extra security. Unfortunately, what the SME needs is a loan of 3–5 years, as well as an extended overdraft to cover the cash flow problems associated with the capital investment the firm is intending to make. Even if the bank branch manager is sympathetic to the request the level of funding required will mean a reference to the bank’s regional office, following completion of a complicated form. Nonetheless, the form, typically a generic, standardized application, is unlikely to be able to reflect the complexity of the company and its financial requirements, and does not distinguish between different types of business. This results in further delay and potential rejection once the bank’s head office applies its standard credit risk algorithm to the application. All these procedures take time and cost. What the SME wants is speed of response and transparency of costs, both fees and interest. The implication of the above scenario might seem to suggest that the fault is on the side of the bank. However, this is not necessarily, or at least not wholly, the case. For instance, the SME may well not have been in touch regularly with its bank; its investment plan may not have been satisfactorily prepared and/or presented; the costs may have been inflated to anticipate a potential investment offer, but one which may still fall short of what was required. These factors, and others, may be relevant to the possibility of the bank being able to respond positively to the request for funding, assuming that it was able and willing to do so. SMEs are not perfect, they are often under time pressures and lack the staff trained in the arts of securing finance from banks, or other financial sources. In addition, there will be the desire to avoid, if possible, any loss of control over the business in terms of regular reporting to the bank. If equity capital were to be offered as the response to a requirement for investment finance then often this too would likely be rejected by the SME, concerned about dilution of equity and control. The position of sole traders3 is rather different to the far smaller numbers of larger SMEs, running from micro-businesses up to corporate entities with perhaps almost 250 employees and a substantial turnover running into many millions of pounds. As reported above there are over 4 million sole traders in the UK. Although sole traders need finance to start up, their initial activity is typically home-based, so their working capital requirements are likely to be low. There are substantial start-up government grants and free provision of advice on accounts management and book-keeping, relations with banks, and advice on marketing. Which explains why starting a business in the UK is both possible 59

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and popular, although not necessarily to be encouraged. To receive the government support, whether direct or whether via start-up government-guaranteed loans from banks, sole traders are typically required to produce a business plan, detailed for the first year and general for two successive years. There has been a considerable growth in self-employment and sole trading in recent years in the UK, as indicated above. The government has encouraged this development, in part to avoid displaced workers from being counted as unemployed. Much of this self-employment has been in sectors such as gardening, painting and decorating, plumbing, building services, cleaning services, homehelps, hairdressing, etc. The revenues generated from these activities, some of which are in extremely competitive business areas, are not substantial, with median profits at less than £10,000 a year (Cribb et al. 2019). There may be some exceptions where certification may be required, for example, plumbing, which may attract significantly higher earnings. Our discussion in this book does not specifically cover this group of individuals who simply wish to generate enough revenue to remain as “self-employed”, rather than seek to develop their business and employ others, becoming a micro-business, and perhaps beyond. Returning, therefore, to the discussion of the wider business behaviour of British SMEs, as described above – particularly as regards financial planning and an apparent general reluctance on their part to attempt to access long-term finance and a long-term relationship with financial providers, including banks – it may be instructive to examine briefly the change in the financial environment both before and following the Global Financial Crisis. For SMEs, the changes were potentially profound. Whatever the position taken by individual SMEs in relation to seeking investment funding in the postwar period up to the financial crisis of 2008, there was a well-known banking and financial structure facing all SMEs. There had been financial market changes ushered in by the deregulation of the late 1980s, but, by and large, this had not modified the banking sector as far as SMEs were concerned. In the UK, where the five major national banks dominated and there were almost no small regional or local banks, 83 per cent of SME funding was via bank overdrafts and credit cards (Ernst & Young 2018). Hence, although the deregulation of the late 1980s had started to transform the UK financial market and its growing global integration – bringing both opportunities and dangers for financial traders – for SMEs nothing changed. In 1998 the euro was launched and the eurozone of 11 countries, although not the UK, was created. The euro was viewed as a key element in the completion of the earlier launch of the EU single market, enabling rapid price discovery across the eurozone. Academic research has suggested that SMEs have a conservative stance to seeking funding (Majuf 1984; Frank & Goyal 2003). To avoid losing sole control of a business the firm will have a hierarchy of preferences. The most preferred 60

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option for the company will be to use internal finance, either from their own resources or from family members (as in the initial phase of the British industrial revolution). The second preference will likely be debt finance and the third and least attractive option will be recourse to equity finance. This theoretical position, although valid in perceiving the desire of British SMEs to maintain control over their businesses, does not quite fit the pattern of British SME behaviour in the nineteenth century when they – unlike their European and US counterparts – viewed bank loans as more threatening in terms of control than the issuing of debentures and preference shares. Given the altered economic and financial environments since 1945, and perhaps at certain stages in the SME lifecycle for many SMEs, the seeking of bank loans may nonetheless be viewed as an appropriate route, in preference to equity finance. The emergence of new alternative sources of finance after the financial crisis, for example, crowd-funding and peer-to-peer lending, may again challenge the position taken by at least some high-growth SMEs. They may decide, as their US counterparts appear to have done, that, for various reasons, the danger of losing some measure of control, whether via a bank loan, if achievable, or capital market equity finance, is acceptable. It is the case that the contemporary funding scene is being made more complex and financial choices more difficult than before for SMEs. The variety of contemporary funding platforms and options will be explored in more detail in Chapter 4. As already noted there is evidence that the relatively benign economic conditions in the UK during the period, 2001–07/08 did see a growth in “structured-term loans” made to SMEs. These loans – effectively time-limited overdrafts, secured on receivables – are principally short-term (1–2 years), though meaningful statistics on the actual length of the loans are difficult to discover. The Global Financial Crisis was accompanied by a severe impact on major British banks, and on the overall UK financial and economic position. The impact of the GFC as far as SMEs were concerned was an immediate restriction of lending by the banks, seeking to rebuild their balance sheets and having to cope with the need to increase their holding of capital reserves against perceived high-risk business investment, including to SMEs. During the post-2008 period, several financial technological innovations and the appearance of new challenger banks altered the financial landscape faced by SMEs. The temporary “retreat” of banks from even overdraft provision in the immediate aftermath of the GFC was accompanied by the new landscape facing SMEs, which appeared to promise alternative funding opportunities for them. The key issue was whether this new scenario was going to be exploited by SMEs, themselves entrenched in a conservative mind-set. The OECD report in 2011 and EU Capital Markets Union launch suggest that reliance of bank lending has been inherently problematic for SMEs since the 61

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Global Financial Crisis. The view is predicated on the basis that the consequent imposition by regulators of higher risk capital requirements placed on banks may have permanently reduced the offer of bank funding to businesses. The argument proceeds by then suggesting that this phenomenon necessitates a much higher provision of alternative SME funding via capital market sources. The evidence from banks (see European Banking Federation Report 2018) does not support this argument. Although access to bank lending (and capital market access) did fall in the first two to three years following the GFC, bank lending to SMEs across the EU, including the UK, has subsequently recovered, with strong growth since 2012. Moreover, in Germany, the Sparkassen – despite profit pressures caused by low interest rates, and defensive mergers reducing the number of banks by 60, and branches by 3,000 – are still providing substantial support to SMEs across their nationwide network (Cassell 2020). Further evidence from the 2018 European Commission/European Central Bank Survey on the Access to Finance of Enterprises (SAFE) showed that the percentage of SMEs for which access to finance was cited as the top obstacle more than halved between 2009 (when the survey was first organized) and 2017, from 16 per cent to 7 per cent. Overall, SME access to bank lending has improved, across the EU, for the fifth consecutive year since 2012 (ECB Data 2018). However, these statistics cover the whole EU. The issue remains how British SMEs are served in relation to bank lending. Some estimate of the overall provision of financial support to British SMEs can be gained from figures for 2016 from UK Finance (2017). Its report showed that SME borrowing at the end of Q2 2016 stood at £109 billion, of which structured-term loans were £86.6 billion, overdrafts were £9.3 billion, £4.5 billion for smaller  businesses and £4.8 billion for medium-sized businesses, and facilities available, but undrawn were £13 billion. The average structured-term loan value approved for smaller businesses in the quarter  was little changed at £82,132 while the average for medium-sized businesses rose to £440,784. It should be recalled that “structured term loans” are, in practice, fixed, short-term overdrafts. This level of support for SMEs had been constant over the previous year,  with small quarterly net increases. In the second quarter, new structured-term loans, less repayments, resulted in overall net lending of £0.5 billion. How in recent years have SMEs responded to banks in relation to borrowing? Some evidence can be gleaned from the UK Treasury Select Committee’s report of October 2018 which reported on the position of SME finance in the UK and on the attitudes of SMEs to seeking finance for investment. The Committee Report picked up on the issue of lack of “trust” between SMEs and banks. The Committee and a number of those providing evidence, such as Suren Thiru of the British Chambers of Commerce (BCC) told the Committee that: “Issues around trust are feeding into what is commonly called discouraged demand. 62

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Businesses are not going for finance in the first place because there are issues around trust. Some are lingering from the financial crisis”. The Committee noted that: “At an industry-wide level, the Banking Standards Board – established to rebuild trust and promote high standards of behaviour in banking – continues to play an important role, particularly through its annual culture assessment programme” (page 6, para 12). How effective this initiative has been is not made clear. The lack of trust feeds into the perception among SMEs that applying for a bank loan would be a waste of time because they wouldlikely be turned down. Moreover, although UK Finance provide figures which show that out of 100,000 loan applications made in 2016/17 some 70,000 were granted, this figure is seriously misleading. Even these figures show a 30 per cent rejection rate which is the highest in the EU; in Germany it is typically 14 per cent. It is interesting to note that, in a 2014 Bank of England survey, reported in a British Business Research report, bank managers estimated that between 0.3–0.6 per cent of SME loans would default in the next 12 months if interest rates remained unchanged.4 The major UK banks operate in a highly centralized manner, decisions on lending have been substantially removed from local or regional branch control and, instead, decided via a “one size fits all” approach. The UK Finance figures also need to be put into the wider perspective. In 2012 it was reported that overdrafts accounted for some 90 per cent of all bank finance supplied to SME; this figure is unlikely to have altered dramatically. In its written submission to the Committee, IWOCA, a micro- and small business lender, noted: “The value of annual total lending approved for micro- and small business plunged by 38.7 per cent between 2013 and 2017, down to £7.2 billion. As part of that, the annual value of loans approved to micro- and small business dropped by a massive 40.2 per cent over the 4 years.” IWOCA argued that this is down to a reduced risk appetite amongst banks coupled with a reluctance to adequately market credit to that important segment of the SME population. These submissions to the Treasury report confirm the unsatisfactory nature of the relationship between British SMEs and British banks. Even if it is the case that a portion of the blame may lie with the unwillingness, for a variety of reasons, of the SMEs to seek bank loans for investment purposes, both sides of the relationship are at fault. What is clear is that UK SMEs and banks will remain in some form of “loose partnership”, tied together via overdrafts, credit cards, and other basic services. The issue is whether banks and SMEs, working together, can develop a deeper relationship; a “full partnership” model. Such a new model would allow, inter alia, continuous advice on sourcing investment funding. The relationship would be both reassuring for the SMEs, particularly those wishing to aim for long-term sustainable growth, and be profitable for the banks. This possibility will be addressed in future chapters. It is now time to look 63

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at the situations faced by German and US SMEs and how their positions may be compared. German and US SMEs: comparisons and contrasts German SMEs tend to operate within networks of association, with often interlocking ownership patterns; a commitment in local and regional communities to an expression of a common social purpose, and a long-term investment perspective which eschews short-term profit-seeking in favour of the maintenance of the longevity of the company. Particularly apparent is the tendency for German SMEs to retain and invest a large proportion of earnings; estimates put this as high as 90 per cent. A situation that is supported, although less so than formerly, by the tax system. In 2012, 53 per cent of German SME investment funding was generated internally. In addition, many SMEs also invested their retained earnings in other SMEs. This leads to what may be characterized as a network model of SMEs, with cross-over holdings across a range of small and medium-sized companies. The high level of earnings retention for investment purposes by German SMEs has to be understood in the context of large number of long-established, family-controlled companies (84 per cent of SMEs are family controlled), with generally a very clear understanding of finance, and very long-term views of their operations. This carries over into a prioritizing of investment in innovation, products and staff training, and distinctive views of the companies’ responsibility to their employees and to the wider local community, in which Sparkassen, play a major role. It is understood in the German SME sectors that business has a clear social purpose. The US business environment is different from that of either the UK or Germany. There is a ready acceptance in the US that a small company may not be successful, and that liquidation will occur. Nonetheless, this situation is accompanied by the view that this experience represents a learning experience, and not a “failure”. The liquidation is often followed by the setting up of a new company and the continuance of business. In the US, the focus on the long term is delivered through not one company incarnation, but two or even more. The company law strictures in the US are more lenient than in the UK and this behaviour is not only condoned, but to an extent, obviating fraudulent activity, encouraged. In rural areas, the continuing importance of agricultural production in the US does witness close, on-going, relationships between agricultural companies, including farms, and local banks. (However, there is some evidence that bank closures, bank mergers, and the availability of alternative sources of finance via internet technology platforms, is leading to a reduction in these links). It also appears to be the case that US SMEs are willing to explore new capital 64

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market sources of funding such as crowdfunding, peer-to-peer lending, and other sources of finance, often offered via technology platforms. US SMEs also appear to accept the penalties that competitive markets impose. The motivation of some owner-managers is being able to work for themselves, be independent and to be able to make personal trade-offs between work, income, and other aspects of their lives. Such SMEs – “lifestyle businesses” – have little aspiration and in some cases, for example, some small hospitality or leisure businesses, little potential to grow (Morrison, Baum & Andrew 2001). However, leaving aside the intrinsic lifestyle predisposition of this group of owner-managers, a significant factor, in the UK, is the impact of the tax system on the behaviour of owners of small businesses (see Miller et al, 2019). Ostensibly the potential impact of the system of income tax relief appears to encourage retention of earnings in the business, but the SME behaviour observed also appears to encourage tax avoidance behaviour – retaining remuneration when profits are high and taking out larger amounts when profits are low, so minimizing the tax liability – rather than using the funds for company growth. It may be, of course, as suggested by Close Bros, that retention of remuneration is necessitated by future cash flow impacts. However, if this UK SME tax-induced behaviour is widespread then this may be a partial explanation for the comparatively low growth and lower lifetime persistence of UK SMEs than their German counterparts, although there may be other cultural and institutional factors involved. This comparison is explored below and in later chapters. While there is no doubt that there are long-established and often family-run SMEs in the UK that do take a long-term view – and wish to emulate their German counterparts with respect to retention of earnings for investment and to develop close relations with their local community – the general financial environment and social culture that they face is not conducive to the successful prosecution of these objectives. The reluctance of UK SMEs to grow is confirmed by the British Business Bank Small Business Finance Markets Report, 2019/20. It reported that: While more smaller businesses are using finance than ever before, the majority remain averse to using finance to grow and develop their business over the long-term. Current use of finance was previously a key predictor of positive attitudes towards, and future use of, finance. However, the share of those using finance that would not be happy to use it to grow their business rose from 43% in 2015 to 62% in 2019. (British Business Bank 2020: 45) Against the apparent weaknesses of British SMEs, there needs to be set contrary arguments. There is evidence that UK SMEs are twice as profitable as their 65

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German counterparts and may be more efficient in their use of capital and labour. Similarly, there are some criticisms of the German system for its less profit-oriented approach, which is seen as, potentially, bringing into question the long-term competitivity of German SMEs. Related to this position are views that the heavy dependence on internal sources of investment and the bureaucratic nature of the German local governance system may tend to inhibit innovation. Hence, some critics consider that the German SMEs should be more like those of the UK, whereas others would like to see more German elements in the UK culture and practice. There is, to an extent, an ideological element in these divergent views. What is clear is that, if the measure of comparison is the broader economic measure of contribution to the overall success of the productivity of the economy – and particularly the strong representation of SMEs in the success of exports – then UK SMEs on average, with some notable exceptions, lag well behind their German counterparts. An historical note, which perhaps exemplifies one significant difference between British and German SMEs, relates to the notion of social purpose. In the UK in the nineteenth century the advent of limited liability for companies was not motivated solely by the desire to protect the owners of capital when risking their capital in the pursuance of business. It was accepted at the time by government that businesses existed not simply to make money for their owners, but also because they had a social purpose, beyond the interests of the owners. Insofar as the business thrived then it would provide employment and income for workers. Thus, the national economy would increase in size and, via taxation, would be better able to fund necessary (and desirable) public goods. This social purpose has got somewhat lost in the perception of small business owners in the UK, and of governments, but not in Germany. As far as comparisons with US SMEs are concerned, UK SMEs are also behind their US counterparts. The willingness of US SMEs to embrace the failure of a specific company and to resuscitate the business in a new company is a characteristic far less noticeable among British SMEs. Partly this is because of the greater willingness of US SMEs to access investment finance from the newer capital market sources of crowd-funding, peer-to-peer lending, etc. Access to adequate investment finance is the key to permit SMEs to invest for long-term growth. Of course, it cannot be treated as a given that all SMEs are focused on long-term growth. This may be the case, even when adequate financial support is able to be accessed. Finance may also be imperative if the growth strategy of the company is deliberately focused on rapid short-term growth, for example, small biotech companies aiming at a future takeover by a larger pharmaceutical company. Taking account of the differing business perspectives of Germany, the UK, and the US, it is possible to suggest three stylised sets of business behaviours: 66

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1. A focus on sustained growth, whether high, medium, or low implies, in Germany, a long-term relationship with the finance partner, almost certainly a local bank; all financial needs, including long-term loans, to be provided by the local bank. 2. A focus on a high level of profit and hence available funds for owner remuneration implies, in the UK, use of short-term funding, for example, overdraft, credit card, or personal savings to cover cash flow needs; short-term loans may be required for equipment replacement, but more likely is the use of leasing or hire purchase. 3. A focus on rapid growth and medium profit implies, as in the US, recourse to capital market finance, over technology platforms and including peer-to-peer lending, crowd-funding, and private investor debt finance; the underlying aim may, in some cases be preparation for a takeover. The above is a highly stylised picture of three broad approaches which, to a degree, fit the cultural business behaviours prevalent in the three countries concerned. There will, in practice, be companies in each of the three countries which will conform to each of the three stylised financial support preferences set out above. The differences in behaviour across countries seem to confirm that, to an extent, cultural behavioural traits may persist over decades and even centuries, particularly when encouraged by the political economy of the country concerned. The comparisons and contrasts also illustrate the potential alternatives available to the average British SME. The obvious question is how likely are British SMEs to choose either of the alternative approaches to business? The British Business Bank (BBB) has attempted, via its role as a credit broker, to facilitate a shift towards greater equity capital market access to SMEs as a response to the already reported problems of securing bank finance. The BBB was set up in 2014, the initial aim of BIS being to bring a number of government financial schemes, advice services and expertise together, creating a “onestop shop” for SMEs to access. The bank was granted “state aid” clearance from the  European Commission  and the programme was subsequently transferred from BIS to British Business Bank plc on 1 November 2014. It is structured as a public limited company and is owned by the Department for Business, Energy and Industrial Strategy. However, the BBB is not run independently of the BIS/ government, unlike KfW in Germany. Since its establishment, it has worked to enable businesses to grow and build UK economic activity. According to the Bank, 93 per cent of the finance supported in the last financial year (2019/20) was working with more than 140 small alternative finance providers, totalling support for £8 billion of finance to 98,000 businesses. However, this attempt to modify SME cultural behaviour is unlikely to succeed without more radical reform. Moreover, not all SMEs will be willing, or 67

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are able, to finance themselves through equity capital markets. The Breedon Committee Report in 2012 suggested that this route could be embraced by UK SMEs, given that only 3 per cent of SMEs used this financing route, but there is no sign yet that this is likely to happen in substantial numbers. Germany seems to offer some indications that such a capital market development can occur, including potentially for medium-sized companies, via the Schuldschein system of private bond placement (see Chapter 4). It is not clear that any of these approaches, other than precisely targeted ones, will work. An example of the latter here is the support of small cap, micro-companies via the partnership approach of the Close Brothers merchant banks to provide asset-based finance. In any case all SMEs will wish to continue to use banks, irrespective as to whether they may also wish to avail themselves of specific capital market types of financing. The constraints on the willingness of SMEs in relation to seeking non-bank sources of finance will depend, critically, on their size, culture, sector, and managerial capabilities. Policy approaches, whether from BBB or elsewhere, should be focused on analysing the SME type, size, and the point reached in its lifecycle. For this tailored approach to work is likely to require a closer supportive relationship than currently exists between banks and SMEs, and probably higher charges in terms of fees and interest rates, as well as the likelihood of continuing credit rationing by the banks. Conclusion The issues raised in this chapter, in relation to the “conservative” culture of UK SMEs, are widely recognized and attempts to influence this culture are being made by a variety of public organizations and private actors, including the UK government. One thrust of the main players has been to promote the whole raft of non-bank, capital market initiatives that are potentially available to UK SMEs to fund investment. In that endeavour this promotion avenue is also supported by the European Commission, whose launch of the Capital Markets Union (CMU) in 2014 had as one of its two objectives an attempt to reduce the proportion of SME finance accounted for by bank lending. However, as it has already been pointed out, the UK was the one country where bank lending was already substantially lower than the EU average. It has been shown that for British SMEs – arising from the complex interaction between their general business behaviour and culture and the unavailability of long-term finance – there is a tendency for them to demonstrate a short-term attitude to business development and investment. For a variety of reasons – some cultural, related to a desire of owners to retain control, some professional, related to inadequate financial planning – there is a shortfall in these firms seeking appropriate long-term finance for innovation and growth. 68

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This behaviour is likely to be detrimental to the overall economic growth of the UK, given the importance of the SME sector. The key issue is whether this short-term perspective, with some of its roots in historical and continuing cultural circumstances, together with an understandable reaction to contemporary banking behaviour, can be altered in favour of a long-term growth perspective. The situation in Germany and in the US is that long-term growth is actively sought by the SMEs concerned. In these two countries, despite cultural differences and business approaches, the SMEs are willing to access the long-term financial support, either from retained earnings, from banks or from capital market sources, to innovate and to fund the long-term growth of their businesses. In the UK there will be a requirement for both British SME businesses and British business banks to alter their embedded attitudes and behaviours. The evolution of SME behaviour towards long-term growth, and the accompanying financial planning, will need to take place in parallel with the evolution of banking behaviour and the banks’ understanding of SME growth needs. This simultaneous development will be required before one may expect any major shift towards bank loan provision of long-term investment finance for British SMEs. There is thus a requirement for mutually driven systemic change. To explore further the potential resistance to systemic change which might be expected from the banks, other finance providers, and the UK government and other relevant players, such as regulators, it is time to examine what appear to be a number of embedded structural problems of the British business banking system. This is the subject of the next chapter.

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According to UK Cabinet Office figures, in 2018, there were in the region of 5.4 million small and medium-sized enterprises (SMEs) in the UK. They represent approximately 60 per cent of employment and roughly 50 per cent of total private business turnover. Their banking business is worth some £2 billion in revenue and SME business loan balances are around £90 billion. By any standards, this is a sizeable market. To date, as we have demonstrated, whatever failings there may be on the side of SMEs, the major banks have not been able or willing to develop their provision of higher value services to the sector with any real success. This as we have seen is a long-standing problem, which has its roots in historical and cultural reasons as well as financial and political economic structures. In this chapter, we will examine the current embedding of banking practices and the relationship of those practices to the oligopolistic structure of British banking, with five very large centralized banks dominating the banking sector. This analysis is a prerequisite to change, successfully, the operating nexus between SMEs and banks. The chapter will utilize the work done by the 2011 UK Independent Banking Commission (the Vickers Commission) referred to in Chapter 2, including the evidence submitted by the author himself to the Commission on behalf of the Global Policy Institute, as well as a variety of more recent work, both academic and official. The chapter will also integrate information sourced from semi-structured interviews with key organizations and potential players in the business banking market. The overall intention will be to: (1) anticipate how far the British business banking sector appears willing to provide the long-term investment finance required to raise the productivity and positive economic impact of the UK SME sector; (2) illustrate how the current UK banking structures and systemic flaws are likely to inhibit any proposed reforms; and (3) explore the alternative finance routes and banking competition which is emerging and how banks are likely to respond to this competition.

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How UK SMEs are currently viewed by major banks SMEs expect from their banks the efficient provision of basic banking services. These they will tend to define as business current accounts, payments and related processes, and overdrafts. Broadly, it could be argued that these basic services are being delivered by British banks to the relative satisfaction of their SME customers. The problem for the SMEs and for banks is that this high volume, relatively low margin, set of services has the potential to be replicated, via technology, by other non-bank providers. The more in-depth services which might hold SME customers to banks, in what is becoming an increasingly competitive environment, are not being provided. It leaves banks not able to provide a fully competitive differentiation from the other non-bank providers. However, the understandable inertia of their SME customers protects the banks’ market. As suggested in Chapter 3, SMEs are not a homogenous group, even excluding sole traders. They range considerably in scale and ambition, from fast-growth, tech start-ups to stable, medium-sized manufacturing businesses. Today, with a growing number of available technology platforms, some SMEs may start to look to other players than the major clearing banks as an alternative port of call for advice and support. But the varying demands of SMEs, as they proceed through their lifecycle, all need to be addressed. The potential advantage of banks is that it is possible for them, if they wish, to provide the support required at each stage of development. At the outset of their establishment, a considerable majority of small firms are highly unlikely to be able, or to be willing, to require access to funds supplied via technology platforms. When being established they are more likely to be reliant on owners’ capital, and some form of bank lending, usually an overdraft. At this stage of the SMEs’ journey, although its financial demands will not be substantial, is when a good working partnership with the bank can be enjoined. Later, financial requirements will increase. In a survey of SMEs seeking finance in 2016 by the Clydesdale and Yorkshire Bank Group it found that of those surveyed: “24 per cent intended to use the finance to hire new staff; 20 per cent planned to invest in new infrastructure or capital equipment; 20 per cent planned to buy or refurbish premises; 18 per cent would use new finance for working capital; 9 per cent said they would invest in Research & Development”. The survey indicates both a willingness to plan for growth and a need for investment capital on behalf of these SMEs. The next link in the chain is the provision of that finance by banks. The importance of banks in terms of this intermediation role is critical to the business strength of SMEs at all stages of their lifecycle. The problem, as the Vickers Commission observed, is that British business banking appears to have ignored this critical economic role. Where relationship banking and 72

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intermediation at local and regional levels remains an active provision for SMEs, the sector remains strong and vibrant, for example, in Germany. In the UK, where local and regional level relationship banking provision to SMEs has disappeared, many SMEs are forced to use overdraft funding and credit cards to support investment needs. Alternative finance via capital markets may become at some stage, for larger SMEs, an attractive proposition. Firms which have survived for over five years and have not been the subject of mergers and acquisitions (almost 50 per cent) are likely to be the target market for capital market provision. This does not rule out the small group of innovative small companies, particularly those in the software and biotech sectors, who may wish, and be able to, avail themselves of public equity market listings or independent public offerings. In all these cases access could be facilitated by a bank. Banks that seek to do more in this sector need to create a more detailed picture of the specific requirements of each of their SME business customers. The services and advice that a technology business just starting out requires will be different to those required by a well-established manufacturing SME. The key question for major banks is whether their current, centralized bureaucratic structures and conventional operating practices are capable of being modified sufficiently rapidly to meet the various challenges, from both competitors and customers. The current perception of the banks is certainly not one of viewing SMEs as potential “partners”. For example, SME customers are typically asked to submit to their banks a copy of their annual report and accounts. But these are generally checked, filed and lie dormant. Successive sets of accounts present a picture of the revenue generation and the gross and net profitability of a company. Alternatively, banks could provide a service to work with the company to understand better how they are performing; the potential profitability of their products and services, and their financial planning (if any). Deploying data analytics, for example, could help companies grow their businesses and would also encourage SMEs to go to their banks for investment funds with a higher degree of knowledge that the bank understands the business proposition. However, for this approach to be successful would mean developing a partnership relationship rather than the current transactional one where the bank acts, and is perceived, as a supplier of standard products and services. One major problem to be overcome, if this development option is to be exercised, is reversing how relations with SMEs have been perceived by the major banks. For the major clearing banks, it will mean substantially altering their business model. The increasing centralization of the five major clearing banks has increased the bureaucratic nature of banking operations. This bureaucratic centralization 73

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has been accompanied by a de-skilling across management structures in the banks. In relation to SMEs, branch personnel and managers have little knowledge of how the companies operate in terms of the markets they operate in, their use of production technology, and their sales and profit performance. There is no requirement for such knowledge. Essentially the only check they need to make is whether the security underpinning the SME’s overdraft facility is still satisfactory (which may simply require an estate agent valuation to be made, if as is frequently the case the security is the property of the owner). Requests for loans are typically passed on to the underwriter/credit risk analyst, who may be based at the regional or head office, with the final decision made by risk algorithm. It is perhaps worth contrasting this “model” with the approach of Handelsbanken. The Swedish bank came to the UK in 2002, and currently has 207 branches in the UK and a small number of regional offices. Around 70 per cent of its loans to SMEs are authorized at branch level. The bank has a culture of decentralization, and a belief in the empowerment of its branch managers and their teams. Its loan attitude is one of low risk and it has a bad debt ratio of 0.05 per cent. Nonetheless, it has a relatively low cost/income ratio: in 2001 this was 45 per cent compared to an industry average of 60 per cent. The major banks will argue that they also supply loans to SMEs. As we have already detailed, according the UK Finance statistics, SME borrowing facilities at the end of Q1 2017 stood at £109.7 billion, of which “structured-term loans” were £85.1 billion, overdrafts were £9.4 billion (and facilities available but undrawn were £15.2 billion). This would suggest that the banks are issuing loans to SMEs. However, as we have previously emphasized, a structured-term loan is a “non-standard” business loan, based essentially on a company’s relatively short-term cash flow performance. These “loans” are based on receivables rather than any fixed asset security, typically maturing in 1 to 2 years. High monthly payments and high interest rates make these loans expensive. In fact, structured-term loans are term-limited overdrafts, at high interest rates, based on anticipated receivables. To call them loans could be considered misleading. For the major banks, to return to “relationship banking” and local decision-making on standard loans would mean reversing years of movement in the opposite direction, plus a substantial investment in training and recruitment. The choice is for the banks to make, should they want to remain as major players in the business banking market for SMEs. However, notwithstanding the critical comments about how the major banks currently view their SME customers, there are some signs of change, as the 2018 Ernst & Young report noted: Lloyds have linked with ING’s Yolt Open Banking API for SMEs; Lloyds have also experimented with securitization via Sandown Gold; HSBC has increased their SME fund; RBS/NatWest have launched a digital SME API, Mettle, and has supported the Alternative Remedies Package of funding (see below); Barclays has 74

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taken a stake in MarketInvoice Ltd; and Santander is developing its own open digital financial services platform. It will be interesting to see how these recent initiatives – which may well seem complex and confusing to SMEs – work out going forward. One significant government initiative is the Alternative Remedies Package (ARP). To an extent forced on the UK government by the European Commission, to avoid assistance to RBS being considered as “state aid”, the ARP scheme represents a divestment of some 3 per cent of the business banking market share of the part, publicly-owned RBS/NatWest. The aim of the ARP is to encourage the banking sector to innovate in response to the need to improve banking services to SMEs. It is an unusual, one-off development, providing significant resources to a variety of banking financial intermediaries and alternative SME financial providers. A brief description is in order. The ARP is two separate elements. First, an Incentivized Switching Scheme (ISS) of £275 million (plus up to a further £75 million in waived switching costs), and second a Capability and Innovation Scheme (CIS) of £425 million. The purpose of the Incentivized Switching Scheme is to provide funding of up to a maximum total of £275 million to “eligible bodies” (essentially small banks and Fintech platforms) as incentives to encourage SME banking customers with an annual turnover of £25 million or less. The 18-month scheme ended on 25 August 2020. The purpose of the Capability and Innovation Scheme is to encourage eligible banks and other financial market participants to: (1) develop and improve their capability to compete with RBS in the provision of banking services to SMEs; and (2) develop and improve the financial products and services which are available to SMEs. The total of £425 million was divided into four allocations to: (1) develop advanced business current account offerings; (2) modernize existing business current account offerings to SMEs in the UK; (3) expand lending and payment systems to SMEs in the UK; and (4) facilitate the commercialization of financial technology relevant to SMEs. Tranches of the total amount were provided to various financial enterprises, principally challenger banks. The largest two tranches of £120 million and £100 million (just over 50 per cent of the total) went to Metro Bank and Starling Bank respectively. Smaller tranches of £10 million went to, for example, Atom Bank and IWOCA (a peer-to-peer lender). It remains to be seen whether the initiative fulfils its promise of changing banking attitudes towards SMEs and their requirements. Banking structure and service provision The oligopolistic British banking sector has five major clearing banks who provide a wide range of services to personal retail customers and a more limited set 75

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of services to business customers, especially SMEs. Following an initial active period, involving a variety of private banks, from the 1860s to the early twentieth century, the process of consolidation has been the modus operandi of the banking sector. Whenever its oligopolistic structure is threatened one of the responses is to merge with and/or to take over competitors: to consolidate. There are two points to make about this behaviour. First, there have been, in the past, government-imposed constraints on the consolidation. Indeed, it is difficult to envisage any further consolidation going beyond the current structure. Ironically, further consolidation was imposed in the case of HBOS when, following the Global Financial Crisis, Lloyds were effectively instructed by the government to accept, hurriedly, taking HBOS into the Lloyds Bank Group. Second, notwithstanding the comments in the Vickers Report about competition (see below), the oligopolistic structure of the banking sector is little different from the structure of the majority of industries which are dominated by a few large companies. It is also not clear that there is either a total absence of competition in certain respects, or that effective regulation would not, in theory, be unable to prevent bank customers from being exploited. The problems associated with the lack of long-term investment finance provision for SMEs is not primarily an issue related to lack of competition. The period from 1900 to 1920 witnessed an extensive consolidation of the sector into a few large banks, such as Barclays and Lloyds. In fact, the process of mergers had started earlier, from around 1880. The consolidation had delivered, by 1920, five dominant major banks which were extremely profitable and had extensive branch networks, alongside six smaller survivors. In 1920, the government introduced legislation preventing further takeovers without Treasury approval. The motivation for merger at this time was primarily to establish and maintain stability, and hence profitability. The larger the banks were the greater their ability to recruit deposits, and hence ample liquidity, in order to make loans to creditworthy business clients, in practice, principally to large companies. This activity represented classic financial intermediation; the recruiting of deposits to permit lending to take place and hence acting as the “broker” between savers and borrowers, albeit only serving the investment requirements of large companies. Some of the structural organization and operational practice which exists today was settled during this period. Characteristically, there was a strong emphasis on maintaining a high level of liquidity, particularly in connection with any industrial loans’ portfolios. Bad debts were minimized by avoiding risky loans, and there was a low likelihood that loans (whether short or long) to small and medium-sized enterprises would be granted. This behaviour was set in the political economic context of the UK’s “soft” liberal market economy approach, evolved during the nineteenth century, at the height of the UK’s imperial dominance. This political choice was in contrast both to the “aggressive” liberal 76

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market economy of the US, with its business endorsement of “creative destruction”, and the cooperative, coordinated market economic approach preferred in continental Europe, typified by Germany. Notwithstanding the slow, but inexorable, global economic decline of the UK from 1914 onwards – masked by the prosecution of two world wars, the postwar reconstructions, financial and economic crises, and the gradual loss of empire – there was little attempt to fundamentally alter the national political economic perspective. This issue will be explored in more depth in the next chapter, for now it is simply noted. Given the existence of the oligopolistic structure, with five dominant major banks, it is worth examining in more detail the operating structures of two of the major banks – Barclays and Lloyds –during the period from 1920 to 1945, and their evolution up to the present-day. Both banks have been in existence throughout the 100-year period. Barclays Historically, the origins of the, then Quaker, bank may be traced back to the eighteenth century and its continuation as a private bank during the nineteenth century. Towards the end of the nineteenth century, small private family banks, such as Barclays, were increasingly unable to compete with the larger joint stock banks. In 1896, 20 small private family banks, including Barclays, combined to form a new bank – Barclay and Company Limited. The bank created as a result of this consolidation had 182 branches and 806 staff, mostly based in southeast England and London. The next 20 years or so saw the bank enlarge further through a series of mergers and takeovers. By 1920 the bank, now Barclays Bank Limited, had become the third largest of the “Big Four” banks.  During the remainder of the twentieth century, post-1945, further consolidation saw the absorption of Martins Bank in 1968 and the Woolwich building society in 2003. Until 1980 Barclays maintained a distributed branch structure, but in that year, it moved to establish a much smaller number of regional offices, later superseded by centralized support services. Barclays Bank Limited became Barclays Bank plc in 1982, and in 1985 the UK and international operations were brought together as Barclays Bank plc, with a new holding company Barclays plc. This centralization process necessitated stronger bureaucratic structures, with direct decision-making removed from the customers at branch level. A further development in the 1980s, following the “Big Bang” deregulation exercise, was the entry of Barclays into the arena of investment banking. In 1986 Barclays established an investment banking operation, which developed subsequently into Barclays Capital, a major division of the bank that managed larger 77

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corporate and institutional business. Barclays Capital became part of the broader business grouping known as Barclays International. Barclays was affected by the GFC in 2008 and as a result its activities in investment banking were significantly reduced, particularly internationally. Following the acquisition of the investment banking and capital markets businesses of Lehman Brothers in North America in September 2008, Barclays Global Investors was sold to BlackRock in December 2009. In 2016 Barclays announced a new strategy, designed to build on its strengths as a diversified transatlantic consumer and wholesale bank, anchored in the UK and US home markets, but with global reach. This also involved the strategic sale of a number of continental businesses, and the withdrawal of Barclays from Africa, although a small shareholding was retained in the new, independent African business, Absa. Following the recommendations of the Vickers Report, in 2018 the Barclays Group announced its largest structural change since the 1980s. The main objective was to separate or “ring-fence” the domestic retail and business bank from the international and investment bank. Barclays plc continued as the holding company, supervising three operational subsidiaries: Barclays Bank UK plc, comprises the UK Retail Bank, UK Barclaycard, UK Wealth and Investments, and Corporate Banking for smaller UK businesses; Barclays Bank plc comprising Corporate and Investment Banking; non-UK Barclaycard, Wealth International, the Private Bank, and Overseas Services; and Barclays Services Ltd, which includes support services such as Group Functions, Operations and Technology. It will be interesting to observe, over time, whether the establishment of a division within the main group, Barclays UK plc covering Corporate Banking for SMEs, makes any significant difference to the bank’s modus operandi as far as SMEs are concerned. Lloyds In the same manner as Barclays the origins of Lloyds Bank may be traced back to the eighteenth century, again with Quaker influence. The origins the bank date from 1765, when button maker John Taylor  and  a Quaker  iron producer and dealer Sampson Lloyd set up a private banking business in Dale End, Birmingham. In 1865, Lloyds & Co. converted into a joint-stock company known as Lloyds Banking Company Ltd, becoming Lloyds Bank Limited in 1889. Through a series of mergers, including Cunliffe, Brooks & Co in 1900, the Wilts & Dorset Banking Company in 1914 and, by far the largest, the Capital & Counties Bank in 1918. As with Barclays, Lloyds emerged to become one of the British “Big Four” clearing banks. 78

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During the twentieth century Lloyds pursued the British banking sector’s consolidation process by merger and takeover, albeit with mixed fortunes. In 1968 the Monopolies and Mergers Commission judged that a proposed merger between Lloyds, Barclays and Martins was against the public interest and blocked the merger. In the following year Barclays acquired Martins. Lloyds continued to seek growth through mergers. Unsuccessful bids were made for the Royal Bank of Scotland in 1984, for Standard Chartered in 1986, and for Midland Bank in 1992. Finally, by 1995 Lloyds had acquired the Cheltenham & Gloucester Building Society and the TSB Group, becoming Lloyds TSB plc and, separately, Lloyds TSB Scotland plc. Lloyds was now the largest bank in the UK by market share. In 1999 Lloyds acquired Scottish Widows, the life assurance society; it also in 2001 made a bid for Abbey National, the building society, but this move was blocked by the Competition Commission. During the aftermath of the GFC, the UK government had serious concerns about the viability of HBOS, the UK’s largest mortgage provider. A private takeover was mooted, and LloydsTSB made a takeover bid for HBOS. The government cleared the takeover and did not refer it to the Competition Commission: it also took a 43 per cent stake in the newly formed bank, that it progressively sold some years later. The European Commission, under its competition policy, ruled that Lloyds must divest itself of 600 Lloyds TSB branches, which subsequently formed a new TSB bank. Lloyds was, and is, predominantly a retail bank and did not suffer the damage, arising from the GFC, that other banks did as a result of their investment banking activities. What this analysis of these two major clearing banks shows is that their sheer size appears to entail a highly centralized and bureaucratic structure, whose operations and services have also become more centralized over time. Their structure, operating methodology, and shedding of branches (Barclays has closed 540 branches between 2015 and 2020 and Lloyds 447) renders any notion of “relationship banking” at branch level difficult to achieve in many places at the present time. The centralized structures are highly adapted to a situation of limited training requirements and minimum expertise asked of branch managers. The latter are principally concerned to manage most branches, to assess the security offered by SMEs requiring overdrafts, and are not required to be able to assess continuously the performance of those SMEs. Insofar as the major clearing banks are concerned, excluding their investment business, one might be forgiven to think that the motivation is to provide a minimum retail banking service to customers, and to use digitization to reduce further the number of branches, and hence reduce unit costs. When SMEs request loan finance, as opposed to overdraft funding (including structured-term loans) which can be withdrawn on call against security, such applications are typically subject to central algorithmic processing, often 79

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with significant delays which tend to dissuade SMEs from even applying. Large companies are also dealt with centrally but are far less likely to be refused loan finance and there are much closer and sustained relationships with the banks at central level. Although only two of the five big banks have been examined there is every reason to believe that these are representative of the group. Moreover, the developments of financial technology, including the use of block chain technology, could be used by banks, which are already using such technologies, to be able to provide a complete schedule of services to SMEs, as they do, to a large extent, to their major corporate customers. This would be one way of meeting the competition which may emerge over the next decade or so. The concentration of the British banking sector in the hands of the “Big Five” banks, accompanied by continuing reductions in the number of their branches, may be contrasted with the situation elsewhere in Europe. There are approximately 150 bank branches per million of population in the UK, approximately one-third of the average in Germany and France (BIS Study 2015). If proximity to clients is important, then further consolidation in the banking sector, especially if it means more branch closures could restrict even further the availability of credit to SMEs. Competition As the history of the approach taken by banks during the twentieth century suggests, if any of the smaller challenger bank competitors reach a size in terms of market share which threatens the dominance of the five “majors” then they are likely to seek to merge or acquire the challenger organization. Although for the time being other, non-bank, market players do not represent a threat to the major banks, there is the possibility, as will be discussed, of a tech giant, such as Amazon offering a fintech based banking service, which would make any merger response impossible. Such a development might entail the major banks responding by utilizing the technology and their access to capital markets to meet the competition by providing their own routes to the capital markets for the banks’ customers. Banks after all are themselves capital market organizations. The relatively recent entry and expansion of foreign banks into the UK (e.g. Santander and ING) offers proof that competitors are able to get established, despite there being supposedly high entry costs, substantially due to reputational barriers. However, it is not clear that new or more competition would, of itself, remedy the SME problem of accessing investment finance. To explore the issue further it will be useful to turn to the Vickers Commission. The Vickers Commission, set up in 2011, was concerned to examine two main aspects of banking in the UK. The first, our main concern, was the issue of 80

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competition, given the acknowledged concentration of the UK banking sector in the hands of five major clearing banks, and its impact on the services provided, including to SMEs. The second issue, no less important, and still relevant to the future of support for SMEs, was to establish the potential to protect the banks’ retail banking operations from their investment banking operations. It was the latter which had been the principal cause of the financial collapse of large parts of the UK banking sector in the aftermath of the GFC in 2008. The Commission reported that banking services to SMEs show the highest level of concentration among the major clearing banks. Some 96 per cent of SMEs with a business current account (BCA) obtain it from their main bank and there is little multi-banking among SMEs. Other products, the report found, were similarly concentrated across the major clearing banks, these included corporate credit cards, deposit accounts, business loans and commercial mortgages. At least 80 per cent of SMEs that used the products obtained them from their main bank. The Commission sought an answer to the problem of this concentration of service provision in the development of a more competitive banking sector, with new entrants challenging both the extent and the nature of the service provision of the major clearing banks. The Commission devoted a considerable amount of space to the issue of competition. However, its analysis of the arguments for greater competition were conventional, looking mainly at reducing market shares and lowering prices/ charges. For example, it ignored evidence, cited by the Global Policy Institute1 (2011) in its initial submission, that showed that recent new entrants to the UK market, such as Santander and ING, had had little or no influence on the availability or cost of finance to SMEs. It seemed unlikely that, aside from a shortterm flurry of tempting offers, any net benefit to banking customers would be substantial and/or lasting. Nine years later little, if any, change has occurred for SMEs, as their perennial complaints about the banks indicate. The Commission also placed great store on stimulating customer switching. This has not happened, except to a limited extent in relation to internet banking. This is despite the implementation in 2013 of the Commission’s recommendation for the introduction of a re-switching service (although without bank account number portability) and to reduce the time and other costs on customers of switching. Competition was seen by Vickers as an end in itself, with consequential positive benefits certain to arise. In practice, extra benefits for customers arising from a greater number of players tend to be confined to initial cost reductions (difficult in any event to monitor and measure with the more complex product offering by banks than is the case with, say, utility companies) and to be short-lived, as market structures and behaviour settle down. As we have seen in recent years in the energy market, price caps are being introduced by regulators 81

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of utilities. Competition per se is not enough to achieve the improved services objectives. None of the above criticism of Vickers should be interpreted as suggesting that it was wrong to pursue greater competition, as one potential way of encouraging improved banking services to customers. However, a strong dose of scepticism needs to be administered in expecting substantial or permanent customer benefits to accrue from greater competition. The oligopolistic structure of British business banking and the inherent problems of the provision of a bureaucratic, centralized structure of the individual major banks cannot be overcome by the simple process of new competitors or by enabling switching. As already touched on in Chapter 2, initially, the advent of new small challenger banks might have offered some hope for a revival of relationship banking, and this avenue might provide easier access to investment finance for SMEs. These early hopes were soon to be dashed. First, these new, small, banks were unable to cope with the regulatory imposition of common banking rules on the provision of equity capital required to match calculated risk-weighted capital for business loans. The standard internal risk-based (IRB) approach to capital requirements for credit risk left the challenger banks with a too high a capital requirement for business banking, some three-times higher than the advanced IRB used by the major clearing banks. Moreover, this challenge was combined with the need to develop or purchase internet banking software, which was designed to manage personal retail banking requirements and not those applicable to businesses. The Vickers Committee’s second task was to suggest measures to prevent the recurrence ofany future financial crisis in the investment banking sector transferring into the retail banking sector, as had happened, with disastrous results, in the aftermath of the 2008 GFC. The resolution of the crisis hit the SME sector particularly hard as banks took steps to rebuild their balance sheets and increase liquidity. The problems, in the aftermath of the GFC, which led to the near-collapse of the UK banking system – and effectively destroyed the independent existence of some large banks – was partly a result of the absence of barriers between banks retail banking activities and investment banking activities, within their universal banking structures. The problems precipitated massive inputs of taxpayers’ funding into UK banks (the 2008 UK bank rescue package totalled £500 billion) and later, continuing budget deficit reduction measures, ostensibly required to resolve the resulting interest payments given the increased public debt to GDP ratio.2 A number of organizations and individuals, including the author on behalf of the Global Policy Institute, submitted evidence to Vickers urging the need to separate, preferably a full legal and economic separation, the two distinct functions/activities of retail banking on the one hand and investment banking on the 82

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other. The rejection by the Commission of this option of recommending a full structural separation in favour of ring-fencing retail banking activities within banking groups was unconvincing. The arguments in favour of structural separation between retail and investment banking, to protect against contagion and taxpayer liability for failure are the same as those for “ring-fencing”.3 The arguments deployed by the Commission against structural separation, compared to ring-fencing are that: (1) there would be a higher economic cost; (2) support from elsewhere in a group would be precluded, and (3) it would require EU approval to prevent other EU country banking groups from evading the prohibition of “mixed” group banking. It was not made clear how the first of these objections is to be sustained. It is not self-evident that separation will be less efficient in terms of cost to the economy than ring-fencing. The second objection is valid, but as the Report observes, having a high ring-fence is supposed to serve the same purpose! The third objection may have been valid at the time; nonetheless, it is difficult to see how separation in one member state would, necessarily, have been, ultra vires in EU legal terms. The inescapable conclusion is that the Commission looked for, barely sustainable, objections to enable the more politically palatable choice of “ring-fencing” to be defended. In the event, the Commission recommended ring-fencing the investment banking activities within the universal banking structure. As the complex set of rules governing the establishment and dynamic operation of ring-fencing have only in the past year, 2019, been implemented, it is too soon to assess how successful they are when tested by a future financial crisis. Conventional competition may yet provide the spur to encourage the banking sector to provide the SME services required. However, most recently competition that is having some impact at the margin is that originating from financial technological innovation. These are the internet-based financial services provided across technology platforms by companies such as Funding Circle and IWOCA. In the United States, this route is being provided, among others, by the large tech giants such as Amazon. So far, these new financial services have not presented a major threat to the British banking oligopoly in the SME market, however, should these services become operational in the UK, it could provide competition for the banks. We will discuss these new services below when considering alternative finance provision. Alternative finance provision: capital market options The 2015 OECD report mentioned ealier concluded that there are a variety of actual and potential capital market instruments which may be adapted and used 83

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to facilitate a higher proportion of investor involvement in the SME market, suited also to the needs of SMEs. One measure singled out was securitization (see discussion below) as an important potential means of spreading risk among financial market participants, including providing “head-room in banks’ balance sheets” thus enabling banks to increase their own on-lending. Another report in the same year, the IOSCO (International Organization of Securities Commissions) report, described various capital market possibilities potentially available to SMEs. We shall examine each in turn. Before doing so, it is important to reiterate that the point in the lifecycle of the SME, coupled with the sector in which the SME is active, will be strong determinants of the relevance of the capital market options available. The order of the list below – which includes at the top the four principal sources designated as alternative finance – ranks the potential attractiveness of the type of funding to SMEs. The preference for peer-to-peer finance suggests the desire for debt funding, at least in the UK, as opposed to equity funding, given the evident desire of SMEs to keep control of their company. Another determinant is the sophistication of the SME management to access and manage successfully whichever type of funding is selected. Of course, the principal determinant, on the other side of the equation, will be the desire of investors to see secure and substantial returns on their potential investments. The thinness of the SME equity and debt-based markets represent a significant barrier for investors, who will prefer the liquidity provided by, for instance, markets for large company debt or equity, or for property. Securitization is last on the list because it is not essentially a separate type of funding, but a mechanism to provide the spread and depth of market liquidity. • Peer-to-peer funding • Crowdfunding • Invoice-based lending • Asset-based funding • Equity capital markets • Debt capital markets • Independent public offerings • Institutional investors • Pooling investments • Securitization Peer-to-peer lending Peer-to-peer lending is analogous to crowdfunding, but there is no equity participation required from the investor. This debt financing approach to providing 84

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funds for SMEs has the largest slice of the alternative finance sector. It may be viewed as a preferable alternative to an SME negotiating an individual unsecured private loan. Such private transactions are unregulated, and the SME is not provided with any security or redress. In peer-to-peer lending there is a structure, that is the peer-to-peer platform and the peer-to-peer lending intermediary organization. Here the intermediary, is regulated by the Financial Conduct Authority (FCA), which thus provides security and assurance to the SME in terms of the proximate lender. Investors/lenders place their money with the peer-to-peer platform. This money is then lent to numbers of different borrowers as separate small loans. Hence, each borrower borrows small amounts from many different lenders to make up the full loan that they require. This “packaging” approach provides both lenders and borrowers with security, it is the securitization dimension. The platform collects the repayments of interest and capital from each borrower and passes them to the lenders. Interest payments will be higher in terms of returns to the lenders. For the SME borrower the access to loans is easier than attempting to source from a bank, and the interest payment is likely to be no higher than from a bank. In 2016, UK peer-to-peer lenders collectively lent £3.55 billion to consumers and businesses (Bone et al. 2016). According to the CCAF, the largest growth area was lending for property, showing a rise of 88 per cent from 2015 to 2016.4 Peer-to-peer business lending became the largest individual market segment, growing by 36 per cent to reach £1.23 billion in 2016. In 2013 it had been only £139 million. Funding Circle, set up in 2010, is the largest and best known of the peer-to-peer platforms (see below for the Funding Circle and securitization). Figures from P2PFA (Peer to Peer Finance Association) show cumulative peer-to-peer lending to UK businesses reached £5.5 billion (around 50 per cent by Funding Circle) in 2018. In the last quarter of 2018 new lending to businesses was £527 million. As indicated above, the apparent preference for this type of debt finance, over the equity crowdfunding described below almost certainly represents the desire for UK SMEs to keep control over their companies, while clearly needing the investment funds provided via peer-to-peer finance. Crowdfunding Crowdfunding has in recent years emerged as a potential funding route for SMEs. Where there is a high level of disposable income and a mature internet, as in the UK, then crowdfunding has become a viable potential funding route. Crowdfunding requires transparency and efficiency in connecting companies 85

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with individual participating investors, raising and delivering funds efficiently. A successful crowdfunding initiative may also provide potential for institutional investors to discover a viable SME investment opportunity. The development of crowdfunding in the UK, either in the form of equity participation or in the form of debt (“peer-to-peer” lending), has been aided by the strongly deregulated UK finance sector and the emergence of a rapidly growing fintech sector. Market research suggests that some 20,000 SMEs in 2015 raised alternative finance through online channels and in total such funding grew to £3.2 billion in 2015 (CCAF 2016). Peer-to-peer lending supplied the equivalent of 13.9 per cent of new structured term bank loans (see below) to UK SMEs in 2015 (Atz & Bholat 2016; CCAF 2016). Equity crowdfunding provided SMEs with £245 million in funding in 2015 and acted as a critical funding source for innovative UK start-ups (Brown et al. 2015). This amount had increased to £272 million in 2016 (CCAF 2017). All of these newer forms of funding appeal to high-growth firms, who make a significant impact to the economy, but who sometimes encounter restrictions when accessing conventional credit, (Vanacker & Manigart 2010; Mason & Brown 2013) and often obtain such credit on unfavourable terms (Rostamkalaei & Freel 2016). Equity crowdfunding involves the sale of registered securities, mostly by early-stage firms (not necessarily start-ups), to both retail and professional investors via internet-based platforms. This mechanism effectively creates informal, small equity capital markets for SMEs willing to explore this route to obtaining finance. The problem is that, inevitably given their size, such markets are not particularly liquid, which is an inhibiting factor for investors. Because of the informal nature of such crowdfunding platforms we know very little about the participating investors; about their expectations of returns, about the demands they may place on the companies; and what protection they might expect. For these reasons future regulatory action is necessary and likely, both for SME borrowers and for investors. Appropriate protective legislation should not seriously inhibit the growth of such “free-wheeling” methods of financial support for SMEs. Invoice-based and asset-based finance The CCAF statistics show some £452 million of invoice-based funding for SMEs, having risen from only £97 million in 2013. It seems likely that this growth is linked to using this form of financing for cash flow reasons. It should be noted that structured-term loans by banks is effectively a form of time-limited overdraft, invoice-based finance. Asset-based financing, essentially either equipment 86

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leasing or hire purchase, has been increasing in recent years. From 2013 to 2017 UK asset-based finance accessed by SMEs grew from £12.9 billion to £18.6 billion, double the rate of the previous four years. This figure is double that of invoice-backed finance and substantially more than bank loan or other modes of finance used by British SMEs. Its attractiveness to manufacturing firms, whose requirements are generally related to fixed capital for plant and machinery, is evident. All these forms of alternative finance have shown increases in the aftermath of the GFC, which witnessed a temporary reduction in lending to business by the major banks, as they sought to repair their balance sheets and increase liquidity. We can now consider other forms of capital market finance which are potentially available to SMEs. Equity and debt capital markets and IPOs There are, of course, formal equity and debt markets, and although a less important route for the majority of SMEs, IPOs, which provide other routes to funding for SMEs. Notwithstanding lowered SME listing costs on equity markets (in comparison with major companies) these costs tend still to exclude all except the very largest SMEs. Even for larger, high-growth SMEs willing to consider venturing on to equity capital markets (or bond markets see below), vis private placements of shares, there are trade-offs to consider. For instance, set against the greater access to funding for continued growth and the higher public profile of the company – thus enhancing the reputation of the company in the eyes of its customers, suppliers and employees – there will be greater pressure on the company continuously to perform well, particularly in terms of higher profits and dividend payments, and the potential for being taken over by another company. These concerns may well be part of the reason for SMEs appearing to prefer to use the more informal and growing crowdfunding equity markets as described above. SMEs which are interested in exploring equity capital markets might also consider debt capital markets which operate in a similar manner to equity capital markets. Preparations to enter these markets require similar detailed prospectuses to be prepared. The choice between the two markets is likely to depend as much on the cultural preferences of SMEs and development of the national capital market structures. The CCAF provided some information on the take-up of these debt instruments in the UK. From a small £2 million in 2013 and £6.2 million in 2015, it suddenly increased to £79 million in 2016. This sudden surge probably explains the development of this specialist segment of the main corporate bond market to accommodate larger SMEs. Some countries have been 87

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exploring a separate bond market segment for SMEs, including latterly the UK. Notwithstanding this development, the listing and compliance costs are a significant deterrent to other than large SMEs. Moreover, such a market would only represent a small segment of the main corporate bond market, and so would not provide investors with the size and liquidity they would normally require. In Germany, the SME market in this debt instrument sector was worth almost $550 million in 2012, with no defaults reported. This represented around 4 per cent of a total private bond market of around $14 billion. However, by number of placements, obviously with much smaller loans, SMEs represented 28 per cent. This Schuldschein5 system of private bond/loan market placement system is a flexible type of capital market instrument which can accommodate loans down to around €5 million with terms of between 3 to 10 years. Schuldschein might be described as a sophisticated peer-to-peer lending facility. Launching the company as a public limited company (plc) on a stock exchange is likely to have a limited appeal to all but a few very large value SMEs given the sophistication and expense of the approach, the ICT company Nvidia in 2000 is an example. The total preparation costs as a proportion of the value of the share offering are by no means negligible – in the UK they are around 11 per cent. Major institutional investors (e.g. pension funds, insurance companies) are unlikely to see the SME market as offering general potential, unless some part of their portfolios is targeted at successful SMEs in a specific sector, for example, the green environmental sector or ICT. For this route to be able to become an attractive alternative for SMEs will require work to be done between the institutional investors, regulators, and SMEs to develop a consistent framework to measure the impact on SMEs and to establish how this potential source of investment can assist in filling some of the gaps in SME funding. Securitization (and pooling investments) In the following discussion it is important to recognize that securitization is more than another specific capital market avenue available to SMEs. It is a far wider concept and financial practice. Securitization6 is a complex form of intermediation between borrowers and lenders. It enables illiquid financial contracts such as loans (or mortgages or credit card receivables) to be transformed into diversified (within or across financial product sectors) and liquid securities. These securities may then be traded between investors. The performance of the securities depends on the underlying assets and the structure of the transformation, but not necessarily the financial situation of the issuer. The substantial advantage of securitization, particularly, for banks as issuers, is that the process of intermediation is split into a series of small steps or units, 88

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so that this collection of units can be traded, and offered to a range of investors having different risk and reward profiles. However, problems can occur where inadequate structuring of the security leads to excessive risk-taking, and eventually a return to illiquidity and the freezing of the market, with disastrous consequences as was demonstrated in the GFC in 2008. Despite securitization being an interesting avenue for SME equity or bond issuance, the problems which arose during the global financial crisis, concerning in particular US mortgage securitization, has meant that investors have been reluctant to participate in this sector of the capital market. Sentiment is now recovering strongly with time elapsed, and the market has appeared to have been developing since around 2013. This mode of participation by SMEs requires a financial intermediary, often a bank as the originator of the loan or another financial intermediary providing the equity. As far as the latter is concerned, this intermediary could be the provider of an online funding platform such as the Funding Circle. For a participating bank, as the originator, it could provide the ability to transfer risk to the market and provide capital headroom for it to make further on-lending, including to other SMEs, although this risk transfer would have to be approved the regulator. The securitization mechanism enables credit enhancement to allow the participation of tranches of essentially illiquid non-investment grade SME loans or equity to be transformed into liquid investment grade quality. Potentially this avenue for SMEs enables the SME to enter, indirectly, into the capital market. Securitization enables investors to invest at a low transaction cost in pools of already assessed SME loans, thereby giving SMEs indirect access to capital market funding. This route appears to offer considerable attractions. It enables SMEs to become a separate asset class which is made, via securitization, investable to institutional investors and other classes of investor who would otherwise be unlikely to invest in SMEs. Where loans are concerned securitization also partly decouples the SME lending from any uncertain dynamics affecting the banking sector (assuming a bank is not the originator) as happened in the aftermath of the GFC. The issue and sale of financial claims on packaged loans are bought by investors in the form of notes called asset-backed securities (ABS).7 This allows the cash flows from the loans, including repayment, to be passed through to the final investors. Initially, a lack of standardization of SME ABS structures, and documentation, appeared to have been a barrier to the development of the SME securitized loan market, in competition with other more standardized financial products. However, recent standardization measures and regulation have been introduced across the EU. This area of capital market finance is currently being exploited in the UK by the Funding Circle, as the largest of the internet-based alternative finance 89

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platforms. In July 2019 Funding Circle announced a tranche of £232 million of securitized loans for small businesses. This tranche, together with a more recent announcement of another of £250 million in November 2019, brings the total of securitized loans issue to just over £1 billion. The SMEs involved include a substantial number outside the UK, including some of those supported by KfW, the German state bank mentioned in Chapter 2. Information on securitized SME loans made is not readily available, but Spain is one EU country where information is available. There are over $2,200 million of securitized bank loans to SMEs which are backed by banks, with some residual part of these funds backed by some Spanish autonomous regions. This securitization market had been nurtured to this size by the government guarantee that allows for multi-originator deals, facilitating entry for smaller lenders with (initially) low volumes of SME loans. In this context it should be noted that the securitization of SME loans in Korea, also backed by government guarantees, has also seen strong growth since 2000. In general, a variety of Far Eastern banking systems, including in Korea, were not overly affected by the GFC. In the UK, after stabilizing in 2011, UK securitization issuance began to fall again in 2012, asset-backed securities fell to £29 billion in 2013, slowly recovering to £33 billion in 2015. The fall in UK securitization activity appears to have been associated with the introduction of the Bank of England’s Funding for Lending Scheme (FLS) in July 2012 and the accompanying increase in the availability of cheap funding for UK banks, ostensibly to pass on in the form of loans to SMEs. However, it is not clear how successful this scheme has been. One of the problems has been that in case of default by the SME the first tranche of losses is still picked up by the bank. Some banks, notably Lloyds, have experimented with securitization. The successful Sandown Gold SME ABS was issued by Lloyds Banking Group in 2010. The loan pool consisted of 1,733 secured term loans (some fixed and some floating) from 1,407 businesses at a value of £806.6 million in total, covered by collateral estimated at a value of £1.5 billion. The value of the individual loans varied between £25,000 and £5.5 million each (more than half were less than £1 million). The SMEs were from all regions of the UK and across many diverse sectors of the economy, although real estate businesses accounted for 15 per cent. Most of the collateral was a form of fixed assets (including a high share of owners’ private houses). The pool was fixed, in the sense of no replacement loans were added, although some loans were inevitably adjusted to take account of changes in terms, collateral and prepayment. The maturity of the loans extended out to 23 years. The Sandown Gold scheme is one excellent UK banking example of a pool of SME loans which were the subject of securitization. The degree of perhaps “over-collateralization” to some extent mitigated its appeal. This securitization route to provide funding for SMEs – despite some early 90

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apprehension about securitization occurring as in the case of those triggering the GFC – is an interesting development. The loan pools in terms of the size and range of exposure, structuring, and management seem to provide a positive opening for banks to support SMEs. Pooling investments offers a less sophisticated, and more direct, method of pooling risk than via securitization. It is generally accepted that individual institutional investors avoid investments in SMEs because of the insufficient size and liquidity of this market class. There is little evidence in Europe of any special class of investment funds for SMEs, although a small investment fund for early-stage high-growth SMEs has existed in London since 2013. It has made about 5 investments each year. Alternative finance: internet-based finance provision The increase in finance provided across internet-based technology platforms – most notably equity crowdfunding and peer-to-peer lending – has been enabled by the rapid development of the application of financial technology (fintech). Essentially this technological development has meant going back to “pure” intermediation with a direct connection, mediated by an information technology platform, between savers/investors and borrowers. Fintech, which has developed most rapidly in the US, China, and the UK, although currently representing only a small part of financing of companies, is attracting the interest of the large IT companies such as Amazon and Google. In June 2017, Amazon announced that Amazon Lending had surpassed $3 billion in loans to small businesses since the service launched in 2011 in the US, reaching more than 20,000 small businesses. As shown, the two main areas where fintech is currently utilized are equity crowdfunding and peer-to-peer lending. Fintech companies make their revenue from brokerage fees, from both investor and borrower. They must assess the creditworthiness of both partners. Indeed, one of the reasons for the slow development of the two main fintech areas is that SMEs have to provide financial information to the companies. Currently, in terms of business, only banks have full information and SMEs are concerned about the need to keep their information secure across internet technology platforms. Of course, for sole traders who might be using Amazon, for example, for personal purchases, then their credit worthiness has already been assessed by Amazon. The issue of how wider financial information on SMEs might be provided to fintech companies to facilitate their alternative finance provision has prompted the CMA to support “Open Banking”, enabling fintech companies (and challenger banks) to access financial information on SMEs held only by banks. The 91

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process is technically complex, principally to provide various layers of security, which does, however, render achieving the objective of transferring the information from the banks somewhat cumbersome. Open banking is therefore making only slow progress. A recent report indicates the technical and other issues involved.8 These concerns of SMEs in relation to the use of IT platforms to source finance for investment, whether loan or equity, raises more general questions of regulation to protect the parties involved and prevent over-risky or fraudulent activity. Indeed whether, or more likely how fast, fintech financial platforms will develop will depend on a variety of factors. Among these will be the regulatory framework which is established; the preferences of business, particularly SMEs; the willingness of investors; the adaptability and flexibility of the internet platforms; and the commitment of the larger IT players to participate. Its development will also be linked with the desire and adaptability of the major banks to provide their own fintech services. As the examples of Lloyds Bank and NatWest shows there are signs that banks are beginning to recognize both the threat and the opportunity presented. This point was made forcibly in the Ernst & Young report on the “Future of SME Banking” (2018). It is important to understand the small relative size of “alternative finance”. In 2015, a study by Nesta, Cambridge University and KPMG found that alternative financing in 2015 saw 84 per cent growth on the previous year, with the sector representing £3.2 billion worth of loans, investments and donations. The figures for 2018 indicate that the market is still growing at £5.5 billion, with new business lending in the final quarter at £527 million, but it is modest growth only and when compared to total lending to all non-financial businesses in the UK, which in 2015 totalled over £205 billion – it has a long way to go! SME attitude to alternative finance provision Certainly at the outset of their establishment, the vast majority of small firms are highly unlikely to be able or willing to require access to alternative finance, and are highly likely instead to be reliant on owners’ capital, and some form of bank lending, overdraft and/or a credit card. Obviously, later in the lifecycle of an SME, access to capital markets may become a more attractive proposition. In the UK, the business culture, aside from early SME development funded principally by owners’ capital, tends to be focused on individualistic, rapid revenue and profits growth, on occasions aimed at the SME being bought out by a larger company. This represents a quintessential short-term approach and, to an extent, prompted by the absence of the availability of long-term bank lending to SMEs in the UK. The political pressure on SMEs to utilize capital market funding 92

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(e.g. from the UK Parliamentary Treasury Committee and from the European Commission in the promulgation of the Capital Markets Union initiative) is not likely to achieve results, given cultural resistance from SMEs. In Germany, by contrast, the ready availability of long-term bank lending for investment tends to lead to a focus on long-term growth and networking with other SMEs. This contrast is a generalization, but it indicates the issues in terms of business culture and financial structure which underlie the differing preferences for the financing of SMEs, as between the UK and Germany. What is clear is that the close and sustained relationships between local German banks and SMEs is a matter of historical record, just as is the lack of such close and sustained relationships in the UK. However, there are signs that British banks are beginning to recognize the potential future threat posed by internet-based technology platforms, including, potentially, the large tech companies, in providing access to investment finance and other banking services. The major clearing banks, as substantial capital market players themselves, could be the channel through which appropriate SMEs could be guided to the appropriate investment finance, whether directly via standard loans or indirectly via various forms of alternative capital market finance. The major banks appear to be responding, albeit slowly, via various collaborative ventures. But the key to change is how willing the banks are to revise their own narrow, business service models in respect of SMEs. Conclusion This chapter has examined the evolution of the British business banking system over the past 50 years, following the easing of the postwar restrictions in 1971. It has shown that business banking during this period has not escaped its earlier historical conditioning. Notwithstanding some recent positive innovative services by some banks, it remains a system which is failing to provide the depth and range of services required to establish a dynamic, expanding SME sector of the UK economy. An underlying problem is the British business banks’ failure to appreciate their wider socio-economic role as financial intermediaries. This role involves the recycling of the liquidity available to banks into long-term loans for SMEs. This point was made in both the 1931 Macmillan Report and in the 2011 Vickers Report. The question for the major banks, individually and collectively, is are they willing to go beyond their operational excellence in delivering basic services at a competitive cost, and provide the deeper support needed by SMEs? It may soon be possible to seek answers to this question as the banks are beginning to experience competitive pressures. The advent of fintech, and its ability to deliver, 93

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across IT platforms, the basic services which are currently supplied by the major clearing banks, provides a potential competitive challenge. Indeed, the more recent fintech innovators are exploring the provision of new forms of intermediation and service to SMEs across technology platforms. The major banks are making tentative steps in this direction by alliances and take-overs. There is also the competition to provide a full banking service, including loans to SMEs, from some of the emerging “challenger banks”. These newer entrants are seeking ways of overcoming the technology and equity capital provision barriers posed for them. New foreign banks may follow the example of Handelsbanken and provide a decentralized, comprehensive service to SMEs. Here the focus will be on continuously monitoring an SME’s overall performance in terms of cash management, profitability, investment assessment, and other business performance markers. Currently a significant proportion of SMEs do inform their banks when they need finance for cash flow or investment purposes, but it appears that only less than a fifth appear to receive adequate advice as to how their needs can best be met. Banks do not currently view advising on financial problems and requirements, beyond providing overdraft facilities, as a service they should or could provide to SMEs. The change proposed, indicated earlier and discussed in more detail in Chapter 7, would involve banks as both business consultants/advisers and, importantly, as investment finance brokers rather than simply providing overdraft facilities. This potential new partnership role will be discussed in the final chapter. The Alternative Remedies Package (ARP) is an interesting development, providing significant resources to SMEs through various financial intermediaries and SME financial support measures. How effective it will be is, at present, too early to judge. For the time being, alternative finance for investment, provided via internet-based technology platforms, does not yet represent a substantial challenge overall to traditional business banking in the UK. Its share was around only 1.5–2 per cent of total lending to all UK non-financial businesses in 2018. But for SMEs, the potential offered if this provision expands, and becomes a trusted source of finance and advice, may yet threaten the major banks’ current position in the market. Perhaps the more substantial competition may, however, come from the new business models of a cohort of the challenger banks. For this scenario to emerge will mean the intelligent use of technology platforms, and the delivery of key business services, to allow challenger banks and other financial service providers to deliver rapid, transparent, and trusted investment finance services, tailored to the needs of individual SMEs. The future challenge for the major banks is whether they are willing and able to move towards providing a comprehensive service to their SME customers and retain their current large share of the SME market.

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However, there are other constraints placed on achieving reform. These are aspects of the general economic and political situation in the UK, as a liberal market economy, which may need to be addressed if banking reform is to be realized. In the next chapter, therefore, we will look more closely at the political and economic positioning of the UK as a liberal market economy and how this may need to become more interventionist in this area of policy. Ironically, the recent measures taken by the UK government to attempt to mitigate the impact of the Coronavirus, by providing loan support to SMEs, have highlighted the inadequacies of the banks in enabling SME access to loan finance.

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5

UK FINANCIAL AND POLITICAL ECONOMIC CULTURE

National political and economic policies and preferences determine the environment in which banking systems operate. They also influence the activities of business, including SMEs, which in turn influence the nature and rate of economic growth. This chapter will analyse the differing political economic frameworks in the UK, Germany, and the United States. It should be said that the two “models” of political economy discussed in this chapter – the liberal market economy and the coordinated market economy – are stylised representations of real economies. Moreover, they have developed incrementally over the past 150 years or so and there has been no specific government decision to adopt one or the other of the models, they have just grown. The UK liberal market economy The origins of the UK’s adoption of a liberal market economy as its preferred political economic approach date back to the changing geopolitical and geoeconomic conditions of the eighteenth and nineteenth centuries and the political philosophy embraced by the intellectual and political elites at that time. During the first part of the nineteenth century the “mercantilist”, protectionist approach to trade had continued from the eighteenth century (and indeed earlier). The spread of the British Empire had accelerated with the dominance of the Royal Navy’s control of sea routes after the Napoleonic Wars ended in 1815. The East India Company had by 1800 already captured and occupied almost the whole of India. The aim of occupying territories such as India and particularly the Caribbean was to maintain control of the supply of staple commodities and Navigation Acts were passed to ensure that as much trade as possible was carried in British ships. However, the middle of the nineteenth century was to see a significant change in British economic and trade policy. Informed by the intellectual contributions

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of Adam Smith and David Ricardo, in the second half of the eighteenth and the first part of the nineteenth century, economic doctrines of competitive markets and comparative advantage in trade were gradually absorbed and endorsed by the political elites. The key shift was the endorsement of Ricardo’s comparative advantage/free trade approach with the repeal of the Corn Laws (which had imposed a high tariff on cereal grains) in 1846. Not only was this the end of mercantilism and protectionism, but at the same time the rise of industrial business interests and the urban middle class was to signal a reduction in the political power of the landowning class. Moreover, in political terms the repeal of the Corn Laws had split the Tory party and caused the resignation of Peel, the Tory prime minister. Liberal governments, committed to free trade abroad and market competition at home, were elected and in 1849 the last of the Navigation Acts was repealed and the Sugar Acts of 1852 removed the protection for Britain’s sugar colonies in the Caribbean. Subsequently, the UK, particularly in the time of Lord Palmerston, frequently dealt with the complaints of merchants abroad by intervening militarily to enforce free trade. The three Opium Wars fought to enforce the opium trade on China between 1839 and 1860 were typical of the attitude taken by British governments throughout the century. By the middle of the nineteenth century Britain dominated world trade and production, producing two thirds of the world’s coal and a half of all cotton cloth and iron production. Imperial free trade facilitated this dominance, until the final quarter of the nineteenth century, when German and US industrialization began to accelerate, and to overtake the UK. Nonetheless, British trade continued to expand and the value of British exports rose from £60 million in 1845 to £190 million in 1869, much of it from increased trading with North America and Latin America. British financial investment in these two areas also increased, with significant repatriated earnings; a trend which would continue. Aided by the role of sterling as a global reserve currency, in the second half of the nineteenth century Britain became the world’s banker. London was the financial centre of the world. Over half of bank deposits was invested in places providing new sources of raw materials and markets for Britain’s industrial goods. The returns from these investments ensured that Britain’s balance of payments remained in surplus throughout the nineteenth century, although not necessarily in terms of the balance of trade. During the final quarter of the century, Britain’s share of world manufactures trade was starting to decline. The German and US economies were becoming larger that the UK, particularly in terms of manufacturing output and the exports of manufactures. Moreover, the earlier nineteenth century technological lead of Britain had also been lost to Germany and the US, who more readily embraced the later electronic and communications technologies. 98

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There was increasing evidence that the protectionist policies of the US and European countries, particularly after 1870, were threatening British exports and subjecting British industry as well as agriculture to severe competition. Nonetheless, the UK commitment to free trade continued. The declining world prices of agricultural goods and raw materials, reducing the price of imports, and the revenues deriving from British investments, enabled the UK to offset an inferior balance of trade with capital inflows. At the same time, politically, “classical liberalism” and a commitment to a minimalist state, and the endorsement of market forces at home and abroad via free trade, became the predominant view of the British political class. This view was espoused strongly by Richard Cobden1 and became the dominant political narrative under the Liberal governments of Gladstone. To an extent politically it also appeared that this view was in accordance with the “Christian civilising mission” of the new Liberal political elite. However, more cynically, it also happened to be in accord with the financial and banking elites in the City of London. Certainly, the role of Britain in maintaining competitive world trade and low global prices of goods was important. In 1913 the UK still accounted for 17 per cent of world imports. This brief account of the history of the mid-nineteenth century adoption of free trade by the UK – coupled with the military dominance, particularly at sea, by Britain – indicates the establishment of a liberal market economy. But one which was also maintained – despite Britain’s accelerating relative economic decline in the last quarter of the nineteenth century – by reliance on exploitation of its empire and its substantial investments overseas which enabled a substantial repatriation of profits. An unfortunate consequence of this policy appeared to be the neglect of the need to maintain substantial home investment in the industrialization phase of its revolution, unlike its major competitors in the US and in Germany. This neglect could have been partly addressed by a change in the culture of British banks at the time to attempt to foster sustained relationships with both large companies and SMEs, offering a range of services, as did German banks. Such an attempt could have been promoted at a time when new technologies were being developed and would have offered the opportunity for Britain to strengthen its position in manufacturing production and exports. Instead, British bank’s preoccupation lay in investing successfully abroad, led by Londonbased investment bankers, and relying on, as it did for many decades into the twentieth century, on its repatriation of its overseas earning to maintain a surplus in its international balance of payments. This lack of sustained investment in companies and technologies entailed a failure to exploit fully the second industrialization phase of the industrial revolution. This relative failure compared to competitors such as the US and Germany followed the UK into the twentieth and twenty-first centuries. 99

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The German coordinated market economy Germany in the nineteenth century faced challenging political and economic circumstances and was influenced by a different intellectual elite from that in the UK. Hence, when Germany became a country in 1870, its experience of cartelization, state involvement, and mercantilist protectionism (via customs unions) in Prussia, and in the other states forming the German Empire, already demonstrated a divergence from the UK approach. The German intellectual who was most influential was the economist Friedrich List (1789–1846). Writing in the first half of the nineteenth century, List advocated a “National System of Political Economy”. However, the term “national” is perhaps misleading. List advocated protection for the nation, viewed as a political and customs union. Indeed, he had been an early advocate of the Zollverein. He was essentially a federalist not a nationalist. For List, the state must intervene to protect developing home industries, to allow them to develop and to prevent them from being overpowered by the competition of stronger foreign competitors. This is sometimes referred to as the “infant industry” argument for protection. List’s comments on Britain were less than positive, accusing the British of cynicism in their discovery of free trade in the late 1840s: Any nation which by means of  protective duties and restrictions on navigation has raised her manufacturing power and her navigation to such a degree of development that no other nation can sustain free competition with her, can do nothing wiser than to throw away these ladders of her greatness, to preach to other nations the benefits of free trade, and to declare in penitent tones that she has hitherto wandered in the paths of error, and has now for the first time succeeded in discovering the truth. (List 1841: 296) Germany under Bismarck followed a protectionist policy as did other Europ­ ean countries, including France, and as did the United States. One contrast here is the maintenance of an activist state in Germany and France, rather than the minimalist state of the Gladstonian Liberals in the UK. This activism also extended to the involvement of the German state with industry and its support of the banking system, in terms of its close relationship with SMEs and associated measures to support technological development and technical training for workers. The industrial production growth of Germany from 1890 up to 1914, relative to that of Britain, in manufacturing and in exports. was substantially greater. The years from 1895 to 1907 witnessed in Germany a doubling of the number of workers engaged in machine building, from slightly more than a half million 100

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to well over 1 million. Britain produced about twice as much steel as Germany during the early 1870s. However, by 1893 Germany’s steel production exceeded Britain’s. By 1914, the earlier situation had been reversed, with Germany producing more than twice as much steel as Britain. Moreover, only one-third of German exports in 1873 were finished goods, but the proportion rose to 63 per cent by 1913. By 1913 German exports were the same as Britain’s and chemical exports were almost 90 per cent of world trade in chemicals. By 1913 industry accounted for 60 per cent of German GDP. In Germany, during this period, by contrast with Britain, Germany exemplified a “coordinated market economy”, with state involvement supporting industry; a banking sector supporting businesses, large and small; the cartelization of major industries, for example, steel and chemicals (promoted by large banks who were themselves cartels), and trade protection, with the country surrounded by tariff walls. This combination, and it is not possible to apportion credit for the growth as between the different factors, certainly resulted in a significant growth in industrial production, productivity and in exports. The behaviour and practice of German banks during this period exemplified the coordinated market economy approach and contrasted with the UK liberal market economy approach. In the industrialization process, German joint stock banks not only supported the cartelization of industrial sectors and their supply chains, but also assisted with their financing in several ways. Large companies, but also smaller companies requiring finance, were aided not only by loans and debt issues, but by the banks playing a detailed role in supplying equity market finance via stock issues, particularly in industries such as the electrical industry where new technologies were rapidly developing. This “interlocutor” role of German banks – mediated via the pyramidal banking structure connecting small, medium-sized, and large banks – was crucial to the rapid industrialization experienced. At the base of the structure was the extensive network of small savings banks (Sparkassen) and cooperative banks, which, governed by public law were involved with local economic development, including business support for SMEs in their local area. Even small German firms in high-growth, capital intensive sectors were able to issue common stock at the same low cost as large issuers. Thus, German capital market efficiency may have been of particular benefit to small, rapidly growing firms in these sectors. In the German banking system firms progressed through a “financial life cycle”. They began their banking relationship by taking very short-term loans (often carried on the books of the bank as overdrafts as in the UK) directly from banks. However, once the firm’s business development was demonstrated to the bank, the bank would, with the agreement of the company, underwrite stock issues for the firm and place those issues within the bank’s network of trusted customers. This process meant that even if new, 101

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risky technologies were involved, suitable finance would be provided. Obviously, fees for this service would be charged by the bank. The bank would remain actively involved in the company’s corporate governance by proxy voting power remaining in the banker’s hands. Because the bank is already acquainted with the company and because of its position as an effective stockholder, it would be better able protect its interests as a creditor. Germany’s substantial industrial growth during the period from 1870 to 1914 was also experienced by another, and different country, the United States. The US liberal market economy In the 1860s, the United States pursued aggressive trade policies. It entered a period of growing protectionism. The average tariff rate on imports of manufactured goods by 1875 was between 40 and 50 per cent in the United States against 9–12 per cent in continental Europe, even at the height of European protectionism. Notwithstanding the country’s commitment to competitive markets domestically, in foreign markets an aggressive interventionist protectionism ruled. As noted by Alfred Eckes Jr, chairman of the US International Trade Commission under President Reagan, “From 1871 to 1913, the average U.S. tariff on dutiable imports never fell below 38 percent [and] gross national product (GNP) grew 4.3 percent annually, twice the pace in free trade Britain and indeed well above the U.S. average in the twentieth century”. The person, who more than any other member of the US governing elite, was responsible for the strong protectionism of the United States, backed by high import tariffs, was Henry Clay. Clay held positions as Secretary of State and Senator for the state of Kentucky, but despite various attempts to get nominated and elected, never became president. However, he was one of the most influential Americans of the nineteenth century. His so-called “American system” took a similar view to List, i.e. to surround the country with external protective tariffs and invest in developing the internal economy of the country, for example, by infrastructure investment. This approach persisted throughout the nineteenth century and the first half of the twentieth century, despite opposition within the US, at the time and later, for instance, from President McKinley (see below). When the United States overtook British industrial production in the 1890s, the argument for tariffs was no longer to protect “infant industries”, but rather to maintain industrial workers’ wage levels. This action maintained aggregate demand in the US economy. Protection further supported the US agricultural sector, important because of its export potential. After the Civil War, high tariffs remained. The Republican Party, effectively the political party of protection, remained in office. Advocates insisted that tariffs brought prosperity to the nation 102

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as a whole and no one was really injured. As industrialization proceeded apace throughout the North-East, some Democrats, especially Pennsylvanians, also became high-tariff advocates. The US exports of electrical machinery, locomotives, steel rails, sugar-producing and agricultural machinery competed easily with UK manufacturers. Between 1867 and 1900 US steel production increased more than 500 times from 22,000 tons to 11,400,000 tons and Bessemer steel rails, first made in the US, replaced the previous wrought iron rails. By 1897 the American steel rail price had dropped to $19.60 per ton compared to the British price at $21 – not including the $7.84 duty charge – demonstrating that the tariff had performed its purpose of giving the industry time to become competitive, and well beyond that point. The US steel industry then became a major exporter of steel rails to the UK selling below the British price. In 1896 Republican President McKinley won re-election by a huge landslide and started talking about a post-tariff era of reciprocal trade agreements. McKinley’s vision was a century too early. Only over the past 30 years, since the 1990s, did the idea of major reciprocal multilateral trade agreements become a reality. Currently, they are threatened again by the trade policies of President Trump in 2020, with a reversion to the Republican Party protectionist instincts. Again, as with the case of Germany, whatever general merit there may have been in the UK policy of free trade, the industrial performance of the British economy over the period from 1870 to 1913 was substantially outperformed by an avowedly protectionist US. The role of US banks was different from those in Germany. In nineteenth-century America, because of the federal constitutional structure and political regulation, there were no large nationwide banks with extensive branch networks as in Germany. Instead there were a large number of “unit” banks, including state-chartered banks, private joint stock banks, and subsequently, federally charted (national) banks. Large and small companies were thus principally reliant on short-term bank loans. This tended to inhibit the amount of investment in fixed capital. This problem impeded the implementation of some technologies, incorporated in machinery and other fixed capital. However, the US had a very fast-growing population, fed by substantial immigration, and vast mineral resources. Hence, while a lack of investment capital might have slowed innovation, it by no means prevented substantial industrial growth in manufacturing and other sectors. US banks had successfully financed the initial industrial revolution in the North-East, and then its extension westward. However, as industrial firms in the new industries developed into large-scale, nationwide producers and distributors, their loan demands rose, but bank regulations that restricted branching and consolidation kept banks small (Lamoreaux 1994). Banks could not meet 103

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the needs of these large industrial clients without concentrating their lending. Moreover, by restricting the size and geographic network of individual banks, the United States not only limited the opportunities for banks to lend directly to industry, but also raised the cost of underwriting and placing securities. Investment banks such as J. P. Morgan & Co. did become involved in financing. This was usually via bond issues, within established sectors such as major railroads and utilities, and these investment banks did become involved directly in corporate governance. However, as suggested above, two other key positive factors were present in the US to offset any inhibiting financial sector factors. First, the massive exploitation of material resources, particularly iron ore, which was converted into steel as a primary ingredient of manufactured goods, led to a massive expansion of manufactures exports. Second, the substantial expansion of the labour force across the US also enabled industrial expansion. The US population increased by 60 per cent from 38.6 million to 96.2 million between 1870 and 1913, with the population of the major cities trebling and Chicago witnessing a 9-fold expansion between 1870 and 1920. However, the key political factor supporting the accelerated expansion of the US exports and industrial growth between 1870 to 1913, and specifically after 1895, was the erection of extremely high tariff barriers. This description of the US suggests that competition, supported by strong trade protectionism, if pursued relatively ruthlessly, can deliver economic growth. The comparison of the UK with Germany is perhaps more instructive. In the US, although trade protection was even stronger than in Germany, the banks did not play the same integrated role with business as in Germany, save for the more limited role of the investment banks. Internal market competition existed in the US, but the liberal market economy approach did not extend to external markets. The lesson for the UK at that time (and perhaps also in 2020) was to be found in the writings of List: that, except within a customs and political union, free trade is likely to constrain severely the economic growth and welfare of a country. Nonetheless, whatever, the trading situation, the urgent necessity is for the banking system to support industry, including SMEs. Germany’s system of a network of local savings banks and cooperative banks provided in the nineteenth century, and subsequently, a strong foundation for business growth. A modified political economy for the UK? Examining how the endorsement by the UK of a liberal market economic approach came about in the mid-nineteenth century, and carried on into the 104

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twentieth century, is instructive, as indeed was the adoption of a different coordinated approach in Germany during the same period. The US presented a different proposition, not in relation to their protectionist policy, which abandoned the free trade element of the liberal market formulation, but there was no general coordination between banks and industrial companies, large and small, as in Germany. This was the case, despite US investment banks being involved in a limited number of large corporations. There has always been a strong trade protectionist element in US policy (including contemporaneously), and the mercantilist approach to trade of Germany is well known, although vehemently rejected by German government spokespersons. This aspect of the abandonment of the liberal market economy rubric is not the main concern of this book. Rather, in terms of a modern modification of the UK’s contemporary liberal market economy, is the interest focused on encouraging close and long-term sustainable relationships between banks and SMEs. In addition, there is a role for the state, going beyond the current measures and institutional structures, for example, the British Business Bank, and some other measures involving government support. Attempting change It is instructive to recall that, in the late 1960s and the 1970s, Conservative and Labour governments did attempt to move the UK in the direction of a coordinated market economy, essentially shifting towards a combination of elements of the German corporatist approach and the French dirigiste approach. Unfortunately, the UK was during that period, and particularly in the 1970s, beset with both external and internal political and economic problems. In attempting to resolve these problems, the UK had, in 1973, joined the European Economic Community (EEC) customs union. Ironically, this move represented a shift towards the customs union and political union policy advocated by Frederick List, and which had served Germany well in the nineteenth century. In the early 1960s, various UK institutional and operational initiatives were brought in by the Conservative government. In 1963, a National Economic Development Council (NEDC) and “mini-EDCs” were established in various industrial sectors. The NEDC comprised representatives of business, trade unions and government. A National Incomes Commission was also set up to “adjudicate” on national wage claims. The Wilson Labour governments in 1964 and 1966 took over this embryonic institutional corporatist structure, which owed much to Germany, and added an element of French dirigiste policy via the publication of a National (Economic) Plan. The Plan set both economic targets and actions to deliver the growth, progress on which was discussed by the NEDC, 105

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which received the industrial and regional reports of the individual EDCs. An Incomes Policy was launched, attempting to contain wage growth, and to mirror the German structure of central corporatist bargaining between business and trade unions. It cannot be said that this shift in the 1960s in the direction of modifying the liberal market economic approach in favour of a coordinated market approach was successful. It was perhaps too substantial and rapid a change to the cultural basis of the UK business environment and its industrial relations structure. Hence, for example, although national wage bargaining did exist in the UK, as in the engineering industry, the agreements reached set minimum rates of pay for trades, but collective bargaining at plant level substantially, if unevenly, increased rates from the minimum. As far as cooperation at plant level was concerned in relation to incomes policy, the voluntaristic2 nature of British industrial relations and the adversarial basis of British trade unions – supported by high levels of membership, and with active shop-steward involvement at local level – was not suited to such a rapid shift towards a corporatist approach. Added to these problems was the fact that British trade unions were not widely organized on an industry basis, as they were in Germany, but on a craft and general basis. The 1970s were a time of considerable social change, and of economic turmoil domestically and internationally. The early years of the decade were a period of economic growth, but this growth was followed by a recession, initiated in 1973 by the oil crisis and the substantial raising of oil prices, which rose by some 70 per cent. At the same time house price inflation occurred, following in 1970 the Bank of England’s deregulation of the mortgage market. This had led to banks as well as building societies moving into the mortgage market. At the same time, the credit card (Access) was introduced by Lloyds Bank and gradually private credit card debt began to increase. The mid-1970s saw a substantial rise in inflation, partly due to trade unions attempting to protect the living standards of their members by seeking wage rises to compensate for inflation. A severe deterioration in the trade current account followed, and a reduction in investment income from abroad on the capital account. By the late-1970s inflation was still high and a growing lack of competitiveness of industry was an acknowledged problem. The perception was that this was a threat to the generally rising living standards of the 1970s. In 1979 the election saw the return of a Conservative government led by Margaret Thatcher, with a radical plan for political and economic change. The plan was not going to see any further attempt to experiment with a coordinated market economy approach: very much the opposite.

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Back to liberalism Liberalism – in its neoliberal individualistic market form, strongly influencing the positioning and policies of the 1979 Thatcher government and following governments – returned. The radical changes introduced resulted partly from a reaction to the relative economic failures of the 1970s, and to the earlier lack of success of the move towards a coordinated market approach during the 1960s. However, it was also a result of a remarkably successful intellectual conversion of major sections of the British economic and political elites to the neoliberal market approach espoused by Friedrich Hayek (1899–1992). As a confidante of Keith Joseph, a senior minister in the 1979 Thatcher government and significant influence on Margaret Thatcher, Hayek’s comprehensive, if never entirely consistent, variant of neoliberalism was influential in policy development during the Thatcher years in the UK. In the United States, his version of neoliberalism was to an extent overtaken by the louder voice and monetarist views of Milton Friedman, whose position was less grounded in the European philosophical tradition than Hayek’s. Thatcher was more a Liberal follower in the Gladstonian tradition than a Conservative. Often when people talk about the neoliberalism of the 1980s, they refer to Friedman’s version of monetarism, as if this is what characterizes neoliberalism. But Hayek was a more sophisticated and subtle thinker than Friedman or other neoliberals. He clearly saw the connection with “classical liberalism”, particularly that deriving from the Scottish Enlightenment and at its political heart was individual liberalism. This linkage led directly back to the Gladstonian liberalism of the nineteenth century, a belief in the efficacy of the competitive markets, free trade, and latterly deregulation, with a strong, but limited, role for the state. Hence, in the 1980s, it can be argued that the liberal market economy had returned to its central place in UK political thinking, notwithstanding the somewhat inconsistent UK membership of the EU. It is perhaps not surprising therefore that the Liberal tradition of Gladstone in the contemporary Conservative Party has eventually led, in 2020, to the UK leaving the EU. These neoliberal market views were not seriously challenged during the period of Labour government between 1997 and 2010, and they have had strong currency over the past decade of Conservative-led governments. Only over the past few years has there been any attempted consensual intellectual and political reaction to them. The two versions of political economy We have contrasted the nineteenth-century history of the political economy of the UK with continental Europe, and specifically Germany with its corporatist

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approach, and to a lesser extent France, with its more dirigiste, state interventionist approach. It has been noted that these countries chose to adopt a coordinated market economy model, with a key role for the state: in preference to a liberal market model in which coordination is left to market competition. It will be useful to indicate in more detail the differences between these two approaches to political economy and to consider how these different political economic approaches have influenced policy in Germany in the twentieth century (Germany is selected rather than France, because of the less direct role of state intervention in broad economic policy terms), contrasted with the UK. This will help us to frame the discussion of reform and change of direction subsequently proposed for the UK. The coordinated market economic (CME) approach I am departing to an extent from the original usage in how these terms are defined and how these two variants of the “varieties of capitalism” are proposed as a taxonomy by Soskice and Hall (2001). However, our use of these terms better facilitates illustration of the differences between the adopted national behaviours of the SMEs; of the national business banking systems, and of the national political economic policies involved. The aim here is to demonstrate the mutually reinforcing behaviours of these three elements in determining national business financing models, including those of SMEs. The political choices originally made after the Second World War in the UK and in Germany (and France) owed a debt to the past, but were driven also by the ambitions for political, social and economic development going forward. As already suggested the choices made in the past were strongly influenced by early-eighteenth- and nineteenth-century intellectual elites and by the political, social and economic positions of the countries involved. But the policies of countries are informed also by the institutional architecture they inherit and whose operation is modified through time. The modifications occur because of internal socio-economic factors and by the impact of external socio-economic events. Hence, although the underlying choice of, say, a CME by Germany or a LME by the UK remained, there were a number of modifications of the prevailing political philosophy which affected aspects of the institutional operation of the political economy in each country (Hall 2007). For example, the 1970s oil crisis and its inflationary aftermath and the abandonment of the postwar Bretton Woods settlement, ushering in floating exchange rates, were two major external impacts which had to be met by policy responses in various countries. One example given by Hall, in the case of Germany, is the development in the 1980s and 1990s of a dual labour market when faced in the 1980s with the need to 108

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generate employment at a time when capital was being substituted for labour in the main economy. The main labour market remained subject to the corporatist approach of collaborative agreements between strong national employers’ organizations and strong national trade unions, although with some shift to agreements between workers’ wages councils and employers at decentralized level. What developed, side by side within this key element of the coordinated economic system, was the German form of the “gig” economy with part-time “mini-jobs”, which did not attract social charges. However, notwithstanding this latter development, around 50–60 per cent of wages in Germany were then, and still are, covered by collective bargaining, compared to 15–20 per cent in the UK today. In Germany there is also cross-firm collaboration in the areas of technology transfer and of vocational training. Moreover, the still strong element of collective bargaining enabled wages to be kept down between 1998 and 2005, under Chancellor Schroeder. This national wage compression enabled export prices to be held down and German export surpluses to be generated. In this manner, the traditional German mercantilist approach to international trade was able to be maintained. These responses enabled Germany to cope with internal challenges, such as the need to assimilate the East German Lander (regions) following reunification, and the loss of the D-Mark attendant on the establishment of the eurozone. What Germany also managed, was to maintain the competitivity and growth of its SME sector. This was achieved by a combination of maintaining its structure of local banking, supplementing this coverage by providing subsidized loans to SMEs, via the involvement of KfW Mitellstand in sharing SME business risks with the local banks. What may be observed is the ability of Germany to maintain the distinctive corporatist nature of its commitment to a coordinated market economy, notwithstanding internal and external challenges. The core institutional and legal constitution structure remains, despite changes in the way in which the institutional structure delivers policies, including supplementing these policies with other actions, for example, the dual labour market. Other examples of such coordinated corporatist interventionism could have been used. For instance, the Gastarbeiter (guest worker) policy adopted in the late 1950s and in the 1960s was intended to cope with the acute shortage of labour at that time. The original intention was to repatriate the guest workers, although in the case of Turkish workers repatriation was a limited success. It is important to recognize that the CME approach in Germany is committed to the establishment and protection of the market economy. However, its maintenance is a responsibility of the state and the other structures established, including in Germany corporatist institutional mechanisms. In Germany, the use of the term “social market” implies that the state will provide adequate social benefits and other policies to attempt to maintain social harmony and the 109

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continuance of market efficiency. An example here is the private housing rental market in Germany, which is tightly regulated, ensuring guaranteed 5-year leases, and agreement between landlord and tenant on rent, over the term of the lease. A contrast may be made with the UK’s limited regulation and free market approach in the policy area of privately rented housing. Liberal market economy (LME) approach The LME is easier to understand as it applies to the UK. However, it should be noted that its approach as a political economic policy in the US, as has already been observed, is different from that of the UK because of its distinctive historical, cultural and institutional set up. Some of the same external factors as those impacting on Germany in the 1970s also affected the UK, both in terms of attempting to ensure the competitivity of its industry and in terms of the potential turmoil in labour markets and wage bargaining. As has been described above – impressed with the interventionist policies of Germany and France – from the mid-1960s an attempt was made by the Labour government to shift to a more interventionist economic approach. This attempt failed, perhaps indicating the difficulty of shifting too quickly from an LME to a CME. The next British “reformation” came in 1979, to deal with the inflationary aftermath of the oil crisis and the forced international adoption of floating exchange rates. On this occasion the initiative was to intensify its LME approach, adopting a neoliberal market economic policy. This approach, under the Thatcher government of 1979 and subsequent governments, was, effectively, to revert to the Gladstonian liberalism of the second half of the nineteenth century. This reversion was accompanied by the privatization of utilities and nationalized industries; the sell-off of public housing and the substantial encouragement of private house ownership; financial deregulation and globalization, and reliance on monetary policy to manage aggregate demand. The succeeding Blair Labour government in 1997 did not essentially challenge the LME intensification in terms of political economy. Indeed, in 1997 it reinforced the role of monetary policy by granting independence to the Bank of England. However, it did introduce ameliorative socio-economic measures, including the introduction of the minimum wage and regional development agencies. The successor Conservative governments following the Blair–Brown years might have been expected – the post-GFC problems notwithstanding – to prioritize bridging the Macmillan funding gap for SMEs as a means of stimulating the business economy. In practice, until 2020, obsessed during the past four years with Brexit, the governments have followed an intensified LME approach. 110

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This approach has led to an economy which has a chronic low level of industrial productivity and a weak export performance in industrial goods, not significantly offset by a relatively strong export performance in services. One perspective on the current UK position on productivity can be achieved by looking at the “real social wage”. In contemporary UK, a combination of falling trade union membership from 13 million in 1973 to 6 million in 2020, the perpetuation of a low minimum wage, and a relatively low level of social charges on employers, has led to a low real social wage. In Germany, despite lowering nominal wages, the real social wage has been maintained at a relatively high level. The UK’s low real social wage has acted as a disincentive to employers to invest in either fixed capital or technology in manufacturing. This sector has fallen behind in terms of, for example, robotics. Instead these conditions have facilitated an economic shift into the services sector. Ironically, this feature is the obverse of the role of real wages in stimulating the first phase of the industrial revolution in Britain. In this context, the need for an innovative, high-growth SME sector, strongly supported by the banking sector, remains an essential element in any recovery of manufacturing. Modification of the LME model In response to the above critique, the adherent to the liberal market economic philosophical approach would presumably retort that in a competitive market the banks and other market participants would be supplying all the services required by SMEs. As in the Vickers report, mentioned earlier, there appears to be a prevalent, but rather naïve, view of markets, which suggests that more competition in SME lending is likely – as in any market – to lead to increased provision of finance to SMEs at lower overall cost. The implication is that increase in supply will reduce costs in the market. This is a comparative static view which is derived from a short-term Marshallian view of exchange markets. In the real world other considerations tend to invalidate the pure theory. In such pure exchange markets, providing there is an auctioneer present, providing there is full information to consumers, and that transaction costs are assumed to be zero, then a market clearing price will be reached. Once information costs are significant and transaction costs also are not zero then the model is not strictly applicable. Once time and investment for production are included the model is even less tenable, without substantial mathematical modification. All these conditions apply to the SME loan finance provision market. In practice, not surprisingly, the endeavour to allow “the market” to resolve the Macmillan Gap has, despite being actively pursued for almost 100 years, not achieved the requisite change. 111

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If competition unaided is not alone going to remedy the absence of the provision of long-term investment finance to SMEs, this does not mean that it has no role to play. There is a measure of competition from specialist challenger business banks and from internet-based technology platforms, providing SME access to loans through peer-to-peer lending and other capital market avenues. The impact appears recently to be leading to some consideration being given by the major banks to developing a more comprehensive and long-term relationship with their SME clients. The problem is that the substantial nature of the reform required for the major banks to deliver such an outcome represents a major stumbling block. A move to a coordinated market economy approach in institutional, regulatory, and state interventionist terms is likely to be required to provide the necessary supporting policy interventions. In the nineteenth century, the UK political elites assumed that their country could prosper by virtue of the existence of the British Empire; the development of new markets in its colonies, and the repatriated profits from its banking investment in South America and the US. From one perspective, despite its reducing share of world exports, and with low cost imports remaining at high levels, this strategy worked. However, the strategy also led to the neglect of investment in manufacturing industry, particularly SMEs, a failure which persisted throughout the twentieth century and into the twenty-first century. During the twentieth century, there was no excuse for the UK not examining, and emulating, the German banking system approach; its integration with business; its provision of direct loans at local level, plus the banks’ facilitation of access to capital market funding through the issue of shares and debentures for German companies, large and small. This policy by German banks had meant that financing of the new technologies and the fixed investment required in the second industrialization phase of the industrial revolution was available to companies, including SMEs. Moreover, the major German banks achieved close business links by their establishing a role as capital market players, becoming underwriters and proxy stock managers, as well as lenders. This close relationship between banks and industry was an issue remarked upon in the 1931 Macmillan Report. The UK financial elite, working out of London as a developing global financial centre, were able to reassure the late-nineteenth century economically liberal political elites that the fruits of the growing investment in infrastructure and other economic activities around the world meant that repatriated profits were more than enough to offset the decline in the export of goods. Indeed, balance-of-payments surpluses were recorded. The advent of the First World War and its aftermath masked the manufacturing economic and trading decline of the UK. Subsequently, during the 1930s, with the belated abandonment of 112

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the sterling gold standard in 1931, and the Great Depression, almost a century of free trade was left behind. The UK imposed tariffs on all imports, including those of food. At the same time, via the 1932 Ottawa Agreement, imperial preference was relaunched, and hence a wider circle of tariff protection was established for the UK and its Dominions.3 Hence, the already existing imperial preference was considerably intensified, a 50 per cent increase in trade in this trading area was experienced between 1930 and 1938 (De Bromhead et al. 2017). From the UK perspective this period saw a fall in both imports and exports, as a percentage of GNP compared to 1913, but a trade deficit remained. However, this focus on domestic production, behind tariff walls, achieved an economic growth of 4 per cent per year between 1932 and 1937, although unemployment in the UK’s depressed regions was substantial. In the contemporary situation, in 2020, there is again the possibility of emulating the structure of the German banking system. In Germany, since 1948, there has been a German state bank, KfW. It is 80 per cent owned by the Federal Republic of Germany and 20 per cent by the Lander (the regional states). It was set up after the Second World War to work with the Marshall Plan on the reconstruction of Germany, but has continued to provide finance, albeit indirectly, for infrastructure and to support the German SME sector, working with local banks. It is the third largest bank in Germany and is funded 90 per cent by borrowing on global capital markets, via bonds issued by the bank. It has a AAA rating from credit rating agencies as its bonds are, effectively, underwritten by the German government. It is run independently of the German state, which means that from a European Union perspective its support to SMEs, indicated below, is not counted as state aid. Some 90 per cent of its annual lending is done through its main business unit, principally to housing and environmental projects. Its other key business unit, more interesting in relation to business banking operations, is the KfW Mittelstand. This business unit lends indirectly to SMEs, via on-lending to the large number of smaller savings and cooperative banks in the regions. It also works through the branches of commercial banks in the same manner and is not, therefore, competitive with them. KfW provides its loans to the local banks which directly lend to the SMEs at low interest rates. In this manner KfW shares the risk with the SME’s bank, which can then lend at a significantly discounted rate to the SME. The British Business Bank, which some might see as an equivalent body, does not operate on this basis and is not independent of the state. Various separate UK government “funding for lending” schemes have attempted to provide similar support via British banks, but the sharing of risk has not copied the KfW model and thus far such schemes have not been as successful. There is no political or economic reason why a British version of KfW could not be set up. 113

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Further discussion on such a possible development will be left until the final chapter. However, a coordinated market economy approach would have other dimensions. In Germany, France and Italy, state intervention – not on an ad hoc basis as in the UK – is seen as part of the role of the state to ensure that the market is continuously serving the interests of business generally and of the wider economy. Barriers to change The alternative view, supported by those political, financial and economic forces in the UK who are dedicated to preserving a liberal market economy approach, is one which prevents an appraisal of the benefits of a shift towards a coordinated market economy approach. For example, business bodies like the CBI and BICC, tend to take a less than enthusiastic view of any radical attempt to alter existing structures and the overall liberal market economic approach. This position is that: (1) business knows how to run business and wishes to minimize “interference”; (2) government support should be in line with what business determines it wants; and (3) government interventions are likely to be damaging to business interests and will, thereby, weaken the economy. This set of propositions might be regarded as a parody of the position of business, but it is not far from the truth. The position taken in this book is also strongly pro-business, in particular, the SME sector, but takes the view that significant and widespread reform is essential if the UK is to develop a vibrant, innovative SME sector, able to lead, as does the German SME sector, a dynamic export sector. Such a reform path will involve state intervention. Unaided competition may work its “magic” in some markets, but, generally, competition can be slow and uncertain in its impacts and may have unintended consequences. It may be countered that so too has radical policy or regulatory change. However, prior impact assessments are used and are able, to a large extent, to prevent negative outcomes from policies. The outcome of competition on the other hand is, by definition, slow and blind! The significant development of regulation in the nineteenth and twentieth centuries implies that state intervention was necessary to prevent damaging business practices, whether in terms of damage to people, workers, consumers, or other commercial companies. By that token, intervention and regulation is needed to encourage the emulation of good practices across sectors or business generally. Regulation may be used therefore as an essential adjunct to competition, both to stimulate innovation (which is the most effective way to reduce costs) and to encourage emulation of good practice across a sector. Appropriate

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intervention can deliver these outcomes, faster and more efficiently than competition alone. Given the oligopolistic structure of the British banking sector it is difficult to see how market competition as it is normally conceived, in terms of increasing the number of market participants and lowering prices, will work. The Vickers Commission tended to take the view that competition would lead to greater choice for customers and lower prices to the consumers of banking services. Despite having over 50 small challenger banks (although, as we’ve seen, most are personal retail banks only and do not serve business customers) and a further 10/11 other foreign banks, neither of these outcomes can be observed. Bank customers, whether personal or business, can see no good reason for switching and the inertia observed at the time of Vickers has remained. The oligopoly maintained by the Big Five will ensure that the prices of services will remain comparable, with only minor variations, which will have no significant impact on overall pricing. With the advent of the development of internet-based financial platforms, there is a need for banks to respond to the challenges of the new fintech competitors. Banks will need to create a more detailed picture of the specific requirements of each customer. The services and advice that a technology business just starting out requires will be different to a well-established manufacturer. The key question for the banks is whether they can continue to invest in the operational excellence required to deliver basic services at a competitive cost, while at the same time developing more responsive digital capabilities to compete successfully with newcomers in the finance sector. Technological change provides the possibility for banks, as capital market players themselves, to be able to provide a greater range of services to SMEs, with, potentially, concomitant increases in revenue and profitability. The only disruptive change in relation to competition for the major clearing banks would be if one of the major technology giants, such as Amazon or Google, decided to become involved in providing finance to SMEs, on a substantial scale via technology platforms. Meeting this competitive challenge will require British business banking to deliver a more comprehensive partnership service to its SMEs. This could be achieved by continuing to provide the same basic services as efficiently as currently, but, in addition, to provide a deeper, comprehensive partnership service. If this call is heeded – provided the changes in SME perspectives, and the relevant modifications to the liberal market economic model, are also made – then this would usher in a key element in the substantial reform package recommended later in this book. It remains to be seen how far and how rapidly significant change from the side of the major banks will take to materialize.

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Conclusion Notwithstanding the adherence to a liberal market economy, and a desire to avoid moving towards the coordinated economy approach of a number of other EU countries, some limited initiatives have been taken in the UK to attempt to address the widely recognized problem of the Macmillan Gap in the investment financing of UK SMEs. There have been institutional innovations and other initiatives, proposed and implemented, to attempt to remedy the funding gap affecting SMEs (e.g. the British Business Bank). Often other initiatives, for example, at the level of UK regions, have been linked with the use of funding from EU sources, via the European Regional Fund and the European Investment Bank, specifically its European Investment Fund. However, these purported remedies have not resolved the problem: the fundamental issues arising from the structure and behaviour of the British business banking sector have not been addressed. Nor have they resolved the wider economic issues relating to the unreformed liberal market economy approach adopted by the British state since 1850, notwithstanding some temporary breaches in the ideological wall. Nor has the advent of the introduction of other European banks into the UK, or the emergence of new smaller challenger banks, appeared to have had, so far, any measurable national impact on the provision of loan finance for SMEs, The key problem remains the inadequacy of long-term financial investment in UK SMEs. This failure has its roots in a deeper, nineteenth-century historical and cultural commitment to a liberal market economy. It has been suggested that, historically, during the 1870 to 1913 period, the absolute commitment to laissez-faire, competitive markets domestically, and to free-trade policies externally, led to a loss of the British industrial and innovation leadership established in the first half of the nineteenth century. These policies led to a significant decline in the British share of manufacturing exports in the second half of the nineteenth century, with the UK being substantially overtaken by both the US and Germany by its end, with France also challenging. The fact that this policy did not lead to a collapse in the value of the pound, tied at the time to the gold standard, and noticeable economic problems, was because of the substantial outward financial investment in other countries’ infrastructure and industry, led by investment banks in the City of London. This outward investment meant that the substantial profits repatriated allowed the UK to maintain a surplus on its balance of payments, and hide the failing performance of UK business, particularly of SMEs starved of adequate long-term investment finance. The early “financialization”4 of the British economy, and the continued failure in the export of manufactures, was carried into the twentieth century, interrupted for a period by the introduction of imperial protectionism during most of the 1930s. This financial economic structure still negates a clear understanding 116

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of the need to energize the key SME sector of the economy in contemporary Britain, via the provision of long-term investment finance. The continuing commitment of the UK political and economic elites to an unreformed liberal market economy, despite experiments in the1930s and the 1960s, remained a problem. More recently, in 1979, the commitment to liberalism was reiterated with the ushering in of a renewed, intensive political commitment to neoliberal market orthodoxy. To produce a shift in the current orthodoxy, and its attachment to the liberal market economy, will not be easy. Aside from the inevitable political difficulties – with the prevailing views of the main political parties, excepting the Labour Party between 2017 and 2019, supporting the liberal market economy approach – there are other wider interests to convince. These include bringing on board business representative organizations, the trade unions, and civil society organizations. The issues concerning how the change may be brought about are discussed in more detail in the next two chapters. There are cultural and institutional changes in British business banking and in SME performance improvement which are required, in addition to state intervention. The next chapter discusses the institutional structures and operational practices of the UK, German and US business banking systems, the performances of British SMEs, in terms of business behaviour, and the role of the state, with reference to optimal structures and behaviours.

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It is evident that institutional and behavioural change is required if the problems outlined in previous chapters are to be addressed. This chapter will first suggest what may be considered the optimum conditions in an economy which need to be met in order to achieve effective financial institutional structures and strong business performance, especially for the key business sector of SMEs. The differing approaches of Germany, the United States, and the UK will then be compared in relation to these criteria. The aim will be to identify the institutional structures and modes of cultural behaviour in the three countries. The intention is not to suggest that there is some perfect set of institutional structures and operational behaviours which the UK should adopt. However, the contrasting situations will provide some clues as to what might, with advantage, be changed in the UK. The potential for changes will then be addressed: covering changes in banking institutional structures and operational practices; potential alterations in the policy approaches of the UK government in dealing with the British business banking sector, and improvements in SMEs’ performance, aimed at more productive interaction with banks. First, a summary list of optimum performance requirements, for banks, for SMEs, and for the state, are set out. Optimal performance requirements Banks Bank lending to business involves risks. This is simply a reflection of the fact that business itself involves risk. Entrepreneurs are the supreme risk-takers. But most businesses need to consolidate their positions and try to reduce risks by achieving a level of competitivity to provide a stable platform to continue in business for many years. Their needs for finance and investment throughout their lifecycle, especially SMEs, will vary. Much of the finance of successful businesses

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may be sourced through retained earnings, but not all. Investment finance and working capital will be required from external sources, especially banks. Historically, the role of banks has been to raise funds from savers via deposits, creating liquid funds, and recirculating these deposits to businesses needing to borrow to invest in productive capital. The businesses will also require working capital and this short-term funding they will also request from banks. Aside from charging fees for services, banks, as businesses themselves, will wish to achieve a return on their assets/capital. This return will be achieved essentially from the difference between the rate of interest paid on deposits and that charged to the business borrowers, as a ratio of their capital assets. The latter interest charged will reflect the risk which the bank takes in loaning to the business which, if it has borrowed to invest, will see a cash return on that investment only in the longer-run, dependent on the estimated revenue return on the investment. This much is clear and obvious, and indeed elementary. In a modern monetary economy, the position of banks is rather different. The advent of central banks means that banks do not need deposits in order to make loans. Banks will make loans to creditworthy borrowers, and the act of making the loan (an asset to the bank) will create a deposit (a liability) which will be held as a reserve at the central bank. In addition, banks are also able to maintain liquidity by borrowing on the inter-bank wholesale money market. Moreover, banks are not simply businesses. They have a crucial economic role that the British business banks seem to have forgotten, perhaps deliberately. The liquid funds of banks, originally, and to a limited extent still, deposits, are short-term funds, i.e. they have borrowed short. However, when they issue investment loans, rather than providing working capital for businesses, these are long-term investments and will be repaid over the term of the loan, i.e. they have lent long. This is the bank’s economic role. However, if you ask any banker in the UK, even the most progressive, they will answer that the injunction that they obey, in practice, is to borrow long and to lend short, the obverse of the key economic role of banks. So, the first optimal requirement for the healthy political economy of a country is that the banking sector recognizes their economic role. The second banking requirement is that investment lending to businesses should be prudent, in that the risk taken by the bank in lending for investment should be carefully assessed, but not so strictly that the investment risks are set unreasonably low. How this economic desideratum is achieved will determine the success of the national economy.

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SMEs The predominant business culture of SMEs should be focused on long-term growth and survival, bolstered by the retention in the business of a large proportion of owners’ remuneration, set aside for investment. Family-run businesses tend to score highly on this requirement, although in the UK and the US family businesses nowadays rarely persist into the third generation. An exception to the long-term growth objective is where the start-up company is in a sector in which a short-term, high-growth strategy aimed at takeover by a large company may be a relevant objective. This strategy tends to most apply to innovative information technology and biotech companies. A further valuable attribute is the close involvement of the SME business in the local community, including mutual supply chain linkages. If there can also be proximity to a local bank or a bank branch then this will also be advantageous. SMEs need to establish efficient financial management systems, both to enable critical cash flow management for their own internal purposes, and so that the companies’ interaction with their bank is placed on a recognized professional footing. The latter condition will be important in any attempt to secure finance for investment from the bank or other financial institution, for example, equity investors. The state and political economy Economic growth performance in any country is influenced by the level and nature of the involvement of the state with both business and the banking sector. This involvement may be mediated in various ways. In some cases, the linkage may involve the state in direct involvement with the banking sector or businesses or both. The establishment of state business banks is one direct mode of involvement with the banking sector and this relationship enables the state directly or indirectly to assist with the financing of SMEs. In Western capitalist economies, direct support of companies is usually substantially constrained. In most countries some form of strategic planning or direction is practised, often directed at promoting and supporting innovation and technological development. Other methods whereby state support is advanced to companies is via the corporate tax system, for example, tax relief to encourage retention of gross profits for investment purposes, start-up grants, export credits guarantees, investment grants and tax allowances, etc. Various subsidized or free advice schemes for SMEs, for example, for financial management or exporting, are other modes of support. In addition, company law procedures should facilitate the establishment 121

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of companies and enable minimal penalties for liquidating a company and rapidly re-establishing a replacement company, save to protect against fraudulent trading. Finally, regulatory institutions and procedures govern a variety of areas affecting banks and SMEs. Regulatory procedures are generally targeted on three main objectives. The first objective is to protect the financial stability and viability of the banking sector and the financial system more widely, and to implement the various international obligations arising from the EU or the BIS arrangements. The second objective is to prevent malpractice and discriminatory behaviour of banks, other financial organizations, and companies. The third objective is to promote competition, to prevent market abuse, and to encourage the financial support of SMEs within the constraints of EU and international organizational obligations. Meeting the requirements We will now explore, in broad terms, the existing structural and operational realities for banks, SMEs and the State in the UK, Germany, and the United States. Notwithstanding the need to provide an international perspective, albeit in summary form, more detail will be provided in the description of the UK performance than in the case of Germany and the US, to avoid repetition of information provided in earlier chapters. The UK Banks The extreme concentration of the UK banking sector, plus the centralized management structures and decision-making of UK major banks, ensures the substantial provision of overdraft finance, against readily assessed security, which can be the company’s receivables or a lien on property. In the case of loans, obviating the traditional asymmetry of information and of benefit between lender and borrower can be achieved in two ways. First, by a detailed assessment of the business risk, via a close examination and monitoring of the business performance of the company concerned by the bank. Currently, for SMEs, this is not generally done. Instead, centralized algorithmic criteria are used to determine accessibility. Second, banks could charge a higher rate of interest, for SMEs. Again, this is not generally done. Instead, credit rationing to exclude some SMEs is the preferred approach. The British business banking sector appears to have become aware of the trend, particularly since 2013, towards some SMEs using internet-based 122

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funding, with peer-to-peer debt borrowing the most prevalent avenue being used. It appears that debt rather than equity is preferred, except for a proportion of start-ups. Banks have, generally, taken the view that the extremely small value, albeit growing, of this market share does not represent a threat and have only tentatively sought indirect participation in the market. The use of asset-based finance, i.e. equipment leasing and hire-purchase, is being provided as SMEs seek finance for fixed capital which remains elusive via bank loans. Provision of investment finance in this manner is one of the routes taken by the Close Brothers merchant bank, in liaison with its Winterflood Securities subsidiary. The major banks are beginning to enter this market, via partners. The major banks could share risk more safely by analysing and monitoring the financial and business performance of the loan applicant company. This is one option which could be explored, although, given current operational practice, not easily. The recent problems for SMEs in accessing the government’s Covid19 business interruption loans exemplify the problem. Banks simply do not have detailed financial information on the SMEs requesting the loans, even though they are acquainted with many of the companies. Another problem faced by innovative SMEs, when trying to recruit capital for investment purposes, is the lack of knowledge on the part of the banks, or other investors, of the market for the service or product concerned. Again, if banks were providing the comprehensive set of services which they could provide then they would have access to both in-house staff and outside experts to assist with their assessment of specific product markets. There is not a structure of local SME business banking in the UK, except for overdraft funding. The five major clearing banks have a continuous drive to reduce the number of local branches, which, in any event, are unable to assess SMEs for investment loan purposes, only for overdraft funding. There are now over 50 small challenger banks in the UK, although most are in London. However, these banks are essentially personal retail banks and the majority are not currently structured or operated to provide business investment support to SMEs. Of these new challenger banks, only three or four are attempting to operate as business banks. It remains to be seen whether any impetus for changed attitudes towards the financing SMEs emerges from the deployment of the Capability and Innovation Fund as part of the 2019/20 Alternative Remedies Package (ARP), described in Chapter 4. The attitude of the UK government, expressed in the disbursement of the ARP, appears to indicate a desire to incentivize a move towards the decentralized branch relationship approach pioneered in the UK by Handelsbanken, which is in line with the recommendations in this book. It remains to be seen whether this indirect message is understood and acted on by the major clearing banks. 123

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Whether the major clearing banks are willing or indeed able – given their current structures and culture, to provide the comprehensive service, including the provision of standard business loans of adequate longevity – is not obvious. SMEs UK SMEs, especially those in manufacturing, tend to focus on short-term outcomes and to be not so concerned with having an investment strategy aimed at achieving long-term growth. It was suggested that this situation is often a “chicken and egg” problem. In the absence of a culture which both reinforces long-term business growth objectives and, via bank lending and comprehensive banking services, provides the investment capital, SMEs are likely to avoid committing to long-term business growth. There is a mutual reinforcement of attitudes, between banks and SMEs which, when enlarged to a macroeconomic level, is damaging to export growth and overall UK economic growth and innovation. It should be recalled that contrary to a common belief around 40 per cent of UK SMEs participate directly or indirectly in exports. The UK also has a substantial services sector, some 80 per cent of GDP is represented by the sector. This split is also replicated in the SME sector. In practice some of the shift to services is partly a result of changes in statistical nomenclature and the close linkage in some business areas between manufacture and services. All the points made above in respect of the behaviour of manufacturing enterprises also apply to service-sector SMEs. Obviously, there are differences, notably that there is less call for investment in fixed capital, except for the provision of property, i.e. office and workshop space, for which funds are more readily obtainable, including from banks. Nonetheless, despite less dependence on fixed capital, service SMEs can still suffer cash flow problems and poor financial and cash management is not confined to manufacturing companies. For some service companies, research and development – which can be capitalized in accounts – is equivalent to an inventory cost which cannot be turned into a product for sale until the results are encapsulated in the final product for sale. This can readily be identified in the case of both software companies and biotech companies for example. For this reason, it is not appropriate for such services companies to use overdraft provision to fund what is research and development capital expenditure. It is interesting to note, however, that the export record of the services sector far outperforms the manufacturing sector. For instance, although manufacturing has a substantial trade deficit with the remainder of the EU, the services sector has a healthy surplus with the rest of the EU. This position is not an explicit criticism of the UK manufacturing sector. One of the explanatory factors, that might be offered, is that, on average, there is a higher value-added across the 124

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services sector, and the value-added will be significantly higher in the area of professional services, including financial services. Finally, as the academic research below confirms, British SMEs, although they are not alone, have inadequate financial management and cash management systems, such that, in general, they are unaware of what substantial financial performance could be achievable or, if they were aware, were often unable to take the necessary steps to achieve the essential improvement. The state In general, the state, given the British liberal market economy approach, does not, in contemporary Britain, except under severe economic stress, such as the current Covid-19 crisis, intervene in the business economy. Obviously, and for good reason, the financial sector is, nonetheless, subject to regulation by statutory regulatory agencies. In the UK, the primary legislation providing the framework for that regulation and the establishment of the agencies is the Financial Services and Markets Act 2000 (FSMA). The regulations involved are supplemented by EU financial regulations, setting minimum standards, and which were directly transcribed into UK law and implemented via the regulatory agencies. There are three main agencies: the Bank of England (BoE), the Prudential Regulation Authority (PRA), a division of the BoE, and the Financial Conduct Authority (FCA). The PRA and the FCA are the lead bank regulators. The BoE is the resolution authority, with primary responsibility for regulatory intervention and exercise of resolution powers in relation to banks that are failing or likely to fail. The PRA’s primary objective, macroprudential policy, is to promote the safety and soundness of those institutions authorized by the PRA, by seeking to ensure that their business is carried on in a way which avoids any adverse effect on the stability of the UK financial system. Its secondary objective is facilitating effective competition in the markets for services provided by those institutions. The FCA is responsible for conduct of business, effective financial markets, consumer protection, and for promoting effective competition in the financial services retail market. Forms of lending that incorporate financial instruments (such as securities, funds or derivatives) are generally regulated under the Directive 2014/65/EU on markets in financial instruments (EU MiFID II) regime for investment activities. Hence a variety of registered banks have permissions to enable them to provide other financial services such as securities brokerage and providing investment advice. However, the bank must establish and maintain an independent risk management function, to implement its policies and procedures. A bank is also required to maintain financial resources equal to or greater than its risk-weighted assets as a cushion of cash, reserves, equity and subordinated liabilities available to the bank to absorb losses during periods of financial 125

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stress. There are two tiers of risk-weighted assets: broadly, ordinary equity (Tier 1) and broadly, subordinated debt (Tier 2). Under the standardized approach, used by most small challenger banks, their assets are given a predetermined risk weighting, set according to the type of asset in question, for example, business loans. To obtain an independent internal risk-weighting procedure (IRB) is an onerous task for the smaller institutions, even for those which have existed for some years. Regulators as well as banks must be able to be flexible and to understand where regulations are being interpreted in such a manner as to be prejudicing the ability of financial institutions to lend to higher risk businesses, and particularly to SMEs. The evaluation of risk-weighted assets is one area where constant attention is required to ensure that it is not preventing loans from being made available to qualifying SMEs. It is in the area of macroprudential policy, operated by the BoE, where attention is paid to the systemic risks of the banking sector as a whole. This goal is achieved by ensuring the resilience of the financial system by reinforcing the stabilization of the supply and cost of credit during upswings. But in downturns, the primary role of macroprudential policy lies in maintaining the flow of lending by allowing buffers of regulatory capital to be drawn down, for instance, as in the case of the need for credit provision from banks in the Covid-19 pandemic. There is a British Business Bank, but this is not a state investment bank on the lines of the German state bank KfW. It operates essentially as a credit broker: providing links to a variety of financing organizations, including some banks, alternative finance providers such as the Funding Circle, and equity finance providers. One problem here is the noted reluctance of British SMEs to dilute owners’ equity. There is a bewildering array of business support schemes for SMEs, some providing useful innovation grants and loan schemes, others providing grantaided consultancy and training, both for start-ups and on-going support. None of these schemes, however, provide the long-term investment needed by SMEs. Germany Banks For historical reasons, set out in previous chapters, the distinguishing feature of the German banking sector (although it is to a more limited extent replicated in France and in Italy) is the large number of local small savings banks (Sparkassen) – the largest global banking network – and cooperative banks. There are three large banks, including the state investment bank KfW. KfW is the third largest, and has, as already described, a specific role supporting SMEs by working through the local savings banks and other banks locally. The two other large German commercial banks, Deutsche Bank, the largest, and CommerzBank are 126

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universal banks, incorporating retail and investment bank structures; they are also concentrated on working with large German businesses. The GFC had an asymmetrical impact on the German banking sector. The two large commercial banks suffered losses, arising from their substantial forays into securitized lending and the contagion spread across global investment banking centres. On the other hand, the Sparkassen savings banks and the local cooperative banks, operating on the conventional financial intermediation model of making loans against their deposit base, were protected against the immediate impact of the GFC. Since 2014, however, because of the post-GFC low interest rate regime applying across the Western banking sector, including Germany, these local banks have found their interest margins, and hence profits, under pressure. This has resulted in a number of mergers, within the Sparkassen network and a reduction in branches, and in the size of their workforce. However, given the ability of the local banks still to avail themselves of discounted loan rates from the involvement of KfW, they have been able to maintain lending to German SMEs. Any impact will have been on requiring more secure collateral for the local banks. This action may have resulted in some fall-off in the volume of new loans to SMEs, with some smaller companies and sole traders being unable to provide appropriate collateral. In Germany, the structure of local banking, via the Sparkassen and cooperative banks, supported by the nationally operating state bank KfW, provides comprehensive support for German SMEs. This provision includes standard discounted loans, up to terms of 30 years in some cases. In this way there is support and encouragement for the long-term growth strategies of German SMEs. SMEs German manufacturing SMEs, and particularly the whole range of medium-sized enterprises, the Mittelstand, are not only focused on long-term growth, supported by investment and re-investment of funds, but also make a substantial contribution to the export strength of Germany. The reasons for this striking difference in the perspectives of UK and German manufacturing SMEs lie partly in the business culture of German SMEs, but is also linked to the support from banks in providing loan and other capital market finance to support investment in innovation and long-term growth. In 2012 bank lending accounted for 28 per cent of German SME investment funding, predominantly supplied by the localized banks. German SMEs themselves often operate within networks of association, with interlocking ownership patterns; a commitment in local and regional communities as an expression of a common social purpose, and a long-term investment perspective which eschews short-term profit-seeking in favour of the maintenance of the longevity of the company. This is particularly apparent in the 127

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tendency for German SMEs to retain and invest a large proportion of earnings; estimates put this as high as 90 per cent. This high level of earnings retention for investment purposes should be understood in the context of a large number of long-established, family-controlled companies (84 per cent are family controlled), with generally very clear understanding of finance, and very long-term views of their operations. The state Overall, the twin cultures of the German banking sector and German SMEs, supported by a coordinating approach by the German state, appears to provide a valuable institutional nexus which supports the provision and use of long-term investment finance. The motivation behind the coordinated market economy approach of Germany is that the role of the state is viewed as critical in supporting the social market, by providing a supportive legal and financial framework. This approach is consonant with state intervention to ensure the efficient national performance of the economy; justifies a cartelization approach to business; a mercantilist approach to external trade, and the maintenance of an interventionist state bank.

The United States Banks The banking system and its structures in the US is notably different from that in the UK (and in many respects from Germany). There is no state bank. Large banks, which are in some cases universal banks incorporate investment banking operations, as well as corporate and personal retail banking. For example, JPMorgan Chase, operates Chase as its retail banking arm. Wells Fargo, based in California, is the largest bank and is essentially a retail bank. Its East Coast equivalent in New York is Citibank. Bank of America which incorporates Merrill Lynch is another universal bank. However, the “unitized” nature of the main banking system, with many small local banks is still extant, although mergers with the larger banks are now increasingly taking place across individual states (see Chapter 2). In agricultural regions, noting that the US is still a major agricultural producer and exporter, there is still to an extent a close relationship between these local US banks and agricultural producers, and associated manufacturing, and biotechnology companies, covering also the agricultural services sub-sector. A growing feature of the US financial market is the development of internet-based technology platforms. Their development is leading to a rapid expansion of equity crowdfunding sources of investment finance for SMEs. This 128

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development, together with significant in-house investment funding via retained earnings and owners’ capital, contrasts with the UK situation. Nonetheless, 50 per cent of US SMEs still complain about the absence of bank-sourced investment finance. It also seems, as the use of equity crowdfunding suggests, that in the US there is less concern expressed about owner-managers having to share equity with outsiders. It will be recalled that in the UK the growth of new sources of platform provided investment finance is via peer-to-peer debt funding, rather than equity crowdfunding. SMEs The need in the US to access bank funding for investment is akin to that in the UK. Firms with fewer than 500 employees, are the backbone of the US economy and employment. They make up 99 per cent of all firms, employ over 50 per cent of private sector employees, and generate 65 per cent of net new private sector jobs. America’s 28 million SMEs account for over half of US non-farm GDP. SMEs are also more inclined to export than are large firms, albeit their export participation is quite limited compared to other advanced nations, with only 5 per cent of all SMEs engaging directly in exporting. However, manufacturing SME exporters still represent 98 per cent of all US exporters and, significantly, 34 per cent of US export revenue (US International Trade Commission 2019). Looking at manufacturing SMEs, where the demand for fixed capital is significant, their relationship with banks to an extent replicates the UK in terms of the problems of sourcing investment finance. However, retained earnings, i.e. owners’ capital, and equity crowdfunding appear partially to fill the gap which insufficient access to investment finance from banks create. SMEs in the US appear also to be more growth oriented. In other areas, software and biotech companies, for example, there is anecdotal evidence that these companies’ high growth is aimed at being bought-out and then starting another company. As in the UK, bank loans in the US to SMEs (less than $1million turnover) in 2017 only accounted for 6 per cent of finance, with retained earnings (63%); owner’s capital (25%), and external finance, including bank loans (12%) (Federal Reserve Bank 2017). However, as these statistics illustrate, in the US, the combination of retained earnings and owners’ capital is used to fund the majority of SME investment requirements. The state The prevailing liberal market position of the US was based originally on an aggressively competitive economic model – supporting the Schumpeterian notion of creative destruction. To an extent this view still prevails in terms of the corporate law stance which for SMEs enables companies to “fail” without substantial obloquy or legal or financial penalties. New companies can arrive directly out 129

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of the ashes of the previous company. This facilitates business owners taking a long-term view. The US Small Business Administration is active in support of SMEs, providing business advice, guaranteed business loans, and advice on federal government contracting. Grants are provided for research and development and for exports. The above comparisons suggest how the UK economy might optimize the structure and functioning of its small business economy, by changing the culture of the banking system and the state, and the performance of SMEs. Before discussing any proposed changes, we should take advantage of some of the recent research in the area of SME performance. SME performance There is now a copious volume of research on SME performance in the UK, the US, Europe, and around the world. Some of the research is indicated below, but a number of dominant themes emerge. Not all of these relate directly to the absence of adequate long-term investment finance, but some do relate directly, and others are indirectly related. For instance, if a company has inadequate financial and cash management systems then, if and when, it seeks an investment loan from a bank the company may fail to present the request for the loan, such that the bank may not be convinced of either the financial viability of the investment or the ability of the SME to repay the loan over a reasonable period of years. (Refusal of loans by banks may not, of course, be entirely the fault of the SME: the bank may itself be at fault). More generally, the research suggests that the long-term survival of any SME is heavily dependent on the effective management of its working capital. Inadequate financial management appeared to be both the reasons given, and from an objective assessment by official receivers, for the involuntary liquidation of 100 UK SMEs (Hall & Young 1991). In an overview of research in this area, Jindrichovaska (2013) indicates that the critical issues in relation to the financial management of SMEs are: (1) the question of liquidity and cash flow management; (2) the question of long-run asset acquisition; and (3) the question of capital structure, securing funding, and the cost of funding. All these issues relate indirectly to the relationship of an SME with its bank. There is a specific problem for banks in measuring credit risk of SMEs, and particularly micro-businesses. Assessment needs to be different from that applied to large firms. SMEs appear to be influenced by their owners more directly and significantly, as one might expect. For this reason, assessing the credit risk of the owner-manager may be a more appropriate measure of the likely risk of default than more standard measures applied to the business (Bhunia 2012). 130

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Another issue, discussed in Chapter 3 in relation to access to finance, is the need for both SMEs and banks, and other potential financiers, to utilize an appropriate conceptual framework. It should be one which recognizes SME growth as a series of stages of development through which the business may pass in its lifecycle. The SME is likely to require different levels and types of funding throughout the enterprise lifecycle (McMahon 1993). A consensus across the literature appears to identify three stylised SME development pathways which may be identified. The first is a high-growth path followed by entrepreneurial SMEs (only around 5 per cent of SMEs). A second is a moderate, steady-growth path (probably accounting for around a quarter of SMEs). Finally, there is a low-growth path: the traditional or life-style SME configuration (probably representing the majority of SMEs). These characteristics – broadly also applying to British SMEs, and linked to enterprise, sector, age, size, and growth variables – have already been discussed in this chapter and in previous chapters (McMahon et al. 1993). In subsequent research McMahon presented a study of financial management characteristics on business growth and performance among SMEs engaged in manufacturing. The author found that “enterprise characteristics” seem to dominate in their impact upon SME achievement, with financial management characteristics, other than use of external financing being relatively unimportant. Development orientation and the existence of internal and external constraints appear to be the most influential enterprise characteristics (McMahon 2001). However, other studies have indicated the importance of good financial management (see below). Moreover, McMahon’s findings do not necessarily contradict these findings. His study states that “competence in financial management, taken together with other functional capabilities, is likely to lead to more effective and efficient management of SMEs and significantly improve their prospects” (McMahon 2001, abstract). Key factors relevant for the UK small business sector appear to be size, age, profitability, growth and future growth opportunities, operating risk, asset structure, stock turnover and net debtors. All of these variables seem, collectively, to influence the level of short- and long-term debt in small firms. The efficient deployment of working capital is therefore an important variable. Managers can create value by reducing their inventories and the number of days for which their accounts are outstanding. Moreover, shortening the cash conversion cycle also improved the firm’s profitability. This view is confirmed by a comprehensive study, involving a panel of 8,872 small to medium-sized enterprises, covering the period 1996–2002 (Michaelas & Chittenden 1999). More generally, emphasis on the importance of entrepreneurship for the success of SMEs can be misleading. Entrepreneurship, as deployed in practice, should be defined as a “bundle of characteristics”. These include competence 131

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in financial management, human resource management capabilities, knowledge and experience in the sector area concerned, plus the one characteristic which cannot be taught (despite what some business schools suggest), i.e. risk-taking. Another relevant factor in European countries is the role of trade credit. On the one hand, larger SME firms with the capacity to obtain resources from the capital markets, and more cheaply, are able to grant more trade credit to their customers. Research also found that these firms react by increasing the credit they grant in attempting to stem falling sales. On the other hand, larger SME firms, with greater growth opportunities and greater investment in current assets, receive more finance from their suppliers. Where firms have alternative sources of finance, they are less likely to resort to requesting supplier trade credit financing. Collaborative and flexible arrangements with suppliers, nationally and internationally, show a strong positive relationship with SME employment and turnover growth; collaboration with local suppliers also has a strong positive relationship with growth in profitability (see García-Teruel & MartínezSolano 2010). Wider research has suggested that for SMEs in many countries, one main problem, which reduces long-term profitability, lies in the inadequacy of financial management practices in small firms. The practices cover a range of issues, for example, monitoring cash flow, assessment of capital investment projects, use of surplus funds to earn returns external to the company, etc. The use of various ratios relating to the return on assets, on sales, etc. are often confusing to firms and the efficacy of such ratios is related to the sector and product profiles of the companies (Kieu Minh Nguyen 2001). Having a comprehensive system for managing capital expenditure, which also manages investments, financial resources, and working capital is a necessary condition for SME success. In an overview of SME research, Jindrichovaska (2013: 92) concludes that: It is no coincidence that successful companies enjoy above average returns on capital investments rather it is proof of the efficiency of systematic management and control of the working capital cycle. Financial managers are concerned with three fundamental types of decisions: capital budgeting decisions, financial decisions and working capital management decisions. Financial management cannot be ignored by a small enterprise owner-manager; or as is often done, given to an accountant to take care of the function. In prosperous small enterprises the owner-managers themselves have a firm grasp of the principles of financial management and are actively involved in applying them to their own situation. One might add that because of British SMEs’ inability to obtain standard loans from UK banks they attempt to use, inappropriately, 132

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overdraft and “structured-term loans” to purchase fixed assets, i.e. as investment, thus creating further pressure on working capital resources. The specific lessons derived from the above research are as follows. Firstly, the owner-manager/entrepreneur of the SME should have a firm grasp of the principles of financial management and should be actively involved in applying them to their own situation; this critical function should not be delegated to the accountant. If there is a finance director, then that person should be in continual discussions with the owner-manager about the situation. The financial performance and the production and business performance of the company are inextricably linked. Secondly, the “cash cycle” – the time (number of days) between purchasing the initial inventory and the receipt of the cash for the sale of the finished product – is a critical cash flow variable for all SMEs and should be made as short as possible. Any upward variation over time should be carefully monitored. Thirdly, the level of remuneration of the owner-manager and other directors should not be allowed to exceed an agreed proportion of retained earnings. In this way the focus will continuously be on long-term company growth, funded partly at least by the major share of retained earnings. Fourthly, good relations and collaboration should be created and maintained with upstream and downstream commercial partners in the supply chains of the company. These relations may facilitate technical collaboration and as necessary the extension of trade credit in either direction. Fifthly, effective human resource management in the sense of being able to engender and maintain the operation of the workforce as a team. In an SME this is the responsibility of the owner-manager. And finally, a good knowledge of the area of business and sector in which the SME is operating. Again, it is imperative that the owner-manager/entrepreneur takes the lead on this area. These operational characteristics will be essential to SME success, whatever the business sector the company is in or whatever its size. Moreover, all of these performance “metrics” will be key factors to be demonstrated in any approach to banks for investment funding. There is a responsibility on the SME as well as the bank in the essential dialogue as the precursor to investment funding. Optimization in the UK Institutional change to the banking sector Following the GFC, UK banks retrenched substantially for 2 to 3 years, even on overdraft provision to SMEs. Ironically, this partial withdrawal from risk-taking by the banks provided an opportunity for these risks to be taken on by new 133

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entrants to the investment finance market, namely the internet-based technology platform providers. These new entrants offered new products such as crowdfunding and peer-to-peer lending, and there was the emergence later of new challenger banks. This challenge – because it is still not a major threat – has not seriously troubled the major banks. The banks still retain SMEs as their customers and provide profitable basic services. However, in the future they may need to be willing to adapt and change the direction in which they have been moving for the past 30 years. There are some recent signs that consideration is being given to the provision of fintech services. Ironically, the current Covid-19 crisis has provided an opportunity for banks, supported directly and substantially by the UK government, to provide loans to SMEs. So far, it appears that the structural problems of the major banks – plus an apparent reluctance of SMEs to take on debt that may make future recovery more problematic – has merely emphasized the structural and operational weaknesses of the banks, highlighted in this book. Risk modelling for banks is complex, and especially so when mixed with uncertainty. However, the mathematics for risk assessment should be kept under review and appropriate advice provided by regulators. The major banks already have sophisticated internal risk-based (IRB) systems. Insofar as there may be increased use of securitization for lending purposes this is an area where the major banks have a substantial comparative advantage. However, an appropriate balance between risk-assessment techniques which may be flawed (as happened during the GFC in the mis-assessment of fat-tailed probability distributions) and calibrated models which enable higher risks to be assessed safely, regulation here is important. One specific issue for regulators is the use of IRB by challenger banks. Although caution is understandable, the position should not disadvantage the competitive challenge from these smaller banks. Some of the characteristics of the German banking system – although not the embedded socio-economic nature of the extensive Sparkassen public savings bank network – could be emulated by the UK. Some will require legislative changes and a shift from a liberal market economy approach to a coordinated market economy approach. Others are for the business banking sector to consider. As far as the US system is concerned, contemporary trends indicate a shift from bank funding to equity crowdfunding across internet-based platforms. This trend appears to be moving at a more rapid pace than in the UK and it is not clear whether it may accelerate in future. If there is to be any significant transformation of the financing of investment in SMEs in the UK then there is a requirement from financial institutions for professional expertise, combined with local knowledge, to enable them to fully understand individual SME ambitions. The changes will need to be both in the institutional structure, practice and culture of lenders and equity investors, 134

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and in the business culture of SMEs. There can be no rapid “institutional fix”. Nonetheless, establishment of a UK state investment bank modelled on the KfW could be considered, together with some innovative approaches to the establishment of local banks or bank branches, working closely with local SMEs. Such a move towards re-establishing local comprehensive banking services and integrating these services with national financial support, could be a possible mechanism to support the UK SME sector. To be successful it would require a broad-based programme aimed at organizational and cultural change within the banking sector. Aside from inertia – and to be fair the not inconsiderable costs of reversing decades of bureaucratic centralization of an oligopolistic banking sector in the UK – there is no reason why British business banking should not develop in the direction of the German structure of banking. A potential reform agenda will be developed in the final chapter. Improving UK SME performance The reasons for the short-termism noticed in segments of the British SME sector are not entirely due to the SMEs themselves, as the previous chapters have set out. Nonetheless, the key task is how to change the short-term mind-set of a significant proportion of British SMEs. The previous two chapters have argued that there is a need for both the banking sector and the state to adopt significant reforms to facilitate a shift in attitudes and behaviour of the SMEs. Nonetheless, the SMEs themselves will, as any changes are being implemented, need to refocus their attitudes, and their business and financial planning, towards long-term growth targets rather than short-term profit maximization, with a reduced share of gross profit going to the owners/managers personal remuneration. Clearly improving financial management practices for British SMEs, which suffer many of the issues discussed above, will not be an easy task. In many cases, some support in this area may be provided by the company’s external accountants. However, as the external accountants are often relatively small firms themselves, who may also be the auditors of the company, there may be conflicts of interest. This is an area where a continuous and comprehensive relationship between banks and their SME partners would enable these services to be provided through the banks. SME companies themselves need to give a higher priority to financial management, closely tied to business plans. Both in the US and in Germany, the evidence suggests that, even if external finance is not available, retained earnings, supported strongly in Germany via the tax regime, can be a substantial source of finance for investment for long-term growth. Obviously, it would be possible for the UK government to give similar tax relief on retained 135

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earnings used for investment purposes. However, this would not absolve SMEs from improving substantially their business and financial plan preparation and adequate monitoring of the performance against targets set in these plans. Above a certain size of SME, the finance director/finance manager should either be an accountant or be trained to a high enough level of competence to ensure that the financial management and associated financial practices are at an optimum level. Book-keeping is essential, but it should not be regarded as a substitute for professional financial management. In relation to capital investment it may be that use of asset-backed finance, either via hire purchase or leasing is appropriate for an SME. For instance, a consultancy services company might wish to provide its consultants with a small fleet of mid-range cars to facilitate travel to client’s premises. Manufacturing companies in the UK are increasingly using asset-based finance: 12 per cent for the typical small company (10–49 employees) in 2016 (Close Brothers: 6). Again, companies do use credit cards as a method of finance. In relation to cash flow requirements this financial device has the benefit of flexibility. However, it is also expensive. If there are recurrent cash flow problems, then other financing avenues should be explored by the director or senior manager responsible for financial management. Another “remedy” for dealing with cash-flow problems – problems that afflict small companies especially in relation to obtaining payment from large companies – is “factoring” or discounting of invoices. These routes may solve the problem, especially if an overdraft limit has been reached, but, if factoring is selected, the SME is handing over the whole of its sales ledger, which may indicate problems to suppliers. In either case the cost would have to be weighed against flexibility. There will be an administration charge, which for a small company is likely to be around 1.5 per cent of turnover, plus an interest equivalent charge of around 2.5 per cent over the bank rate, until the invoice is paid. Assuming a turnover of £250,000 per annum, and an invoice value released of £25,000, the cost would be around 8 per cent, per month on each £1,000 released to the factoring/invoice discounting company. The state The crucial regulatory action for the state to assist SMEs is the issue alluded to above: namely bringing in legislation to compel large firms, and state and public institutions, to settle invoices from SMEs. This would greatly assist SMEs to manage their critical business variable, cash flow. The case for a state investment bank has been illustrated with reference to the key role played in Germany by KfW Mitellstand, supporting SMEs via local 136

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banks. In the final chapter, a practical model of an equivalent British state bank is set out in detail. This last brief indication of state action required to optimize the performance of the UK SME sector points to the wider issue, which involves coordinated action by all three parties: the state, the business banking sector, and the SMEs. The environment so determined will then influence the access to credit for creditworthy SMEs. The determination of creditworthiness will then depend on how transparent the SME is to the potential lender. This will be influenced by the financial information available to the different categories of lenders, i.e. financial statements, small business credit scoring, asset-based lending, factoring, fixed-asset lending, leasing, relationship lending, and trade credit. The choice of financial access avenue for a specific creditworthy SME depends on the sources of information available for that firm, as well as the appropriateness of the various techniques available to the potential lender, i.e. underwriting, loan contract structures, and monitoring techniques applicable for the firm in its specific environment. Of course, it would be possible for the government to impose financial disclosure requirements, either on SMEs or on both parties to the lending transaction, with probably a de minimis limit. Such a rule would encourage better and more transparent financial management by SMEs. In relation to SMEs and banks it is critical that, even if investment finance is not achieved via a standard bank loan, that the SME recognize the value of retaining a close link with its bank for strategic financial reasons. The more comprehensive the service offered by the bank the more important will be the “partnership”. This will still be the case even if the company has managed to secure long-term finance via an alternative non-bank source. Conclusion This chapter has suggested that there are closely linked fault lines in the UK in relation to the inadequate institutional business banking structures and operational practices; the short-term perspectives and business behavioural practices exhibited by a substantial number of SMEs, and some of the liberal market economic positioning of the British state. These fault lines can be traced back to historical developments from the middle of the nineteenth century and which continued into the twentieth century and contemporaneously. Some of the general cultural inertia in the UK derives not always from a reluctance to develop a critical analysis of the problems, but rather an unwillingness to face up to the radical changes required to address the problem and to face down opposition from vested interests. The Vickers Committee on banking in 2011 provides a perfect example. In relation to its main task – to argue for 137

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a safer retail banking system to protect customers, shareholders and the taxpayer – its arguments for a structural separation between retail and investment banking were the same as those for imposing a ring-fence within banks. Given that the former solution was preferable in that it offered more clarity, it might have been thought that it would be the one recommended. In the event, and under pressure from the banking sector, it recommended “ring-fencing”. As this solution has only recently been implemented by the banks, in 2019, it remains to be seen how successful it will be. A similar radical analysis has been developed in this book: it is hoped that the suggestions may be implemented. Substantial institutional reforms will be required of both the British business banking sector and in the fiscal and regulatory environment surrounding British SMEs. These reforms will need to be facilitated by a comprehensive shift away from the UK’s prevailing liberal market economy approach towards a coordinated market economy approach. This implies intervening in the business sector various ways to ensure the development of a well-funded dynamic and innovative SME sector, focused on long-term growth and exporting. Significant progress on reform will take time. To achieve progress there needs to be the commitment and involvement of an activist and interventionist British state, supporting the requisite systemic changes needed. In Chapter 7 below we will set out a potential reform agenda. The debate in this book is about: (1) reforming British business banking; (2) improving the performance of British SMEs; and (3) encouraging the British state to adopt a coordinated market economy philosophy. The aim is to develop a strong growth-oriented and export-oriented SME sector, comparable to that in Germany. In this context it would seem perverse not to include a brief reference to the contemporary issue of Brexit. A Brexit postscript As far as institutional banking reform and SME attitudes are concerned our analysis suggests that the UK should emulate the position adopted by the German banking system and the growth orientation of German SMEs. The political adjustment advocated would also move the British state’s mid-nineteenth-century commitment to the liberal market economy – which has roots going back to the Scottish Enlightenment – towards the coordinated market economy which is reflected in the political economy of the large EU member states, and preeminently Germany. Hence, the main thrust of the argumentation in the book has been to suggest a major shift towards the German banking structures and the revival of relationship banking at local branch level, and a more activist role of the state. This closer identification between the UK and the EU in relation to the 138

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UK’s political and socio-economic perspectives may be challenged by Britain’s departure from the European Union on 31 January 2020. Despite being a European power for all its history, Britain (or more specifically England) has never identified itself as being inside Europe. It is not surprising therefore that since the First World War, from 1919, the majority view of the UK political elites has been to lean towards political dependence on the United States. This has been reinforced, particularly since the end of the Second World War, by cultural colonization,the consumerist invasion of US goods and services, and even cultural practices. The unconscious cultural hegemony induced by these factors is much deeper than in continental Europe, particularly France. One major theme of this book has been to suggest that culturally and politically it will be possible to switch to a coordinated market economy model akin to that adopted by Germany. This CME approach would enable the changes to be made to develop a more innovative, growth-based British SME sector. These changes remain necessary, independently of whether the UK, post-Brexit stays close to the EU, at least in manufacturing, or attempts a nineteenth-century independent international trade approach, albeit without an empire! The contentious issue of Brexit is now resolved. The UK is about to embark on a new, independent British journey. Whatever the UK’s future trading and political relationship with the EU, there is an imperative need to recognize the role of the banking and financial sector in providing the investment capital for British industry, particularly manufacturing. As short a time ago as 1950, UK manufacturing employed 40 per cent of the workforce and accounted for 25 per cent of world exports. In 2020 manufacturing employs only 8 per cent of the workforce (12 per cent of GDP) and its exports represent 2 per cent of world exports. Some of this relative decline is a statistical result because of world economic growth; country shifts in manufacturing, and greater production of services. However, the figures should be a stark reminder that the UK is not the dominant industrial power that it once was and that the urgent need is to increase its industrial productivity and expand its industrial base, particularly the SME sector.

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Time for change? The book has sought to provide an analysis of British business banking, its SME customers, and the political and economic environment within which it operates. The analysis has been set in a historical context, going back to the inception of the UK’s industrial revolution spanning the end of the eighteenth century and the first part of the nineteenth. The subsequent period of industrialization and banking, running from around 1830 into the twentieth century, has also been described. Finally, the period from the early twentieth century to the present day has been examined in detail to answer the key question of the apparent lack of constructive engagement between British business banking and UK SMEs, and the associated lack of long-term investment finance provided to this key industrial sector. To provide a comparative analytical perspective, the UK historical and cultural account has been accompanied by contemporaneous comparisons of the German, French and US experience. This approach has yielded interesting insights into the derivation of contemporary twenty-first century business banking behaviours, institutional development, SME cultural behaviour, and the manifest political economy environment in the UK. Critical of the apparent inattention of the major clearing banks to their socio-economic role as financial intermediaries, particularly in relation to SMEs, it has been argued that blame also attaches to the dominant short-term culture and behaviour of British SMEs. It has also been suggested that the operational peculiarities of the form of liberal market economy of the British state has led to inadequate interventions from government to rectify the problems faced by SMEs in seeking and obtaining long-term investment finance. This is not to suggest that various short-term interventions have not taken place, but they have not tackled the underlying deficiencies of the lack of structural engagement of the major clearing banks with the SME sector. Many previous reports, investigations, and initiatives have failed to achieve the necessary reform to SME funding in the UK. The lack of a close relationship between British banks and British business – and particularly the small and 141

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medium-sized enterprise sector – has been remarked upon and criticized in a variety of official reports over almost 100 years. Various institutional attempts have been made, particularly during the twentieth century, and again during the past 20 years, to remedy the absence of provision of long-term investment finance by the banking sector to the SME sector. None of these attempts have been successful, except at the margin. The funding gap for SMEs, first remarked on in the 1931 Macmillan Report, is still unbridged, a century later. Reforms – enacted and progressed with alacrity – are essential at this juncture in the UK’s economic history. For more than a century, linked to arresting the decline of the UK in global economic and political terms, reform of the British business banking system has been avoided. In 2020 – with the challenges of Brexit ahead – it is time to begin the process of reversing the over-centralization and bureaucratization of the British business banking sector. A new relationship between forward-looking SMEs and an innovative British banking system, with the active involvement of the state, supporting a state investment bank, is possible. Such reform can provide a springboard for the renewal of UK manufacturing, together with the on-going development of an innovative services sector, focused on the SME sector. The Covid-19 experience During the process of completing this book the UK, along with the rest of the world, has been coping with the coronavirus pandemic. With many businesses being forced to close during a period of “lockdown”, the UK economy entered recession, with the second quarter of 2020 showing a record fall in GDP of 20.4 per cent (ONS). Government measures have included the provision of public grants and loans to businesses, including a furlough scheme paying as much as 80 per cent of the wages of laid-off employees up to £2,500 per month. The self-employed have been supported by a grant scheme. Support for business, especially SMEs, was first offered in the form of loans guaranteed by the government, but to be applied for via banks. The main business loan support scheme, the Coronavirus Business Interruption Loan Scheme (CBILS), entailed the government providing an 80 per cent guarantee of the amount of any loan granted. In practice, the requirement on the banks to assess the SME in terms of its suitability for receiving a standard commercial loan – i.e. the need for management accounts, cash flow forecasts, business plan, etc. – meant that few loans appeared to be being approved for SMEs. The government then introduced the Bounce Back Loan Scheme (BBLS) which provided a 100 per cent government guarantee, on a 6-year loan at 2.5 per cent from £2,000 to £50,000, with no capital or interest repayment or the first 12 months. 142

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There would be no fee and, crucially, no personal property guarantees required. Effectively the loan is simply transferred through the bank. The BBLS scheme was better tailored to SMEs. The latest available figures from HM Treasury indicate that up to mid-October 2020, some 73,094 CBIL loans had been approved (46 per cent of those applied for) and 1,336,820 BBLS loans had been approved (80 per cent of those applied for). The above problems with CBILS – and the need for its supplementation by the almost automatic BBLS for SMEs – arose because of the banks’ needing to “assess” the borrower’s status as if applying for a commercial loan. As we have noted the difficulty is that the major clearing banks simply have no clear metrics to be able to assess the creditworthiness of SMEs. The BBLS obviated any need to provide supporting documentation other than a simple recording of the application and a brief check for potential fraud. In Germany, in its Covid-19 support to SMEs, the utilization of KfW and the network of local savings banks (Sparkassen) and cooperative banks made the process of providing the half a trillion euros of support to German SMEs extremely simple and rapid. If the UK had a National Investment Bank, the problems of delivering SME financial support to SMEs would have been easier, especially with the local relationship banking. It may be that the experience of Covid-19 in the UK will lead to a renewed energy to be put into both the necessary banking system reform and the establishment of a National Investment Bank, as prerequisites for supporting the enhanced development of the UK SME sector. A radical approach is required: one which attempts to take account not only of the complex nature of the requirements for finance across the SME sector; the attitudes and practices currently embedded in British business banking, but also the role of the British state and its 170 year-long commitment to an “unmodified liberal market economy”. In what follows, various possible reform proposals are suggested which recognize the specific structural failings of the British banking sector and of the specific political economy approach embraced in the UK, as well as failings in the perspective and behaviour of British SMEs. Some may argue that the problems outlined are ones which the “market” will “solve” and which does not require the substantial changes suggested below. The response is that – notwithstanding the recent provision of alternative capital market access to finance across internet technology-based platforms and by innovative investment finance provision by some smaller organizations – the major clearing banks have remained inherently conservative in their approaches to investment support for SMEs. In the absence of radical change to the banking system, including state intervention, the UK situation will be highly unlikely to evolve the close, long-term working relationships and investment provision that SMEs require, and which, for instance, are evident in Germany. 143

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It is argued that the US model of liberal market capitalism does not offer much to the UK in terms of potential institutional reforms – the cultural differences between the UK and the US are greater than sometimes imagined – although the US attitude to innovation and the business environment which encourages starting again, rather than considering business failure as a sin, is a cultural lesson which perhaps should be absorbed. Need for reform The wider national economic benefits of delivering an innovative, growth-oriented British SME sector are considerable. It is imperative that this key economic sector becomes the driving force for a substantial expansion of the UK’s manufacturing exports. The long-standing unwillingness of British business banks to accept their socio-economic role of financial intermediation, i.e. recycling liquidity into long-term loans for SMEs, was remarked on in the 1931 Macmillan Report, in the 2011 Vickers Report, and the 2012 Breedon Report. It is imperative that this role is overtly recognized. If regulatory changes are required to facilitate this role then they should be made. There are opportunities to be taken by improving the delivery to SMEs of comprehensive banking services, including long-term investment finance, in the form of either standard business loans or other capital market provision. This will entail the major clearing banks adopting a “partnership” model, practised in the UK by Handelsbanken. This approach also underlies the UK government’s motivation in recent delivery of the Alternative Remedies Package. The position, both historically and in contemporary Britain, is that, despite some more recent signs of modest reform, the British business banking sector is not fit for purpose. Without substantial reform and development of services, it is failing to perform its crucial economic role of financial intermediation in respect of SMEs. However, to achieve the renaissance of the British SME sector, which is urgently required going forward as the UK leaves the EU, will also require a radical change of perspective and business practice by SMEs themselves. Rapid adoption by SMEs of improvements to their business and financial planning, will be necessary to take advantage of any potential changes made by the British business banking sector. The momentum to institute these changes will have to be facilitated by the British state, adjusting the current liberal market economic structures and policies in the direction of a coordinated market economy approach. This will entail a more interventionist approach to devise and implement the required policies and institutional reforms, notably by establishing a genuine state investment bank. 144

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The reform agenda set out below will take time to implement. The only successful revolutions are ones that are implemented incrementally. Any revolution needs a prime mover. To initiate this one the impetus should come from the UK government. But any success will depend, crucially, on the engagement of the main private market participants, the banks and the SMEs. A reform agenda Banking structures and practices The essential change as far as the British business banking sector is concerned is to be able and willing to return to full relationship banking at branch and/or regional level, i.e. “partnership banking” and constructive engagement. Despite continuing branch closures, there are currently branches of the major clearing banks in all urban areas with populations above around 50,000, and within relatively easy reach of smaller urban areas and villages, so a physical infrastructure exists. More difficult issues concern staff training, technical infrastructure, and most significantly, the considerable cultural change required, reversing a century of centralized bureaucratization. Ironically, the oligopolistic nature of the sector would enhance not obstruct such a change. “Follow my leader” would be the order of the day for the five major clearing banks, whichever one moves first. The few small challenger banks conducting business banking are already moving in the direction of providing the comprehensive service provision urged of the major banks in previous chapters, including the provision of investment finance via loans. The Handelsbanken network, with over 200 branches, is already there as an exemplar. Threats do exist for smaller challenger banks: they may over-reach themselves in an attempt to achieve rapid growth, and noting the aggressive moves by the major banks in the past to deal with competitive challenges, some may be in danger of being taken over. There are some signs, for example, actions by some of the majors and some UK Finance comments, that the major banks are moving to deal with another potential threat to their basic service provision and the provision of various investment finance products. This new threat which has emerged in the last decade is from the internet-based technology platforms, more specifically the potential investment in these platforms by foreign-based banks and hedgefunds, and even more dangerous the tech giants like Amazon. Despite future business finance scenarios being uncertain, there is a potential for an existential threat to the major banks, given their constrained, conservative stance on SME business loans. The change recommended here should be seen by the major banks as one which is responding positively to a long-standing demand for 145

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investment finance from SMEs. In the light of a technologically changing environment affecting both business and banking, the provision by the banks of a comprehensive service, defined as a “partnership model”, would be the correct response. It represents a return to relationship banking for SMEs, but deeper than before and with the intelligent use of digital technology. The comprehensive partnership service envisaged will cover a variety of specific services and will require both changes in operational structures and the training of staff at all levels. An alternative mode of service provision, avoiding the necessity of staff training, and speeding up the provision, might be to outsource the new services. There would still, of course, be a cost, but this could be spread over a large number of companies. That such a new, innovative service is required has already been recognized by the UK government. The objectives of the deployment of the funds allocated to financial intermediaries under the Comprehensive Innovation Fund, as part of the Alternative Remedies Package, is an indication of the desire to move the banks to a more intensive relationship with SMEs. The core element in the new partnership arrangement proposed will be a close relationship maintained over a long period, which would include advice on business planning and financial management. This service should enable evidence-based, appropriate judgements to be made in relation to demands for finance for capital investment from the company, as the company moves forward. The bank and the SME would develop and progress together, based on their on-going collaboration. Obviously, there will be a lower level of involvement with established sole traders who wish to remain sole traders. This group represents a substantial majority of SMEs, so the extension from their current basic level of service will not be extensive. For this reason, the new service may need to be provided at a level intermediate between current regional and branch levels. The service should also provide access to other products than direct bank loans, such as access and support to enable SMEs to avail themselves of “alternative finance” of various types of capital market access, via internet-based technology platforms This support should include placement and brokerage services. The Schuldschein initiative in Germany is an example. The changes suggested represent an evolutionary path to the provision of business banking services to SMEs which could have been initiated, by the major clearing banks, at any point during the last century! SME attitudes and behaviour It has been argued that as well as those changes to the institutional structure and operating practices of the major banks outlined a further fault line has been 146

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the short-term business perspective and behaviour of British SMEs, particularly in manufacturing, and the lack of adequate financial management practices. Although to some extent this short-termism may be attributed to the absence of investment finance from the banks, this is not the complete story. Compared to both German and US SMEs, it appears that the use of retained earnings, even when gross profits are high, is not to fund investment. Instead there is a tendency for these earnings to be taken out of the business as remuneration of owner-managers and senior directors. Lifestyle rather that company growth appears to be the general preference. In Germany this use of retained earnings to fund long-term growth is facilitated by a benign tax regime which favours reinvestment. However, it also appears to be a cultural preference of German SMEs. What is required – if a comprehensive shift in vision to making the priority for British SMEs, long-term growth rather than short-term profits and, in some cases, lifestyle – is a greater attention to both business planning and professional financial management. If this combination of reforms to SME perspectives and operational behaviours can be achieved then the SME sector response, to the institutional banking reforms suggested above and below, will be able to be positive, constructive, and successful. The pressures on avoiding unemployment in the UK economy over the past decade – encouraged by government policy to keep unemployment figures artificially low – have encouraged many laid-off employees to set up in business, primarily as sole traders. In many cases this results in low annual incomes and reliance on in-work benefits. There are good reasons for choosing to be a sole trader, but in many cases the sectors involved are extremely competitive and the opportunities for developing a growing business are limited. Setting up and running an SME aiming at growth is extremely challenging (as this author has found). However, it is also rewarding. If there can be an external financial services environment which becomes truly supportive of SMEs, many more will be able to succeed. For the UK, the success of the SME sector, both manufacturing and services, is a key route to developing an innovative and growing economy, able to be a successful trading economy in an increasingly competitive world, in or out of the EU. The agenda for reform will only work if it is systemic and involves both a reformed business banking sector and reformed SME behaviour. The final partner in implementing the systemic change is the state. State action and involvement As the commitment of the UK, not always articulated, is to a liberal market economy which has existed for the past 170 years it would be too much to expect 147

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a rapid movement towards a coordinated, increasingly interventionist, political economy. Although the German localized business banking structure could not be replicated in the UK, some parts of Germany’s “constructive engagement” between its banking sector and SMEs could be mirrored. The relationship banking approach so evident in Germany at the local level, and illustrated by Handelsbaken in the UK, is one area and it would be possible to facilitate a British KfW Mittelstand approach to supporting local bank investment in SMEs. For instance, it would be possible to alter the terms of reference and the modus operandi of the British Business Bank (BBB) to achieve a structure, including regional investment bank branches, approaching that of KfW. However, I will argue that it would be preferable to establish an entirely new state investment bank, with regional branches in England, and, potentially, the other nations of the UK, who have already taken steps in this direction. There is already a Scottish Investment Bank, enacted in April 2020 and due to start operating in late 2020. There is also a Wales Development Bank. These banks will both invest directly in SMEs and other companies. As such they do not replicate the operational mode of KfW, or, as envisaged, a new state investment bank. These banks could be integrated into a UK state investment bank, although it seems unlikely that this would happen in the case of the Scottish Investment Bank. Northern Ireland does not have a separate public investment bank and so would participate, via its own national bank branch. Before suggesting a possible structure and operation of a British State Invest­ ment Bank, consideration should be given to a set of other potential measures to be taken to improve the provision for investment and support for SMEs. Legislation is required to enable stronger regulatory action by the Financial Conduct Agency (FCA) to be able to bear down on direct private lending to SMEs, linked to a government campaign to warn SMEs about unauthorized private lending. A government review is required into the potential for securitization to be used, with protection, to become a significant financial route for SME funding whether by banks or by technology platforms. This may require legislative and regulatory action. The government has recently – 11 March 2020 – introduced a Term Funding Scheme (TFSME), operating via the Bank of England, to assist banks to provide loans to SMEs. This follows previous, similar “funding for lending” schemes which in some circumstances assisted SMEs – in relation to asset-based finance, the scheme enabled deposits to be paid by SMEs. However, the previous schemes appear not to have made any significant improvement in the major banks’ attitudes to SME loan provision. The new scheme needs to be closely monitored by the government to ensure its objectives are met.

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A British State Investment Bank Were a National Investment Bank (NIB) to be introduced it should be established as a holding company. Importantly it should act as a financial intermediary institution which will on-lend to other banks, which themselves will have the direct interfaces with business enterprises. In this manner it will avoid any direct competition with conventional banks. In this respect it will be different from the Scottish Investment Bank and the Welsh Development Bank which lend directly to businesses. The NIB must also, unlike the British Business Bank, operate completely independent of government, although its initial mandate will be from government. Although initially funded by a UK government bond issue, subsequently the NIB, as does the KfW, would be financed via issues of its own bonds on global capital markets, albeit effectively guaranteed by the UK government. This independent mode of operation will also avoid any political problems for the NIB in terms of state aid within trade agreements. KfW, the German state bank operates in an analogous manner, i.e. as an intermediary, and has been cleared by the EU under the state aid rules, and this should apply under other international trade agreements. The NIB should be staffed to include people with top-level banking and commercial skills, able to deliver strong regional and national economic benefits and thus create an institution that will endure and should have wide cross-party support. It may be a useful exercise, therefore, to set out how such an institution might operate. In more specific terms the objectives, management, and operating procedures of the National Investment Bank could be as follows: 1. To deliver public policies, specifically business investment financing, pursuant to a government mandate in the following areas: • Addressing the long-term funding gap to SMEs and high-value local business supportive projects, particularly in regions outside of London and the South-East; • Addressing the long-term funding gap for technological progress and innovation, specifically involving SMEs; • To deliver against these mandated responsibilities in ways consistent with UK government policies in other areas. 2. Achieve these objectives by making, facilitating, engaging in, and encouraging investments, lending and related activities including or with respect to: • The lending of money; • The grant or provision of credit or other related and appropriate support;

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• The investment of money in investments and other financial assets (including securities, whether debt or equity or hybrid in character) and to hold, sell or otherwise deal with such investment or other financial assets; • The grant or provision of guarantees, security, insurance or support; and • The grant or provision of other financial products, in all of the foregoing cases, with or without interest, security or consideration, and whether directly by the company as lender, investor, co-investor or in any other capacity or through financial intermediaries, which the board considers will, or are reasonably likely to, directly or indirectly, facilitate the Bank’s objectives. 3. To act as a holding company, and to do all other things that the board considers ancillary, incidental, or conducive to the attainment of the foregoing objects and the company shall have any and all powers which the board considers ancillary, incidental or conducive to the attainment of the foregoing objects. 4. To achieve reach and penetration quickly, the NIB would work through selected existing banks to deliver loan facilities. Such partners would be chosen for their understanding of NIB aims, their performance in delivering these, and their standards of corporate governance. It appears intuitively likely that smaller challenger banks may be more inclined to work in the ways preferred by the NIB, but all potential partners, including the large commercial banks would be explored. 5. The NIB would operate via on-lending, at discounted rates to other smaller private banks and branches of the major clearing banks (after the fashion of KfW Mittelstand). The key to its successful operation in the UK would be to establish links with a significant number of commercial banks. A change in banking culture will not occur without partner banks clearly understanding NIB goals and being given incentives to meet them. The NIB would need to specify the terms on which it would do business with partners and the products it would offer its target markets in terms of regions and sectors. The target markets would be assessed on factors such as regional investment gap or opportunity analysis rather than the current Treasury approach of maximizing net present value that tends to favour investment in the South-East. 6. Assuming an “unleveraged” programme in years 1 and 2 – a transitional period is likely to be necessary – the “return” for the NIB would be loan rate less government bond rate, less start-up costs, less losses. 150

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7. Easing the constraints on the banks is a main aim of having a NIB. By on-lending from low interest rate bond finance, the NIB is able to offer discounted long-term loans toappropriate companies. The principal advantage of the NIB is the ability, via the banks’ lending directly to businesses, to discount substantially the risks involved in non-asset backed business loans, and the even more substantial risk with long-term loans. It is important to recognize the magnitude of the change envisaged, albeit a gradual change over a period of years. Steps would need to be taken to prevent banks from calling in current loans and using NIB funding to raise profits on what are existing loans, but which may be, reported, inadvertently, to the NIB as new loans. 8. On the financial regulations applicable to the NIB, the general point to note is that Basel III and CRD IV regulatory standards and implementation frameworks aim to define boundaries around the dynamic optimization process (of capital, liquidity, etc.) within listed bank entities. The NIB will maintain appropriate standards irrespective of whether it falls under such frameworks, it will not be testing parameter limits.

Management The management of the NIB would be achieved via a two-tier board structure: a supervisory board of directors and national and regional operations. The supervisory board (SB) would be responsible for setting the overall policy framework of the NIB, within the parameters set by government policy; for allocating the resources available to each of the regional branches (in consultation with the Operating Board, OB), and for appointing and overseeing the OB and the efficiency and equity of the OB operating mandate. The SB would be responsible for the appointment of the Chief Executive Officer (CEO) who would be accountable to the SB and also accountable directly to the government in relation to the expenditure of public money (as with the CEO of the BBB). It is suggested that the SB should be of a size to be representative, but not over-large. Its chair could be either the Chancellor of the Exchequer (or, as a substitute, the Chief Secretary) or the Secretary of State for Business, Energy and Industrial Strategy, etc. (or, as a substitute, a senior Industry Minister). Remaining members might include senior ministerial representatives of Scotland, Wales, and Northern Ireland, key council leaders, senior trade union officials and other business organization representatives. At the level of national and regional operations a key objective of the NIB would be to support the objectives of industrial and economic policy, in both 151

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manufacturing and services. In order to achieve this, the NIB would have regional development banks in the nine regions of England, plus Scotland, Wales, and Northern Ireland. These regional offices would establish, as rapidly as possible, relationships with private and public local banking institutions, such as digital banks and challenger banks. The main advantage of regional offices would be the ability to take advantage of local networks and knowledge, which, given the quantity of annual funding involved, is unlikely to be feasible for a centralized institution. Moreover, on-lending via regional offices would be more accountable to regional stakeholders via regional boards. For the devolved administrations, management and oversight of the investment bank would be left to the devolved government to establish, within the broad framework suggested here. It would be essential for the development banks to maintain a strong working relationship with the NIB as this will give them far greater access to capital and risk-sharing than would not otherwise be available. The regional/national branches of the NIB, acting under regional boards and with autonomy for the direction of on-lending, would be regional development banks. Both financial economies of scale and organizational transparency suggest that a regional branch system is superior to legally distinct regional entities. A corollary of this is that regional branch funding would be allocated centrally. It is suggested that NIB funding should be such as to enable expansion of its balance sheet to approximately £150 billion over a ten-year period, via its issuance of NIB bonds on the global capital market, albeit that the bonds would, for some time, be effectively underwritten by the UK government. The annual resources of each of the regional branches, set by the SB in consultation with the OB, would be allocated with a view to taking advantage of local opportunities and to closing the extreme disparities in infrastructure investment and high productivity employment between the South East of England and the rest of the UK. Given the location of significant manufacturing output and employment in the Midlands and North of England, and, assuming participation, Scotland, Wales, and Northern Ireland, resource allocation could also target sectoral rebalancing of the UK economy. Conclusion In Germany, the key role played by the state investment bank, KfW, is crucial to the success of German SMEs, and especially to the Mittelstand, the medium-sized companies that play a major role in the export success of Germany. However, this part of the corporate business environment is one of the elements of the supportive economic environment provided by the German coordinated market economy. The long-term, low interest banking and equity support for 152

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the SMEs provided by KfW is delivered via a localized set of savings and cooperative banks that have close working relationships with SMEs in their areas. A British National Investment bank (NIB) would initially have to operate in a manner that takes account of the characteristics of UK banking structure and behaviour, while over time modifying that behaviour. The NIB would replace the British Business Bank (BBB) and operate in a substantially different way, although the BBB structure and modus operandi could form a limited institutional core of a future NIB. Its mission would be focused on three principal objectives: 1. To deliver against mandated business investment responsibilities set by the UK government in ways that are also consistent with government policies in other areas, for instance the green investment agenda; 2. To address the long-term funding gap of small and medium-sized enterprises and high-value local business projects, especially in areas outside London and the South-East; 3. To support business development involving technological progress and innovation, especially that of SMEs. The NIB, unlike the BBB, should operate as a financial intermediary, lending to other banks, and independent of government. This positioning mode of NIB operation would avoid any political problems for the NIB in terms of state aid within international trade agreements. In this respect it will be different from the Scottish Investment Bank and the Welsh Development Bank which lend directly to businesses. Although initially funded by a UK government bond issue, subsequently the NIB, as with KfW, would be financed via issues of its own bonds on global capital markets, albeit effectively guaranteed by the UK government. In this manner, together with the suggested return to relationship banking and improved financial management and the adoption of a longer-term growth perspective, supported by appropriate taxation changes, the UK would be able to close the long-standing “Macmillan Gap”, and to improve the UK’s export performance. The advent of Brexit provides adequate justification for radical reform.

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Introduction 1. “An empirical examination of discouraged borrowers in the UK” (ERC Research Paper 2018). 2. The Coronavirus Business Interruption Loan Scheme (CBILS).

Chapter 1 1. Athough Bill of Exchange was defined in English law only in 1882, they were used by merchants across Europe for centuries prior to this enactment. 2. The South Sea Company was created in 1711 by converting debt, including government debt, into equity and used to launch the company into a failed transatlantic slave trading venture. The company later underwrote government debt, but fervid speculation in its shares (the “bubble”) led to the financial collapse of many its investors and government debt had to be resecured. 3. The terms, “liberal market economy” and “coordinated market economy”, abbreviated to “LME” and “CME”, were used by Hall & Soskice (2001) to define “varieties of capitalism”. 4. For a detailed explanation of the structure, operation, and political role of the Sparkassen in Germany, see Cassell (2020). 5. A bill of exchange is a negotiable credit instrument where the debtor agrees to pay a specific sum of money at a specified future time, often 90 days. Bills of exchange have been used since the Middle Ages. The bill is issued by the drawer (the seller/ creditor) and accepted by the drawee/acceptor (the customer/debtor). The bill must be signed and dated by the parties. The bill may be passed to various third parties, each of whom must endorse the bill by countersigning the bill. On presenting to or through a bank the bill will be discounted by the amount of interest proportional to the time remaining on the bill. On the due date whomsoever is holding bill must be paid by the drawee/debtor/acceptor. The financial standing of the acceptor is the key to the safety of the transactions involved.

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6. The “Long Depression” was a worldwide price and economic depression from 1873 to 1896. The decline in economic activity was the most severe in Europe, especially France, but less so in the United States, where the impact was principally on prices and profits. 7. Joseph Schumpeter (1883–1950), an Austrian economist, introduced the idea of “creative destruction” to argue that a positive feature of market capitalism was to allow inefficient companies to fail in order to permit successful ones to thrive.

Chapter 2 1. “Until 1971, the London clearing banks were, in effect, required to maintain a minimum ratio of cash and liquid assets to deposits of about 30 per cent. For this purpose, bills, including Treasury bills, counted as liquid assets, but gilts did not. Selling gilts to absorb Treasury bills made the banks less liquid and effectively tightened monetary policy” (see Allen 2012). 2. The eurodollar market refers to the dollar-denominated accounts at foreign banks or overseas branches of American banks. 3. An example was a housing corporation which apparently received a revolving loan of £5 million, based of course on the security of the property portfolio. 4. A “derivative” is a contract between two or more parties based on the value of an underlying asset which can be various types of financial assets, for example, bonds or commodities. A derivative contract can be either to mitigate risk (hedging), for example, the future price of a commodity, or to assume risk in the expectation of future profit (speculation). The problems arose in the GFC because of the complex bundling of derivatives covering assets with differing risk profiles. Believed to spread risk, in fact it led to unknown risks and collapse and contagion globally. 5. UK legislation governing the amount of capital required and the procedure necessary to establish a bank in the UK implemented the EU Capital Requirements Directive (CRD IV), itself a transposition of the Basel III global standard into EU law.

Chapter 3 1. The Insolvency Service, Monthly Insolvency Statistics and https://www.statista. com/statistics/818691/small-and-medium-sized-enterprises-germany/. 2. A structured-term loan is, effectively a time-limited overdraft facility secured on company receivables. 3. As a sole trader, you run your own business as an individual and are self-employed. You can keep all your business’s profits, after payment of income tax on them. 4. Reported in British Business Bank research report May 2015 (24).

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NOTES

Chapter 4 1. The Global Policy Institute is a London-based research institute and think tank. 2. There is no specific ideal value of this ratio, it various across countries. What matters is that it is not rapidly rising on an on-going basis. 3. Ring-fencing aims to draw internal boundaries (sometimes termed “Chinese walls”) around risky investment activities and “safe” retail banking activities within the same banking organization, with constant internal and external regulatory monitoring to ensure compliance. 4. The figures for the alternative finance sector in the UK are principally drawn from the survey conducted by the Cambridge Centre for Alternative Finance (CCAF) (2017). 5. A “Schuldschein” is a financial instrument which combines characteristics of both a corporate bond and a classic loan and can be traded. Under German law, the Schuldschein is a private placement – a bilateral loan agreement which is exempted from any EU MiFID II regulation, including the need for any securities prospectus requirements. Typically, the term is 3–10 years and the value between €5–20 million. 6. See British Business Bank research report 2015 for a description of securitization and its potential for SMEs 7. A useful description of how ABS securitisation works was provided by the National Audit Office in November 2016 8. UK Finance, Open Banking: Future State, June 2020.

Chapter 5 1. Richard Cobden was an English manufacturer, radical and liberal statesman, associated with two major free trade campaigns, including the Anti-Corn Law League. 2. This term is used to distinguish the historical position of British trade unions who until relatively recently were suspicious of being involved in formal “Works Councils” and becoming members of “Supervisory Boards”, both of which are common across Western Europe 3. The term “Dominion” was applied, before 1939 to the following countries of the British Empire: Canada, Australia, New Zealand, the Union of South Africa, Eire and Newfoundland. 4. A broad political economic definition of “financialization”, matching the reference to the use of the term here, is given by Palley (2007: 1): “Financialization is a process whereby financial markets, financial institutions, and financial elites gain greater influence over economic policy and economic outcomes. Financialization transforms the functioning of economic systems at both the macro and micro levels.”

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165

INDEX

agricultural development  8, 10, 11, 15, 17 Allen R. C.  9, 10, 11 alternative finance  83–93 asset-based  86, 87, 136 banks involvement  74, 91 crowd funding  85 equity/debt markets  87, 88 peer to peer lending  84, 85 schuldershein  88 SME response  92–3 internet platforms  91–4 alternative remedies package  75, 94 incentivized switching scheme  75 capability and innovation fund  75 attempting change  105–7 bank definition  9, 42 Bank of England  41–2, 63 bank notes  20 independence 43 banking (industrial revolution) France  18, 25–7 Germany 22–5 United States  27–9 United Kingdom  19–22 banking regulation  38 banks (UK) service provision  75–7 banks view of SMEs  72–5 Barclays branches  79, 80 history 77–8

Bank of Credit and Commerce International (BCCI)  42 bills of exchange  19, 21–2 Bolton Committee  55 Breedon Committee  68 Brexit 138–9 British Business Bank  65, 57, 113, 149 British Chambers of Commerce  62 British state investment bank  149–52 British SMEs  53–63, 67–9 breakdown 54 complex needs  58–9 culture  3, 55, 68 building societies  39 capital markets union (EU)  1, 21, 60, 61, 68 role of banks  9, 10 cartels (Germany)  25 challenger banks  47–8, 51 cities  8, 10 City of London  99 Close Brothers  58, 65, 123 competition 80–2 concentration of British banks  34, 36, 43, 73, 74, 80, 82 cooperative banks (Germany)  23–4 coordinated market economies  2, 100, 106–10 Hall and Soskice  108 Germany  100–102, 108–10 Covid-19  95, 142–4

167

INDEX

Enterprise Research Centre (Aston University) 55–6 entrepreneurial phase (UK)  1, 7 Ernst & Young  57 European Banking Federation  62 financial intermediation  9, 34, 46, 120 financialization (UK)  2, 22, 116 financial management (SMEs)  121, 125, 130–33 financial regulation  125–6 free trade (UK)  97–9 French banks Credit Agricole  18 history 25–7 German banks, history  22–5 German SMEs  64–6, 67–8 culture  69, 127 Girobank  37, 39 global financial crisis  44–6, 61–2 great moderation  44 Hall, Peter  108–109 Handelsbanken  74, 94 Industrial and Commercial Finance Corporation (ICFC)  37 imperial preference  31, 113 industrialization phase  4, 7 industrial revolution (British) entrepreneurial phase  8–11 industrialization phase  21–2, 31 industrial revolution (French) industrialization phase  15, 16, 31 industrial revolution (German) industrialization phase  13, 14, 31 industrial revolution (US) industrialization phase  16–8, 31 interbank market  41 joint stock companies  20, 25 KfW  36, 113, 126, 152

168

liberal market economy  97 attempted change in UK  104–107 reform 110–15 role in UK  97–9 US 102–104 lifecycle of SMEs  56–8, 72 List, Friedrich  100 Lloyds branches  79, 80 history 78–9 retail banking  81 Macmillan Report  4, 35, 53 manufacturing  35, 50, 98–9, 114, 124 Mittelstand  4, 53 mercantilism Germany 100–1 UK 97 US  92–3, 104 modern british banking  33–51 national investment bank  149–52 OECD 61 open banking  91, 92 optimal performance (Germany) banks 126–27 SMEs 127–8 state 128 optimal performance (US) banks 128–29 SMEs 129 state 129–30 optimal performance (UK) banks  119–20, 122–4, 134–5 SMEs  121, 124–5, 135–6 state  121, 125–6, 137 partnership banking model  63, 73–4, 115, 123, 145–6 protectionism Germany  31, 128 UK 113 United States  31, 102–104

INDEX

Quakers  7, 10, 19 reform agenda  144 banking 145–6 SMEs 146–7 state 147–52 relationship banking  4 retained earnings  120, 129 risk modelling  82, 134 savings banks (Germany)  23–4, 62, 127 Scottish Investment Bank  148, 49 securitization 88–91 SMEs performance (general)  130–33 sole traders  59–60 steam power  14, 16 structured term loans  61, 74 tariff protection (Germany, USA) 100–103 term funding scheme  148 transport role  11, 14, 17

Treasury select committee (UK)  62–3 Trustee Savings Bank  39 US banks history  27–9, 103–104, 128–9 US Civil War  17 UK banks concentration  34, 43 history 33–51 loans to SMEs  74, 128–9 overdrafts 74 structure 75–7 UK Finance  62, 63 US SMEs  67–8 culture 129 Vickers Report  45–9, 71, 72, 80–83, 138 structural separation  81 competition 81 Welsh Development Bank  148, 149 Wilson report  40 zollverein  13, 22

169