How business can bypass banks

Sterling pound notes Image copyright AFP
Image caption The government wants to make it easier for small businesses to borrow

Banks in Europe, including the UK, are far more important to the provision of credit than is the case in the US. Roughly, European banks provide 80% of our credit needs, compared with 20% in the US - where securitisation that allows investors to lend is massively more significant.

So if our banks are knackered, which all of them have been to a greater or lesser extent, then they become less able to fulfil all the borrowing needs of the economy. And they'll instinctively shy away from those borrowers perceived to be riskiest.

Which is the short explanation for why many small and medium size businesses complain that banks are letting them down - and why it has become such an important economic and political issue to stimulate lending to a sector so central to the capacity for recovery of the UK economy.

It won't surprise you therefore that ahead of next week's Budget we'll have yet another government-commissioned report on how to mend the UK's skew-whiff system for financing business - this one chaired by the outgoing chief executive of the insurers Legal & General, Tim Breedon.

What is striking about where he ends up, as I understand it, is that he will encourage businesses to wean themselves off their addiction to bank finance and do more to help themselves. Or to put it another way, he believes there is a vast amount of money locked up in industry's relatively inefficient supply chain - and if this money can be released smaller companies would have much less need for external finance.

The best way of seeing this is in the mismatch between the vast and record cash reserves of our biggest companies at a time when many of their smaller suppliers are complaining that they are strapped for cash and can't borrow what they need.

In aggregate British companies' cash holdings stood at a record £731bn in the autumn of last year. Or to put it another way, the UK corporate sector has more than enough liquidity or cash to service the entire financing needs and more of British small companies.

So for Breedon the aim is to get the money from a big company buying goods and services to the smaller companies supplying those goods and services.

This can be done in two ways: by speeding up payment or by getting companies to in effect lend to their suppliers.

It has of course been a government ambition to accelerate the payment of invoices for a couple of years now. Breedon however has noticed that when payment terms are accelerated at the top of the chain - when for example the government pays promptly - there is a benefit to the supplier dealing directly with the end buyer, but not necessarily to those smaller companies sitting below the main supplier.

So one of his main recommendations is that the ultimate purchaser, whether it's government or Tesco for example, could put much more pressure on whoever they pay for stuff and services to speed up payments to the smaller suppliers that contributed at an earlier stage in the production chain.

That said, there may be a limit to how fast big companies will pay their suppliers, for fear of eating into their own profit margins. But they are in a position - at no cost to themselves - to help smaller companies borrow much more cheaply than when those smaller companies borrow on an overdraft.

What Breedon wants to see is an expansion of invoice and bill discounting.

The basic idea is almost as old as banking itself. If you are small company that has supplied goods or services to a big company, such as any of the giant supermarkets, everyone knows that the supermarket chain is good for the money. So as and when a Tesco or an Asda has accepted the invoice submitted by a supplier, that supplier ought to be able to get a bank or finance house to turn that invoice into cash.

And the cost to the supplier of immediate cash payment by the bank, in respect of the implicit interest rate or discount on the bill, ought to be tiny - because the bank is in effect lending to the safe big company, which ultimately honours the bill, not to the riskier supplier.

The relevant underlying point is that if big companies were to speed up and standardise the processes for accepting invoices, so that these invoices could be more readily used for short-term loans from banks and finance houses, there would be a one-off substantial release of cash for smaller businesses.

And there could be a multiplier in respect of the creation of credit - because when banks lend via this form of so-called asset-backed finance, they are allowed by the capital-adequacy rules to allocate half as much of their precious capital resources as when providing overdraft loans.

Which is another way of saying that banks can afford to give £1m of finance to a company that is asking for early payment on the back of an accepted invoice for every £500,000 of overdraft that the same company would no longer need.

So although the problem remains when it comes to banks that we can't live with them and we can't live without them (many would say), there is a way for companies to take greater control of their financial destiny and be less at the mercy of the banking system.