International Finance

SMEs: The double-edged sword of disintermediation

Fragmentation of SME credit markets requires business owners to be more knowledgeable

Charles Thorburn

February 3, 2015: Financial markets have gone through a roller coaster in the past eight years, and whether it’s been bank bailouts, sovereign debt crises or LIBOR fixing scandals, the world of finance has been a large part of the news flow. While the sector is highly important for places like the City of London, Manhattan and Hong Kong, it constitutes well below 10% of GDP value added in most other places around the world.

The SME sector in contrast, is the lifeblood of most developed and developing economies alike. In the UK, the SME sector accounts for roughly 60% of private employment and around 50% of private sector turnover. This is an immense contribution from a sector that receives very little plaudits.

Bank lending has changed

The intersection between SMEs and finance has traditionally been very well defined. A business owner discusses their options with the branch manager at their local high street bank, and apart from the odd transaction with asset based lenders or factoring houses, largely trusts his or her house bank to solve the company’s financing needs. This isn’t a bad model if the branch manager builds long-term relationships and knowledge of the local business community while enjoying a local lending mandate.

Unfortunately, that type of set up is more the exception than the rule today. As banking groups consolidated leading up to the crisis, efficiencies were sought by way of automation and centralisation of credit decisions. Discretion was taken away from local branches and delegated to credit committees completely removed from the customer. Qualitative assessments were replaced with quantitative ‘black box’ credit decisions.

Big data and modern IT capabilities do make these types of policies more feasible in theory. But when automated credit decisions are used as a stand-alone solution rather than a tool, it creates risks. While not specifically related to SME loans, the credit crisis was an excellent example of an over-reliance on computer models that effectively took human judgment out of the process and caused a lot of very questionable credit decisions.

SME credit in a post-crisis economy

Before the crisis, credit conditions were lax. Credit was available whether the decision was made centrally or locally. Post crisis however, the situation has changed. While high street banks are keen to emphasise that they are back to lending and are trying to support the economy, that is not always the experience of business borrowers. The banks are not lying; credit is ample, so long as your requirements tick all the carefully defined boxes in the banks’ credit processes. Banks require things like two years of profitable trading, no recent changes to management, an asset base to be used as collateral and personal guarantees. These criteria are typically sensible input factors that will, on average, be quite predictive of credit quality of a potential borrower.

The silver lining

This all seems very depressing if you are a business owner with a missing checkbox and a rejected credit application. There is a bright side to the story though.  A combination of the tightened credit criteria of high street banks, new technology and support from regulators has enabled a range of alternative finance providers to enter the scene. These lenders include specialised asset based lenders, direct lending funds, hedge funds, institutional investors, challenger banks and peer-to-peer websites. What they all have in common is the view that the high street banks have ‘dropped the ball’ somewhat and that there is an opportunity to lend to good credits in the SME market.

As an illustration of this, RBS published their Independent Lending Report in 2013, a study designed to investigate the status of SME lending in the UK. They found that in 2007, bank lending to SMEs was £50-60 billion higher than what the sector could prudently carry. The same number for 2013 was a £30-35 billion shortfall. This gap is what the alternative lenders are seizing upon and helping to cover.

There are a many myths surrounding SME credit. One of the most persistent ones is that all lenders look for the same things. It is true that all lenders will want to be comfortable that they will get repaid, but that is pretty much where the similarities end. The focus can vary from being comfortable with the business idea and the people running the company, to purely looking at the assets available for collateral or the distribution of customer orders over time. Everyone has their own approach, and it is important for borrowers to speak to the correct people if they want to ensure a fair chance of reaching their financing goals.

The good news is that the options available to a potential borrower in the UK are quite a lot wider today than eight years ago. However, the service you may expect from your house bank is in many cases worse. This puts more pressure on management of companies to widen their search and financial know how in order to find the right solution.

If you feel that you need some support in this process, the first step could be to engage with trusted advisors such as board members/accountants/lawyers. The other option is to speak directly to a dedicated debt advisor who has a good understanding of what type of lending will be available and appropriate for your firm. Being the proprietor an SME debt advisory, I know that like lenders, advisors vary significantly both in approach and quality. When you speak to an advisor, make sure that there is a well-defined and transparent process in place, so that you get a service that is appropriately aligned with your business needs.

Charles Thorburn is the co-founder of CreditSquare Limited

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