Recent figures show that banks became increasingly cautious about small business finance in 2019, particularly during periods where Brexit uncertainty peaked. With economic uncertainty likely to continue for some time as the UK renegotiates its trading relationships post-Brexit, who is going to step forward to fund British SMEs?

Interest rates on new bank loans to SMEs experienced a sharp spike in late 2019, going from 2.56 per cent in September to 3.05 per cent in October, their highest level since the credit crunch. Although rates have since returned to a more sensible 2.6 per cent, it does show how dramatically lending conditions can be impacted by change in sentiment over Brexit.

The effects of Brexit on small business finance can also be seen in how much banks are lending. The value of bank loans made to SMEs has increased by just 4 per cent since June 2016, compared with a 16 per cent increase for large businesses over the same period.

Could these lending conditions get tougher again once the UK exits the EU? With trade agreements still to be negotiated, there remains much uncertainty about what the economic consequences of Brexit will be for businesses. Until these terms are determined, banks will likely continue to be cautious about the types of businesses to which they lend.

While they undoubtedly generally have smaller and weaker balance sheets, it’s also due to the fact that their client bases tend to be much smaller in number and less diversified – the risk being that they are likely to be impacted more by an economic downturn, even if it only causes the loss of one of their clients.

End of the local bank manager

Since capital holding requirements were tightened in the wake of the last credit crunch, banks have also been under regulatory pressure to reduce their exposure to small business finance.

Another major driver of the fall in SME lending is the change to how high-street banks operate over the last decade. The traditional bank manager has virtually become extinct. Much decision-making is now centralised or automated, with the result that there are few staff at high street bank branches with the requisite knowledge of how small businesses operate. That results in inflexible, occasionally unhelpful decision-making on lending.

What about challenger banks?

So, if high street banks are not going to lend to SMEs, will challenger banks? Following the credit crunch, these new banks were heralded as a viable source of lending for small businesses, filling the gap left by the major banks. However, recently these banks have largely adopted the same cautious approach to small business lending as their bigger counterparts.

Research has shown that growth in lending by challenger banks has tailed off with only a 4 per cent increase since 2018, suggesting that challenger banks are being more conservative about who they lend to. The Prudential Regulation Authority (PRA) recently wrote a letter to the CEOs of challenger banks, asking them to consider reining in their lending book growth. This suggests that challenger banks are not likely to grow their lending faster in the short to mid-term.

‘Challenger banks are not likely to grow their lending faster in the short to mid-term’

Why small business finance matters

Why does funding of UK SMEs matter? Small and medium businesses are crucial to the UK economy, accounting for three fifths of employment in 2019 and generating around half of turnover in the private sector (£2.2tr) according to the Federation of Small Businesses. Small businesses bring innovation into the economy and their size can make them more adaptable and better equipped than large businesses to respond to changes within the market.

So, what forms of SME funding can make a difference for growth businesses? The government’s flagship tax relief programmes, the Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS), enable growth businesses to secure funding. Investors are granted significant income and capital gains tax reliefs, and even a loss relief cushion, to incentivise them to invest in businesses that qualify for EIS or SEIS.

Since its introduction in 1993, over £20bn has been invested in EIS. However, despite the considerable benefits for both businesses and investors, use of the scheme has dropped in recent years, with funding for companies using EIS for the first time dropping from £1.1bn in 2015/16 to £759m in 2017/18. This drop is likely due to government restrictions imposed on the types of businesses that can raise funds through the programmes.

EIS is one of the most effective ways for growing businesses to raise patient capital, and comes with significant benefits for investors, enabling them to reduce the amount of capital gains tax they pay. In order to ensure that the programme continues to help businesses, the government should consider easing restrictions on the types of businesses eligible for EIS.

• Increase the cap on investments into SEIS, which is currently limited at £150,000
• Lengthen the eligibility period in which companies can qualify for EIS and SEIS

Small businesses are the backbone of the UK economy and more must be done to ensure that they receive the financing they need to compete and thrive. The upcoming Budget on 13 March would be a good place to start.

Gary Robins is head of business development at Growthdeck