A gateway to better lending - learning from the German model

THE IDEA of looking to continental Europe for an answer to Britain’s problems might look little short of barmy in the current economic and political climate. The UK economy is enjoying a boom while the German economic powerhouse is slowing and the rest of the eurozone is on the cusp of recession. Meanwhile, on the political stage, the only argument is over when there will be a referendum on whether Britain should quit the EU.

But it can easily be overlooked that UK business lending is still suffering its own private recession. Lending to firms dropped by £1.9bn in December, leaving the total stock of corporate debt almost 25% below its peak in late 2008. Loans to SMEs fell by £1.2bn, a 12-month low.

In contrast, corporate loans in Germany rose by 1% between 2011 and 2012 in the face of the eurozone crisis, according to DZ Bank. This is especially good news as Berenberg Bank estimates the country’s 2.1 million so-called Mittelstand companies contribute €1.3trn (£1.08trn) to domestic GDP.

Following the global financial crisis, UK politicians have emphasised the importance of increased focus on the SME sector to build a sustainable recovery. So far there has not been dramatic improvement. According to Holger Wessling, general manager of DZ Bank, loan rejection rates in the UK are twice those in France and Germany.

Almost a quarter (24%) of SMEs applying for an overdraft were turned down in 2011 while more than a third (34%) seeking a loan ended the borrowing process without success.

And there seems to be little relief for firms. More recent figures in the SME Finance Monitor from BDRC Continental found that 25% of firms applying for an overdraft in the third quarter of last year did not get a facility, while more than a third (35%) seeking a loan failed to get one.

“I think that a rejection rate of a quarter is quite high,” Wessling says. “I think we can take it as a fact that SMEs face huge difficulties.”

One possible reason for this is the very different structure of the banking systems. In the UK, the largest five banks account for almost 90% of the SME banking market share. Wessling says that business lending does not play a strategic role for UK banks: “I have not found in the statutes of any bank any references to SME lending.”

More competitive

The German banking system is simply more competitive. It comprises three pillars: private banks such as Deutsche Bank, cooperative banks and state-owned savings banks.

In the UK, a majority of the shareholders of the dominant UK banks are often overseas-based investors. “How much can you expect them to have a particular focus on SME lending in, say, the north of England when the strategy is to be a global bank?” asks Wessling.

By contrast, 60% of the German market is operated by banks that are domestically owned. There are more than 2,000 individual banks in Germany, which compares with about 370 in the UK. “There is just more competition in Germany,” says Margarita Tchouvakhira, a vice-president at KfW, one of the largest state-owned banks which has a mandate to support business investment.

In the UK, politicians of all the main parties have set out plans to boost corporate lending by banks. The most notable are the government’s Funding for Lending Scheme and the Business Bank. Labour has set out a plan to create two new “challenger banks”.

Stephen Haseler, director of the Global Policy Institute (GPI) at London Metropolitan University, welcomes the “serious debate” in the UK “about whether we should break up universal banks and encourage competition to keep lending moving”. And this call for reform is loudly echoed from the front line of business.

“There does need to be a change of culture,” says Simon Hanson, business development manager for the Federation of Small Businesses in the North East. “We need more competition – both in terms of the number of banks and the range of services. Banks tend to treat small businesses as if they are a group of businesses that are exactly the same, irrespective of size. They don’t want to know.”

Wessling agrees, saying the difficulties many UK SMEs face in raising money are due to the small number of large banks. “The larger the organisation, the more process-oriented and centralised the decision-making is,” he says. “Large banks live on economies of scale.”

One example is C2M(UK), a green innovation company in Spennymoor, Durham. It won a €740,000 European Union grant for a 12,000 square-foot factory to make recycled glass hybrid , a construction material with just 0.001% of the carbon footprint of traditional material, as long as it could get a €232,000 bank guarantee.

Managing director Gary Thompson says that he was astounded when his bank, HSBC in Gateshead, said it would only give a guarantee for a fee of £8,500 if he put in a €232,000 deposit on account for 36 months.

“I ended up putting the money in myself and from C2M’s revenue stream for the first 18 months,” he says. “We have lost something in the region of £14.5m of work last year because we couldn’t get the line built.” HSBC said it could not comment on an individual case.

Banks under threat

Banks do need to respond to the challenge, according to Neil Bellamy, UK director for technology, media and telecoms (TMT) at NatWest: “We have to change or die. As Steve Jobs said, banking is a necessity – bankers are not.”

He says banks must improve professional expertise at the face-to-face level and suggests banks have specialists in key fast-growing sectors such as TMT, healthcare, manufacturing or property.

“If you can talk to someone who knows your sector, that’s a good move,” he says, adding that TMT start-ups grow very quickly and need “high-level advisory” at the very early stages.

Banks are indeed under attack. One positive side-effect is that the UK has a more developed range of alternative sources for finance than Germany does. This includes crowd funding, asset-based finance, venture capital, supply chain finance and retail bonds.

But again, there is a negative side. UK SME owners rely far more on their own savings, often using their home as collateral and racking up high-cost credit card debts.

“Credit cards play a role in the UK but don’t really play a role in SME financing in Germany,” says Wessling. “Is it desperation because they can’t get anything else? If so, that’s not right and there should be alternatives.”

This year may offer a once-in-a-lifetime opportunity to achieve cultural change. Michael Lloyd, a former European Commission official and now senior research fellow at GPI, says that politicians, banks and businesses need to find a way of mimicking the German techniques of investing for growth over the long term.

“This does mean changing the culture so we do get the balance right between risk and reward,” he says.

At the same time, the government needs a structure of regional banks to which the Business Bank can lend on and for which it can act as a guarantor. “The German model does provide equity funding, mezzanine funding as well as loan funding and all of those are important,” says Lloyd.

It appears this message is getting through. Ron Emerson, the new head of the British Business Bank which is modelled on KfW, said in January that it would focus on start-ups and early-stage companies that had difficulty raising finance from commercial banks and investors because they lacked a track record.

In particular, it would provide partial guarantees of loans and provide the whole spectrum of equity, debt and mezzanine finance. Lloyd says the next stage will be to allow it to raise funds on the capital markets by using the UK’s AAA rating.

Time for change

However, the UK version has a long way to go before it can hope to match its 70-year-old German counterpart, which has total assets of €476bn and lent €17.3bn to the German Mittelstand in the first nine months of 2013.

Lloyd says that establishing a business bank to match the efforts of the likes of KfW is likely to be a long-term process: “This is not going to produce fruits in the short term but a commitment to a long-term process.”

Thompson at C2M says that he knows of German firms that have had much easier access to finance. “What needs to happen here is to have people who actually understand the needs of small business,” he says.

He would welcome the creation of a UK version of KfW. “We need a system like the German model that can actually fund SMEs and take an active interest but everything at the moment seems to be at arm’s length. You’re just another number,” he concludes. ?