SMEF0056

Written evidence submitted by Impact Investing Institute

ABOUT US 

The Impact Investing Institute is an independent non-profit, established in 2019 as a partnership between the UK government and leading firms in the capital markets. Our ultimate goal is an economy that is socially and environmentally sustainable, and we believe that capital markets need to be part of the solution. 

Investment decisions shape the world around us. To create an economy in which people and the planet can thrive, we need to transform the way capital is invested. Impact investing is an effective tool to realise this transformation: it channels capital towards solutions to the world’s most urgent challenges, like climate change and rising inequality. 

We act an accelerator for the impact investing field, by connecting mainstream investors and new ideas that, together, have the power to unlock solutions to the world’s most urgent challenges. Practically, this means three things: 

-          We connect capital to impact to drive positive environmental and social change in the world

-          We support investors to put impact at the heart of their commercial investment strategies 

-          We advocate for impact investing as a powerful tool to deliver positive change for people and for the planet

We partner with a wide range of people across the UK and internationally to achieve these goals. We combine credibility and expertise with institutional finance, alongside independence and connectivity across capital markets, policy makers, civil society and the public sector. 

We would welcome the opportunity to provide further information and provide oral evidence if desired.

RESPONSE TO CALL FOR EVIDENCE

We welcome this call for evidence into the financing of small and medium-sized enterprises (SMEs), which acknowledges that “Small businesses are the lifeblood of local communities, powering economic growth and fostering innovation and an entrepreneurial spirit.”[1] Specifically, ensuring the financial inclusion of underserved places and people is vital in providing a solid foundation for more resilient communities in deprived areas. Greater access to financial services:

-          Boosts economic growth, by increasing business activity and income-generation opportunities

-          Promotes employment creation, boosting incomes and savings, and access to essential services

-          Reduces inequality and poverty, by empowering marginalised groups and building financial security. Expanding SME access to finance also offers significant synergies with other policy objectives – for example, it can support the transition to net zero by empowering communities to drive their own decarbonisation.

We are responding to this call for evidence because we believe there is a significant opportunity to mobilise institutional capital to increase finance flowing to SMEs through Community Development Finance Institutions (CDFIs). The Impact Investing Institute’s place-based impact investing (PBII) programme is already addressing key challenges in the CDFI sector. Below we outline how public investment combined with a supportive legislative framework would trigger additional private funding for CDFIs, which in turn would narrow the SME finance gap.

We have structured our response around select questions from the call for evidence, which we signpost below.

cHALLENGES AND BARRIERS

What are the key challenges Small Medium-sized Enterprises (SMEs) face when seeking finance?

The Bank of England has estimated the annual unmet funding need for all SMEs at £22bn[2]. The latest available research published by government in 2022 shows that 700,000 small businesses struggle to access affordable finance on the right terms.[3] Key challenges include:

-          High rate of decline: since the last Treasury Committee review of SME finance in 2018,[4] the success rate of applications for smaller bank loans has fallen from 80%[5] to around 50%[6].

-          Lender perception that SMEs are high risk and unprofitable: often, viable SMEs lack the track record, credit history or security required by traditional lenders to get finance. The relatively smaller loans and consequently smaller revenue generated from them makes lending to SMEs too ‘unprofitable’ for banks. Social enterprises also face difficulties in accessing finance: their leaders identify a lack of understanding among investors of their operating and business models, despite a collective turnover of £60 billion.

-          Weakening of local banking network: branch closures and a reduction in the role of traditional bank managers mean that banks do not know their customers as personally as they once did. Centralised call centres experience high staff turnover and are process driven. Over 60% of small businesses describe the relationship with their main bank as merely “transactional” and 20% of small businesses say they have a weak relationship with their banks and wish it was better.[7]

-          SME reluctance to apply for finance: SMEs are more reluctant to approach banks due to concerns about the process, fear of the loan request being rejected, and fear of the bank restricting existing facilities. Potential applicants for bank loans are now less confident of getting approved than they were 5 years ago, falling from 50% in 2018 to just 25% in 2023.[8]

Is securing access to SME finance particularly challenging for women, people from ethnic minorities, people from certain social classes, or any other group? Is so, what should be done about it?

Access to finance for SMEs and social enterprises is further impacted by geographical location, borrower demographics and size. Regardless of someone’s ethnic background or gender, businesses should have equal opportunity and access to finance. Ensuring that women and ethnic-minority entrepreneurs can access the finance they need is key to the UK’s economic output, growth in productivity and SME innovation. 

-          Businesses led by people from ethnic minority backgrounds are almost four times as likely to be rejected for finance[9] compared to white business leaders, but add £25 billion to the UK’s economy.[10]

-          Women-led SMEs suffer double the bank loan decline rate compared to other businesses. Yet £250 billion in value could be added to the UK economy if women started and scaled new businesses at the same rate as men.[11]

Community Development Finance Institutions: a market solution

Through which channels do SMEs find the most success when seeking funding and why?

Community Development Finance Institutions (CDFIs) are mission-driven, independent social enterprises set up specifically to serve individuals, communities and businesses that are unable to secure credit through mainstream lenders. They provide debt finance and support through a relationship-based approach to lending.

CDFIs play a vital role in providing finance to underserved SMEs by:

-          Filling a gap in the market: around 99% of businesses lent to by CDFIs have been turned down by another lender, despite being viable – over 90% of CDFI borrowers successfully repay their loans and grow their businesses. This makes CDFIs complementary to the banking sector.

-          Creating a pathway to business and economic growth: SMEs that previously did not have access to mainstream finance become future bank customers, contributing to economic growth through sustainable business growth and innovation. 

-          Contributing directly and immediately to the levelling up agenda: CDFIs’ annual lending data consistently demonstrates that they lend disproportionately more to areas and groups which are more likely to be declined for bank finance, such as women or ethnic minority-led businesses – around 50% of CDFI lending goes to the 35% most deprived areas in the UK.

The CDFI sector has yet to receive major investment by large commercial players – but the interest is there, as is the appetite to take the finance on from the CDFIs themselves. This is evidenced by the Community Investment Enterprise Facility (CIEF), launched in 2018 to provide CDFIs with some of the capital they need to meet demand, help increase understanding of the financial and social impact of CDFI lending, and attract other mission-driven investors to achieve long-term stability. As of 30th June 2023, the fund has deployed £69m to four CDFIs across the UK, helping meet the needs of 937 underserved micro, small and medium-sized enterprises (MSMEs). The significant success and reach of CIEF has led to the planned launch of an expanded version in late 2023 for continuity of capital, with investment from a major UK high street bank. CIEF2 is expected to invest around £62m in 800 MSMEs.

By scaling CDFI lending, more businesses that cannot access credit from mainstream lenders are created and supported, fostering wealth and regeneration in communities across the UK.

pathway to growth: RECOMMENDATIONS TO GOVERNMENT

What role can financial innovation play in SME finance? Is there more the government and the regulators can do to improve access to finance through innovative firms?

Should the Government do more to enhance SME access to finance? And, if so, what? 

In the US the Treasury approved a fund, (State Small Business Credit Initiative (SSBCI)) for incentivising and supporting underserved businesses. Does the UK need similar provisions? 

We have identified the following areas of innovation, government support that could unblock SME access to finance and unlock significant flows of capital into the sector.

1. Mobilising capital

The main barrier to expansion of CDFI lending remains sufficient affordable capital. There is currently no existing mechanism that caters to the ability and appetite of institutional investors to allocate funds to the CDFI sector at scale. ​Mobilising capital at this scale would deliver a step-change in the capacity and capability of CDFIs to lend to communities excluded from mainstream banking.

The Impact Investing Institute has worked with a coalition of organisations to design and demonstrate appetite for a National CDFI Funding Vehicle that would enable over £500m of commercial capital over 5 years to flow to SMEs that are currently underserved with credit. It has already secured in-principle commitment from a major UK high street bank and there is evidence of interest from several other financial institutions, but government action is required to unlock this opportunity.

Recommendations to government:

-          Amend Community Investment Tax Relief (CITR) to raise the £2.5m limit for a funding vehicle (wholesaler) to on-lend to a single retail CDFI. CITR is a vital tool for supporting CDFIs to raise investment to lend more to SMEs, and we welcome the changes made by HMT in the Spring 2023. However, as it currently stands, it cannot be used in conjunction with a large fund. The proposed £100m vehicle would need to be able to allocate to 40 CDFIs (100m ÷ 2.5m) – not only are there only 35 CDFIs across the entire country, but only about 6-8 of them have the capacity to take on finance at scale. Additionally, the CDFIs that are in scope have a deployment capacity much greater than the £2.5m threshold, which therefore restricts their reach and impact.

-          Allocate government seed funding, which could come from Dormant Assets, as equity risk capital in the National CDFI Funding Vehicle. A major barrier to mobilising private-sector investment into CDFIs is the risk (perceived or real) involved – including risk of capital loss, uncertainty of return, or simply concerns about untested business models. A small proportion of government grant funding is necessary to provide the first-loss capital that would incentivise private investment into the fund – and have a significant multiplier effect on the UK economy. This would be the first ‘blended finance’ vehicle to deploy capital to CDFIs at this level of scale, but there is substantial evidence of the UK government successfully deploying grant funding in blended finance structures for the social investment sector (including National Lottery Community Fund, Arts Council England and Sports England, as well as the Dormant Assets Scheme).

2. Creating a supportive regulatory environment

In the US, private sector capital is much more active in driving inclusive growth and building prosperity in underserved and marginalised areas. This is driven partly by major legislation and regulatory requirements, such as the Community Reinvestment Act (CRA), a federal legislation which requires banks to lend to all communities, including distressed and disadvantaged ones. The maturity of the US CDFI market demonstrates that there is a huge amount to be gained from closer partnership between mainstream financial institutions and places, including better outcomes for those places and financial returns. Public policy support and subsidy, trade associations and rating systems have been critical to the success of US CDFIs.

The US government has also played an active role in using guarantees to build the CDFI sector. The US CDFI programme launched in 2010 to provide federal backing for the sector through credit enhancement. The programme allows eligible CDFIs to raise bonds of $100m or more with a 100% federal guarantee. Over $1.6bn has been channelled into the CDFI sector as patient, low-cost capital using this tool. These loan guarantees effectively act as a collateral substitute, allowing small businesses to access finance on reasonable terms despite their lack of sufficient collateral.

Recommendations to government:

-          Retain an SME Loan Guarantee Scheme as a crucial tool for long-term economic development. Loan guarantee schemes in the UK, such as the Recovery Loan Scheme (RLS), have been key for CDFIs to offer discounted fee rates and boost lending to underserved and underrepresented viable small businesses – 80% of UK CDFI lending uses RLS.

-          Introduce stronger legislation and incentives to compel banks to invest in CDFIs, such as the Community Reinvestment Act in the US. For example, a Fair Banking Act[12] in the UK would provide an opportunity to forge a partnership between larger retail banks, CDFIs and government to tackle financial exclusion. Under the Act, banks and building societies would be required to disclose the extent to which they are meeting the needs of financially excluded people and small businesses in the diverse communities they serve, determine the level of action needed to address the problem, and provide mechanisms for doing so.

3. Unblocking barriers to scale

A lack of reliable CDFI data prevents institutional investors from understanding typical aggregated key metrics for the sector. A common reporting framework and data would facilitate greater investment into CDFIs. The Impact Investing Institute is working with a major UK high street bank and Responsible Finance on a feasibility study for a data solution, which would aggregate CDFI financial and impact data in a way that would be beneficial for potential investors and for informing CDFI lending decisions.

Additionally, CDFIs need to invest in their infrastructure (e.g., systems, people and marketing) in order to take on more investment and effectively deal with increased levels of activity. The Impact Investing Institute is working with Responsible Finance on a Capacity Building Programme, supported by funding from government, to enable CDFIs to increase their scale and reach of delivery.

Recommendations to government:

-          Allocate government grant funding to CDFIs to invest in their infrastructure, data reporting and capacity. This includes continuing to invest in the capacity building programme run by the Impact Investing Institute and Responsible Finance. Funding could come from dormant assets; legacy funds for CDFIs such as the Regional Growth Fund; a UK version of CRA such as the Fair Banking Act; and/or a British Business Bank fund dedicated to community lenders.

The current referral system does not incentivise banks to make referrals to CDFIs when they are unable to provide finance to small businesses.​ As few as 8% of ‘declines’ are referred on using current platforms. This means that, although most lending by CDFIs goes to previously declined and discouraged borrowers, less than 2% of their customers come through referral platforms. However, there are enormous potential synergies created from referrals: a CDFI customer of today is often a bank customer of tomorrow. CDFIs complement bank activity as opposed to being direct competitors, therefore improving the effectiveness of the bank referral programme is essential to amplify impact and extend CDFIs’ reach.

Recommendations to government:

-          Commission a government review of the current bank referral platforms, to identify key obstacles and solutions, and trial a referral pilot project.

-          Introduce greater incentives and stronger legislation that compel banks to co-operate with CDFIs.

September 2023