SMEF0104

Written evidence submitted by Paragon Bank

Background on Paragon Bank

Paragon Bank (PB) is a specialist lending and savings bank, authorised in February 2014. The bank is the principal entity of the Paragon Banking Group PLC (PBG), which has been trading since 1985. The business is managed through two lending divisions: Mortgage Lending, including buy-to-let, and Commercial Lending, which includes Development Finance, SME Lending, Motor Finance and Structured Finance. These are principally funded through our retail deposit base, supplemented with wholesale and central bank borrowings.

Paragon’s SME portfolio is significant. As of 31 March 2023, our SME Lending loan book stood at £735.3 million and we increased new lending to UK SMEs by 21% during the first half of our financial year to £220 million. We provide finance to customers from a wide range of sectors, including construction, transport and logistics, technology, manufacturing and professions finance.

SME lending and mid-tier banks

SMEs are the engine room of our economy, generating around 60% of all private sector employment and accounting for over half of all private business turnover[1]. However, access to funding for SMEs has been a long-standing problem and its estimated only 33% of smaller businesses are using any external finance – the lowest share since the data series began in 2011[2]. This issue has been difficult to solve, particularly given the current structure of the UK financial system centred on a group of very large banks and building societies that have proven unable to provide the level of support to SMEs that is required.

Mid-tier and specialist banks such as Paragon are well placed to support SMEs as they cover segments of the market that are otherwise poorly covered or not served at all by the large banks. They can tailor products to customers in ways that the large banks cannot and their geographical spread, deeper roots within the communities they serve, comprehensive knowledge of their customers and more personal and innovative services they provide mean that their reach covers the whole of the UK.

The large UK banks typically focus on medium to larger-sized business, with larger loan quantum and lower risk. Specialist banks, particularly with a regional focus operate in a smaller deal size space with potentially greater levels of complexity, requiring higher levels of engagement and often at a higher risk level.

However, our ability to finance more SMEs and individuals, like that for most other mid-tier and specialist banks, is restricted by a number of factors:

(1)    Funding costs are a significant differential between large banks and specialist/mid-tier banks

Funding is crucial to providing the capacity for financial institutions to lend to individuals and businesses. However, the ability of mid-tier and specialist banks to fund their lending capacity is proportionately more difficult and expensive than for the large UK clearing banks.

Clearing banks obtain significant benefits from their historic dominance in the retail savings and current account markets. They have significant amounts of customer balances that they are paying little to no interest on. According to CACI, as at February 2022, retail savings paying less than 25bps accounted for c. £625bn of deposit balances, with c.£450bn personal current accounts paying virtually no interest. The vast majority of these balances are with the clearing banks where the weighted average rate for new deposits is around 0.10%[3] , while mid-tier and specialist banks tend to be price takers in the savings market, paying best buy rates to attract depositors.

The consequence is that the clearing banks will avoid paying c. £13bn of interest annually to customers[4] with this amount likely to increase as rates rise. This is obviously a crude calculation, but it demonstrates that this is a significant issue that has an impact on the “real economy”; it also means that a large pool of potential funding sits with the clearers that – for the reasons set out earlier – are not best placed, nor incentivised to lend to those SMEs in the regions that have historically struggled to access financing; segments of the market that mid-tier and specialist banks have, in some cases, risk appetite to finance.

At the same time, the increase in the number of new banks has created an intensification in the level of competition in the savings market. This benefits customers, but the consequence is that the larger, more established mid-tier and specialist banks like Paragon have to work harder and pay more for deposits, impacting the lending we do both in terms of type and pricing. Of course, the large banks (as set out above) are unaffected by this increase in competition.

One of the potential solutions to this is Open Banking, the centre piece of the 2016 CMA’s remedy to improve competition in Retail and SME banking markets. The CMA’s review found that lack of data sharing, low customer engagement and barriers to switching gave the incumbent large banks an unfair competitive advantage. Adoption of Open Banking was initially slow but has been accelerating, driven by the increased use of Open Banking payments, which reduce costs relative to other payment platforms. However, it is unlikely the full Open Banking functionality will be delivered on plan, therefore limiting its impact in the near and medium terms. More should be done to expedite implementation and adoption across the industry.

The Recovery Loan Scheme is helpful. Lenders, with the knowledge that there is now a scheme that will run for a good period of time, can support a wider range of businesses in the regions given the Government guarantee, which will require lower levels of capital. However, there are a number of elements of RLS’ design that could increase its effectiveness.

The primary issue with RLS relates to the level of the Scheme Lender Fee and the reduction in the guarantee coverage from 80% to 70%.  In addition, the maximum term of six years can impact affordability insofar as an applicant may be viable and meet core eligibility criteria, but unable to repay the loan within six years; whereas they could access RLS if longer tenors were permitted.

It also has elements that are more difficult for borrowers to navigate than the Enterprise Finance Guarantee, which was the British Business Bank’s mainstream Credit Guarantee Scheme prior to COVID-19. An example of this is the borrower requirements and attestations under the Subsidy Control Framework which, prima facie, is more complex than comparable disclosures for EFG which operated under the EU’s de minimis regulation. UK Finance believes RLS can be improved by adjusting the scheme to reflect concerns in these areas.

(2)    Regulatory barriers to growth for specialist and mid-tier banks hold back lending

Enabling mid-tier and specialist banks to grow and provide proper competition to the large banks will provide SMEs with greater choice and options when looking to obtain finance to grow their business. However, regulatory barriers to growth are holding this back.

Whilst the barriers to entry to become a bank have been reduced (as can be seen by the 30 new banks authorised since 2013, of which Paragon Bank is one), the barriers to growth for specialist and mid-tier banks remain stubbornly high. As Sam Woods, Deputy Governor of the Prudential Regulation Authority, noted in his Mansion House speech in 2019, “It is notable that no new bank has successfully become a large bank” and this remains the case four years later, with limited prospect of it changing anytime soon.

Opportunities to enhance the position of the mid-tier and specialist banks to remove some of the critical barriers to growth have not been taken by the Bank of England, namely:

• MREL – Whilst some improvements were made to the requirements following the review undertaken in 2021, the overwhelming issue remains the indicative thresholds set at total assets of £15-£25m, materially lower than international comparators, effectively requiring non-systemic banks to hold capital in line with big banks – in other words, mid-tier banks being treated as systemic banks. Given the significant increase in capital requirements (a doubling of core requirements), a lot of firms will be wary of crossing thresholds, thereby reducing or just not growing lending volumes.

As EY noted[5] in a paper published in September 2021, the net impact of the cost of MREL requirements for the leading 11 UK mid-tier and specialist lenders, would lead to foregone lending of c.£42bn over five years[6]. As part of the simplification of the regulatory regime and to enable mid-tier banks to grow, MREL thresholds should be aligned with other key thresholds such as the Leverage Ratio[7].

• Internal Ratings Based (IRB) approach – This is a critical area where the large UK banks have a significant competitive advantage over mid-tier and specialist banks. Paragon, like several other banks, is currently seeking to obtain IRB accreditation, but it is a slow process, especially as the PRA changes its methodology. This is delaying the entry point for new applicants, whilst extending further the relative competitive advantage of the big banks. It should also be noted that when the large, IRB banks have to change methodology, they are not required to revert to the Standardised approach in the interim and therefore are not subject to higher levels of capital as the non-IRB banks– this again provides a competitive advantage to the large banks. Whilst IRB accreditation doesn’t have a direct impact on SME lending as IRB risk weights are typically on par or higher than the standardised approach for this asset class, a reduced capital requirement more broadly would enable lenders to direct greater funding capacity to this customer group.

We believe that the PRA should consider a range of additional measures to improve the IRB accreditation process for IRB aspirant firms. This includes: a) improved resourcing with some form of fee structure paid for by banks, b) Ringfencing of resources specifically for IRB aspirant banks, and c) Contingent approval of models with remediation undertaken via supervisory oversight.

(3)    Capital considerations – Concentration risk

All banks and building societies must hold capital for high levels of concentration to sectors, geographies and borrowers. This is entirely reasonable and is a key part of good credit risk management practices. However, UK domestic banks and building societies are penalised for lending solely in the UK – in other words, UK domestic banks must hold additional capital for being a UK domestic banks. This is regardless of whether the bank’s lending is geographically diverse within the UK. The application of this approach excludes residential mortgages, so will be more focused on SME lending. The additional capital required can be significant and will have a direct impact on whether certain loans are undertaken or not.

The ability of some firms to apply a credit offset (that is reducing the capital held by the level of over-capitalisation of mortgage lending calculated on the standardised approach versus IRB benchmarks) can alleviate some of this additional capital, but some firms will not be able to use this. At the same time, for IRB aspirant banks like Paragon, as soon as IRB approval is obtained, the ability to apply this offset is removed. This additional capital requirement will play an even greater role in lending decisions and strategy to optimise a capital position.

The PRA should re-consider P2A concentration risk with the approach simplified so that domestic UK firms are not penalised, particularly where lending is evenly spread throughout the various UK regions.

(4)    Future regulatory changes

As set out by UK Finance in its response to the PRA’s consultation on Basel 3.1. (CP15/22), the SME support factor should not be completely and suddenly removed as part of the implementation of Basel 3.1 in January 2025. The combination of the removal of the SME support factor and the new capital rules set out in Basel 3.1. will lead to higher capital requirements on bank lending to SMEs and will have a knock-on impact on the financing costs for SMEs impacting UK and international competitiveness.

This will directly impact SME lending to the UK economy at a time when such borrowers are suffering from the impact of an economic slowdown and will occur simultaneously with the repayment of TFSME drawings further reducing the capacity of banks to lend to SMEs. In setting out its planned removal of the support factor, the PRA has not undertaken any significant evaluation of the appropriate calibration of SME risk weights nor of the impact of the SME support factor. Three detailed European central bank studies have found the retention of the SME Support Factor is appropriate in calibrating overall SME risk weights.

We would recommend that any reduction or withdrawal of the SME support factor be implemented on a transitional basis, so its impact is reduced and managed over a period of time.

We also suggested in our feedback that a bold step would be to retain the support factor but align it to the mitigation of systemic risk from climate change. This would help to support objectives not just at the Bank of England but across the industry. The support factor could be conditional/available only to those SMEs that have met certain standards relating to climate change/implemented climate change initiatives.

September 2023