SMEF0105

Written evidence submitted by the Federation of Small Business

 

The Federation of Small Businesses (FSB) welcomes the opportunity to submit evidence to the Treasury Committee on SME finance.

FSB is a non-profit making, grassroots and non-party political business organisation that represents members in every community across the UK. Set up in 1974, we are the authoritative voice on policy issues affecting the UK’s 5.5 million small businesses, micro businesses and the self-employed.

FSB responses to the call for evidence are detailed below.

Industry issues 

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

Application process

SMEs can find the application process for finance challenging. FSB research has found key reasons for difficulty include the length of the application (62%), lack of communication or inability to talk to someone about the application (36%), the application requiring information SMEs could not access (26%) and the cost of the application itself (19%).

However, when ease of application is broken down by the different types of finance SMEs applied for, there is some variation in results. Overdraft facilities, credit cards, and asset finance are three of the most common types of finance sought by SMEs, and around two thirds of applicants for each[1] found the application process easy. Traditional bank loans, however, were only considered easy by 37% of SMEs, this likely illustrates the increased requirements for information from banks and the narrowing of eligibility criteria.

Cost of finance

Another key challenge for SMEs seeking finance is the cost of finance. In Q2 2023, the cost of finance was reported to be one of the top three barriers to growth for 8% of SMEs, up from 2% in Q2 2022. Of the SMEs who applied for finance, 30% were offered an interest rate of 11% or more, compared to Q2 2022 when only 12% of SMEs were offered this rate.

The high costs of interest rates are impacting SMEs overall business costs. Of the small businesses experiencing increased costs in Q2 2023, 20% identified financing costs as one of the main causes.

Success rates

In Q2 2023, 61% of small businesses were successful in their application for finance. However, across 2022 there was a worrying trend with an average of 45% of SMEs successful in their application, well below the pre-covid success rate of 65%. It should be noted, however, that the applications which are not successful in any given quarter are not necessarily rejected – a proportion of the applications will be pending at the time we surveyed respondents.

Chart: Small Businesses credit application success rates


Source: FSB - Verve ‘Voice of Small Business’ Panel Survey

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

In terms of the more common forms of finance applied for, credit cards appear to have the highest success rate, followed by asset finance, then overdraft facilities. Bank loans see lower success rates than those other forms of finance.

How accessible is finance for SMEs of different sizes? 

In Q2 2023, the availability and affordability of credit by small businesses was considered good by 12% and poor by 52%, however, looking specifically at the self-employed, these figures were 7% and 58% respectively.

FSB data shows 59% of SMEs applied for finance over the last five years. When broken down by size, 43% of self-employed, 61% of micro-businesses and 72% of small businesses applied for finance so the larger the business is, the more likely it is to have applied for finance.

Self-employed and micro businesses often face multiple difficulties when applying for finance such as not having assets to secure loans against, reluctance from lenders to lend to smaller businesses, and, for start-ups, limited transaction history within that line of business.

Is finance available to allow SMEs to scale up from venture capital funding? 

According to FSB’s Small Business Index, 2.3% of total financial applications were for venture capital finance. We are of the view that the issue is not the availability of venture capital funding, the UK has the second most active and capital-intensive venture capital market in the world, but rather the issue is rooted in the mismatch between the demand and supply of finance that allows for businesses to scale up and the accessibility of the finance.

How successful has the Bank of England’s Term Funding Scheme with additional incentives for SMEs (TFSME) been at encouraging banks to lend to SMEs? 

The scheme came into effect March 2020, when Bank rates were cut to 0.1 and the reduction was largely transmitted to low lending rates for small businesses. In Q2 2020, 85% of small businesses were offered interest rates below or up to 4%. Those offered interest rates below or up to 4% remained relatively high at 82% in Q3 2020, 75% in Q4 2020 , 76% in Q1 2021. For the first 12 months of the scheme, SMEs had benefited from the ultra-low rates passing through.

However, the rate of small businesses offered interest rates of up to 4% tumbled 48% in Q2 2021, 43% in Q3 2021 and 48% in Q4 2021. The Bank kept interest rates at 0.1 for the majority of 2021, only raising it to 0.25 in mid-December 2021

Therefore the success of the scheme is mixed, it appears that for 2020 the first year of 0.1% interest rates, small businesses benefited from ultra-low lending rates, however in 2021 this number was greatly reduced from the high of 85%.

What role do credit reference agencies play in supporting SME finance?  

Credit reference agencies play an important role in ensuring the SME lending market is competitive and that alternative lenders can access data from the big banks to support better decision making about finance for small businesses.

 

This is growing in importance with the rise of challenger banks and SMEs increasingly looking for alternative finance providers. In 2022, challenger banks made up 55% of the market share for gross lending to SMEs, the highest on record. It also marked the second consecutive year in which the challenger and specialist banks’ share exceeded that of the big five banks, with nominal gross lending of £35.5bn[2]. With an ever-growing share of the market taken by challenger and specialist banks, it is increasingly important they have access to accurate and correct information about SMEs to ensure the right financial decisions are made.

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? 

FSB SBI data for Q2 2023 showed that female-led small businesses were more likely to view accessibility and affordability as poor at 61% compared to 47% of men, and this was reflected in financial decision-making as only 9% of female business owners applied for credit compared to 14% of men in Q2 2023.

Women’s lower rate of finance applications could be influenced by their higher levels of rejections. For example, overdrafts are a highly successful form of finance for small businesses, with FSB’s 2022 finance survey suggesting only 13% having been rejected, however this is number is 21% for women-led small businesses compared to 8% for male-led small businesses.

Women’s higher rates of rejection for finance leads to them been discouraged from investing, 41% of women-led businesses planned not to invest within the next two years compared to 32 per cent of male led businesses. This contributes to a significant lost of economic revenue, up to £250 billion of new value could be added to the UK economy if women started and scaled new businesses at the same rate as men[3].

FSB recommends the Government and the FCA to work with industry leaders to address barriers that disproportionately affect women-owned businesses when trying to access certain financial products. For example, credit reference agencies should consider reasonable adjustments to assessment where a gender bias could affect credit scores. Reasonable adjustments should be considered and implemented to mitigate the disproportionate effect of systematic bias, such as the wage gap, and episodes of economic inactivity, such as pregnancy and maternity, that can contribute toward a lower credit score among women applying for business finance. These reasonable adjustments could level the playing field and demonstrate that a lower credit score does not always equate to a riskier individual or business.

FSB recommends that the sector must actively work to tackle unconscious bias. Industry leaders should do more to promote gender equality and female representation from the workforce to the boardroom, as female business owners would feel more comfortable applying for credit from businesses where women are more visible.

FSB recommends the BBB should expand the Start Up Loans scheme. Evidence from the BBB shows that Start Up Loans have consistently helped more female and ethnic minority entrepreneurs to establish and grow their businesses; a commitment to increasing the provision of Start Up Loans will encourage and boost enterprise across the UK.

FSB also believes that the FCA should require lending bodies to record the gender and ethnicity of those seeking finance and to report this data along with the success rates to the FCA on a quarterly basis. Having to report this data is likely to alter the culture and behaviour of banks for the better.

Regulatory issues 

Do SMEs have adequate and appropriate access to a complaints procedure when in dispute with their bank or lender?  

SMEs with a turnover of less than £6.5million and fewer than 50 employees currently have access to the Financial Ombudsman Service (FOS). According to FOS, their service covers 99% of small businesses in the UK, but there still remains 55,000 SMEs without access to a complaints procedure to dispute bank and lenders, and this is now more profound with the imminent closure of the BBRS. The Government must consider a service or an expansion of an existing service (FOS) to capture small businesses who are currently too large for FOS eligibility but are not of the scale to have the money, appropriate legal representation and time to sue their bank. FSB therefore believes that the remit of FOS needs to be expanded, as we explain in a subsequent answer, to capture small businesses with higher turnover.

With small businesses vulnerable and increasingly reliant on access to finance and the types of finance lenders are willing to give them, it is vital that SMEs have access to an adequate complaints procedure.

How effective has the Lending Standards Board’s Standards of Lending Practice been?  

The Lending Standards Board has provided a benchmark for good SME lending practice in the UK, driving fairer outcomes for SMEs and their customers. However, the self-regulatory body has limits to what extent it can force the financial services sector to adhere to its codes as it can only provide oversight of members who sign up.

Whilst all major banks have signed up to the Lending Standard Board, a number of challenger and specialist banks, as well as alternative finance lenders are not members. FSB supports the work of the Lending Standard Board’s to ensure SME lending is fair and with 45% of the SME lending market controlled by the major banks, their adherence to the Board’s codes is important. However, for the Lending Standard Board to be fully effective, it would need to capture the wider SME lending community.

How well does the Financial Ombudsman Service (FOS) work for small business complaints? 

FOS has generally provided a fair and adequate services for less complicated small business disputes, however feedback from FSB members has highlighted that FOS can lack expertise to handle complex SME dispute cases. This issue could be rectified by Government increasing the resources of FOS as well investing in staff’s ability to deal with complicated cases.

There is, however, an inherent bias against SMEs in the way in which FOS operates. . FOS complainants have to disclose fully their case but they are not given full disclosure of what the banks’ say in response. SME complainants have no opportunity to challenge the banks’ version of events. We know of cases where FOS has accepted inaccurate statements from banks. This can be remedied by complainants being given full disclosure prior to a decision being reached.

Is the FOS’s existing role in SME finance appropriate? If not, how should it change? 

FOS existing role must be expanded to ensure that more businesses can access its services. The current criteria, for SMEs which have a turnover below £6.5m and less than 50 employees, are too narrow. With the closure of the BBRS, there is a need to ensure that small businesses do not fall between cracks when seeking redress against lenders.

FSB therefore supports an increase in the threshold at which businesses can take cases to FOS. As far as FSB is concerned, there are two leading options. The first would be a maximalist expansion of scope, whereby all SMEs (up to 249 employees) are included within scope of FOS. It is not hard to imagine cases of a business with over fifty employees, or with turnover higher than £10.2m, who would find themselves at a huge disadvantage in a dispute with a large bank, particularly in terms of the disparity legal resources that the two parties could call upon.

 

The second option, which would be the more minimalist option, would be to raise the threshold to a turnover of £10.2m and 50 employees, but set to be updated each year with RPI. It is vital that thresholds should be uprated annually by RPI in order to ensure that inflation does not erode eligibility.

 

At the same time as the threshold is raised, FOS would need to recruit employees with experience and expertise to take forward the new expanded role of FOS. However, whilst in the short-term this will place temporary stress on FOS to improve, they should take this an opportunity to improve their operations and standards as in the long run the general quality and expertise of FOS will increase. As indicated above FOS must ensure full disclosure to SMEs in dispute with their lenders so that they have the opportunity to challenge bank evidence. It will also be important to ensure an affordable appeals process exists, as FOS will not get every decision right.

 

Even if the scope of FOS is to be expanded, there will still be some cases that FOS is unable to deal with effectively, either because a medium-sized business falls outside the scope of the ombudsman, or because the case is too complex. For these cases, consideration should be given to establishing a financial tribunal that businesses can use, which could be funded by a levy on all large lenders. This would provide a more affordable and less risky option for small businesses which may be unable or unwilling to take the risk and costs of engaging with the courts system. A statutory Tribunal system would also  be beneficial to the banks. Tribunal decisions create binding precedents that remove uncertainty and thereby reduce costs for all in the long run.

 

How effective has the Business Banking Resolution Service been, and what lessons can be learnt from it?

The BBRS has not been effective, with only seven banks signing up to the service, and fewer than thirty cases resolved at a reputed cost of £40 million. One lesson learned from the failure of the BBRS was that it was far too restrictive in eligibility, with little willingness from the BBRS to address this. The failure of the BBRS to take on the advice of the SME liaison panel, which was set up to feed SME concerns back to the organisation, has contributed to its lack of effectiveness.

The Government, when initially setting up the BBRS, did not wish it to be a statutory body on the basis that it would be more costly and slower process for SMEs. However, the design of the BBRS restricted its ability to adapt through rule changes, as any adjustments to the current eligibility, rules or processes needed to be set and approved by the banks.

In the future, the Government should:

  1. extend the remit of FOS so it captures a larger number of SMEs,
  2. Change FOS operating procedure so that SMEs are given full disclosure and hence the opportunity to challenge banks’ evidence
  3. Set up a financial tribunal system, to deal with larger, more complex cases.

These changes would ensure affordable and accessible dispute resolution is available for SMEs. This would give SMEs more confidence to see finance to grow their businesses and invest new, energy efficient technology, which is need to meet the Government’s net zero commitments. It would also enhance the UK’s international reputation as a place to do business.

Should SMEs have the same level of consumer protection and deposit insurance limits as retail consumers? 

FSB supports the FCA’s Consumer Duty which has recently come into force. Small businesses, especially towards the micro-sized end, behave similarly to individual consumers when accessing financial products. The majority of small business owners are not financial experts, and the breadth of available products can be overwhelming. FSB views the Consumer Duty, which shifts the onus onto providers to ensure that the products being offered are understood, have clear terms, and avoid hidden fees, as a step in the right direction to ensuring that small businesses are being offered products in their best interests.

Should commercial lending to SMEs be brought into the regulatory perimeter? 

Currently a person does not need to be authorised by the FCA to lend money commercially to SMEs. Whilst this allows for SMEs to access lending they may not otherwise through banks, the FCA must strike a balance between free flow of capital and ensuring there are sufficient protections. The FCA acknowledged in their regulatory perimeter report that SME lending is a longstanding issue and is largely unregulated[4].

 

Given the wide-ranging financial sophistication of SMEs, there are small businesses that may take on risky activity due to limited choice or poorly managed expectations and under the current system, these business will be left vulnerable.

 

Anecdotally, we have noted an increase in the number of small businesses asked to take our personal guarantees for loans. FSB has concerns that due to the unregulated market of commercial lending, a personal guarantee can essentially turn a business loan into an unregulated personal loan. FSB is concerned about the impact of the use of personal guarantees on small business behaviour, and believes it merits further attention from the FCA.


However, extending regulation to commercial lending should not be done lightly. The significant increases in FCA fees, and the costs and complexities of becoming (and staying) a regulated lender - which usually involves hiring a consultant - means that simply increasing the scope of the regulation to cover SME lending will likely lead to a short term reduction in the number of lenders in the market. The FCA needs to reduce regulatory costs for smaller regulated entities.

What impact will the PRA’s proposed Basel 3.1 capital requirements framework, and in particular the proposed removal of the SME support factor, have on SMEs in the context of the PRA’s objectives? 

SMEs currently benefit from an SME supporting factor of 0.7619, around three-quarters of the normal requirement to hold capital, therefore easing lending for SMEs compared to large corporates.

The UK’s economic environment for SMEs today is arguably even more challenging than the 2008-09 climate and that of 2014, when the SME supporting factor was introduced to alleviate the impact on SMEs of stricter capital requirements. With SMEs being heavily dependent on bank lending, the introduction of the supporting factor provided improved lending conditions for SMEs, as the lower risk weight encouraged banks to deploy capital for SME lending, thus helping to stimulate the economic recovery.

FSB is concerned about the potential reduction in SME lending by up to £44 billion if the SME supporting factor is removed, as forecast by Oxera[5]. The report findings, that the removal of the SME supporting factor would contribute to a reduction in SME lending of £21 billion from banks who use the standardised approach and £23 billion from banks who used their own internal ratings based approach, would mean serious consequences for SMEs’ access to capital, along with further economic ramifications.

FSB’s research shows that small businesses across 2022 reported an average 45% success rate in credit applications, and whilst Q2 2023 saw the success rate climb up to 61%, closer to the pre-covid historical average of 65%, the accessibility and affordability of credit remains challenging.

FSB is concerned that removing the SME supporting factor would further disincentivise the banks and depress lending activity across the market. The share of small firms offered interest rates of more than 11% was 30% in Q2 2022, compared to 6% in Q1 2022. In response to the potential higher risk weights for SME lending and the additional capital costs banks would face, we would expect to see an increase in interest rates and cashflow consequences for SMEs. It is therefore imperative that the PRA does not proceed with the proposed removal of the SME support factor.

Government policy issues 

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

The FSB has a number of recommendations to improve the lending environment for SMEs. Some are for the Government to implement, some for the British Business Bank, some for regulators, and some for the Bank of England.

What has the impact of the Covid Bounceback Loan Scheme (BBLS) which was followed by the Recovery Loan Scheme, been on SME finance? 

FSB’s SBI data shows successful credit applications for SMEs peaked in Q2 2020 at 81%, a record high which was inflated by the introduction of CBILS and BBLS. The £47.4 billion (BBLS) and £26.4 billion (CBILS) provided urgent and necessary access to finance to millions of small businesses in the UK. The schemes’ importance in aiding business survival during the height of the pandemic cannot be overstated.

The BBL was the more popular scheme amongst FSB membership, many members have provided stories of the BBL scheme as preventing them from bankruptcy and the introduction of Pay As You Grow has provided flexibility to manage repayments without constricting cashflow.

 

How useful is the British Business Bank? Does its finance hub improve SME access to finance? 

The BBB has to an extent fulfilled its objectives to drive sustainable growth, enable transition to net zero economy and support access to finance for smaller businesses, however there is still room for improvement given the ongoing need for accessible and affordable finance for SMEs.

The BBB will be central to what the Government does next to improve prospects of SMEs and scale ups. However, the BBB is limited in its ability to make investment and finance decisions and constrained by the Government budget. The Government’s annual assessment of the BBB has an impact on investor confidence, as investors do not know what the new KPIs or policies will be, making the direction of the BBB’s work volatile, and this could be a disincentive to invest.

The BBB could benefit from greater operational independence. The BBB is not able to make innovative investment decisions, such as investing in late-stage venture capital without Ministerial approval, delaying the flow of capital in the economy.

The BBB finance hub provides SMEs with access a ‘one-stop-shop’ site that provides a range of business guidance and support, the hub could benefit from wider public exposure to encourage the SME community to access the site.

Ensuring access to banking

Although not specifically highlighted as a question for the inquiry, we believe there are certain improvements that need to be made to the regulatory system, in order to ensure better protection for those small business owners and individuals who are left without bank accounts due to their bank’s sudden decision to close an account. As a first step, we believe that we need better data to be made available to the regulator and reported on publicly. FSB therefore proposes that:

 

1. The FCA should require that all bank account closures initiated by a bank should be reported to the FCA together with the reason for the closure and the demographics of the account holder (for example gender and ethnicity data).

 

2. The FCA should publish quarterly the number of closures with a breakdown of the reasons for the closures. This data should be anonymised, but breakdowns published by sector, region, and demographics including protected characteristics to highlight any disproportionate impacts on particular groups.

 

3. Bank customers should be informed when their accounts are being reviewed (except in the case of suspected money-laundering) and given an opportunity to respond.

 

4. If a bank decides to close an account it should give the account holder 3 months to find alternative facilities.

 

5. There should be duty on those granted a banking licence to provide basic banking facilities for the unbanked.

 

 

September 2023


[1] 64% found overdrafts easy, 69% found credit cards easy, and 64% found asset finance easy.

[2] Small Business Finance Markets 2022/23 https://www.british-business-bank.co.uk/wp-content/uploads/2023/02/J0189_BBB_SBFM_Report_2023_AW.pdf

[3] Alison Rose Review https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/784324/RoseReview_Digital_FINAL.PDF

[4] FCA Perimeter Report https://www.fca.org.uk/publications/annual-reports/perimeter-report#lf-chapter-id-lending-sme-lending-

[5] Oxera ‘Impact of PRA proposals for implementing Basel 3.1 standards in the UK’ https://www.oxera.com/wp-content/uploads/2023/03/Impact-of-the-PRA-proposals-for-Basel-Standards-in-UK_FINAL_edit.pdf 20 March 2023