Written evidence submitted by Royal Bank of Scotland

[SME0093]

 

The Royal Bank of Scotland (RBS) is pleased to respond to the Treasury Committee’s call for evidence as part of its inquiry into SME lending. As the biggest lender to small businesses in the UK, we understand the importance of the sector and welcome policymakers’ efforts to support SME growth. We also understand that we, more than any other bank, have a special obligation in the UK, having been rescued by taxpayers during the financial crisis.

RBS has recently announced major initiatives which underscore our commitment to doing more to support our SME customers. The conclusion of our strategic review will see RBS adopt a simpler structure that better understands and supports customers’ needs, moving from seven divisions to three businesses – personal & business, commercial & private and corporate & institutional.  Our ambition is to be the best bank for UK customers, built on strong capital foundations and able to support businesses to grow and play their full role in the economy.

RBS has also committed to acting on all of the recommendations of the Independent Lending Review, led by Sir Andrew Large, which identified how the bank could enhance support for SMEs. While the Independent Lending Review was designed to address specific issues within RBS, we hope that its findings provide useful analysis for policymakers and the industry more widely.

RBS’s submission considers the areas of interest raised in the inquiry’s Terms of Reference and draws on our experience of both the strategic review and the Independent Lending Review.

RBS also notes the OFT/CMA is currently conducting a detailed review of SME banking and it is co-operating fully with that market study.

Access to SME finance

The economic recovery is now taking firmer hold and we have seen welcome improvements in SME appetite with new loan approvals in Q4 2013 up 14% from the prior quarter and up 39% compared with Q4 2012 while gross lending increased to £1.8bn in Q4 2013 from £1.5bn in Q4 2012. We remain committed to building a bank that earns its customers’ trust and are determined to play our part in supporting our customers as they seek to expand and invest.

As a major lender to SMEs we must strike the right balance between our desire to lend to customers and managing our risks prudently. Making sensible credit decisions is not only in the interest of the bank but also our customers; lending must be appropriate in order to support business growth. Indeed, affordability was cited by the Independent Lending Review is the most important factor underlying prudent lending to SMEs. We believe that SMEs that have a sustainable cashflow to service and an ability to repay credit are currently able to access that credit. While the Independent Lending Review recognised that there is room for improvement, it noted that in the majority of cases, we are making the right credit decisions.

The review found that RBS had succeeded in delivering a number of critical changes to our SME business since the onset of the crisis including re-balancing and stabilising the balance sheet to lay the foundations for sustainable growth for both RBS and its SME customers. It found that, in contrast to 2008, RBS’s profile is now consistent with that of a market leading SME business, whose share of lending is broadly in line with its share of customer relationships. However it also found that although we had planned to grow SME lending, and had made the requisite capital and funding available for this, we had not achieved lending volumes in line with our plans. Despite our intentions, a significant number of our customers perceived that we were not open for business.

Recognising the above, we have already made or are in the process of making a number of changes to our business which will enable the bank to better support customers, increase our ability to lend and improve confidence encouraging our customers to approach us with lending requests. These include:

Through these measures the bank will be able to support thousands of additional businesses with their expansion plans; we have committed to increasing gross term lending to SMEs by at least 10% to over £9bn in 2014. We have also set ourselves the aim of becoming the number one bank for SME customer service, as measured by an upcoming survey by the Federation of Small Business and the British Chambers of Commerce.

It is important, however, to remain realistic about what can be achieved in the near-term. As noted by the Independent Lending Review, RBS’s share of total lending by high street banks to SMEs remained steady at approximately 40% in 2008-2010. It has since fallen to around 33%, but still exceeds the bank’s market share of SME customers of between 25-30%. Moreover, 32% of RBS’s total loans outstanding at the end of 2013 categorised as to SMEs were to commercial real estate development and investment. This remains a significant risk concentration that we must continue to reduce, though we have been working to identify areas where we can prudently increase our lending in this sector. We expect the continued run-off of our excess commercial real estate exposure to continue to weigh on our net lending performance.

We also observe that many businesses retain strong cash positions and have little desire to borrow; our own data shows that SME deposits increased by 13% in 2013. This is also reflected in the BDRC SME Finance Monitor survey, which found that in Q4 2013 77% of SMEs questioned fitted into the definition of “happy non-seekers of finance” while only 6% could be described as “would-be seekers of finance”, who had wanted to apply for a loan or overdraft but felt that something had stopped them[1].

SME desire to seek finance

Source: SME Finance Monitor Q4 2013, BDRC Continental

Many customers have also increased their loan repayments and reduced their overdraft utilisation, which dropped to 37% for SME customers at the end of 2013 compared with 42% a year earlier. This equates to £3.6 billion of available overdraft funding that our SME customers have access to but are not using.

 

 

 

 

 

 

 

 

Source: RBS internal data

 

 

The SME credit market

The SME market has seen significant shifts in market share over recent years with increased competition from challenger banks and alternative providers. RBS’s share of SME lending has declined steadily, as noted above. Others, however, have gained market share within the bank lending market, such as Santander which has increased market share from 10 to 11% over 2013. Some of the strongest net lending growth in recent months has been seen from competitors such as Aldermore (+£345m in the last nine months of 2013), Shawbrook (+£136m in the same period) and Handelsbanken (which has increased its loans to SMEs by 18% in 2013).  We have also seen significant increases in the use of non-bank finance. SME funding through leasing and asset finance has more than doubled since 2011, according to the National Association of Commercial Finance Brokers. RBS has seen a similar trend through our own asset and invoice finance affiliates, Lombard and RBS Invoice Finance. For example gross lending to SMEs by our asset finance business, Lombard, increased by 12% in the year to Q4 2013. Our invoice finance business increased 9% over the same period.

We are working hard to lend to businesses against the backdrop of both increased competition and cash-rich SMEs. Gross lending in Q4 increased by 21% although net lending has been impacted by significant run-off in both our commercial real estate lending and ‘non-core’ division. We are therefore taking tangible measures to improve our lending and service to SMEs, outlined above, which will enable us to put our lending capacity to best use and support SME growth.

Alternative forms of finance can offer more appropriate solutions for SMEs than a traditional overdraft or term loan, depending on the particular circumstances. In line with this trend, RBS is also seeing increasing competition from alternative sources of finance. These alternative sources of finance are dependent on borrower circumstances but widely available. Peer-to-peer lending, though still small in absolute terms, has been showing extremely rapid growth rates. Indeed, the Financial Conduct Authority’s recent policy statement (PS14/4)[2] on the regulatory approach to crowd funding cited research that showed loan-based crowd funding platforms raised £480m in 2013, of which £193m was to businesses, an increase of 211% compared to 2012, and investment-based crowd funding platforms raised £28m in 2013, an increase of 618% compared to 2012.

We regard these alternative sources of finance as both competitors and, in some circumstances, better suited to the customer’s needs than a traditional bank product or service. With this in mind, RBS is committed to raising customer awareness of alternative sources of finance and helping customers to choose the right product. We have improved the signposting to such alternatives, particularly when we have declined a customer’s loan application.

It is important however to caution expectations that the lending market will fill the perceived gap in provision of finance to SMEs. Many SMEs seeking loan finance are in fact either overleveraged already or if not they do not have sufficient cashflow to service the debt. On the latter this is most notable for young start-up businesses. In reality in both situations, equity finance is often more suitable than debt. The lack of equity finance adapted to the small business market has been remarked on in a long series of official reports, but remains unresolved. Bank finance remains ill-adapted to this need, and would in fact exacerbate the financial position of some companies whose requirement is patient/equity capital without near term interest charges.

Furthermore, pricing in the SME lending market has not yet recovered to offset the increasing funding, credit risk and capital costs that have become apparent since the financial crisis. The Independent Lending Review commented:

“Between 2000 and 2007, the interest rate charged by the banks generated a return on capital broadly in line with the hurdle rate expected by shareholders, given the regulatory capital requirements of the time.

“From 2007, the interest rate charged to customers fell as the BoE base rate was reduced sharply, although this reduction in the base rate was not fully passed on to customers and therefore the banks’ margin over base rates increased from ~2% in 2007 to 3% in 2011. However, in the same period, the incremental funding costs for banks increased (from <0.5% to ~3.5%), as the financial crisis made it more difficult for banks to access funding. The overall cost of capital also increased (from ~1% to ~2%), as regulators responded to the financial crisis by increasing the amount of capital banks are required to hold against lending. Because the increase in funding and capital costs was greater than the increase in the banks’ margin over base rates, lending to SMEs became less profitable to banks than it was in the pre-crisis period.

“Since 2011, the incremental cost of bank funding over base rates has decreased again as economic confidence has improved. As a result, lending now generates a return on capital of approximately 3–7%. This means that lending – as a standalone product – does not yet meet the hurdle rate of return expected by shareholders.”


Average economics of UK SME lending for banks, 2000-2013[3]

Banks with a more comprehensive suite of services, including transaction services, may be able to achieve hurdle rates of return on their overall business. However, at current pricing levels SME lending per se may not attract many new entrants.

Perimeter of regulation

Whilst we sympathise with the idea of exploring other ways in which lending to SMEs can be supported, we question whether extending the perimeter of regulation to include commercial lending would help the supply of finance to SMEs.

Increasing the scope of conduct regulation in this manner would increase the operating costs of providers of SME lending, further depressing the weak returns on such lending noted above. Costs of compliance, which include a significant fixed cost element, would also disproportionally affect smaller, challenger banks.  Taken together, these costs are likely to dampen the supply of SME funding.

We believe the case for regulation supporting increased SME lending should begin with evidence of a clear market failure – for instance, that systematic poor behaviour by banks was preventing SMEs from making sensible finance requests.  We do not believe there is evidence suggesting this.

Were there to be such evidence, however, it is worth noting that the FCA expects firms to act with integrity across all of their activities, and would potentially be able to investigate and take action against firms, without necessarily needing to extend the regulatory perimeter.  Supervisory intervention or indeed voluntary responses (e.g. through industry codes of practice) can sometimes be better alternatives than simply looking to a regulatory response. 

In general, therefore, any proposal for taking regulatory action needs in our view to consider carefully the root cause(s) of the identified problem that needs fixing, and to consider the most appropriate and efficient means of addressing these.  Past experience has shown that regulation is not always the most relevant or effective response. Indeed, international experience has shown that examples of state intervention in lending have resulted in poor outcomes for lenders, borrowers and the economy.

Appeals

We believe that building awareness of the appeal process is a fundamental part of supporting UK business and are keen to do whatever we can to assist that awareness.

As a consequence, over the last six months we have put considerable effort into raising awareness, both working across the industry and on our own account, including:

Nonetheless we do recognise the need to do more, and will be writing again this year to all 1m of our SME customers on both the right to appeal and alternate sources of finances. We are also improving our lending processes to contain clearer guidance on appeals and a way to capture confirmation from our customers that they are aware of the appeals process.  

The overturn rate for RBS decisions, which has been independently audited by Professor Russel Griggs’s team, has been relatively steady since the appeals process was introduced back in 2011 at around 16%. This is significantly below the industry average overturn rate and shows that we are getting more decisions right first time. Many of those that are overturned look very different from the original customer request, largely because of customers finding additional contribution in the interim period; deciding they actually need less than they originally asked for, and other reasons which result in a revised, but for the customer, a satisfactory outcome.

RBS has committed to becoming the number one bank for business customers in the UK; ensuring effective appeals and complaints processes is a central plank of this achieving this objective. Through the reforms to our structures and processes outlined above, we are confident that we will lend more while better serving our customers’ needs. In addition, we have implemented a programme to reduce SME customer complaints by 50% by the end of 2017.

Interest rate hedging products

The FCA’s monthly updates publish bank by bank progress against the five stages of the regulator approved process and show RBS making good progress through its case load. While RBS has the greatest number of cases in the review as a result of our market share, the majority of our cases are vanilla, short term products and with relatively few of the complex ‘Category A’ products. At the time of the last update from the FCA, RBS has made over 3100 redress offers to customers - more than any other bank.

Forbearance

Following the financial crisis a large number of businesses experienced difficulties, particularly in the commercial real estate market in which RBS lent heavily, meaning that the bank has needed to support a significant number of distressed businesses over recent years. The extent to which banks should show forbearance to businesses during the economic downturn has been discussed among stakeholders over recent years. For RBS, foreclosure is always the last resort not just because we can save jobs and livelihoods, but if we can sustainably preserve a company that is by far the best business outcome for us and them, and the wider economy. Nonetheless the bank must make judgements about whether companies can be rescued. We assess each case on its own merit and will only look to foreclose on a business once all other options have been exhausted.

Conclusion

We are fully committed to supporting SMEs and are undertaking major reforms to our structure, conduct and culture to ensure that customers are at the heart of everything we do. We welcome policymakers’ efforts to encourage SME lending and look forward to working together in reaching this shared goal.

 

March 2014

 

 

[1] SME Finance Monitor Q4 2013, BDRC Continental. http://www.sme-finance-monitor.co.uk/

[2] http://www.fca.org.uk/static/documents/policy-statements/ps14-04.pdf

[3]Independent Lending Review – Bank of England Trends in Lending/Oliver Wyman analysis. N.B. Actual price shown is measured by the Bank of England as the industry median price at which new variable rate loan facilities were originated. It is shown here as the full price paid by the customer, i.e. base rate plus the interest margin charged by the bank.