Is local banking the answer?

Local and regional banking is seen as a solution to Britain’s over-centralised financial sector and ongoing growth problems. Sonia Sodha examines the evidence.

Five years after the financial crisis, economic growth has finally returned: in last December’s Autumn Statement, the Chancellor George Osborne was able to declare that Britain is now growing faster than any other western advanced economy. Amidst the relief of recovery, it’s easy to forget that as Shadow Chancellor, he set himself a more challenging test. Not just to restore growth, but to build a new economic model by rebalancing growth away from household consumption towards more sustainable business investment and exports.

Yet the growth we are starting to see has an all-too-familiar feel: it is again being fuelled by rising levels of personal debt and a re-expanding housing bubble, helped by government schemes that make the cost of credit cheaper. And the OBR has revised down its estimates of what investment and trade will contribute to growth. So it is unlikely the return to growth will eliminate the debate about the long-term health of Britain’s growth model.

One popular proposal to aid rebalancing and boost sustainable growth has been to make the case for a network of regional or local business banks to ensure growing businesses, particularly small- and medium-sized enterprises, can access the finance they need to grow. The source of inspiration is Germany, where a system of regional and local banks have long been a significant part of its banking infrastructure, with its group of local banks (the Sparkassen) one of the largest banking groups in Europe, with over 40 per cent market share of business loans.

This article interrogates whether a German-style system of local banks could indeed be a solution to Britain’s growth problem. It argues that they would have a lot to offer both the business and personal banking markets, but that they are not the answer to unlocking the growth potential of Britain’s small- and medium-sized enterprises. Instead we have more to learn from schemes such as the Small Business Investment Research (SBIR) and Small Business Investment Company(SBIC) programmes in the United States.

Start with the problem, not the solution

It is vital small businesses are able to access the capital they need in order to grow and create jobs. Research by NESTA has highlighted that high-growth SMEs account for only 7 per cent of all companies yet between them generate over half of all new jobs in the economy.

There are two inherent market failures in small business finance. The first is in access to early stage finance, particularly for science and technology start-ups. The risks associated in investing in cutting-edge technology and science can be high, yet the societal benefits to transformational innovations such as touchscreen technology can be far greater than the benefits to any one company. As Mariana Mazzucato has argued in her book The Entrepreneurial State, that means private investors are unlikely to take these big bets, holding back growth and progress.

The second is in access to growth capital for small high-growth companies. The fixed costs of due diligence on a potential investment tend to be similar regardless of whether a company is small or large; yet the potential wins from investing in a large company are bigger. This means that investors are less likely to invest the relatively small amounts that these companies need. A lack of growth finance is partly why owners of high growth companies based in the UK like the technology firm Autonomy often end up selling to larger companies.

As Demos Finance has highlighted in its report Finance for Growth, the idea that a lack of business lending by the banks is holding back high-growth companies is a myth. The majority of SMEs will never and do not want to become high-growth companies; for them being able to access bank loan finance is important to helping them plug gaps in cashflow to remain ‘steady state’ or pursue incremental growth. There is not much evidence, even in a post-financial crisis world, that there is latent demand for business loans that banks are unable to meet. And bank loan finance cannot and should not fill the gap in the market for early stage and growth capital: if the financial crisis proved one thing, it is surely that it is not the role of banks to take big and risky bets with savers’ deposits.

‘Mission-based banking’

This is why it is wrong to look to the Sparkassen – as appealing a model of banking as they are – as a solution to business growth. The Sparkassen are a network of over 400 local banks across Germany, established in municipal law. They essentially represent an old-fashioned, ‘mission-based’ model of banking: they take money from personal and business depositors, invest it safely, and lend it out. They have a public interest mission to offer universal bank accounts and offer credit to local SMEs. What sets the Sparkassen apart from institutions like credit unions in the UK is their scale. They are governed locally but share a national IT and risk-pooling infrastructure, and together are the largest single banking group in Germany, with a 40 per cent market share in deposits and in business and personal loans. As a significant player they have helped shape the way in which the German banking system operates, excelling at relationship banking and forcing other banks to compete in the same way.

But it would be wrong to think the Sparkassen are filling a gap in the market for business loans, lending to risky businesses that other banks would not lend to. If anything, they are probably more conservative and risk averse in their lending decisions than privately-owned banks. This is why they have been stable, with not a single bank affected by the financial crisis. (This is in contrast to the network of German Landesbanken, or regional banks, many of which started acting more like investment banks in the 1980s and 90s, going bankrupt as a result.)

The Sparkassen model has much to offer though in terms of improving the extent to which business and personal banking is customer-focused. If a group of credit unions like the Bank of Salford and London Mutual could come together to realise economies of scale in IT and risk-pooling, this could be an important step towards replicating the model here in the UK. National risk-pooling would need to be a central feature if a network of local banks were to be successful on any scale, particularly if they were engaged in business lending. Regional banks that lend and draw deposits in a limited area are clearly inherently riskier.

The American model

If the answer to the business funding gap isn’t a network of local banks, what is it? The United States has two particularly effective state-backed business financing programmes that plug the key market failures and which have been fundamental to the growth of companies like Apple and Intel. The SBIR programme, referred to by innovation expert David Connell as ‘the world’s largest seed fund’, channels contract-based government funding for R&D to high-tech small businesses. Federal agencies award funding in two stages, with contracts of up to $850,000 available. Inspired by the success of the US programme, the UK government launched a similar initiative here, but it remains 15 times smaller than the US version allowing for the different sizes of the UK and US economy.

The SBIC programme aims to plug the gap in growth capital for businesses looking for long-term patient capital of between $250,000 and $5m. The way it works is that the government effectively leverages investment by private investors in small and growing businesses by putting government-guaranteed debt into their investment funds.These funds then invest in growing businesses via a mixture of debt and equity finance. Investment decisions are left entirely to the private investors; the only stipulation is on a maximum size of investment.

The programme is revenue neutral: an annual fee is charged to funds that covers the cost of default, which is rare and since 1992, fees have exceeded the costs of default. The programme combines the power of the government guarantee with private sector intelligence: the scheme works because it is the private investors who stand to gain or lose the most via their leveraged funds. There is no equivalent in the UK, where government has instead focused efforts on investing directly into state-backed venture capital funds, many of which have performed dismally.

The German Sparkassen model may not be the solution to market failures in business growth finance, but it still has much to offer in terms of encouraging other banks to compete on the basis of user-focused, ethical banking. Like most other European countries, the UK used to have its own network of local and mission-based trustee savings banks. But as happened across most of Europe, they were bought out and consolidated, eventually becoming the TSB which in time was bought by Lloyds. Lloyds has now been forced to divest 600 branches to reform the TSB. Does the Sparkassen model offer us an opportunity to come full circle?