Media Briefings

Banks’ Vital Role In Providing Finance For Small Businesses In The UK

  • Published Date: October 2009


In ‘normal’ times, most small firms, most of the time, get what they seek in terms of outside
finance. That is the central finding of a study of the financing of over 2,500 small and
medium-sized enterprises in the UK.
But the research by Andy Cosh, Douglas Cumming and Alan Hughes, published in the
October 2009 issue of the Economic Journal, also finds that banks are by far the largest
providers of finance to this sector of the economy. They conclude that:
‘In the current recession, circumstances for both the demand for and supply of
finance are constrained. But as demand conditions improve and the demand for
finance rises, the role to be played by banks will be critically important.
‘It is essential that policy measures are in place to ensure they have the asset base
and structure to ensure that they can play that role.’
The researchers note that there is a ‘Catch 22’ facing small business owners – when you
don’t need finance since business is going well, it’s easy to obtain it; but when profits are
low and you need external finance, no one returns your call.
This is particularly true for young, innovative firms without an established track record.
Banks tend to steer clear of these riskier businesses and they are too small to be of interest
to the venture capitalists.
This research, which took place before the recession, addresses three questions that have
great relevance to understanding the ways in which the capital market will need to work if
the small business sector is to be funded effectively in the recovery:
 What causes small companies to need external finance?
 How much do they seek and from whom?
 How successful are they in obtaining the finance and what determines this?
The research draws on unique data on the financing of over 2,500 UK small businesses,
looking from the small firm’s point of view rather than those of the finance providers and
identifying the full range of sources of capital that they use.
The accepted way of understanding firms’ choice of sources of finance is called the
‘pecking order hypothesis’. This recognises that finance providers face risk and uncertainty
about the small firms applying to them for finance and this is priced into the terms on which
they are prepared to lend or invest.
As a consequence, small firms will prefer to use internally generated funds before turning to
external finance. Since equity finance is more risky than debt finance (no regular return and
paid out last in the event of business failure), its cost is higher and so the pecking order
hypothesis is that debt finance will be used before resorting to equity. The pecking order of
first internal finance, then debt and then equity is reinforced by the desire of small business
owners to keep control of their businesses.
Overall, the research supports this idea. Firms seek external funds when their profits
cannot support their business needs. And they seek to borrow the funds (banks, leasing,
invoice discounting) rather than seeking equity finance (venture capital, business angels,
owners).
Around 38% of firms in the survey sought finance. The firms most likely to seek finance
were those with high growth ambitions and with high capital expenditures relative to their
profits.
The amount sought by these companies was about £100,000 though some sought
substantially more. The same factors determining the decision to seek external finance,
plus the ratio of a firm’s debt to its assets, also influenced the amount sought.
At first, a higher debt ratio increased the amount sought but at higher levels of the ratio, the
amount sought decreased. This suggests that firms recognise the limitations to the amount
they can borrow relative to their assets.
Of those seeking finance: 81% approached banks; 50% hire purchase/leasing; 16%
factoring/invoice discounting; 14% approached the owners of the business; 9% went to
venture capitalists; and 9% to business angels. Banks were by far the largest providers of
finance to the businesses; this emphasises the key importance of bank lending.
Overall, the firms were successful in obtaining the finance they sought and 81% of the
amount they sought was obtained. But while firms often get the capital that they seek, firms
do not always obtain capital in the form that they would like.
Rejection rates were low for larger businesses, but higher for small, young, innovative
firms. The highest rejection rates were from venture capitalists (46%). Bank rejection rates
were 17% and the lowest rates were for asset-based lending such as leasing (5%).
Banks favoured larger firms operating in less risky areas. Leasing firms, trade customers
and suppliers, invoice discounting and owners were more likely to provide finance for more
profitable businesses. Venture capitalists and business angels financed larger, more
innovative, growth-oriented businesses.
ENDS
Notes for editors: ‘Outside Entrepreneurial Capital’ by Andy Cosh, Douglas Cumming and
Alan Hughes is published in the October 2009 issue of the Economic Journal.
Andy Cosh and Alan Hughes are at Cambridge University. Douglas Cumming is at York
University in Canada.
For further information: contact Andy Cosh on 01223-335551 (email: adc1@cam.ac.uk);
or Romesh Vaitilingam on 07768-661095 (email: romesh@vaitilingam.com).