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CHAPTER SEVEN: CONCLUSIONS

7.1 This final chapter starts by drawing upon the findings of both the demand-side and supply-side research to address the primary question that lies at the heart of this study before presenting the conclusions of the business survey and the interviews with the bankers separately.

Is there evidence for market failure?

7.2 The primary purpose of this study has been to assess the extent to which there is evidence of market failure in the market for finance involving SMEs and commercial banks in Scotland. Specifically, to what extent is there evidence of good, robust business cases for finance being refused by the banks which might be an indication of sub-optimal lending practices by the banks? Alternatively, to what extent can the failures by SMEs to obtain bank finance be attributed to the unsuitability of the business cases that they are putting to the banks ( i.e. demand-side issues)? As discussed in Chapter 1 (section 1.2), these are not easy questions to answer as there are numerous factors that can effect the relationship between SME owner/managers and bank managers and therefore the chances of a business securing the funding it needs, not least the willingness and ability of the entrepreneurs to share the risks involved, the problems of information asymmetry, and various factors that can influence perceptions on both sides. However, putting these complications aside for a moment, has this study produced evidence to support those who argue that there continues to be market failure relating to SMEs access to finance in Scotland?

7.3 The first point to emphasise is that, taking the 2006 ASBS (Scotland) survey as a whole, it is only a very small minority of businesses that experience problems in accessing finance; in the twelve months leading up to the survey, just under a fifth of SMEs sought bank finance and of these, just under a fifth experienced difficulties. Put differently, only 6.3 per cent of the 1014 businesses surveyed reported problems in accessing finance and just over half of these, 3.4 per cent of the total surveyed, were businesses that had approached banks for finance. Moreover, not all of these will have had their applications for funding turned down as the problems may have been of a different kind. In fact, the ASBS (Scotland) data show that 1.6 per cent of SMEs were unable to go ahead with investment projects in 2005-06 because of problems in accessing bank finance, suggesting that even in cases where bank finance was refused, many firms were able to find other ways of funding their projects. There are also sound reasons for expecting the proportion of SMEs experiencing problems with bank finance to be smaller than these findings indicate in the population of Scottish SMEs as a whole, given that manufacturing SMEs were over-represented in the ASBS (Scotland) survey and that it has been shown that these are more likely to encounter problems accessing bank finance than firms in other sectors.

7.4 It is the 20 businesses in the business survey conducted for the purpose of this research where no bank funding was received which therefore become the focus of attention in assessing the extent of supply-side market failure relating to the banks. The business survey revealed that almost two-thirds of the owner-managers of these SMEs believed that they had been rejected because of lack of collateral and trading status, whilst around one third believed that they had been rejected due to the bank's concerns about the strength of the business case that they were putting forward. It was from these latter cases that the five scenario cases that formed the basis of the interviews with the bank managers were selected. It was the opinion of the researchers together with advice from the banking expert that these were the strongest business cases from amongst the 20 businesses that were turned down for bank funding. Of these five, it is significant that there were only two that the interviewed bankers considered were worth serious consideration and stood a good chance of being supported, since the others raised too many concerns about financial and strategic management issues. And of these two, one did actually receive the funding it was seeking by 'shopping around' the banks. This leaves just the one case that was actually turned down for finance and that would appear to be an example of supply-side market failure. The protocol analysis conducted with bank managers would appear to show that there were very few SMEs from the 20 that were turned down for bank funding that might be considered 'borderline' cases. For the rest, it was not difficult for the researchers to understand why the applications for finance had been refused.

7.5 Having said that, much of course depends upon the degree of risk that the banks are prepared to take and judgements about market failure cannot be divorced from views about what is a reasonable level of risk for banks to accept. There is a view, strongly expressed by some of the interviewed SME owner-managers, that the banks tend to be over-cautious and risk averse. The research evidence does provide some support for this view in that it tended to be the more risky projects, especially those involving diversification into new product and market areas, which were most likely to turned down by the banks. Thus the banks attitudes to risk may have the effect of discouraging some of the more innovative, higher risk projects from going ahead which, it might be argued, may constrain business growth and competitiveness.

7.6 At the very least, this research has identified a number of problems in the relationship between banks and SMEs which need to be addressed. In particular:

• There are clearly a number of difficulties relating to manufacturing businesses that relate to the problems of financing new product and market development and investing in upgrading plant and machinery. The owner/managers of manufacturing businesses frequently criticise the banks for being risk averse and having difficulties understanding the nature of their business.
• One of the most common criticisms of the banks by SME owner/managers is the length of time that it takes to come to a decision and how initial favourable indications at the local level can be misleading when the application is later rejected at a higher level within the bank. In a fast moving and fluctuating business market, SME owner/managers frequently have to respond to opportunities quickly, but it is felt that the banks seem not to appreciate this. The research identified a number of cases where the application for bank funding was in the end successful but where the delays on the part of the banks were at a cost to the businesses they were servicing.
• Unfortunately, there were very few start-up firms in the ASBS survey which was the primary data source for this research so they are under-represented in this study. More work is therefore needed on the relationship between start-up businesses and banks and the extent to which market failure may be occurring here. There is some indication from both previous research evidence and the interview conducted for this research with the PSYBT that there is a funding gap relating to new business ventures. There was also little evidence from either the business survey or the bank interviews of the Small Firms Loan Guarantee Scheme being used to provide funding for younger businesses where lack of security may be a concern to the banks.

7.7 The rest of this concluding chapter summarises the key findings from first the business survey and then the interviews with the bank managers.

Business Survey - Conclusions

7.8 The results of the survey of 51 businesses, conducted as part of this study and based on SMEs that had previously participated in the 2005 and 2006 ASBS (Scotland) surveys, leads to the following conclusions:

• Those businesses experiencing problems accessing bank finance (39 of the 51 that were interviewed) were typically well established businesses that were growth seeking and disproportionately from the manufacturing, retailing, wholesaling and hospitality sectors. The most frequently mentioned financial constraints were lack of development finance, particularly affecting manufacturing firms, and cash-flow problems, particularly affecting the retail and hospitality sectors.
• The median project cost for which finance was sought was £105,000, with a median external borrowing requirement of £85,000. On average therefore 81 per cent of the project cost was sought from external sources. However, the scale of borrowing requirements amongst the surveyed businesses ranged from £5,000 to £80 million.
• Two-thirds of those businesses seeking bank finance also considered alternative sources, with around half of them actually approaching alternative sources, mainly for grants, soft loans and equity finance (for some larger firms). There is some evidence of a perceived 'gap' in the equity investment market for finance of up to £1 million due to the lack of interest from equity investors for investments below the £1 million threshold and, according to owner-managers, the cautious and risk averse approach of the banks.
• A striking finding is that almost two thirds of the businesses approached only one bank, typically their existing bank, and did not 'shop around' once their application for finance had been rejected. This may suggest concerns about the time and resources involved in approaching other banks, uncertainty in approaching banks with which they were not familiar, or a 'discouraged borrower' effect. (The supply-side interviews indicated that difficulties are more likely to be encountered by 'new to the bank' customers - relationship banking suggests that the existing bank is likely to be more sympathetic to funding requests).
• Just over half of those businesses which had encountered problems accessing bank finance had had their application turned down. The less successful applicants for bank funding tended to be: manufacturing firms; businesses operating at a loss; businesses seeking smaller scale loans; projects relating to working capital requirements (typically overdrafts and small scale loans); and projects related to new products and market development (typical of manufacturing firms).
• Half of businesses used external assistance with their loan application: one third from accountants and one fifth from either Business Gateway or Scottish Enterprise (typically in the case of larger firms seeking equity finance). A number of firms complained about the cost of accountancy and consultancy advice required in order to support bank loan applications. In terms of improvements to the services provided by the banks, a number of owner-managers were in favour of banks providing a broader range of SME advisory services and nearly one fifth mentioned that they would like to see banks becoming a one-stop-shop for all sources of business finance.
• Almost one third of the businesses that were unsuccessful in obtaining bank finance indicated that a lack of collateral and/or lack of trading record were the main reasons for not receiving a bank loan, whereas less than a fifth of them mentioned providing an insufficient business case as the reason for rejection. Some businesses complained about receiving inadequate feedback from the bank as to why their application was unsuccessful.
• A major area of criticism amongst the businesses that had problems accessing bank finance focused on the applications process. Two-thirds of them complained about aspects of the way in which banks processed their applications: one fifth complained about delays in the decision making process; one eighth stated that information provided by the bank was misleading (particularly about overdraft facilities and differences of opinions between local and centralised levels of the banks); and one tenth noted that there was no link between bank finance and alternative sources of finance. Two fifths of applicants for bank finance took more than six months to get a final decision. Delays were caused by referring applications to centralised teams and bureaucratic procedures.
• A number of owner-managers referred to specific difficulties in obtaining overdraft facilities, particularly for new businesses in the retail and hospitality sectors. Some claimed to have initially been offered overdrafts at start-up, but were then unable to obtain them once they had started trading.
• Despite the difficulties they encountered, over half of the businesses that reported difficulties in accessing bank finance were able in the end to undertake the whole project that they had required funding for and a further eighth to partially deliver projects. This leaves just under a third that were unable to go ahead with the project because of lack of funding. Where banks were not prepared to advance the funding themselves, they were sometimes able to suggest, or in a few cases introduce, the businesses to other external sources such as equity investors.

Bankers Interviews - Conclusions

7.9 The protocol analysis of the case studies together with the discussion of the banks' procedures and lending criteria leads to the following overall conclusions:

• Bank managers place heavy reliance on personal relationships and knowledge of SME business owners, building up relationships over a period of time. They are prepared to invest considerable time in visiting premises, interviewing managers, and becoming familiar with businesses. A primary requirement for any proposition from either existing or new business customers is to understand the nature of the proposition and the serviceability and sustainability of the proposed venture. Thus, although bank managers have targets for new business, it is easier for existing business customers to seek funding, particularly where this might fall outside established 'norms', such as highly geared propositions, or relatively large credit facilities compared to the size of the firm and turnover.
• Banks have standard financial 'models' that are followed in terms of financial requirements, although there may be considerable discretion exercised by individual bank managers, dependent on seniority. In addition, it is clear that bank managers would, as far as their discretion allowed, seek to support established businesses with which they have an established personal relationship. The financial modelling process produces a result which indicates the category for the strength of the proposition in terms of risk/reward, but with latitude for bank managers to use discretion. However, given the segmentation applied by the banks, it will be easier for larger SMEs to obtain funding. Although how the SME market is segmented varies between the banks, micro and small firms are likely to have their propositions credit-scored (reducing the extent of bank manager discretion and flexibility). This is likely to make propositions from small firms that differed from bank 'norms', such as highly geared propositions with limited security, difficult to accept, especially if there are any issues with credit history and the trading track record.
• A number of factors can affect the financial modelling process and hence the extent of latitude and discretion of managers. Entrepreneurs seeking to start new businesses will find it more difficult because of the lack of any trading history. In such circumstances previous experience, age and credit history of the entrepreneur will be important. These are likely to be credit-scored which may limit the flexibility that bank managers have, especially as such proposals are referred for final approval to a central credit department.
• Additional factors include location and sector. Although no sectors are excluded by the banks, SMEs in competitive sectors may find it difficult to raise finance, especially if they are operating in ways that do not fit the banks' own internal guides on benchmarking for the sector. A similar comment can be made on location. Rural locations can be difficult environments for SMEs, having limited local markets and limited networks and resources. Large areas of Scotland, the Highlands and Islands and the South of Scotland, qualify as rural under Scottish Government definitions ³. SMEs in such localities seeking to grow and raise finance may find it difficult to raise bank finance, especially if reliant on local and regional markets.
• Security is a secondary factor, but nonetheless important. Established SMEs with limited security will find it difficult to raise finance for propositions that contain higher risk or do not meet banks' financial modelling requirements. Changes to the Small Firms' Loan Guarantee Scheme following the Graham Review by the UK Government, has meant that the banks have in some cases reduced their use of the Scheme, moving from 'occasionally' making referrals under the Scheme to 'rarely'.

7.10 Whilst this study has produced little evidence of there being an issue of market failure relating to SMEs access to bank finance in Scotland, the above conclusions do nevertheless raise a number of more specific issues relating to the nature of the relationship between SME owner-managers and the commercial banks which are deserving of further attention by both the banks and the Scottish Government.

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