Banks, in providing - or not providing - loans for start-ups, or for small firms to expand, can potentially play an important role in aggregate productivity growth. In the UK, Small and Medium Sized Enterprises (SMEs) make up about half the private sector economy in terms of turnover and employment. UK SMEs remain dependent on banks for the large majority of their external funding. So banks decisions on whom to fund, and who to no longer fund, could make a big difference.
The concern that I have discussed before is that a reduction in UK bank lending to SMEs, as banks try to rebuild their balance sheets, would hurt the ability of the more productive SMEs to expand. This in turn would impact on economy wide productivity. There is a longstanding concern that banks that have balance sheet problems of their own will keep ‘zombie firms’ alive to avoid writing off loans, and that this will restrict their ability to lend to new more dynamic firms. UK liquidations have been unusually low in this recession.
The Funding for Lending Scheme (FLS) attempted to encourage greater aggregate lending by banks, although it did not initially discriminate between lending to SMEs and household mortgages. Subsequently the government’s Help to Buy programme threatened to divert more of the scarce resource - bank lending - from SMEs. (The possibility that lending to households could ‘crowd out’ lending to firms is examined in this study.) So it is to the Bank of England’s credit that they recently decided to focus FLS on SMEs, and the Chancellor - perhaps grudgingly - agreed.
However there may be another process behind the UK's productivity puzzle that has to do with banks, but not the volume of bank lending. About a third of bank lending to SMEs is accounted for by one bank: the Royal Bank of Scotland. (At the time of the financial crisis its market share was 40%: see the Independent Lending Review commissioned by RBS, page 25.) It has become increasingly clear that the RBS has been a seriously mismanaged bank. At the end of 2011 the Financial Services Authority issued a report which was extremely critical of the quality of management at RBS. Part of that poor management included a huge expansion in property based loans before the financial crisis. When those loans went bad, it was many of their SME customers who took the hit, according to a report just issued by Lawrence Tomlinson, the "entrepreneur in residence" at the Business, Innovation and Skills Department. Among other things the report alleges that RBS has been forcing viable businesses with short-term cash flow problems into its corporate restructuring arm with the aim of forcing foreclosure and then making a profit from selling off property assets.
When a bank does close down a firm, there is usually a difference of opinion over long term viability, and so the process is bound to be unpleasant. But from an economy wide perspective, you would hope that a bank was reasonably efficient at protecting those firms with innovative potential, because these firms will not only end up repaying their loans, but will be the basis for a mutually profitable future partnership. But Hamish McRae argues that gradually this ‘duty of care’ that banks once had with their customers has been replaced by a desire to flog products. And as the PPI scandal illustrates, banks seem not to worry about whether their customers need these products, as long as the sale is made. In terms of SMEs, some of the major damage may have been done by interest rate swaps: often complex hedging products which buyers may have not understood, or may have been missold. RBS appears to be heavily exposed to compensation claims involving these products.
This example nicely illustrates the problem that appears to be at the heart of banking today. Products like interest rate swaps could potentially be useful to small businesses, protecting them from risk. This is how the expansion of the banking sector was portrayed by the banks themselves - they were selling innovative products that benefited their customers, and therefore the economy as a whole. But if these products are mis-sold, either to those who did not need them or by false claims about what they do, it is just a case of successful rent seeking (using the term in its wider sense): obtaining money from bank customers and providing nothing useful in return.
It is very easy to get carried away with indignation at all this. As scandal after scandal emerges involving the UK banking sector, the only thing that seems to keep pace is the growth in bankers’ salaries. Growth which the UK government is trying as hard as it can to protect. And in the case of RBS, last year this bank even failed to keep its most basic service of operating a payments system going! But this post is designed to pose a rather different question.
Is it possible that this combination of rent seeking and incompetence by the UK’s foremost provider of loans to SMEs had impaired the ability of the bank to ensure that firms that were more efficient and productive survived? Did this bank, and perhaps other banks, become so engrossed in selling products to customers that it no longer allocated what loans it did make efficiently? Could this, alongside low levels of overall lending, be a factor behind the puzzle that recent UK productivity growth has been so low both historically and in relation to other countries? We will probably never get good aggregate data on this, but that does not mean it has not happened.