CandidCapital

A constant refrain heard in the UK in the last forty years has been "Why don't the banks do more to back British innovation?" There are good reasons why many, perhaps most, technology businesses are beyond the pale for bank lending.

Debt providers obtain their reward from the margin of interest over the cost of providing funds. Suppose that a bank lends to a small company at a margin of 2% (1). Suppose further that the bank has a cost/income ratio of 50%: it employs people and installs software systems to assess the risk, approve and manage the loan. This means that its net income before tax is likely to be only about 1% of its loan book.

Even if the bank generated additional lending income—by taking a 1% arrangement fee, say—it would start to lose money if more than about 1.5% of its lending went bad. Most established banks have provisions of 0.5% or lower for bad and doubtful debts. The margins for error are small. One additional company defaulting in a portfolio of 100 customers may only represent 1% of funds advanced, but if none of the funds are recovered, the bad debt rate will treble (from an average of 0.5% to 1.5%) and its net margin after costs will reduce to barely economic levels, depending on when in the life of the loan the default occurs.

Sum lent per customer: £100,000
Number of customers: 100
Total portfolio value: £10,000,000

Arrangement fees 1%: £100,000
Annual margin income 2%: £200,000
Total lending income: £300,000

Net income @ 50% cost income ratio £150,000 = one-and-a half customer loans before bad debts

Does this matter? For many years British banks were urged to be more like their German counterparts by acting as funding partners for industry. However, more recently the weakness of the German banking sector has led to a wider appreciation of the need for ‘strong’ rather than ‘generous’ banks: “In my view, the biggest contribution Deutsche can make to Germany is to be as big and as profitable as possible. In the end only a strong bank can be a reliable partner for business.” (2) And bank profitability has wider economic implications for the UK: “In just six months UK banks paid enough in taxes to cover a third of the Government’s Transport Bill, or the annual budgets of the Department for Environment Food and Rural Affairs or the Department for Constitutional Affairs.” (3)

But are technology firms really more risky than other small companies? Or is it just that the banks believe that tech firms are riskier and so do not proceed with appraising lending propositions in the tech sector? What little evidence there is suggests that tech firms may indeed be a better credit risk than average (4); much more empirical research is required on this issue for the UK to build up its innovation sector. As one experienced manager put it to us: “Even the toughest lenders want to hide under the desk when a proposal comes in that involves coloured wires or Petrie dishes; they’re glad if they can turn it down because of high gearing.”

It also appears that banks without specialist appraisal procedures confuse uncertainties (how well the technology works, size of the market, quality of management team) with risk. Generalised uncertainties could be converted into specific quantifiable risk through long-range empirical mapping of the behaviour of technology customers. But no UK bank has yet stayed in the tech sector long enough to establish suitable risk assessment tools as part of standard credit systems.

(1) “Data supplied to the Bank by the main banks suggest that the average margin over base fell during 2003 to around 2% at the end of the year.” Bank of England: Finance for Small Firms – An Eleventh Report, 2004 p11
(2) Josef Ackermann, Chief Executive of Deutsche Bank; Financial Times, 17 March 2003, p7
(3) The Times, London, 7 August 2004, p48
(4) Cowling M, Murray G, Gryges H and Licht G: Survival and Growth (2002-05)

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