After the financial crisis in 2008, the role of banks in our economic recovery was often widely discussed, with many doubting their intentions, and people’s trust in the financial sector at an all time low. We now face the prospect of another recession – which may very well be deeper and more severe than the last one – and there are likely to be many questions about not only how the country recovers economically, but how many small and medium sized businesses will survive. Different regions will be facing different problems, and this time, we might want to take a more localised approach – one which may boost the chances of a quicker recovery and make our local economies more resilient against future shocks. Back in 2015, our report Community Chest proposed a dramatic shake-up to the UK’s banking system – calling for the establishment of a network of local banks with a specific remit to support local economic growth.
Read the introduction below, or the full report here.
The UK’s economy is unbalanced in two important ways. First, it relies too much on debt-fuelled consumption, and not enough on business investment and exports. By common consent, this model of growth damages productivity and leaves the wider economy vulnerable to shocks. Second, the UK has stark geographical imbalances. There is a broad north–south divide, with a particular dependence on London for wealth creation. This report explores whether local banking might help address either or both of these two problems: helping facilitate business investment and generate growth around the country.
The report also examines whether local banks might help create local economies more resilient to shocks. Following the financial crisis, the UK economy entered a downward spiral. Contractions in credit negatively affected business performance, which in turn contributed to further credit contraction. This effect was mitigated in some other European countries where local banks played an important role in sustaining SME lending, improving the resilience of local businesses and national economies.
The fundamental argument of the report is that while measures to produce greater competition in the banking system are welcome, the UK needs different types of banks, not just more banks. This is because shareholder-owned banks, which must produce high returns on capital, find SME lending expensive and difficult to justify beyond a certain level. SME lending can be profitable, but not as profitable as other forms of investment, such as mortgage lending. Firms that are expensive for banks to assess are not given loans, even if they are credit-worthy. This partly explains the SME funding gap.
This is a structural problem, likely to be exacerbated by recent regulatory changes. The credit crisis demonstrated the need for banks to protect themselves better against risk – at least until they can be allowed to fail without claiming money from the taxpayer. The new Basel III regulations stipulate that banks must hold more capital in general – and for SME lending in particular. Therefore, a form of lending that already faces pressures on profitability is likely to become less, not more, attractive in the coming years. Local banks could offer a way of squaring the circle, by helping extend credit to SMEs without the need to undo the new regulations.
Shareholder-owned banks will retain a vital role in the UK economy, but the UK would benefit from greater diversity in its banking sector. Unlike other industries, it matters not just that the sector is profitable and successful on its own terms, but also that it is able to provide credit to credit-worthy businesses in the rest of the economy. Different models of banks would help extend lending further in the SME lending market, benefiting local areas and the economy as a whole.
In other countries, such as Germany and Switzerland, there is greater diversity in banking. In addition to commercial banks, there are banks that are not shareholder-owned. These banks are profit-making but not profit-maximising. They operate with a dual bottom line: to turn a profit and to promote the local economy. Their dual bottom line is the reason why these local banks are more disposed towards SME lending. Because they have no obligation to maximise returns on investment, SME lending helps them fulfil their remit to promote local economies. The fact that these banks do not need to provide dividends to shareholders also helps improve rates of return to depositors.
Local banks therefore fill an important niche in many countries. They provide what the Federation of Small Businesses (FSB) describes as ‘plain vanilla lending’:1 loans that are low risk and give a low return to the lender, producing profits which are steady but unspectacular. Local banks also provide loans to businesses, whose credit-worthiness may be expensive to assess, but are credit-worthy nonetheless.
The key point is not that local banks have a higher risk appetite; it is that they have a lower profit requirement. Paradoxically, this can also make local banks safer than commercial banks, whose appetite for higher profitability often leads them to produce much more volatile results over time. Local banks tend to have a steady performance, with more consistent returns on capital and a more conservative approach to holding capital reserves.
As a consequence, local banks have also been able to bolster the economic resilience of areas in some cases. Because the Sparkassen survived the financial crisis in reasonable health, for example, they were able to work with the Kreditanstalt für Wiederaufbau (KfW), the government-owned development bank in Germany, to extend credit to businesses in their areas. This ability to lend ‘counter-cyclically’ contributed towards more resilient local economies being established and a quick return to growth for the Germany economy as a whole. In contrast, commercial banks, which had pursued more aggressive strategies before the crisis, had little option to focus on repairing their balance sheets, rather than lending to SMEs in its aftermath.
The report argues that the UK would benefit from having a network of local institutions with a specific remit to lend to SMEs. This network would complement the work of commercial banks, by extending credit lines to credit-worthy businesses and lending ‘counter-cyclically’ when commercial banks retrench. There are several local initiatives in the UK aimed at establishing local banks which might be supported and built on.
However, the UK needs to learn the right lessons from local banks in Europe and beyond. The German Sparkassen represent a model to be emulated, with their dual bottom line, strong governance arrangements and networked structure. However, the Spanish ‘cajas’ demonstrate what can go wrong with the model if these features are not in place – especially when local banks suffer from either political interference or exposure to wholesale financial markets.
The report concludes that a network of local banks should be built in the UK from the ground up. Neither central nor local governments should seek to create or own local banks. Instead, the British Business Bank should act as an investor in independent, local initiatives. In doing so, it should help bring different, independent organisations together as part of a shared network, to support and scrutinise one another, while benefiting from economies of scale.
The report is structured as follows:
- Chapter 1 examines arguments for ‘rebalancing’ the UK economy – and progress to date.
- Chapter 2 explores the way SMEs in the UK access finance.
- Chapter 3 looks at regional patterns in UK bank lending to SMEs.
- Chapter 4 focuses on recent policy interventions in banking and SME finance.
- Chapter 5 details local banking models from other countries around the world.
- Chapter 6 identifies local banking initiatives within the UK.
- Chapter 7 concludes that the UK would benefit from having a national network of independent local banks and sets out policy proposals for bringing this about.