ECONOMIC AFFAIRS: Enterprise bank urgently needed for Australia
by Evan Jones
News Weekly, July 21, 2012
Small business is the backbone of the market economy, goes the myth. In terms of employment percentages: yes — probably also innovatory potential. In terms of market and governmental support: no.
A key arena where small and medium-sized enterprises (henceforth SMEs) experience adversity is in the raising of capital for both start-up and for expansion. The rise of institutional banking has only marginally catered to SME concerns.
In 1929, after the New York stock market crash, the British government set up the Macmillan Committee on Finance and Industry to determine the cause of the global economic slump and to discover whether the British banking and financial system was helping or hindering the country’s trade and industry. The committee’s 1931 report (apparently mostly written by the economist, J.M. Keynes) highlighted that the British finance sector neglected the needs of industry in general. Subsequently, the neglect of SMEs in particular became known as the “Macmillan Gap”.
The Macmillan Gap is always with us. There are structural reasons for the gap. The pre-eminent banking institution, the trading bank, depends on short-term funds and its loans duration is necessarily constrained. The trading bank historically facilitated trade, the overdraft being its essential credit instrument.
SMEs need overdrafts, but also long-terms loans. With deregulation, banks have increasingly tapped global capital markets for additional funds, but these generally remain short-term in orientation. Banks also face greater administrative costs per dollar of revenue earned from SME loans.
There may also be cultural inhibitions to provide an adequate service — bank managers may feel less inclined to cater to those of lower status in the business hierarchy.
SME loans always carry an interest rate premium for the so-called greater generic risk of lending to that sector; but banks perennially lend large sums indiscriminately to corporate borrowers and suffer large-scale losses. There is a seeming irrationality in this structure of major bank-lending priorities, rate structures and the dismissive approach to the SME sector.
Governments have, on occasion, stepped in to attempt fill the Gap. The period after World War II was evidently a key moment, when governments felt that they had a mandate for new directions.
David Merlin-Jones and Lucy Hatton, in their book Extending Lending: The Case for a State-Backed Investment Bank, give a potted history of three institutions in three countries — the Industrial and Commercial Finance Corporation (ICFC, UK, 1945), the Small Business Administration (SBA, USA, 1953) and the Kreditanstalt für Wiederaufbau (KfW, [West] Germany, 1948).
The ICFC was initially funded by the British clearing banks themselves, under pressure from the government. The ICFC would consider loans to applicants not considered suitable by the banks. The “comparative advantage” of the ICFC was in management expertise to discern promising prospects. Regionalisation was an important supplementary principle that brought bank officials closer to their customers.
Tensions between bank funders, not least in the context of economic cycles, were perennial. Belatedly, the ICFC acquired greater autonomy in 1959 by seeking funds directly from the market. But it also went to the stock exchange with a share offering. Although small, the ICFC was henceforth under pressure to attain short-term profits for shareholder interests.
Later activities expanded the ICFC’s ambit — a 1962 acquisition of a subsidiary oriented to “hi-tech” lending, and the 1967 creation of a subsidiary to facilitate mergers (the latter increasingly taking priority). The political arena gradually became less cognisant of its original primary role, and less supportive. In 1973, it was merged with another specialist lender also created in 1945 — the Finance Corporation for Industry, established to finance large firms, especially steel. The merged entity was eventually rebadged as 3i Group, in which guise it survives today as a conventional deal financier.
Compared to its comparators, the SBA was created in an off-hand fashion. Business in general had been offered financial support during the 1930s Depression, then small business in particular during World War II and the Korean War. When the Reconstruction Finance Corporation, seat of Depression/war support, was abolished, the SBA was created as replacement for SME support. In terms of scale, the SBA has been a substantial success (although it has its virulent critics). The authors note that the SBA currently has 219,000 loans worth $45 billion.
The SBA makes no loans itself, but provides guarantees for borrowers for loans from commercial banks. The SBA also administers the Small Business Investment Company program. Initially Cold War-driven, the SBICs are private-managed funds providing equity, but regulated by the SBA. From the 1960s, the SBA became a vehicle for affirmative action, strategically targeting minority would-be entrepreneurs. The SBA has also administered, since 1964, a mentoring program undertaken by retired business executives.
Germany’s KfW is the grand curiosity. It was created by the American and British forces of occupation, after World War II, to facilitate the reconstruction of West Germany, as a bulwark against the new Soviet threat. The KfW was (and remains!) a channel for Marshall Plan funds, and KfW loans were applied strategically in the staged reconstruction of the West Germany economy, starting with basic industries, and later moving to support for SMEs.
Germany retains a self-conscious commitment to SMEs (the Mittlestand), with the KfW the most successful SME bank in the world. The KfW contributed to the rebuilding of an SME sector in the eastern (former communist) states of a now unified Germany. The KfW has multiple arms, one involving export-support programs, including loans to importers of German manufactures. (How Germany avoids condemnation from the European Commission with such nationalist programs is not clear).
Two other banks (and countries) could readily have been added to this story. First, Canada’s Industrial Development Bank. The IDB was created in 1944, within Canada’s Central Bank. The IDB’s significant contribution would have remained obscure outside Canada, save for a detailed company-sponsored history by E. Ritchie Clark in 1985. The IDB was responsible for giving SMEs an integral place in post-WWII Canadian development. The IDB even provided training and advice for the establishment of development banks in developing countries. The IDB underwent a number of reincarnations, now as the Business Development Bank of Canada. It survives, a miracle, although its earlier mainstream SME focus has been diluted.
Second, Australia’s Commonwealth Development Bank. Curtin/Chifley Labor created a (rural) Mortgage Bank Department (1943) and an Industrial Finance Department (1945), within the central banking division of the Commonwealth Bank. When the Reserve Bank was split off in 1959, Jack McEwen, Country Party leader, initiated legislation to merge the two departments into the Commonwealth Development Bank (CDB), aimed at family farmers and small business.
Like the ICFC, the CDB, through selection of lending officers with rural/industrial experience, developed a skilled hands-on relationship with borrowers. It did not offer cheaper loans, but lent on business viability (“cash flow”) rather than merely on taking customer assets as security.
The CDB received bipartisan support through the 1980s until then Treasurer Paul Keating began the privatisation process of the parent Commonwealth Bank. The CDB was consistently profitable, but not at a commercially attractive scale. With the full privatisation of the CBA in 1996, the CDB was unceremoniously abolished, with the now moribund National Party sitting on its hands. Alas, the CDB has lacked its chronicler.
There are myriad hurdles facing the establishment and maintenance of a viable SME bank. Typically, the national financial establishment will be antagonistic. Private trading/commercial banks (Germany apart) prefer to monopolise the SME loan market, while simultaneously treating it with disdain. (The US is exempted in this regard, because banks, otherwise voracious, benefit from the SBA guarantee umbrella).
There is the basic issue of source of funds, and the intrinsic asymmetry — lenders’ preference for potential liquidity versus an SME bank’s need for longer-term loans. Add the tension between the need for reasonably stable pricing of loans in the context of the post-deregulation volatility of financial markets. Then there is the issue of loan mix — the products/services spectrum from the mundane to the risky. And there is the tension between the inevitably politicised character of an SME bank’s lending priorities and the threat of political chicanery (a broader public interest versus pork-barrelling).
The promising dimension of this troubling scenario is that an SME bank can work because it has worked in the past. An essential ingredient is that the culture of the bank must be appropriate — personnel must embody a specialised competence, commitment and integrity appropriate to the customer base. I have personally interviewed ex-managers of the CDB, and their communal commitment to the particular character of that institution has been transparent.
It goes without saying that the requisite culture diverges from the now rampant corrupted banking culture. There remain bankers who have been disgusted at the general tendency of their industry, but they are now spread to the four winds, and their like is currently not being nurtured.
Merlin-Jones and Hatton discuss only the prospects for an enterprise bank their own country, Britain. They take heart from the fact that British governments have recently made pragmatic gestures in the right direction. David Cameron’s Conservative-Liberal Democrat coalition government has mooted a “Green Investment Bank”, with £3 billion start-up funds, to help Britain meet its climate-change commitment targets. The authors support the principle but worry about the restricted focus. The Labour Government created the “Enterprise Guarantee Scheme” in 2008, a program that could be readily incorporated into an enterprise bank entity. A more coherent institution is thus not a huge step.
Unfortunately, the current environment in Australia is probably the least conducive environment imaginable. The Big Four banks rule the scene. SME and family farmer lending is treated cavalierly. Worse, banks perennially act unconscionably in this arena against their powerless customers. The regulatory agencies are complicit in inaction; the political arena demonstrates utter indifference. An enterprise bank would ideally offset a seriously dysfunctional service in current Australia, but the prospects of getting one (re-)established is a pipe-dream.
Dr Evan Jones teaches political economy at the University of Sydney and has written extensively on the plight of small business in Australia.
The Case for a State-Backed Investment Bank
by David Merlin-Jones
(London: Civitas, 2012)
Paperback: 135 pages
RRP: UK£9.50 (avail. from UK)