UK must find financing solution before economy is starved of funding

Keeping an eye on the news of the financial world, this week I was struck by the number of often contradictory stories relating to financing. Governments everywhere are struggling to find the right balance between ensuring banks hold enough capital to be secure, while still being able to lend to people and businesses to help the economy expand. But in the UK, the government and regulators are sending out particularly mixed messages.

The government has been keen to push banks to lend, particularly to small businesses, last year even brokering a deal – called “Project Merlin” – in which banks agreed to increase their lending to SMEs.

At the same time, though, regulators have pushed banks to tighten lending requirements (ie, no more 100% mortgages) and hold more capital. Basel III will introduce higher capital requirements for banks at the international level and the European Union parliament is looking at how to implement the new rules here. But the UK wants the power to go beyond EU rules with even stricter capital requirements – to the point that David Cameron vetoed a new EU treaty in December in order to get his way.

Not surprising that the Bank of England reported in February that banks had fallen £1bn short of the agreed Project Merlin lending target.

The government also believes that more competition in banking will lead to greater lending, and that different models such as mutuals will promote more responsible banking. The sale of Lloyds branches to the Co-op would achieve both in one swoop. Lloyds has been forced by the EU Competition Commissioner to dispose of the branches by the end of the year (because its merger with HBOS at the height of the financial crisis created an uncompetitive monster). And a bigger Co-op would give a boost to mutualism.

Yet, in order to buy those Lloyds branches, the FSA will require the Co-op to fundamentally change its corporate structure and governance - to be more like a bank, less like a mutual and shift power from its democratically elected board to bankers.

With bank lending unlikely to increase any time soon, businesses are more reliant other sources of funding. But again, in the UK there are mixed messages. On one hand, the government says it supports non-bank financing such as peer-to-peer lending, community finance institutions (like local social enterprises and credit unions), asset leasing and invoice finance.

But on the other, the latest Finance Bill includes a measure under which venture capital trusts that invest in small companies could lose their tax benefits – although the UK can blame having to comply with European rules for this one.

Non-bank lending is woefully under-developed in the UK compared to other developed markets. Even its corporate bond market is behind that of other countries in Europe and in the US, in terms of private placement of debt.

Yes, regulators need to make sure UK banks are safe. But the government needs to realise they have a situation where businesses rely disproportionately on banks for their financing. If they are going to restrict banks’ ability to lend, they need to put their money where their mouths are and do more than just say they support alternative sources of funding. They need to actually create an environment where these alternatives can flourish - restricting them with the same rules imposed on banks as punishment for the financial crisis will help no one.