Treasury subsidises small-business loans

Too-clever banking may have played a role in getting us into the economic and financial mess we're in.

But the Treasury hopes that a bit of financial engineering of its own will help to get us out.

The Chancellor, George Osborne, is aiming to use limited quantities of taxpayers' money to unlock private-sector cash and to stimulate activity by private-sector businesses, at a time when those businesses are scaling back investment and expansion ambitions.

The most eye-catching initiative, which goes by the name of credit easing, could reduce the interests costs on £20bn of loans for small- and medium-size businesses by around 1% over the next couple of years.

Then there's a separate proposal to subsidise to the tune of £1bn the creation of new private-sector funds that would lend to all but the very biggest businesses - in competition with the banks that currently dominate business lending.

Finally, the Treasury will be giving technical assistance to pension funds, to unlock around £20bn of British pension savers' cash for investment in roads, rail, and other infrastructure projects - to get British pension funds providing capital to improve infrastructure in the way that Canadian and Australian pension funds already do.

All three initiatives will probably be seen as useful help for the private sector, at a time when conditions are extremely tough.

But none, to use David Cameron's metaphor about what the ailing eurozone needs, will be seen as a "big bazooka" for the flatlining British economy.

Of the three, credit easing may have the biggest short-term effect.

This is what it involves.

First, the Treasury is taking back from the Bank of England £40bn of the £50bn of guarantees it has provided to cover losses on possible purchases of corporate bonds under the Asset Purchase Facility.

That was a scheme set up early in 2009, at the height of the recession, to allow the Bank of England to purchase the debt of companies, in the hope that this would make it easier and cheaper for businesses to borrow at a time when financial markets were not functioning properly.

The Bank never used anywhere like the full £50bn. And the Governor of the Bank, Sir Mervyn King, has advised Mr Osborne that it can continue to function adequately with a continuing guarantee of just £10bn.

So there is - in effect - £40bn of capacity to support finance for the private sector going begging (so to speak).

And that's what Mr Osborne has decided to deploy, in an attempt to channel finance to smaller businesses - which (as you can't have missed) have been complaining that the banks have not been providing enough credit and charge too much for what credit they do provide.

Now the important thing to stress is that the Treasury is not providing direct loans to small businesses. Taxpayers' cash is not being handed over.

What is happening, under what will be named the National Loan Guarantee Scheme (a moniker dreamed up for the last Tory manifesto), is that some of what banks borrow from investors - up to £20bn of the debt that banks sell in the first couple of years of the scheme - will have a guarantee from the Treasury.

To put it another way, the lenders to the banks will know that in the unlikely event that the banks can't pay them back, taxpayers would pay them back.

So the inherent riskiness of these loans will be lessened - and that means that the banks will be able to borrow at lower interest rates.

Here are the important bits of all this:

1. the Treasury will insist that all the money the banks borrow in this way must be lent to smaller businesses (defined as any business with turnover or sales of less than £50m); and

2. the reduction in the interest rate paid by the banks, the effective subsidy to the banks provided by taxpayers, must be passed on to small businesses, in the form of a cut - of around 1% - in the interest on loans provided to them.

So, if all goes to plan, smaller businesses should be able to borrow in total around £20bn at an interest rate around 1% cheaper than would otherwise be the case.

Which should be helpful to them. But won't transform their prospects.

It is important, for example, to be aware that guaranteeing banks' debts in this way may not lead to any increased supply of credit to small businesses.

The Treasury would like to see an increase in the availability of credit. And will distribute the guarantees to banks in a way that, it hopes, makes it most likely that there will be more credit available.

But the Treasury concedes that a rise in net lending can't be taken for granted.

Here's the reason why there may not be many more loans to smaller companies: the eurozone crisis is making it much harder for banks to borrow, so the new guarantee from taxpayers may simply fill a hole in the banks' financing needs rather than allowing them to borrow additional money.

None of which is to say that credit easing is a waste of time.

In today's challenging economic circumstances, providing confidence that there will be £20bn of finance available at slightly cheaper rates is probably not to be sniffed at.

Anyway, I've probably bored you into a near-comatose state with all this. But there are a couple of other points to make.

What the Treasury is proposing is similar to a smaller scheme already run by the European Union's publicly-owned bank, the European Investment Bank.

Via British banks, it has provided lower-cost loans of £2.3bn in aggregate to more than 7,500 small UK businesses over the past three years.

Now for the Treasury, what matters about the EIB's trailblazing is that the EIB has a mechanism for auditing and checking that the finance and subsidy it provides to British banks is actually passed on to businesses: the Treasury will use the EIB's verification procedures.

Also, the Treasury will share out the guarantees to banks based on a formula that takes into account whether individual banks have been increasing or shrinking the amount of credit provided to smaller businesses: so any bank that's providing relatively more small-business loans will be rewarded with disproportionately more of the taxpayer guarantees.

An official also told me that the Treasury would try to increase competition in the market for business loans, by favouring smaller so-called "challenger banks" when allocating the loan subsidies.

Which in theory means that Santander will get more of the subsidies relative to its current share of the small-business market, whereas the overwhelming market leader, Royal Bank of Scotland, will get fewer of the subsidies.

As for the timing of all this, credit easing should be up and running by January - whereas as the other two initiatives will take longer to have an effect.

One of them, called the Business Finance Partnership, will make available £1bn of real cash, for which investment firms can bid.

The idea is that private-equity firms, such as 3i, or fund managers such as M&G, will match whatever dosh the Treasury provides in this way, and the combined sum will form the equity capital of brand new funds that will then lend to businesses with turnover of up to £500m.

The idea is that since the £1bn is equity capital for the funds, or the portion of the funds available to absorb losses on credit provided to businesses, it can be "leveraged up" or multiplied by borrowing from investors.

So, for argument's sake, if it was distributed between five funds, along with equity capital provided by the five funds' respective backers, and the total equity capital was then leveraged with debt by five times, this would could make available £10bn of loans to businesses.

Note that this is very different from the guarantees provided in the credit-easing scheme. The £1bn is real money at serious risk of incurring losses.

Even so, the Treasury says the £1bn could be just a start. Broadly it sees the £1bn as a trial sum, being deployed to "prove the concept". If it were to work, more money would be made available.

And again there is a model for this scheme, in this case a fund created by M&G a couple of years ago, called the M&G UK Companies Financing Fund, which to date has lent £630m to seven companies, including Stobart Group, Barratt Developments and Taylor Wimpey.

As you can see from the M&G fund, the recipients of the help are pretty big companies, which for various reasons did not want to borrow from banks and were unable to raise the money they needed on capital markets by selling bonds to investors.

To put the £20bn of credit-easing and £1bn for the Business Finance Partnership into some kind of context, every year our big banks provide just over £100bn of actual loans to businesses, on the Bank of England's figures.

I am immediately going to confuse you by citing two other figures: under this year's "Merlin" deal with the Treasury, the big banks are committed to make £190bn of credit available to all businesses and £76bn of credit available to small- and medium-size enterprises or SMEs.

However, the Merlin figures include unused credit facilities, so they are supposed to show what companies could borrow, not what they've actually borrowed.

Also the definition of an SME for Merlin is a business with a turnover of £25m or less. Which means the annual credit needs of companies with turnover of up to £50m is probably over £100bn.

The conclusion to be drawn, whether you define the market in the way that the Bank of England does, or the way that the Merlin deal does, is that £20bn of subsidised finance is significant but not transformative.