By Melanie Lund and Jane Wright of the Bank’s Domestic Finance Division.
The small firms sector makes a significant contribution to the UK economy. In 1997, firms with 49 or fewer employees accounted for around 40% of total turnover in the United Kingdom and 45% of total employment.
The sector offers banks profitable opportunities, though not without risk. In the recession of the early 1990s, for example, the banking sector suffered large losses from its loans to the small business sector. The major clearing banks had to make provisions of around £3 billion against this part of their loan book. The problems experienced by the banks were intensified by the collapse of the residential property market, against which a high proportion of their lending was secured. Though these losses did not amount to a threat to the financial system as a whole, they did represent a reputational risk to the banks and reduced their profitability. Moreover, these problems served to highlight the fact that many firms in this sector had been inappropriately financed in the past.
More recent trends in small firms financing suggest that there has been a steady improvement in how finance providers service the market. However, against a background of sustained economic growth, it is difficult to distinguish improvements resulting from structural changes in the financing of these firms from those resulting from better trading conditions. The recent slowdown in the growth of economic activity will test the robustness of the improvements.
This article looks at the economic theory on the provision of finance to the small firms sector, underlining the problems of risk assessment of these firms by banks, the main providers. It then reviews how the patterns of small firms financing have changed over the past decade, making it less likely that the high levels of business failures in the previous recession will recur. It also focuses on competition in this market as a means of facilitating improvements. One area where improvement in the provision of finance is less evident is in the supply of risk capital for technology-based small firms.