ACCESS TO FINANCE REVIEW Stage 2 review

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1 ACCESS TO FINANCE REVIEW Stage 2 review Professor Dylan Jones-Evans Bristol Business School University of the West of England

2 November

3 TABLE OF CONTENTS TABLE OF CONTENTS...3 EXECUTIVE SUMMARY...5 Bank funding...5 Alternative sources of funding...5 Finance Wales...6 The Development Bank for Wales INTRODUCTION RECOMMENDATIONS AND ACTION FROM STAGE 1 OF THE REVIEW BANKS LENDING PATTERNS TO SMES...14 UK trends in bank lending...14 Trends in bank lending in Wales...17 Cost of lending...20 Rejection rates...21 Summary ALTERNATIVE SOURCES OF FUNDING...24 Trends in non-bank lending...24 Invoice discounting and factoring...24 Asset finance...25 Building Societies...25 Informal investment...26 Venture capital...28 Peer-to-peer lending and crowdfunding...29 Funding of social enterprises...31 Summary FINANCE WALES...34 Cost of lending to SMEs

4 The cost of borrowing and EU reference rates...37 Finance Wales s strategy...40 GBER and De Minimis...42 Summary THE WAY FORWARD...45 The five principles of public funding for SMEs THE DEVELOPMENT BANK FOR WALES...51 Mission and objectives...52 Funding...52 Organisation...53 Summary GLOSSARY OF ABBREVIATIONS

5 EXECUTIVE SUMMARY Bank funding Whilst the UK banking sector states that it remains ready to lend, the data shows that the value of borrowing approved facilities to SMEs in Wales is actually falling by 30 per cent since Q Differentiating by size of firm, the data shows that the borrowing levels of small firms have fallen during the last two years whilst the number and value of lending approvals to medium-sized businesses have also flatlined during the last 12 months. Whereas there have been efforts by the UK Government to introduce cheaper lending, this has not been translated into increases in the number of loans from the banks. The report estimates a total funding gap of around 500 million per annum for those businesses who want to get access to funding but have been refused support by the banks in Wales. This is clearly an upper limit as a proportion of those applying for funding may not be in a position to receive it from any source although it does exclude those that are reluctant to go to the bank for funding because of the current uncertain economic conditions or have been actively discouraged from doing so. A large part of this problem may be attributed to the way that banks are currently assessing risk, valuing collateral and whether to invest in certain sectors. Therefore, is a new challenger bank needed within Wales - either in the public or the private sector especially as it will face many of the same issues that are affecting the current set of high street banks? Alternatively, is there a more effective way for the Welsh Government of working alongside current providers whilst, at the same time, encouraging access to other types of alternative finance? It is important that banks and the Welsh Government do not operate in isolation in terms of the provision of finance to SMEs and there have already been negotiations between the Welsh Government and the high street banks to develop a referral system for those businesses turned down for bank lending and to work more closely in developing the potential of growth businesses in Wales. Alternative sources of funding During the last 12 months, there has been increased use of invoice discounting, leasing and other forms of non-bank finance, possibly as a result of decreased lending by the high street banks. Building societies, however, seem to be withdrawing from being a potential source of funding for SMEs in the immediate future. Overall demand for funding remains relatively low partially due to a lack of understanding and awareness of different alternative sources of funding amongst the business community. The Welsh Government could look at using its resources to provide more information on these alternative sources of funding whilst also considering whether they should form part of existing lending schemes. There is considerable scope to improve informal investment and venture capital as a source of funding to SMEs in Wales. To date, informal investors have not been used as effectively as they could have been in supporting start-ups in Wales, despite the relative success of xénos. More could also be done to ensure that there is greater focus on venture capital for growth firms at all stages of development within Wales. New support networks should be developed for growing firms, especially as financial support alone is not in itself sufficient to secure the success of early stage businesses. There have been positive discussions with peer-to-peer (P2P) lenders and crowdfunding firms and there is an opportunity for the Welsh Government, through working in 5

6 partnership with such organisations, to stimulate greater use of these sources of finance in the future. Discussions with the banks suggest that one potential route for promoting P2P lending and crowdfunding would be via a direct referral system from Welsh High Street banks, Finance Wales and Welsh Government itself and this should be explored in further detail. The Welsh Government could consider investing in peer-to-peer funding as an alternative mechanism for financial support. This would be particularly attractive given the weaknesses in some of the current models in delivering finance to SMEs. The same could apply to crowdfunding through the development of a new co-fund, working with existing providers, which could help to stimulate the start-up market in Wales. The funding of social enterprises is an important area that was not the focus of this report although there may be synergies with some of the financial solutions being put forward for the SME sector. Finance Wales According to data submitted to the review, Finance Wales is offering higher rates of interest on borrowing to SMEs within Wales than it needs to under European Commission (EC) State Aid guidelines. The evidence gathered also suggests that Finance Wales has not utilised the full range of financial instruments available under EC regulations. For example, with two thirds of Wales classified as qualifying for the highest level of aid, General Block Exemption Regulation (GBER) could have been used to subsidise the interest rates on loans to hundreds of SMEs and been a significant policy tool for Welsh Government. In addition, there is no state aid impediment to Finance Wales offering cheaper loans to the vast majority of micro-businesses under de minimis regulations if it so wished. It remains unclear as to whether Finance Wales is still essentially operating as a commercially oriented fund manager in all but name. Given this, the Minister may have a view as to whether Finance Wales is fit for purpose or whether the organisation needs to be taken in-house into the Welsh Government so that it can focus on its economic development role for the Welsh economy. The Development Bank for Wales The evidence from the review indicates that public sector financial support in Wales seems to be fragmented and more relevantly, the organisation tasked with providing debt and equity finance to SMEs is not specifically focused on developing the Welsh economy. The Welsh Government needs to develop an approach where public funding for SMEs is affordable, focused on economic development, is supplemented by business support and is oriented towards the needs of the business customer. It is also critical that the public sector does not displace the private sector but works alongside the banks and other stakeholders to address a market failure in the provision of finance to SMEs. Therefore, the review recommends the establishment of a Development Bank for Wales that will be created by bringing together all the financial support schemes for SMEs within the Welsh Government, the funds managed by Finance Wales and elements of Business Wales, as well as UK Government schemes such as UK Export Finance and the Business Growth Fund. It will: Act as a gateway for business and financial support to ensure access to the right type of support is provided to SMEs; 6

7 Work in partnership with the banks and other public and private sector partners to provide loans, guarantees, grants and other financial instruments, all of which will maximise the state aid exemptions available to provide affordable debt finance to Welsh business; Develop specific consultancy and business support services for Welsh SMEs as found in exemplar organisations around the World; Gather, collate and provide detailed information on the SME sector in Wales to enable the Welsh Government and other partners to understand the dynamics of the Welsh economy; Establish close relationships with Welsh Government economic bodies including the sector panels, the enterprise zone boards, city regions and Industry Wales; Ensure a focused approach to the provision of financial and business services to microenterprises, regional SMEs and high growth firms. The Welsh Government is urged to examine the feasibility of this approach urgently to ensure that a viable and coherent approach to supporting SMEs in Wales is put into place as quickly as possible. 7

8 1. INTRODUCTION In January 2013, the Minister for Economy, Science and Transport announced an independent review into access to finance for SMEs in Wales. Supported by a voluntary advisory panel from academia and business 1, the aim of the review has been to examine how effectively SMEs in Wales are served by existing sources of funding, identify areas of particular challenge and provide recommendations for action. During the last ten months, an extensive and detailed consultation has been carried out through meetings with over 140 representatives of the banking sector, other financial institutions, the Welsh and UK Governments, intermediaries, academia and businesses. This has been supported by a substantial amount of data collated from various sources and interviews undertaken with a range of other publicly funded bodies in other countries, including Canada, Finland, Germany, Scotland, Sweden and the USA. In addition, the Welsh Conservatives and Plaid Cymru have submitted their own solutions to supporting funding for SMEs in Wales to the review, some elements of which have been considered by this review and integrated into the final conclusions. The report for the first stage of the review, published in June 2013, analysed the situation regarding the access to finance of SMEs in Wales and focused specifically on the role of banks. It also presented information on other forms of alternative finance that are available to SMEs. As part of the review, a number of recommendations regarding access to finance in Wales were made and, as this report will show, the Welsh Government has already moved quickly to implement a number of these during the last five months. Given this, the second stage of this report will update the information on bank support and alternative sources of funding to SMEs in Wales. It will also, following a request by the EST Minister, examine the strategy undertaken by Finance Wales in terms of supporting SMEs in Wales, focusing specifically on the cost of borrowing. However, the main aim of this part of the review was to consider whether the current situation in Wales regarding access to funding was fit for purpose and, if not, what should the Welsh Government do about it. So what does the review tell us? Very little seems to have changed in terms of lending by the banks to Welsh SMEs in the last six months. Despite the cost of borrowing being at historically low levels, the British Bankers Association s (BBA) own statistics show that lending to SMEs remains stagnant. The report also estimates that there is a funding gap of around 500 million in Wales between the demand from SMEs and the current supply by the banking sector. In terms of alternative finance, data from various organisations National Association of Commercial Finance Brokers (NACFB), Asset Based Finance Association (ABFA) and the Finance and Leasing Association (FLA) shows that there has been increased use of invoice discounting, leasing and other forms of non-bank finance during the last 12 months, although this has not been sufficient enough to alleviate the demand from the SME sector for funding. In terms of supporting growth businesses via sources such as informal investment and venture capital, there is a need to ensure that there is funding at all stages of the life cycle of such businesses and, more importantly, that every effort is made to leverage greater amounts of private sector funding into Wales. Finally, there have been positive discussion with peer-topeer lenders and crowdfunding firms and there is an opportunity for the Welsh Government, through working in partnership with such organisations, to stimulate greater use of these sources of finance in the future. As part of the second stage of the report, the EST Minister also requested that a specific analysis should be made of the cost of loans by Finance Wales as this may be an impediment 1 These advisory board members are: John Antoniazzi, former partner at Deloitte in Wales; Katy Chamberlain, Chief Executive of Business in Focus; Professor Robin Jarvis, Head of SME Affairs, The Association of Chartered Certified Accountants (ACCA) and Professor of Accounting, Brunel University; Professor Phil Molyneux, Dean of the College of Business, Law, Education and Social Sciences and Professor of Banking and Finance, Bangor University; Huw Morgan, former Head of Business Banking, HSBC Bank plc; Chris Nott, Chair of the Financial and Professional Services Sector Panel and Managing Partner of Capital Law LLP; Professor Stephen Thomas, Professor of Finance, CASS Business School, City University London; Mark Woolfenden, Managing Director, Afonwen Laundry. 8

9 to the availability of debt funding by Welsh SMEs. The evidence gathered suggests that not only have the interest rates they charged by Finance Wales to Welsh SMEs been higher than the reference rates which provide guidelines to the cost of loans by state banks, but there has also been a failure to fully utilise other state aid regulations to support lower interest rates to SMEs. One possible explanation for this approach is Finance Wales s mission, since 2007, to become an independent and self-funded investment fund. However, this is a strategy which seems to have taken precedence over a role that, during the difficult years of the economic downturn, should have focused on supporting SMEs in Wales as part of the Welsh Government s economic development remit. Therefore, the Welsh economy is in position where SMEs are still facing difficulties in accessing funding from the banks and, as yet, there is no significant increase in alternative sources of funding although it is growing. Public sector financial support seems to be fragmented and more relevantly, the organisation tasked with providing debt and equity finance to SMEs is not fit for purpose, as it is not focused on developing the Welsh economy. Given this evidence, the review has concluded that if Wales is to have an effective publicly supported financial ecosystem that benefits the economy and supports SMEs to grow and develop, then five principles must be adhered to. These are: Every viable business in Wales should get access to funding at an affordable price The primary role of government-backed funding for SMEs is to drive forward economic development It is not the role of the public sector to displace the private sector but to address a market failure in the provision of finance to SMEs It is critical that business and skills support is offered alongside financial support to businesses in Wales rather than as separate elements Funding solutions should be customer-oriented. Therefore, the review recommends the establishment of a new Development Bank for Wales that would adhere to these principles and become the single source of public funding for Welsh SMEs. To achieve this, it will bring together the various business grant schemes within the Welsh Government, the funds managed by Finance Wales and various elements of Business Wales programmes. It will also partner with the UK Government to provide finance from programmes managed by UK Export Finance and the Business Growth programme. Following careful consideration, we believe this is the most pragmatic and immediate response to get funding flowing into the SME sector to enable it to grow and develop its potential. Wales remains the poorest region of the United Kingdom and the future success of its economy will be determined by the ability of its businesses to become more competitive and innovative. To achieve this, the public and private sectors must work together and take advantage of every available tool that the nation has at its disposal to not only provide the funding the economy requires for growth and development but, through the creation of a Development Bank for Wales, create a model of excellence for others to follow. Professor Dylan Jones-Evans Bristol Business School 9

10 2. RECOMMENDATIONS AND ACTION FROM STAGE 1 OF THE REVIEW The first part of the review into access to finance examined the current situation regarding various aspects of funding to SMEs in Wales and made sixteen recommendations. Following the publication of the review, it was agreed that Welsh Government officials would begin to implement the recommendations immediately and this section provides an update as to progress to date. Recommendation Recommendation 1 Welsh Government needs to ensure that Wales, and Welsh businesses, gets a fair share of funding from the new Business Bank. Recommendation 2 The Welsh Government needs to consider whether mechanisms such as microlending or community-based lending to smaller local businesses should be encouraged and supported. Recommendations 3 to 6 relate specifically to bank lending policy. Recommendation 3 Security against the loan and affordability of repayment, rather than the cost of borrowing, have been cited in the interviews with banks, intermediaries and small businesses as being one of the main obstacles to accessing bank finance. Therefore any intervention by the Welsh Government should focus on these two critical obstacles. Recommendation 4 Local decision-making by banks is seen by many businesses as critical in ensuring that their business case is considered fairly. Yet there is very little evidence of this happening with higher-level credit decisions being made outside of Wales. Given this, Welsh Government is encouraged to open up discussions with the main banks to ensure that Welsh regional managers make the final credit decisions for all Welsh businesses. Action The Minister for Economy, Science and Transport has written to the Secretary of State for Business, Innovation and Skills, Vince Cable and met with the acting Head of the Business Bank, Keith Morgan, seeking to ensure that Wales is fairly served by the Business Bank. The Welsh Government will consider this recommendation within the broader framework of the review. The Minister for Economy, Science and Transport has sent the Stage 1 Report to the Chief Executive of the British Banker s Association and Regional Heads and Chairmen of the main high street banks. The Minister has met with several high street banks to discuss the issues raised in the Stage 1 Report. A Guide to Welsh Government Business Funding Programmes has been produced by the Welsh Government and presentations have been made to several high street banks. Welsh Government officials are developing new joint initiatives with the banks to improve Welsh SMEs ability to access finance. Welsh Government will maintain an open dialogue with the banks to continue to improve the funding landscape for companies in Wales. Recommendation 5 There needs to be greater transparency in the lending process. This is to ensure that SMEs, especially those without any formal financial support internally, know exactly what is required in terms of preparing an application to the bank (business plan, cash forecasts, support from an 10

11 intermediary). In exchange for the provision of this information, banks would then agree to examine each potential funding request in more detail as opposed to basing their decision using the credit-scoring software that is normally applied to the majority of applications. Such a banking covenant could ensure greater transparency and accountability within the lending process and Welsh Government could work with the BBA to pilot such a scheme in Wales Recommendation 6 Welsh Government should examine the disconnect between the business support programmes it offers and the funding supplied by the banking community in Wales. It needs to consider how it can work more closely with banks to ensure that they recognise the support available to Welsh firms and by promoting its take-up, improve the quality of business proposals and information supplied to the banking sector. Recommendation 7 Welsh Government should raise the issue of the detrimental effect of Basel III rules on SME lending directly with the UK Treasury and BIS. This will enable the UK Government to make representations directly to the Basel Committee on Banking Supervision to recommend that SME lending should be excluded from consideration in terms of determining suitable capital and liquidity within the banking system Recommendation 8 Welsh Government should examine how it can help facilitate better access to the wide range of commercial lending opportunities that are available to SMEs through nonbank lending channels. This could be achieved through partnership with organisations such as the NACFB and the development of a specific commercial portal on lending for SMEs. The Minister for Economy, Science and Transport has written to the Secretary of State for Business, Innovation and Skills, Vince Cable and the Bank of England highlighting the detrimental effects of the Basel III requirements on SME lending. Welsh Government officials are developing new joint initiatives with funding organisations to improve Welsh SMEs access to information on the funding options available and to improve their ability to access such finance. Recommendation 9 There are currently low levels of informal investment in Wales that could be addressed by (a) raising awareness of equity investment by angels as a viable form of funding amongst growing SMEs and (b) developing an equity guarantee scheme to attract further investment by private individuals into Welsh businesses. These potential interventions, and the role of Welsh Government in supporting them, will be explored in further detail during the second half of the review. This recommendation is examined further in the Stage 2 Report. The Welsh Government will consider this recommendation within the broader framework of the review. 11

12 Recommendations 10 and 15 relate specifically to Finance Wales Recommendation 10 Finance Wales has had a positive impact on formal equity investment within the Welsh business community. However, the Welsh Government will need to consider how it builds on this success, especially in terms of having a specific vehicle for equity funding in the future. It also needs to develop programmes that create demand for venture capital not only for new start-up businesses but also growth firms where equity investment is key for further development. Recommendation 15 As the sole shareholder, Welsh Government needs to determine the future strategic direction of Finance Wales and, more importantly, the role it should play in the future financial landscape for Welsh business alongside other providers. Recommendation 11 The lack of availability of trade credit is an issue that leads to many smaller businesses seeking short term funding for working capital from banks. The Welsh Government should explore how it can use its power as the biggest purchaser in Wales to encourage its own suppliers to adopt supply chain finance or similar schemes to support their suppliers. In addition, it could set an example by ensuring that all contractors operating within the public sector in Wales have to pay their suppliers within a maximum 30-day period (and ensuring that it adheres to such a policy itself). Recommendation 12 Further discussions will take place with building societies in Wales to assess their potential role in supporting SMEs to access finance, especially in terms of commercial property lending. At the request of the Minister for Economy, Science and Transport these recommendations are examined further in the Stage 2 Report. The Welsh Government will consider these recommendations within the broader framework of the review. The Welsh Government is reviewing current procurement policies in light of this recommendation. Following further discussions on the role of building societies in supporting access to capital within the Welsh economy there seems to be reluctance from building societies to expand into other forms of financial support for the business community. Instead, the message is that they want to focus on what they are doing already and doing it better for their customers. Full details of these discussions can be seen on page 24. Recommendation 13 The Welsh Government should examine how UK Government funds can be used more effectively to support businesses in Wales, potentially through the provision of matched funding through its own resources. In particular, as it currently does On 14 October the UK Government funded Start Up Loans programme was introduced in Wales. This will form an integral part of the Business Start Up Service and be administered through the existing Business Start Up provider network. 12

13 not provide any loans to those start-ups that create the vast majority of jobs in the economy, the Welsh Government needs to develop an appropriate mechanism for this type of support, based on the Start-Up Loans programme operating in England, although this should be applicable to all new businesses and not only those started by year olds Recommendation 14 There is a major opportunity for Welsh Government to take the lead in supporting alternative sources of funding such as peer-to-peer lending and crowdfunding, either through partnership or direct funding. It could also raise awareness of both types of funding through its various business support programmes. Recommendation 16 This review has shown that there is a lack of regional data, especially for Wales, as a devolved nation. If policymaking within the Welsh Government is to be based on evidence, then it is critical that UK organisations in both the public and private sector are made fully aware of the implications of devolution and the need for accurate data being collected at a regional level. Welsh Government Officials continue to liaise with the UK Government Officials to explore how Welsh firms can better access UK Government funding initiatives. This recommendation is examined in the Stage 2 Report. The Welsh Government will consider this recommendation within the broader framework of the review. The Minister for Economy, Science and Transport has written to the Secretary of State for Business. Innovation and Skills, Vince Cable to highlight the issue of regional data collection. The Welsh Government is also working with some of the banks on initiatives which could provide more useful, Walesonly data. 13

14 3. BANKS LENDING PATTERNS TO SMEs This section will update the data from the first report and will examine whether the situation regarding access to finance from the banks to the SME sector in Wales has changed since it was published in June UK trends in bank lending In terms of loans to businesses, the latest available data show that, in terms of gross lending, a total of 308 billion has been lent to all non-financial businesses in the UK since September (Figure 1). Of this, only 26 per cent ( 80 billion) have been lent to SMEs 3 and net lending, after repayments, for UK SMEs has gone down by 10 billion. This suggests that there continues to be little appetite by firms for bank lending or, as some suggest, a lack of credit being made available to smaller businesses. As of August 2013, there was a total of 420 billion of fixed term loans outstanding to the banks from non-financial business in the UK, with SMEs accounting for 36.7 per cent ( 154 billion) of this amount. Therefore, and contrary to expectation, the Bank of England s statistics suggest that there has been no substantial increase in the level of lending to SMEs during the last 12 months (September 2012-August 2013). In fact, there has been an overall decline of 1.2 billion during this period and the only monthly growth in net lending to SMEs (excluding overdrafts) since September 2011 has been in March 2013 and May 2013, despite claims from the high street banks. Figure 1: Gross lending (excluding overdrafts) to non-financial businesses, Bank of England Statistics on monetary financial institutions loans to non-financial businesses, by size of business, SMEs are those businesses with annual debit account turnover on the main business account less than 25 million; large businesses are those with annual debit account turnover on the main business account over 25 million. 14

15 Table 1. Loans to SMEs by region, Q Q All SMEs London South East South West East Midlands West Midlands Value of loan balances ( m) Q3 92,443 19,737 12,325 9,900 4,962 7,780 6,692 6,207 2,716 9,779 4,229 8, Q4 90,970 19,504 12,417 10,285 5,078 7,913 6,788 6,231 2,766 9,769 4,365 5, Q1 90,303 19,130 12,138 10,425 5,158 7,931 6,841 6,228 2,723 9,538 4,360 5, Q2 88,983 19,032 12,004 9,834 5,077 7,770 6,669 6,112 2,705 9,529 4,269 5, Q3 88,199 18,608 12,076 9,878 5,003 7,695 6,613 6,058 2,710 9,439 4,341 5, Q4 87,571 18,465 11,963 9,823 4,968 7,655 6,577 5,995 2,701 9,369 4,287 5, Q1 88,402 18,505 11,953 9,880 4,942 7,682 6,575 6,258 2,716 9,488 4,326 6, Q2 87,878 18,257 11,832 9,846 4,956 7,721 6,620 6,274 2,697 9,314 4,284 6,078 No. of loan facilities approved 2011 Q3 49,910 7,774 5,874 6,036 4,183 4,123 3,872 3,516 2,023 5,373 2,949 4, Q4 43,074 6,270 5,238 5,178 3,615 3,637 3,492 3,126 1,625 4,814 2,526 3, Q1 47,191 7,338 5,310 5,934 3,296 3,852 4,504 3,116 3,012 4,644 3,336 2, Q2 38,802 5,897 4,372 4,958 2,414 3,214 4,042 2,653 2,202 3,709 2,748 2, Q3 37,662 5,363 4,026 4,964 2,398 3,218 3,924 2,530 2,043 3,722 2,779 2, Q4 32,353 4,950 3,154 4,346 2,061 2,540 3,018 2,202 1,777 3,278 2,394 2, Q1 38,384 5,572 3,853 4,757 2,052 2,813 3,864 2,666 2,425 3,474 3,169 3, Q2 36,779 5,548 3,510 4,317 1,972 2,867 3,612 2,213 2,676 3,352 3,117 3,596 Value of loan facilities approved 2011 Q3 7,330 1, Q4 6,529 1, Q1 5,550 1, Q2 4, Q3 4, Q4 4, Q1 4, Q2 4, New loans 2011 Q3 5,920 1, Q4 5,744 1, Q1 6,077 1, Q2 5,009 1, Q3 5,218 1, Q4 4, Q1 5,136 1, Q2 4, East of England Yorks & Humber North East North West Wales Scotland 15

16 Table 2. Overdrafts to SMEs by region, Q Q All SMEs London South East South West East Midlands West Midlands Value of overdrawn balances 2011 Q3 13,658 1,411 1,373 1, ,155 2,401 1, , , Q4 12,697 1,280 1,300 1, ,068 2, , , Q1 12,717 1,591 1,483 1, ,171 1,039 1, , , Q2 12,643 1,438 1,448 1, ,189 1,084 1, , , Q3 12,353 1,405 1,436 1, ,123 1,023 1, , , Q4 11,480 1,316 1,344 1, , , , Q1 11,648 1,339 1,411 1, , , , Q2 11,207 1,254 1,271 1, , , ,292 No. of overdraft facilities approved 2011 Q3 68,916 8,923 8,720 9,310 4,542 6,391 5,813 5,433 2,679 6,114 4,529 6, Q4 63,092 8,382 8,464 8,282 4,352 5,630 4,837 4,648 2,469 6,036 3,973 6, Q1 72,010 10,634 9,248 9,217 4,235 6,215 6,332 5,043 3,875 6,232 4,924 6, Q2 59,723 8,755 7,787 7,500 3,424 5,203 5,764 4,475 2,914 5,248 4,146 4, Q3 59,021 8,559 7,331 7,323 3,529 5,246 5,632 4,380 2,914 5,156 4,308 4, Q4 53,885 7,945 6,805 6,857 3,044 4,662 4,907 3,907 2,623 4,785 3,819 4, Q1 56,216 7,727 6,725 7,503 2,931 4,635 4,752 4,007 3,054 4,624 4,296 5, Q2 49,161 6,678 5,545 6,263 2,524 4,212 4,210 3,467 3,092 4,115 4,046 5,009 Value of overdraft facilities approved 2011 Q3 1, Q4 1, Q1 1, Q2 1, Q3 1, Q4 1, Q1 1, Q2 1, East of England Yorks & Humber North East North West Wales Scotland 16

17 The other main form of debt funding from banks to SMEs is via an overdraft i.e. a short-term loan giving customers the right to overdraw their bank account by an agreed amount and which is normally repayable on demand. According to Bank of England data, there is a total of 34.6 billion of overdrafts with UK businesses, with SMEs accounting for 42 per cent (or 15.5 billion) of this amount. This has fallen by 25 per cent since September 2011, indicating that banks have been put under pressure, through Basel III arrangements, to reduce their risk through such lending to SMEs. Various conversations with banks, customers and intermediaries also suggest that there has been acceleration in businesses having their overdrafts withdrawn because of a lack of utilisation and then being encouraged to move into invoice discounting. Whilst it is argued that this may be more effective for managing cashflow, this type of finance is not suited to every business and may cause difficulties over time. Therefore, in terms of total loans and overdrafts, SMEs owe a total of 169 billion or 37 per cent of all lending to businesses in the UK. This equates to an overall reduction in debt finance facilities of around 25 billion (or a 13 per cent decline) since September At this stage, there is no clear evidence that this situation will change soon although hopes of a growing economy may transform the appetites of both the banks and SMEs towards increased lending and borrowing respectively. There are also mixed messages regarding lending emerging from the latest version of the SME Monitor 4, which reported that in Q2 of 2013, 44 per cent of SMEs using external finance (loans, overdrafts, credit cards), up from 39 per cent in Q1. This was higher than the 36 per cent of SMEs who met the definition of a permanent non-borrower, expressing no interest in external finance. However, this growth is in non-core products offered by the banks with the use of core bank products (overdraft, loan or credit card) remaining flat at 33 per cent. Indeed, overdrafts are now only used by 18 per cent of SMEs, the lowest since the SME Monitor was created. Instead, the growth is coming from other forms of external finance (such as leasing, invoice discounting, grants and loans from directors), with use increasing to 21 per cent, up from 15 per cent in recent quarters. Trends in bank lending in Wales As stated in the first report, the main source of information on regional lending can be obtained from the BBA, which publishes limited regional data on a quarterly basis, although this information only dates back to the third quarter of The updated statistics enable an examination to be made as to how Wales has been performing during the first two quarters of The latest data 5 shows the following: Current value of loan balances in Wales in Q2 of 2013 was billion, which equates to no substantial change on the position at the end of 2012 (table 1). The value of overdraft balances had increased, during the previous six months, from 623m to 656m (table 2). This represents 4.9 per cent of the total UK lending by banks (loans and overdrafts) to SMEs, with 86.7 per cent of all banking in lending in Wales being in the form of loans, slightly lower than the UK (88.7 per cent). During the 12 month period Q Q2 2013, the banks approved 11,459 loan facilities for Welsh SMEs with a total value of million. The average loan was 76,016, the lowest of any UK region, with an average loan of 58,403 for small firms and 185,359 for medium-sized firms; A total of 16,469 overdraft facilities were approved for Welsh SMEs over the same period with a total value of million. The average overdraft for SMEs was 20,738, the lowest of any UK region with an average overdraft of 14,610 for small firms and 56,648 for medium-sized firms. The average loan for businesses with a turnover of less than 1million (i.e. small firms according to banking definitions) remains relatively high (as compared to what would be expected from most micro-businesses) and suggests that microenterprises may not be getting 4 BDRC Continental (2013) SME Monitor Q2 2013: The changing mix of external funding? August 5 British Bankers Association (2013) Banks support for SMEs - Quarter

18 access to the smaller loans they require 6. This supports the finding from the first report namely that whilst bank funding is available to businesses in Wales, many newer and smaller businesses do not get the funding they require, at least relative to the rest of the UK. To examine this trend over a period of two years, table 3 examines the change in the value of loan balances for Wales over time as compared to the UK. Table 3: Change in loan book and overdraft balances, Wales UK, Q Q All SMEs M % change Change in loan balances Wales % Change in overdrawn balances Wales % Change in loan balances UK - 4, % Change in overdrawn balances UK - 2, % Small firms Change in loan balances Wales % Change in overdrawn balances Wales % Change in loan balances UK % Change in overdrawn balances UK % Medium-sized firms Change in loan balances Wales % Change in overdrawn balances Wales % Change in loan balances UK - 3, % Change in overdrawn balances UK - 1, % Overall, the comparison shows that the amount of loans and overdrafts to SMEs in Wales has actually increased by 55 million (or 1.3 per cent) between quarter 3 of 2011 and quarter 2 of In contrast, the amount of lending to SMEs at a UK level has decreased by 4.6 billion, a fall of 4.9 per cent. More detailed examination of the data shows a considerable difference in the lending profile of small firms and medium-sized firms in Wales. Whilst medium sized firms in the UK are facing difficulties in accessing finance, the loan balance for this size of firm in Wales has increased by 14.2 per cent over this period. In contrast, there has been a decline of 232m in the value of loan balances for small Welsh firms, which is the largest overall decline of any UK region over this period. This decline accounts for 40 per cent of the total UK fall in loan balance for small firms. This supports the indications from interviews with stakeholders that it is smaller firms that are struggling to get loan funding from the banks. This view is also evidenced by the findings from the most recent Bank of England Agents summary of business conditions 7 which suggests that whilst credit availability has continued to improve gradually, Availability of finance remained polarised between very easy conditions for large companies, both for bank and capital market finance, and tight conditions for smaller companies holding few assets or operating in riskier sectors. For smaller companies, however, access to non-bank financing had increased further, and there were reports of greater activity by some challenger banks albeit often in lower-risk lending, such as asset finance. There has also been an 8.9 per cent fall in overdraft balances for small firms during this period ( 33 million) although this is half that of the UK average. To explain this trend, banks have indicated that the reason that small firms overdrafts had been withdrawn or converted to invoice discounting was because of a lack of utilisation. For example, data from the BBA regarding overdraft facilities shows that only around 53 per cent is currently utilised by SMEs 8. Whilst this leaves almost half the agreed borrowing commitments available as headroom funding for businesses to draw on, it is reducing year on year. 6 Microcredit is defined by the EC, as a loan or lease under EUR 25,000 to support the development of selfemployment and microenterprises (which are defined by the EC as less than 10 employees, and a turnover of less than 2million) 7 8 BBA (2013) Statistics Bank support for smaller and medium-sized firms, 2 nd quarter

19 Whilst examining the decline in loan balances is one way of estimating the amount of funding that is available to Welsh firms, it is also worth examining the loan facilities that have been approved between 2011 and This data shows that whilst there have been fluctuations in the number of loan facilities approved for SMEs during the last two years, the number of loan facilities approved for medium-sized firms has remained almost flat (Figure 2). Figure 2: The value of loan facilities approved for small to medium sized enterprises in Wales, Q Q Figure 3: The number of loan facilities approved for small to medium sized enterprises in Wales, Q Q

20 In terms of the value of loan facilities being offered to SMEs in Wales (Figure 3), this has declined by 58 per cent since Q with the value of lending to mid sized firms falling by 140 per cent over this period (from 159 million in Q to 66 million in Q2 2013). In fact, it would seem that the main decline occurred between Q and Q2 2012, with the number and value of loans to medium sized companies reaching equilibrium and staying there for the last 12 months. A similar pattern has been observed for overdrafts, with the value of such facilities for mid-sized firms in Wales falling by 67 per cent in the last two years. Cost of lending It is not only the supply of lending from the banks that is critical to SMEs but also the cost of lending. This review has found it almost impossible to get any relevant data from the high street banks on the cost of lending to Welsh businesses. In fact, there is an argument made that it remains difficult to get any data on the cost of borrowing as the spread over relevant reference rates that SMEs face on new borrowing can vary widely, taking into account various business-specific risk and credit quality factors. As a result, there is no single definitive measure of loan pricing, though statistical and survey data can provide broad estimates. Figure 4: Indicative median interest rates on new SME variable-rate facilities, The latest report on trends in lending from the Bank of England 10 (Figure 4) shows that indicative median interest rates and spreads on new variable-rate facilities to all SMEs has fallen slightly in recent months, according to survey data from the Department for Business, 9 This is the median by value of new SME facilities priced at margins over base rates, by four major UK lenders (Barclays, HSBC, Lloyds Banking Group and Royal Bank of Scotland). Data cover lending in both sterling and foreign currency, expressed in sterling; (b) Median by value of SME facilities (new loans, new and renewed overdrafts) priced at margins over base rates, by four major UK lenders (Barclays, HSBC, Lloyds Banking Group and Royal Bank of Scotland). Data cover lending in both sterling and foreign currency, expressed in sterling (c) Smaller SMEs are those with annual debit account turnover on the main business account less than 1 million (d) Medium SMEs are those with annual debit account turnover on the main business account between 1 million and 25 million (e) Weighted average of new lending to PNFCs of all sizes by UK monetary financial institutions (MFIs) for advances less than or equal to 1 million. Data cover lending in sterling. The Bank s effective interest rates series are currently compiled using data from 23 UK MFIs. 10 Bank Of England (2013) Trends in Lending, October

21 Innovation and Skills. This shows that the median interest rates for SMEs stood at 3.55 per cent in August , which equates to a reduction of 1.84 per cent since November For small firms, the median rate was slightly higher at 4.74 per cent - a reduction of only 0.93 per cent that suggests that those with limited negotiating power are paying more. Another indicator of pricing on loans to smaller businesses (PNFC) - the Bank of England s measure of effective rates on new corporate lending for advances of 1 million or less - was broadly unchanged over this period 12. The reduction in interest rates over time was reflected in a recent survey from the Federation of Small Businesses 13, which showed that the cost of finance continues to reduce for UK small businesses. In Q3 2013, the average interest rate to small firms was estimated at 5.5 per cent, down from 6.3 per cent a year before. Within this average, almost a third of small firms report being offered loans at 4 per cent interest or lower in Q up from the 22.3 per cent of firms at the same time a year ago. At the other end of the scale, the share of firms being offered interest rates of 6 per cent or higher has fallen back notably, with just 7.2 per cent of businesses being offered rates of 11 per cent or over, down from 9 per cent in Q Similar reductions over time in the costs of loans have been found in the latest editions of the SME Monitor. For example, two thirds of the SMEs within the Q2 survey 14 stated that they were paying 6 per cent or less for fixed rate loans (with 23 per cent paying less than 3 per cent). Therefore, this evidence suggests that the cost of borrowing to SMEs remains low although evidence from the first stage review suggests that the main difficulty remains one of getting access to the loans with the banks still applying strict rules with regard to security, affordability and the viability of certain sectors. For example, one of the sector panellists noted that the high street banks have "black-listed" whole sectors, in which our businesses trade, and have been very risk adverse regardless of the considerable financial strength, and low gearing, of our group. Without the latter I do not believe we would have been able to finance our investment strategy at reasonable rates. Rejection rates As stated in the first report, if a business is declined lending following a formal application for a loan, it has the right to appeal the decision. This is because the UK banks, through the BBA, have agreed a new set of principles for appeals that are monitored and scrutinised by an independent team of reviewers, ensuring that the banks have implemented a fair, prompt and transparent appeals process. According to the latest review 15, the banks have received almost 5,500 appeals since the inception of the new process in 2011, with 39 per cent overturned in favour of the customer and, as a result, an estimated 30 million in lending was put into the economy in its first two years. 4.6 per cent of the appeals have come from Wales, slightly higher than its share of the UK business population. Detailed case data on a regional basis are only collected on those appeals which have been reviewed and the case selection is predominantly skewed towards reviewing those cases overturned in favour of the customer so that there is a better understanding of the reasons for overturns and whether any process improvements may be appropriate. In those cases, 46 per cent of the appeals were overturned in favour of the customer in Wales and it is worth noting that the main reason given the author of the review, Professor Russell Griggs, for the relatively high number of successful appeals was that banks rejected applications too early without giving them thorough consideration. This suggests that a considerable number of businesses that are, of sufficient quality to attract bank lending, are being turned down because of internal processes within the banks themselves Both these measures may not entirely reflect the true cost of credit facing SMEs, as they do not include the impact of cash-back deals or changes in fees. In addition, these rates may be affected by changes in the risk profile of borrowers, which could vary over time. 13 Federation of Small Businesses (2013) FSB Voice of Small Business Index, Quarter 3, 2013, September 14 BDRC Continental (2013) SME Monitor Q2 2013: The changing mix of external funding? August 15

22 Whilst banks are obligated to inform those declined for lending of the appeals process, the latest edition of the SME Monitor 16 suggests that amongst those initially declined, awareness of the appeals process remained low (only 15 per cent of those initially declined for an overdraft in the last 18 months and 7 per cent for those initially declined for a loan). It is also worth noting that most of the firms declined rated the subsequent advice given by the bank as to issues such as other sources of potential funding as poor (70 per cent for declined overdrafts and 62 per cent for declined loans). As the first report noted, both the banks and Government could do more to ensure that those that are turned down for lending are not only given the opportunity to appeal but to look for alternative sources of funding. In the case of Wales, such action could be a major step in increasing lending to businesses. For example, if the banks approval rates for lending are 70 per cent, as the BBA suggests 17, then this would indicate that, extrapolating the data from the regional data discussed earlier in this section on bank lending to SMEs in Wales, that there are nearly 5,000 Welsh firms that have been turned down for loan funding during the last 12 months and a further 7,000 for overdrafts. The total is probably higher given that a number of businesses are actively discouraged from applying formally to the banks for support. In fact, as the review into RBS lending practices by Sir Andrew Large recently pointed out, the bank discouraged a disproportionate amount of businesses from making formal applications and its staff were risk averse 18. Therefore, the report estimates, by utilising this data, that there is a minimum of half a billion pounds lending gap within the Welsh economy 19. A similar estimate can be made from the recent NAO report on access to finance for SMEs, which indicated that the funding gap (the difference between the funding required by SMEs and the funding available) for the UK as a whole is 10 billion to 11 billion 20. Whilst it is likely that a significant proportion of those turned down may not be ready for funding, if SMEs that do not receive finance from the banks could be supported with their application or to get access to other sources of funding, then this would have a significant effect on supporting business within the Welsh economy. There are a number of implications from this finding including ensuring that more Welsh businesses are investment ready and there is more effective signposting to alternative sources of funding Summary The first report highlighted some of the main issues regarding lending by the banks to SMEs in Wales. Whilst the banks are stating that they are ready to lend, the data shows a very different picture, with the value of borrowing approved facilities to SMEs in Wales actually falling by 30 per cent since Q Differentiating by size of firm, then the data shows that the borrowing levels of small firms have fallen during the last two years whilst the number and value of lending approvals to medium-sized businesses have flatlined during the last 12 months. This is a conundrum as the evidence is clear that the cost of borrowing is at its lowest levels ever with evidence that the Funding for Lending scheme is starting to have an impact on the interest rates charged by some banks 21. Nevertheless, in recovering from previous recessions, banks have not had to contend with changes in the regulatory landscape that have changed the cost and balance sheet dynamics of providing credit. The funding drought that then affected the SME market, especially in the period , has also eroded confidence amongst the business community. Whereas there have been efforts by the UK Government to introduce cheaper lending with rates 16 BDRC Continental (2013) SME Monitor, 2013 Q2 report, July This is calculated by examining the total amount loaned to SMEs in the last month and then extrapolating the gap by using the rejection rate of the BBA to work out how much could have been lent to those turned down 20 NAO (2013) Improving access to finance for small and medium-sized enterprises, November 21

23 reducing as a result, this has not been translated into increases in the number of loans from the banks. This has left a total funding gap of around 500 million per annum for those businesses who want to get access to funding but were refused support by the banks in Wales. This is clearly an upper limit as a proportion of those applying for funding may not be a position to receive it from any source although it does exclude those that are reluctant to go to the bank for funding because of the current uncertain economic conditions or have been actively discouraged from doing so. Nevertheless, it gives an estimate, albeit a crude one given the lack of statistics from the banks themselves, of the finance required by the Welsh SME sector that is currently not served by the high street banks. As suggested in the first stage of the review, a large part of this problem may be attributed to the way that banks are currently assessing risk, valuing collateral and whether to invest in certain sectors. In that respect, the question is whether a new challenger bank is needed within Wales - either in the public or the private sector especially as it will face many of the same issues that are affecting the current set of high street banks? Alternatively, is there a more effective way for the Welsh Government of working alongside current providers whilst, at the same time, encouraging access to other types of alternative finance? It is important that banks and the Welsh Government do not operate in isolation in terms of the provision of finance to SMEs. Following the first stage review, there have already been negotiations between the Welsh Government and one of the high street banks to develop a referral system for those turned down for bank lending although closer links between business support and access to finance could also sustain this process. In addition, another bank has stated its intention to work closely in developing the potential of growth businesses in Wales. Given this, regular formal meetings could take place every six months between senior officers at the banks and the Welsh Government to discuss the challenges facing the Welsh economy and the way to address these challenges together.

24 4. ALTERNATIVE SOURCES OF FUNDING An important part of this review is to examine how other types of lending to SMEs in Wales can help close the finance gap that currently exists for some businesses. As noted in the progress on the recommendations from the stage 1 review, a number of these issues are currently being examined by the Welsh Government most notably that of trade credit, and will not be discussed further in this report. However, as the section below will show, there have been some developments in the field of alternative sources of lending, which is a significant factor given that banks continue to struggle to lend to SMEs in Wales and the rest of the UK. Trends in non-bank lending The first part of the report examined, in detail, the different types of alternative finance that is available to businesses in Wales. Six months later, the evidence suggests that whilst traditional bank lending continues to decline, there has been an increase in the level of nonbank lending to businesses across the UK. For example, evidence from the NACFB shows that the use of alternative finance options for small businesses has reached its highest ever point in According to the NACFB, use of alternative sources of lending to SMEs has been increasing with a recent survey of its commercial finance intermediaries showing that: Alternative lending to the UK's SMEs has climbed to 10.5 billion in 2013, up from 9 billion a year earlier. This growth of 17 per cent means that overall funding for small businesses is at a five-year high. More relevantly, this represents a 64 per cent increase from 2008/9 and the largest contribution to SME funding from NACFB financial providers in the last five years. Buy-to-let accounted for the largest amount of lending (23 per cent) with a contribution of 2.4 billion in 2013, followed by leasing and asset finance with 2.3 billion and commercial mortgages with 2.2 billion. Invoice finance deals contributed 674 million. Commercial mortgages showed an increase of 46 per cent more deals as more businesses explored this route SME funding through leasing and asset finance has grown by 12 per cent in the same period and made its largest contribution to small business funding since before the recession. It now makes up 22 per cent of alternative loans to small businesses compared with just 7 per cent in Growing awareness of this funding route among the small business community saw 2.3 billion of loans secured through NACFB members during and boosted the average number of deals by 59 per cent. Businesses also enjoyed greater access to leasing and asset finance with 11 per cent more NACFB brokers now active in this area. The value of peer-to-peer lending and other new forms of small business finance also grew by 80 per cent in the last year, providing SMEs with 501 million worth of loans from NACFB members in This is the first time this figure has exceeded half a billion pounds. Invoice discounting and factoring Additional data from ABFA, which has 140 members across the UK, also seems to suggest that there has been a recent growth in asset-based finance (factoring and invoice discounting) during the last year. The latest industry figures (for April-June 2013) show that: Whilst the number of clients has only grown by 1 per cent, the total funding advanced by the ABFA s members to firms has increased by 10 per cent year on year, the balance rising from 15.8 billion to 17.4 billion (June 2012-June 2013). Sales from firms using asset-based finance have also risen markedly, reaching billion in June 2013, a rise of some 12 per cent in the past year, with businesses utilising export factoring (29 per cent) and export invoice discounting (24 per cent) showing a considerable increase in their sales during the last quarter Service-based firms account for 29.5 per cent of all clients and manufacturing firms account for 29.3 per cent.

25 Both small and large companies using asset based finance, with advances to small firms ( 500K 1 million turnover) recording 6.2 per cent growth in the last quarter alone, whilst larger companies ( 50 million million turnover) have similarly seen growth in advances of some 14.3 per cent. ABFA members only work with around 43,000 UK businesses, with an estimated 2,100 clients in Wales 22 which demonstrates that there is considerable scope for further development of this alternative source of finance although there continues to be misconceptions about the products in the current context of mistrust of the financial services industry and the fact that, like most forms of commercial finance, asset based finance products are not regulated products. To deal with the latter issue, ABFA launched their own Code, Professional Standards and Complaints framework in July 2013 overseen by a new Professional Standards Council for the industry. This may provide further confidence in the industry and encourage more SMEs to utilise asset-based finance in the future. Asset finance Asset finance, which comprises mainly of leasing and hire purchase products, is also an area that has seen growth in recent times. As the Federation of Small Businesses s (FSB) submission points out, the attractiveness of asset finance is that it is more predictable and agreements will not be cancelled by lenders (due to the structure and contractual nature of deal), which helps all businesses, especially those with limited capital. Usually the credit line is secured with the asset being leased rather than any other business or personal asset, which is also a key benefit. The FLA has worked with the UK Government to ensure that asset finance is included in various programmes aimed at improving the availability of credit for SMEs, such as Funding for Lending. This is estimated to have supported up to 300 million of asset finance for investment in new equipment in 2,000 businesses 23. As of 2013, the UK s leasing market to both consumers and businesses is one of the largest in Europe worth around 76 billion. The latest data from the FLA show this trend is continuing, with asset finance for business growing for the fifth consecutive month in August 2013 (by 3 per cent to 1.5 billion). Growth occurred in most asset sectors over the previous 12 months including plant and machinery finance (13 per cent), commercial vehicle finance (15 per cent), and IT equipment finance (6 per cent) and business equipment finance (3 per cent). Building Societies During the initial interviews for the stage 1 report, it was suggested that building societies could become more involved in lending to the SME sector, especially in commercial mortgages where they have previously specialised. In May 2013, the Nationwide unveiled plans to develop and offer a full range a financial services to SMEs, playing an increasing role in providing credit to an important part of the UK economy 24. This seemed to give the clearest indication yet that building societies could be looking to provide alternatives to bank lending, especially given the extension of the Funding for Lending Scheme. However, in August 2013, the Nationwide announced that it was its plans were unlikely to take effect until 2014 at the earliest 25. Following further discussions on the role of building societies in supporting access to capital within the Welsh economy, this was not unexpected. Interviews with stakeholders suggested that traditional commercial mortgages, which building societies could diversify into, were managed better through the banking sector. And whilst there are commercial investments into areas such as social housing and residential investment, there seems to be reluctance from building societies to expand into other forms of financial support for the business community. 22 ABFA do not yet collect regional statistics so this an extrapolated estimate from data collected from a number of ABFA members 23 Finance Leasing Association (2013) Annual Review

26 Instead, the message is that they want to focus on what they are doing already and doing it better for their customers. A similar view was expressed from the Bank of England, which suggested that there might be a reluctance to step up commercial real estate lending given the losses experienced by a number of building societies since the crisis and the depressed nature of commercial property outside of London and the South East of England. With building societies not having the requisite expertise in underwriting of commercial loans and the requirement for additional capital buffers against any increased commercial lending, it is the view of the BoE that it is unlikely that the sector will be able to participate in developing the SME market in the future. Informal investment The first report emphasised the importance of accessing greater amounts of private sector funding to Welsh SMEs, especially through ensuring that more informal investment by business angels is attracted to Wales 26. This type of investment has enormous potential in developing the Welsh economy if utilised properly, as it tends to focus on high potential startups, innovative or technology-intensive firms. Most of these cannot access traditional funding due to their lack of collateral, limited cash flow and investment risks to investors. There have been two positive developments in terms of informal investment in Wales since the first report was published. The first is the extension of the UK Government s Angel Co- Fund to all parts of the UK in July 2013 that was previously only available in England. It invests amounts of 100,000 to 1 million into SMEs with high growth potential, working in partnership with syndicates of experienced business angels 27. This could present an opportunity for increased amounts of funding to be channelled to businesses in Wales and it is critical that a system is put into place that ensures business angels in Wales take full advantage of this new scheme. The second is the creation of the Dragon Seed Enterprise Investment Scheme (SEIS) Fund by xénos the Welsh business angel network - in partnership with Amersham Fund Managers and Seed Mentors. This aims to focus mainly on start-ups through attracting 1 million of funding from private investors who are prepared to support Welsh businesses. It is a welcome proposal in that it combines a mentoring model with seed capital (with specialist mentors being provided from xénos registered investors). Such initiatives, if joined up in a coherent way, could help to boost investments in high potential companies in Wales. This is something that is needed, as one of the issues that emerged from the second part of the review is the lack of an overall coherent policy focus in Wales on high growth start-ups where the majority of angel funding could and should be utilised. For example, the High Potential Start-Up programme developed by the Welsh Government seems to be performing well although there seem to be no actual formal linkages with Wales only business angel network. There is also again a failure in terms of using the entire business support system in Wales to ensure that all viable businesses that require finance can look for different sources. For example, whilst xénos receives enquiries per year, only are passed onto investors with no system in place to refer them to other sources of funding. Again, business support and financial support instruments in Wales could be working more closely together and there is no reason why those proposals that are rejected by xénos cannot be referred to other sources of funding and support, especially if their business plans are not yet fully developed. There were discussions held with representatives of xénos and a number of issues emerged as to the current disconnect with other aspects of the business and financial support system. These included: 26 There has been no updated information provided on EIS during the last six months although xénos has reported four companies receiving investment of 200,000 with a further 800,000 of private sector leverage attracted 27 BIS (2013) 100 million fund to support business growth goes national https://www.gov.uk/government/news/100-million-fund-to-support-business-growth-goes-national

27 Lack of capacity and time to undertake due diligence of proposals, especially as angel investors are expected to put their own time and money to do the very necessary due diligence before making an investment. This can deter them from becoming angels in the first place, restrict the number of deals they can do and extend the due diligence period to the extent that companies run out of time to raise the necessary funds; More support is needed for entrepreneurs to ensure that their business plans are specifically investment ready for business angels and, where necessary, that they have a greater understanding of concepts such as valuations; Higher levels of support for investor readiness as new members of xénos can take up to two years before making their first investment and greater support is needed to help develop and prepare individual for equity investments Gaining access to a wider network of business angels outside of Wales, which could result in more deals being completed; Adjusting UK Government schemes to local conditions. For example, given the lower amount of angel funding requested by Welsh business, the current rule for the Angel Coinvestment Fund (minimum of 100k investment) may be restricting access from this source of co-funding for smaller deals; A lack of awareness by high net worth individuals of the potential of using SEIS and Enterprise Investment Scheme (EIS) for investing in small businesses as part of their portfolio; Few links between the High Potential Start-up programme and xénos and almost none with the university sector. One suggestion, supported by a number of respondents, was for a more specialist fund that would focus on start-ups and seed funding. For example, given the limitations of the current process, xénos suggested that there is a requirement for a Wales Angel Co-Fund for Start- Up and Early Stage Businesses that would focus exclusively on providing seed capital to high potential start-ups and would co-invest with experienced angels. Such funding should fit into the lifecycle approach to support high growth businesses in Wales. Linking into established and successful programmes, such as Angels Den 28, could help to develop an active and ultimately self-sustaining entrepreneurial ecosystem that will, by increasing levels of scalable entrepreneurial activity in the economy, drive economic growth and job creation. Whilst xénos is clearly continuing to be proactive in trying to develop its impact on Welsh business, discussions with others within the informal investment field in Wales and elsewhere suggested that the current model operated by xénos acting as a hub and facilitator for individuals to come together to form a syndicate to invest in a single company may need to evolve. In Scotland, the current approach is to focus on the development and support of angel groups, which are essentially a formal group of individual angels established with the intention of investing together in multiple deals over an extended period of time. Their advantages over individual or syndicates of business angels are quality dealflow, multiple skills, diversification of risk and more funding. The emergence of such groups has been promoted and supported by LINC Scotland, the national association for business angels in Scotland. It has not only helped existing groups of business angels to work more efficiently but has acted as an incubator to new syndicates. With twenty angel groups comprising of over 800 investors operating across different regions and in different sectors, informal investment has been taken to a new level in Scotland - in August 2013, the first Scottish angel investor network for women, funded by high net worth women, was launched in Edinburgh 29. The advantage of the angel groups concept is that it does not solely rely on the traditional business angel who invests directly into a business and then becomes personally involved in its development. Instead, these groups are made up of silent angels who are high net worth individuals that are willing to invest in high potential Scottish businesses but are not interested in either assessing the initial deal or the subsequent management of the investment. Instead, they are happy to piggyback onto the judgement of experienced angels within their syndicate. As a result, this has opened up

28 substantial amount of additional capital from high net worth individuals into the Scottish SME sector. It also gives the SME an advantage in that it now has potentially twenty different groups of investors to approach for support. The Welsh Government s Creative Industries sector panel suggested that sector-specific angel networks should be encouraged in Wales, and angels (or syndicates of angels) with specific creative sector expertise would be a valuable resource, able to provide both finance and mentoring. According to the latest data for investment by angel groups in Scotland, the total aggregated investment (i.e. including co-investors) has increased from 6.8 million in to 30.9 million in 2012 (peaking at 34.5 million in 2011) 30. In contrast, the value of xénos deals over the same period has increased from 1 million to 3.9 million. This may suggest that there is an increasing appetite for angel investments across both countries but it clearly demonstrates that the scale of investment is somewhat different, even though the business population of Scotland is only 1.6 times that of Wales. This is not to say that xénos is not fit for purpose but the model being adopted in Scotland is attracting higher levels of informal investment through the group model. With evidence from Europe, North America and Australasia showing that angel investing is changing from an individual process to one in which angels are joining together in organised and managed groups to invest, there is clearly an opportunity to do the same in Wales. The key issue is how xénos could evolve into such a model over time as there needs to be different and more effective mechanisms to attract greater number of investors to support early stage businesses in Wales. For example, the Welsh Government could develop its own co-funding approach in a number of key sectors, such as creative industries, ICT, energy and environment and life sciences, to attract greater amounts of private sector investments into these growing industries. This could take various forms, ranging from support for specific angel groups, direct matching grant support to the development of new financial instruments, such as the creation of an equity guarantee scheme that could, as an innovative tool, be funded through the UK s Business Bank. There is also the question, if co-funding results in larger deals, in how crowdfunding can be utilised to support smaller investments into new businesses. However, it is not only the smaller end of the market that may have difficulty in attracting financial support. Another experience from Scotland, highlighted in the paper by Mason et al. (2013), is the fact that whilst the angel groups are providing capital for deals under 1 million, there has now emerged a further equity gap beyond this stage that even the biggest syndicates cannot fund. In this respect, any new funding model in Wales must consider how it can support the demand for growth funding in amounts of 1 million or more, potentially building on initiatives such as the new Life Sciences Fund but extending it into other sectors such as energy and environment, creative industries and ICT. Whilst funding over the lifecycle of a business is not a new concept, there has been no focus to date by Welsh Government in having a coherent approach to supporting high potential and growing firms over their lifetime. Undertaking such a process should not be too difficult if the different elements of business and financial support already in existence could be brought together and supplemented by other developments. Venture capital The latest data from the British Venture Capital Association (BVCA) shows a mixed picture for venture capital investment in Wales 31 : A total of 37 Welsh companies received venture capital investment of 87 million in Whilst it represents a decrease on the 50 companies that received funding in 2011, the amount invested had increased by 74 per cent. This represented 4.5 per cent of all venture capital backed companies in the UK but only 1.5 per cent of the total amount invested; 30 Mason, C., Botelho, T. and Harrison, R. (2013) The transformation of the business angel market evidence from Scotland, Adam Smith Business School, University of Glasgow, August BVCA (2013) Private Equity and Venture Capital Report on Investment Activity 2012

29 The average investment per business into Wales was 2.3 million, which was the second lowest of all the UK regions (after Northern Ireland); Only ten per cent of this funding was for venture capital (seed, start-up and early stage) within Wales, with the largest amount of funding going into later stage deals (40 per cent); The two sectors receiving investment were healthcare and consumer services ( 52 million) and oil and gas, basic materials and industrials ( 30 million). As stated in the first report, Finance Wales has had a positive impact on formal equity investment within the Welsh business community, despite some significant recent losses in the market. However, some respondents have suggested that there is a need to develop programmes that create demand for venture capital not only for new start-up businesses but also growth firms where equity investment is key for further development. In this respect, there has been a positive development during 2013 with Finance Wales recently appointing Arthurian Life Sciences Ltd to manage a new 100m fund which will invest in life sciences and related medical, pharmaceutical and healthcare companies currently based in Wales (as well as those companies from across the UK, Europe and the rest of the world where such investment will bring meaningful developmental and economic benefit to Wales). The fund will make initial investments of between 500,000 and 5,000,000 and will preserve capital to provide follow-on investments. This is a welcome development and one that could result in funds being established for other key sectors such as ICT and the creative industries although, as with informal investment, there remains some disconnectivity between the development of such funds and other elements to support high growth firms in Wales. However, there is a question as to whether there should be a more strategic approach to supporting growth firms and their funding via equity investments? As stated in the first report, there needs to be a more comprehensive approach to the funding and support of innovative businesses in Wales as, done properly, this could have a transformational effect on the Welsh economy. It is surprising to find that Finance Wales investment teams have no formal relationships with private equity and venture capital firms that operate in the same deal range (which includes the Business Growth Fund that operates in the 2-10million space). Research has shown that venture capital firms benefit from having a wide range of relationships, especially if these involved other well networked venture capital firms and this leads to improved performance, as measured by successful exists in particular 32. Currently, Finance Wales only semi-formal relationship is governed by a memorandum of understanding (MOU) with Fusion IP. There also seem to be no links with UK Government programmes that provide equity for growth businesses. For example, there have been no Welsh investments from the UK Innovation Investment Fund (UKIIF) established in 2009 as a 150 million venture capital fund of funds that aims to drive economic growth and create highly skilled jobs by investing in innovative businesses where there are significant growth opportunities. In addition, the 197 million Enterprise Capital Fund, which is intended to address a long-term structural weakness in the provision of risk capital for SMEs in the UK, has only made investments of 5.1 million in three Wales-based companies. This equates to 1.8 per cent of all investments and 2.5 per cent of the value of investments from the fund. If Wales had received its fair share of this funding, an additional 12 million of potential funding could have been invested into Welsh businesses. It is also disappointing that the Business Growth Fund still only has one investment in Wales SHS Integrated Services despite research showing that the potential Welsh market for their funding is around 85 mid-sized growth firms. Peer-to-peer lending and crowdfunding As the first report noted, there is increasing attention being placed by SMEs on peer-to-peer (P2P) and crowdfunding as new types of lending platforms to raise capital. However, there 32 Hochberg, Y.V., Ljungqvist, A, and Lu, Y. (2007) Whom You Know Matters: Venture Capital Networks and Investment Performance, Journal of Finance, Vol. LXII (1) pp

30 has been concern that both P2P lending and crowdfunding need a regulatory framework to protect both investors and businesses. Last month, the Financial Conduct Authority (FCA) outlined how it will regulate these alternative sources of funding. For example, consumers willing to lend money to companies through peer-to-peer websites will receive explanations of the key features of the loans as standard. They will also benefit from an assessment of the creditworthiness of borrowers before granting credit, and crowdfunding sites, or platforms, will need plans in place to ensure loan repayments continue even if a crowdfunding company collapses. A fourteen-day cooling off period will allow both borrower and lender to withdraw without penalty from the agreement if either changes their mind. Whilst crowdfunding is already regulated, the FCA believes that investments should only be promoted to those who understand the inherent risks or have the financial capacity to cope with any losses. These regulations will apply from April 2014 and will make the P2P and crowdfunding market more accessible, help foster competition and facilitate access to alternative finance options while also providing additional consumer protection. The largest P2P lender in the UK is Funding Circle. As of the end of last month, it had lent over 166 million to over 3,000 businesses since it was started at an average lending rate of between 7 per cent and 9 per cent (which is lower than the average cost of funding from Finance Wales). In Wales, Funding Circle has lent 6.4 million to 108 businesses at an average of 59,000 per firm. This is a considerable acceleration on the funding situation back in June 2013, when 4 million had been raised for 72 Welsh businesses, and perhaps reflects the current stalemate in lending from the banks. Wales has also developed its first ever P2P platform last month. Funding Empire, based in Cardiff, has been set up by a number of professionals coming together to combat the problem of banks not lending to businesses. Unlike some other P2P lenders, Funding Empire accepts loan applications from start-ups and provides them with free mentoring and support to ensure they are ready to apply for funding through the platform. The other important development in alternative funding is crowdfunding i.e. the collective effort of individuals who network and pool their money, usually via the Internet, to support efforts initiated by other people or organisation. The two main crowdfunding platforms currently in the UK at the moment are Crowdcube which is meant for users to invest small amounts and acquire shares directly in start-up companies - and Seedrs - which, as a nominated agent, pools the funds to invest in new businesses. To date, there has been one investment by Crowdcube in Wales, namely Affresol in Swansea, which has developed a technology process that produces a "synthetic" concrete (called TPR) from waste diverted from landfill. Seedrs has twice raised money for Walesbased start-up Veeqo - the first round raised 30,000 from 66 investors and the second round 120,000 from 32 investors. Currently, there is no Welsh crowdfunding organisation although there are advanced plans to develop one in the next few weeks that, whilst it will be based in Wales, will also invest more widely. One of the advantages of crowdfunding is that it is an extension of the current informal investment funding model operating through business angels, albeit with more participants. However, the evidence gathered seems to suggest that Wales has not yet grasped the opportunities that are available from crowdfunding, especially in relation to being part of a coherent approach to supporting high potential start-ups that may need some initial financing before going to more established funding sources. As a recent Scottish report noted 33, there seems to be very little knowledge amongst potential start-ups, through the business support system, of the opportunities that are available from crowdfunding. 33 Twintangibles (2013) Crowdfunding the Scottish perspective, a report for the Glasgow Chambers of Commerce

31 Funding of social enterprises Whilst this review has focused primarily on access to finance issues affecting privately owned SMEs, it acknowledges the important and potentially expanding role played by social enterprises, and meetings have been held with various organisations to discuss potential solutions, including the Wales Co-operative Centre. Whilst there is no statutory definition of a social enterprise, it is generally accepted they are organisations that are largely defined by their commitment to a social mission, which conduct entrepreneurially driven trading operations. Surpluses generated by these operations are usually expected to be reinvested for the purpose of furthering the organisation s social mission. The Welsh social enterprise sector is broadly similar in character to that of the privately held company sector. Whilst there are a small number of large organisations, it is generally dominated by small and medium sized social enterprises. Irrespective of size, all social enterprises with ambitions to develop their business need to access growth capital although because their ownership and balance sheet structures reflect their social mission, social enterprises tend to be constituted as companies limited by guarantee. This denies them recourse to shareholders for the purposes of raising capital and, as a consequence, they are largely debt funded. Within Wales, the social housing movement has illustrated the capacity of parts of the social enterprise movement to innovate. By funding their investment needs via the bond markets and asset backed loans, Registered Social Landlords have demonstrated the benefits that can flow from operating at scale. The financing requirements of smaller social enterprises are served by a number of funds. For instance, the Wales Council for Voluntary Action effectively operates as a fund manager for the Community Investment Fund. This applies a combination of public money, in the form of grants and its own resources and is meant to address projects with a higher risk profile. The market is also served by specialist banks - such as Unity Trust and the Charity Bank - that raise their funds from commercial sources. Evidence suggests that the average loan to a social enterprise across the UK falls within a range of 150,000 to 175,000, although this may be smaller in Wales. Facilities tend to be secured loans with a typical maximum value of around 1.5 million. Whilst there is no overwhelming evidence to indicate whether a funding gap exists in this market, it is possible there may be issues at the larger end of the scale. This might arise in the case of a start-up that needed to acquire significant assets to fulfil its business plan. In considering the development of any remedies, it is imperative they must be designed in a way that avoids the creation of a market distortion since this could run the risk of hampering the commercial development of a market that is still in its infancy. Any proposals for introducing new publicly funded measures should be discussed with the licensed and regulated banking institutions that act as specialist lenders to social enterprises and draw their funds from commercial sources. However, there may be an opportunity to establish a specific fund that is dedicated to providing financial solutions for social enterprises, as well as the co-operative and mutual sector. Although not directly related to issues around access to finance, it is noted that public funds have been committed to the provision of business advice services intended to meet the unique requirements of social enterprises. Nevertheless, if the Welsh Government s ambitious objectives for the role of social enterprise in the economy are to be met, then two structural issues should be addressed. The current arrangements appear to be fragmented and run the risk of diluting the overall impact of the programme. They also enable the provision of advisory services but they do not incorporate the participation of a regulated social lender. Therefore, there is scope to develop an approach for social enterprises that brings together finance and business support for the sector. For example, there is considerable potential offered by investment readiness programmes that combine specialist advisory services for the sector with specialist lending experience for the sector. As will be discussed later, this may be an option that Welsh Government may consider as part of the solution going forward.

32 Summary This section has examined how non-bank lending has recently developed in Wales, supplementing the evidence provided in stage 1 of the report. The data suggests that, possibly as a result of lower lending by the high street banks, there has been increased use of invoice discounting, leasing and other forms of non-bank finance during the last 12 months, although it is disappointing that building societies seem to be withdrawing from being a potential source of funding for SMEs in the immediate future. Despite the increase in nonbank lending, one of the real concerns raised by both the NACFB and ABFA is the lack of awareness of alternative sources of funding amongst the business community. Both organisations suggest that there is funding available but that the demand remains low due to a lack of understanding of different alternative sources of funding. Since the first stage report was published, the Welsh Government has been in talks with the NACFB to develop various means of co-operation to ensure that Welsh SMEs can get access to non-bank lending. Similar discussions have been held with ABFA to examine how public sector business support could and should be providing information on these alternative sources of funding for their clients. In that respect, this report agrees with the FSB in that there is still scope for greater market penetration and awareness amongst businesses and that the Welsh Government could look at using its resources to provide more information on these alternative sources of finance whilst also considering whether they should form part of existing lending schemes. In terms of more specialised funding, there is considerable scope to improve informal investment and venture capital as a source of funding to SMEs in Wales. To date, informal investors have not been used as effectively as they could have been in supporting start-ups in Wales, despite the relative success of xénos. However, the current xénos model could be improved and this was a view of its own representatives and others externally. There also seems to be a lack of coherence when it comes to the management and development of equity funding in Wales and more could and should be done to ensure that there is greater focus on venture capital for growth firms at all stages of development within Wales. There is also a greater role that can be played in helping to develop new support networks for growing firms, especially as financial support alone is not in itself sufficient to secure the success of early stage businesses. For example, the Finnish Innovation Agency Tekes has proposed that it will use 20 million annually to boost the seed and early stage venture capital market, mainly through a variety of small targeted funds. An evaluation of the Scottish Enterprise Seed Fund 34 also noted that one of its successes was that those participating had access to finance from the fund and co-investors, as well as business advice from the Scottish business innovation and support network. As far as the review has noted, there is not a specific joined up approach between business support and finance that is operated via xénos, Finance Wales or other public funds, and which is targeted at Welsh growth businesses. Therefore, in terms of supporting growth businesses via sources such as informal investment and venture capital, there is a need to ensure that there is funding at all stages of the life cycle of such businesses and, more importantly, that every effort is made to leverage greater amounts of private sector funding into Wales. There have been positive discussions with P2P lenders and crowdfunding firms and there is an opportunity for the Welsh Government, through working in partnership with such organisations, to stimulate greater use of these sources of finance in the future. Discussions with the banks suggest that one potential route for promoting P2P lending would be via a direct referral system from Welsh High Street banks, Finance Wales and Welsh Government itself and this should be explored in further detail. In addition, the FSB has suggested that the Welsh Government could consider investing in peer-to-peer funding as an alternative mechanism for financial support. This would be particularly attractive given the weaknesses in some of the current models in delivering finance. For example, with the UK Government currently lending 20 per cent of every loan to all businesses, discussions with Funding Circle 34 PACEC (2013) Economic Impact of the Scottish Enterprise Seed Fund, Final Report

33 have suggested that Welsh Government could create a top-up for this (between per cent of any loan) so to ensure that Welsh companies get specific access to the funding they require. Therefore, if the Welsh government were to set up a new 2 million P2P Investment Fund, this could generate an additional 170 investments into Welsh businesses. In terms of crowdfunding, the Welsh Government could again play a more active role in raising awareness and understanding of this concept. In addition, with the scale of business angel deals increasing, there is scope for the development of a specific funding mechanism to support the number of investments below 50,000 that are too small for most angel syndicates or groups to make. Therefore, a Welsh crowdfunding co-fund, working with existing providers, could help to stimulate the start-up market in Wales, but would have to form part of a more coherent approach to the support of new businesses. Finally, whilst this report was not established to consider the funding of social enterprises there may be synergies with some of the financial solutions being put forward for the SME sector. It is therefore proposed once the report from the Co-operatives and Mutuals Commission is published, the Welsh Government may wish to consider how any financial and business support for the social enterprise sector can be integrated into the proposals of this review.

34 5. FINANCE WALES The first part of this review noted the role of Finance Wales, which is wholly owned by the Welsh Government, in providing finance to Welsh SMEs since its creation in It is currently managing over 200m worth of investments in Wales over four live funds 35, namely: The 150 million Wales JEREMIE Fund that aims to encourage effective investment in small and medium-sized businesses. The Fund is backed by the European Regional Development Fund, the Welsh Government and the European Investment Bank; The 40 million Wales SME Investment Fund which is backed by the Welsh Government and Barclays and invests in micro, small and medium-sized firms; The 6 million Welsh Government-backed Wales Micro-business Loan Fund; The 10 million Wales Property Development Fund, which makes loans to small and medium-sized Welsh construction companies developing small-scale, non-speculative commercial and residential property. In addition, Finance Wales has responsibility for the also manages three funds in England namely the North East Growth Plus Fund ( 20 million), the North West Funds for Loans Plus ( 45 million) and the Tees Valley Catalyst Fund ( 10 million). The latter was launched in June One of the key themes that emerged was that of the cost of debt lending, which a number of respondents had suggested was often higher than the rate offered by the banking sector in Wales. For example, a number of the Welsh Government s sector panels had concerns about the effectiveness of Finance Wales, stating that interest rates on offer are too high for the market and the security required against loans can be too onerous for small businesses. Following the first stage of the review, Finance Wales made a formal response to the Minister in which it was suggested that this conclusion was incorrect. The argument used by Finance Wales was that it had to charge higher rates of interest because it had a higher default rate than the banks. As a result, the Minister requested that an examination of the cost of lending and the approach taken by Finance Wales to supporting SMEs should form part of the second stage of the review. This will also help to inform how the Welsh Government s role could change in delivering finance to businesses in Wales. Cost of lending to SMEs Since it was established, Finance Wales has operated a number of funds, all of which have charged different costs of borrowing to Welsh SMEs. As table 4 shows, the difference between the average cost of borrowing across all of the funds and the average EU base rate has actually increased from 0.43 per cent in 2001 to 9.69 per cent in In addition, it is worth noting that the current Bank of England estimated median lending rates for SMEs was 3.55 per cent in August If the difference between the cost of borrowing on each loan since 2001 and the EU base rate at the time is tracked, the difference between the two begins to increase considerably in 2008 (Figure 5). As will be discussed later, the rationale which has been adopted by Finance Wales for these higher levels of borrowing costs to SMEs will be discussed later and its veracity will be examined in more detail. This is important historically but in terms of this review, the focus will be on the four main loan funds operated by Finance Wales namely Finance Wales III (the interim fund), JEREMIE Fund for Wales, the Wales Micro-business Loan Fund and the SME Fund 36. Since October 2007, there have been 743 loan investments made by Finance Wales across these four funds. As Figure 6 shows, 73 per cent of these loans have attracted a cost of borrowing of 10 per cent or higher and there have been only thirteen investments at a rate lower than 8 per cent. 35 Finance Wales also acts as the Holding Fund for the Wales Life Sciences Investment Fund on behalf of the Welsh Government although the fund itself managed by Arthurian Life Sciences Limited 36 Finance Wales suggested that as it manages various funds that range from straight debt through to mezzanine and quasi-equity products, data would be difficult to provide to the review. Therefore, detailed statistics were requested on loans only which make the majority of the borrowings from Finance Wales.

35 Table 4. Finance Wales average interest rate for all loans, YEAR OF INVESTMENT AVERAGE INTEREST RATE (ALL FUNDS) INTERIM FUND JEREMIE LIF OBJ 2 LIF TRANS LOANS OBJ 1 LOANS OBJ 2 LOANS TRANS RESCUE & RESTRUCTURE FUND SMALL LOAN FUND WALES MICRO- BUSINESS LOAN FUND WALES SME FUND WALES PROPERTY FUND AVERAGE /08/2013 AVERAGE EU BASE RATE

36 Figure 5. Cost of borrowing on Finance Wales loans, EU base rates,

37 Figure 6. Number of Finance Wales loans by the cost of borrowing, October Therefore, the evidence seems to suggest that Finance Wales loans are more expensive than the median for UK banking sector, although this must be mitigated by the fact that, according to EC regulations, state-backed funders must offer standard loans at rates that reflect the credit worthiness of the business and the collateral offered against any possible default so that this reflects market rates. The cost of borrowing and EU reference rates Finance Wales is an organisation that is wholly owned by the Welsh Government and, given this, there is expectation that its primary aim must be to support the Welsh economy, particularly the SME sector. One instrument in achieving that would have been through lower interest rates to businesses, especially at a time when banks were not lending for other reasons such as lack of collateral, affordability and overexposure in some sectors. As with all financial instruments supported by European and state funding sources, Finance Wales loan funds have to comply with EC regulations on reference and discount rates 37. Simply put, guidelines have been developed as to the minimum cost of borrowing that can be charged so that it reflects market rates, i.e. is similar to what the private sector would offer and therefore does not breach state aid rules. To determine the actual rate, a new methodology has been drawn up by the EC that takes into account both the credit rating of the business and the collateral it will offer for the loan (table 5). Table 5. European Commission guidelines on loan margins Collateralisation Rating category High Normal Low Strong (AAA-AA) Good (BBB) Satisfactory (BB) Weak B Bad/financial difficulties (CCC) Therefore, for an average SME with a satisfactory credit rating (either from a credit agency or a national/government institution) and normal collateral 38 that is applying for a loan, the financial institution utilising European or state funding to support its loans programme must, to 37 European Commission (2008) Communication from the Commission on the revision of the method for setting the reference and discount rates (2008/C 14/02)

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