When the chips are down how do SMEs fare with their banks?

British small businesses are probably on better terms with their bankers now than they have ever been but dropping their guard could be a big mistake, says Richard Willsher

The Bank of England's April 2003 report, Finance for Small Firms, notes that, in 2002, 'SMEs accounted for almost 54% of gross value added in the economy excluding the public sector and almost 40% of net capital expenditure. In some sectors, productivity of SMEs exceeded that of larger firms'. The Federation of Small Businesses (FSB) says that Britain has 3.7m small businesses while having only 10,000 large companies. So small businesses account for a huge proportion of the nation's business activity and, therefore, of its wealth generation.

The funding that oils the wheels of this mass of activity is of critical importance. And there would probably be much less discussion if it had not been for the fact that in the recession of the early 1990s the banks, who had problems of their own, deserted small businesses, causing many to experience financial difficulties and to fail. Bankers will admit privately that they made a big business and a public relations error in this period and it has taken more than a decade to get relations with small businesses back on track.

But they have been successful in healing the wounds and small businesses these days are, on the whole, happy with their banking relationships. 'We do regular surveys among our members with regard to their satisfaction levels with banks,' says Stephen Alambritis of the FSB. 'There doesn't seem to be any problem with access or the cost of the finance now - either the cost of money to be borrowed or access to that money.'

He adds that there are some outstanding issues 'around charging structures for accounts and being able to switch more easily from one bank than another to get a better deal'. The Forum for Private Business echoes these views and adds that its members are pleased that their concerns were vindicated by the findings of the Competition Commission's March 2002 investigation, Supply of Banking Services to SMEs. It concluded, among other things, that there was a lack of competition between banks offering business banking services and that overcharging was costing small businesses £725m more than it should have done.

It is still the case that the four largest providers, LloydsTSB, HSBC, The Royal Bank of Scotland Group and Barclays, account for 87% of the small business banking market. Philip Middleton, the partner who heads Ernst & Young's retail banking practice, says that although newer players are trying to compete, generally the barriers to entry are relatively high. This is largely because the cost of setting up and maintaining a nationwide business banking network is prohibitively expensive in terms of risk and reward.

In terms of how small businesses arrange their funding, the Bank of England's report and figures produced by the Competition Commission are illuminating.

The bulk of funding is provided by loans (40% of businesses surveyed), leasing and hire purchase (44%) and overdraft facilities (24%). The figures suggest that there has been a shift from overdrafts to term loans, which probably bodes well for the long-term prospects of businesses. Many of the problems of the early 1990s had to do with an over dependence on repayable-on-demand overdrafts, meaning effectively that banks could recall their funding at a moment's notice. No business can live with that in times of recession, especially not a small one with few assets.

Despite experiencing a growth in volume of business of about 20% a year, only 8% of SMEs use factoring and invoice discounting. Given that full factoring services enable companies to outsource their credit and debt collection functions, as well as providing them with the certainty of getting paid through the use of credit insurance, relatively few businesses avail themselves of the service. This may change as a result of the Brumark judgement, which weakened banks' use of fixed charges over sales revenues. Banks are now tending to encourage small business customers to fund themselves through invoice discounting or factoring, where the rights of the factor to receivables are clearly and unequivocally documented in legally actionable form.

Robin Jarvis, ACCA's head of small business, says that an important aspect of the banking relationship for small businesses is understanding how banks think. Many now fully appreciate that banks do not have what Ernst & Young's Philip Middleton describes as a 'moral duty to support small businesses'. Their main concerns are the returns they make for their shareholders and in running a viable system. Jarvis says that it is important SMEs understand the decision processes and the sorts of triggers that cause banks to arrive at their credit decisions. For example, to go into unauthorised overdraft while applying for a business loan will raise questions about creditworthiness. It would be better to use an alternative source of funds and maintain a better credit profile with the bank.

Interestingly, small businesses are, as a community, net providers to the credit system. The Bank of England's report says 'small business deposits with banks again rose in 2002 and exceed total borrowing by over £3bn'. This could indicate that small businesses are becoming more skilled in treasury management, maintaining precautionary cash balances and deposits rather than relying on borrowings.

But, according to the Forum for Private Business, the banks now acknowledge that call centre treatment of small businesses has been, in some respects, a disaster. Costs may have been minimised but what small businesses need is to speak to bankers who are able to make business decisions more or less on the spot.

Another long outstanding issue, yet to be addressed according to the FPB, is the time it takes to clear cheques. Three or four days of waiting for funds to be available for drawing is frustrating for small businesses and also raises suspicions that the banks are merely sitting on their money. It must also be said, however, that despite often free money transmission facilities available to them, a surprising number of businesses often do not use electronic payment systems such as BACS to pay or receive funds.

Another shortcoming that the FSB highlights is the long lead-time that is still involved in switching an account to another bank. However, Philip Middleton suggests that businesses should shop around to get the best service and costs.

Perhaps more important than these issues is the risk of a bank falling upon harder times itself and cutting lines of business or services. Middleton says that, these days, unlike the early 1990s, banks have better risk management systems and are more sensitive to public opinion. Nevertheless, he recommends businesses not to put their financial eggs in one banking basket. The annals of banking are full of cases of over commitment in particular areas of business and then having to scale back. The facts of the matter are clearly that, despite severe competition between banks for good banking business, small firms will always be very junior partners in business relationships with large banks. Accordingly, having more than one banking relationship and avoiding over dependence on a bank is a wise strategy. History shows us that, when the chips are down, banks will look after themselves and their shareholders before they will look after a small business customer.

Richard Willsher is a financial and business writer with a background in investment banking. He is former editor of The Investor magazine.