Financing Investment Reforming finance markets for the long-term Alfie Stirling and Loren King ippr commission on Economic Justice

IPPR  | 

 Financing Investment Reforming finance markets for the long-term

15

IS THERE STILL A FINANCE GAP? 

Nonetheless, at a disaggregated level, there remain concerns that the 

allocation of finance in the UK may not be optimal. Prompted by the finance 

and investment environment since the financial crisis, the Bank of England is 

seeking to understanding the extent to which the supply of finance is failing to 

support productive investment. A first report in the summer of 2016 described a 

mixed picture, with the main conclusions being that the UK lacked sufficient data 

(Bank of England 2016). But their disaggregated analysis of rates of return data 

in particular did find evidence consistent with a continuing finance gap. All else 

being equal, if finance markets are working properly, the supply of credit would 

be expected to flow to the greatest opportunities for a high return. Over time, 

this would mean that high rates of return tend to revert back to the average. 

Conversely, persistently higher rates of return over time in some areas may 

suggest something is wrong. Modeling by the Bank of England using data from 

1996 to 2012 found that on average across the period lending to small firms had 

a 3 per cent higher rate of return on capital compared to large firms, a result 

that was robust even after controlling for industrial sector, internal funding and 

collateral (ibid). Younger firms also had a statistically significant higher rate of 

return on capital compared with mature companies.

On their own, the higher rates of return found by the Bank of England could simply 

reflect a risk premium for small businesses, or else methodological issues in 

measuring the stock of assets. The argument that the supply of finance may be 

part of the problem, however, is supported by collaborative academic research by 

analysts at the Centre for Macroeconomics, the Bank of England and the Institute 

for Fiscal Studies (IFS). Econometric evidence from data going back to 1970 found 

that the relationship between the degree of dispersion in rates of return, both 

across and within sectors, and the flow of capital resources towards higher rates, 

had changed since 2008, with finance becoming much less responsive to new 

opportunities (Barnett et al 2014). The authors concluded that frictions in the 

financial system were likely to have contributed to the collapse in UK productivity 

growth since 2007. This is further supported by additional internal research at 

the Bank of England which showed that contractions in the supply of credit had 

a large impact on investment, productivity and wages, even after controlling for 

consumption in the economy (Franklin et al 2015).

A closer look at SME loans also reveals that the recovery in aggregate net 

lending appears to have been driven entirely by net lending to medium-sized 

firms only (see figure 5). Net lending to small businesses, those with less than 50 

employees, has been negative in all but one quarter over the last five years. This 

means that new lending to small firms has been insufficient even to maintain 

the level of outstanding credit to small firms, let alone expand upon it as might 

be expected during an economic recovery. Small businesses are still 10 per cent 

less likely to have their application approved than medium-sized businesses 

(BBAa 2017), and they are also most likely to cite the cost of external finance as 

a major obstacle to investment (Saleheen and Levina 2017). The success rate 

for loan applications does not appear to have changed much since 2012 but 

demand for loans from small companies fell by 25 per cent between 2012 and 

2015 (IPPR calculations using BBAa 2017).

IPPR  | 

 Financing Investment Reforming finance markets for the long-term

16

FIGURE 5

Net lending to small business within SME has still not recovered and continues to fall

Net lending (£ million) to small, medium and all SMEs, Q3 2011–Q1 2017

Small

Medium

SME

-£1,500

-£1,000

-£500

£0

£500

£1,000

£1,500

20

11 Q

3

20

11 Q4

20

12 Q1

20

12 Q2

20

12 Q

3

20

12 Q4

20

13 Q1

20

13 Q2

20

13 Q

3

20

13Q4

20

14 Q1

20

14 Q2

20

14 Q

3

20

14 Q4

20

15 Q1

20

15 Q2

20

15 Q

3

20

15 Q4

20

16 Q1

20

16 Q2

20

16 Q

3

20

16 Q4

20

17 Q1

Note: The BBA defines small firms as those with 0-50 employees and medium-sized firms 

as 50-250 employees

Source: BBAb 2017 

There is particular evidence of a finance gap among the fastest-growing small 

firms. High-growth start-ups are key drivers of economic expansion and account 

for a disproportionate amount of job creation (Haltiwanger et al 2013). Yet recent 

analysis by the British Business Bank found that the supply of growth loans (up 

to a value of £2 million), specifically for small fast-growing companies, fell short 

of demand by between £170 and £870 million in 2014. The authors argued that 

the gap would be significantly larger if loans between £2 and £5 million were 

accounted for as well. This is especially concerning given that the UK already 

sits behind other comparable economies in the success rate of such companies. 

Despite having a relatively large number of start-ups, the UK was the second worst 

performer (out of a panel of 14 OECD countries) for the percentage of micro firms 

who grow to over 20 employees in three years (for example 3 per cent in the UK, 

compared to 6 per cent in the US) (BBB 2017).

Given the current crisis in productivity and wages – and the political consensus 

on the need to tackle this – ensuring that business finance meets current levels of 

investment demand should be just the minimum requirement for policy makers. 

The real question is not whether business finance is sufficient to support current 

needs, but whether it is capable of supporting and driving an improvement in 

productivity through higher capital investment in the economy. It is certainly true 

that we need better quality data to understand the direction of causation between 

demand and supply. But the evidence of continuing frictions in the supply of 

finance – even for the UK’s current low-wage, low-productivity economy – should 

be a serious cause for concern. 

IPPR  | 

 Financing Investment Reforming finance markets for the long-term

17

THE PROBLEM OF REAL ESTATE 

Due to its role in money creation and the safeguarding of savings for retail 

customers, the mainstream banking industry, on average and in aggregate, is 

made up of highly collateralised lenders. This has been further emphasised 

since the financial crisis, with the international Basel III Accords tightening 

safety requirements, expanding capital buffers and precluding large volumes of 

unsecured lending that had previously been tolerated – all of which have limited 

the activities by banks in originating loans for SMEs (Angelkort and Stuwe 2011). 

Nonetheless, bank lending in the UK is particularly focused away from  

non-financial businesses by international standards. Loans to UK businesses 

account for 5 per cent of total UK bank assets, compared to 11 per cent in 

France, 12 per cent in Germany and 14 per cent on average across the rest of 

the Eurozone (European Central Bank 2017). Bank lending to the non-financial 

economy in the UK is also disproportionately dominated by real estate. As figure 

6 shows, the ratio of real estate lending to business loans is notably lower in the 

UK than in the Eurozone. Real-estate loans to business and individuals account 

for over 78 per cent of all loans to non-financial UK residents. After stripping out 

real estate, loans to UK business account for just 3 per cent of all banking assets 

(Bank of England 2017).

5

FIGURE 6

The ratio of real estate lending to business loans is significantly lower in the UK 

compared with the Eurozone

Mortgage and business loans as a proportion of all banking assets, UK and Euro area

Business loans

Loans for house purchase

0%

5%

10%

15%

20%

25%

30%

Euro area

UK

Source: European Central Bank 2017

The disproportionate focus of UK financial institutions on real estate bodes poorly 

for expanding productive investment among smaller firms. The bulk of real estate 

5 

These calculations consider only loans made to UK residents in Sterling. Loans in foreign currency to 

UK resident are excluded since we are primarily interested in loans that are most likely to contribute 

directly to investment in the UK.

IPPR  | 

 Financing Investment Reforming finance markets for the long-term

18

loans and mortgages do not increase the productive capacity of the economy nor 

contribute to GDP growth or higher wages; instead their primary effect is to drive 

up asset prices (Werner 1997). The reliance on collateralised lending in mainstream 

banking is also consistent with the evidence of a finance gap for small, fast-

growing business discussed above. More importantly, it suggests the banking 

industry is poorly positioned to boost UK productivity growth beyond its present 

low rate by helping such firms increase their capital base.

The evidence suggests that firms that are unable to access collateralised lending, 

but would otherwise represent viable investments, are likely to be systemically 

underfinanced by banks. In a recent Bank of England survey, nearly 25 per cent 

of SMEs said they were constrained in their borrowing by the need to provide 

collateral (Saleheen and Levina 2017). Furthermore, not only is more than two-

thirds of lending to small and mid-sized corporations

6

 secured on property, 

but a third of total lending also comes with a personal guarantee, with a claim 

against personal residential property (Bahaj et al 2016). While firms regularly 

use their own real estate assets to secure investments, recent Bank research has 

highlighted that the residential real estate assets of firm owners are also a key 

source of investment collateral). Bahaj et al estimate that a 10 per cent increase in 

directors’ house prices boosts firm investment by 0.2 per cent, while for corporate 

real estate, investment increases by 0.9 per cent.

7

 This explains the strong positive 

correlation between house prices and business investment: the role of collateral 

make investment effectively dependent on stable or growing real estate prices.

Allowing the rate of small business finance to be determined by the availability 

of real estate collateral is particularly concerning given the recent trajectory 

in intangible investment. As the economy becomes increasingly reliant on 

service sectors, the profit return on labour will become increasingly contingent 

on less tangible assets such as skills, management models and computerised 

information. Technological advances have seen intangible investment become 

larger than tangible investment every year since the early 2000s (Goodridge et 

al 2016). In 2014, investment in intangibles was worth £133 billion – made up 

of spending on training, organisational systems, design, software, branding – 

compared with £121 billion for tangibles (Ibid). However, intangible assets are 

notoriously difficult to measure, and they are therefore rarely conceived as a 

possible source of collateral. 

Some of the market in non-collateralised financing of small and growing firms is 

currently met by venture capital and private equity investors. While only 6 per 

cent of all SMEs consider equity funding, 12 per cent of start-ups do (Ipsos MORI 

2017). The recent growth in alternative finance markets such as private equity, 

peer-to-peer lending and crowdsourcing is encouraging and positive. These 

types of funding have gained a foothold in areas of the market not reached by 

banks by providing capital to riskier projects. Successful providers of risk capital 

are able to take on these projects by utilising specialist expertise in the firms 

and sectors in which they invest, making up for a lack of collateral through a 

more sophisticated assessment of the risks and opportunities, as well as by 

charging a higher risk premium. However, this area of the market is recovering 

no faster than general bank loans to SMEs and, like bank loans, private equity is 

disproportionately focused on medium-sized firms, as opposed to small ones. 

Gross flows of alternative and equity finance have remained consistently at 

around 35 per cent of gross bank loans since 2011 (IPPR calculations using BBB 

2017) This suggests that equity finance will not be able to grow sufficiently to 

6 

Defined here as firms with turnover of less than £500 million

7 

Though the residential real-estate price effect is smaller, it should be noted that the UK median firm 

has corporate collateral only worth 6 per cent of turnover. By contrast, the directors of the median 

firm have residential property which between them is worth around 20% of annual turnover.

IPPR  | 

 Financing Investment Reforming finance markets for the long-term

19

meet the level of demand for financing not backed up by traditional collateral 

which is required in a higher investment UK economy. 

At present, two structural weaknesses appear to prohibit the growth potential of 

alternative finance. First, private equity can be prohibitively expensive,

8

 while also 

requiring a loss of control for business owners. Second, whereas bank lending to 

SMEs is distributed reasonably proportionately to the distribution of SME firms 

across the country, alternative finance is skewed heavily towards London-based 

companies. London-based firms account for just over 20 per cent of all high-

growth firms across the country, yet they receive almost 50 per cent of equity 

investments and more than 60 per cent of all venture capitalist investments 

(Hatfield 2017). 

POLICY PROPOSALS 

The available evidence suggests that there are still problems in the supply 

of finance across firms, particularly small high-growth businesses. A lack of 

financing for these firms is particularly worrying since they are a principal vehicle 

through which the UK economy needs to transition from its low-capital, low-wage 

equilibrium to a higher-capital, high-wage one. Our analysis suggests that this is, 

in part, an opportunity cost problem. Because banks can focus on intra-financial 

sector activities, and on real-estate, they are unlikely to devote the resources 

necessary to understand and evaluate the uncertain and specialised investment 

opportunities that high-growth firms tend to pursue. 

To address this, there is a strong case that policy-makers need to adopt a new 

approach to banking incentives. Rather than seeking to increase aggregate levels 

of funding through horizontal interventions such as the funding for lending 

scheme that make all business lending more attractive, government needs to 

shift the balance of incentives for different banking assets. Based on both the UK 

experience and that of other countries, there are at least three ways to do this.

1.  Boost alternative finance markets, especially outside London and the Southeast.

2.  Rebalance incentives for bank lending to small business by creating a market 

in non-tangible collateral and raising the risk premium for real estate.

3.  Create new specialised investing institutions that are restricted by their 

governance mandate to invest only in tightly defined markets. 

The first of these options is already being pursued by government through the 

British Business Bank and it would appear to be having some success. IPPR has 

previously recommended that the BBB should address the geographic imbalances 

in alternative financing by making geographic dispersion and diversity a more 

explicit part of the institutions mandate (ibid). This is a proposal that we reiterate 

here.

On the second of these options, we propose that the Government and the Bank 

of England examine two complementary policy initiatives: supporting the private 

sector to use intellectual property (IP) as collateral in lending markets; and 

increasing the relative costs of real-estate loans. A number of countries, such as 

Malaysia, Brazil and Singapore have sought to develop IP-backed lending schemes 

(Brassell and King 2013). Even in the UK, private investors increasingly look at IP to 

evaluate businesses. However, a more expansive use of IP as a form of collateral is 

currently inhibited by a lack of public information (ibid). As such, a clear inventory 

of the IP and intangibles held by firms could help lenders better assess the value 

of these assets and the extent to which they could be used as collateral. As it is 

8 

The actual cost of private equity will vary depending on the equity share of investors and the 

profitability of the firm (the more profit a firm makes, the more valuable the equity and the more 

expensive the original investment). 

IPPR  | 

 Financing Investment Reforming finance markets for the long-term

20

already focused on improving information flows between businesses and lenders, 

the BBB could play a major role in developing such a registry. It could develop a 

toolkit to help lenders assess the value of intangibles, and more directly it could 

require, whenever private lenders make use of its schemes, that IP and intangibles 

be identified and valued in the financing process. 

Separate measures could also be taken to increase the relative costs of real 

estate lending. The Bank of England’s Funding for Lending Scheme (FLS) and the 

Term Funding Scheme (TFS) both give private banks access to cheap funds on the 

condition that the savings are passed on to the non-financial economy. The FLS 

scheme allowed private banks to swap assets for Treasury Bills, which could in 

turn be used to borrow cash at low rates on wholesale debt markets. The Bank 

has gradually adjusted the terms of the FLS in response to the external credit 

environment, for example excluding mortgage lending from the benefits of the 

scheme in January 2014 in order to improve incentives for SME lending. The Term 

Funding Scheme was announced in August 2016 to help ensure the benefits of a 

lower interest rate were passed on to the rest of the economy, by allowing banks 

to swap assets for central bank reserves. We propose that the Bank of England 

adjusts the terms and conditions of either or both of these schemes, or examines 

the case for a new scheme, to increase the cost of funds for real estate loans and 

to reduce costs for lending specifically to small firms within SMEs.

SPECIALISED BANKS 

There is also a strong case for institutional innovation in business finance markets: 

in particular, for the creation of specialist banks or state investment funds that are 

restricted to investing either in certain sectors or in certain regions of the country. 

There is growing evidence that, in countries which have them, public banks 

have proved better suited to provide patient capital for high-growth firms than 

traditional investors. Even in those sectors with a highly developed venture capital 

market, most fast-growing firms still struggle to tie down long-term financing, 

with most investors expecting a return within three to five years (Laconic & Tulum 

2011). Some sectors, such as biotech, are more suited to moving from one investor 

to next because of the availability of natural exit points in the development of 

drugs (Lovering et al). But for most industries the innovation process has far more 

risks and uncertainties (Mazzucato 2016). Because their governance priorities 

do not necessarily require short or even medium-term profits, public banks can 

provide more stable financing over a longer time horizon. Many of the existing 

state development banks internationally were created in order to take advantage 

of precisely this attribute. KfW in Germany was created to fund post WWII 

reconstruction, while Brazil’s BNDES’s original purpose was to fund large-scale 

infrastructure projects. More recently, state investment banks have stepped in to 

fill in the post-recession vacuum in green energy lending (ibid).

In addition to being more patient, specialist public banks can also be effective 

at lending to areas of the economy not always reached by traditional banks and 

investors. In a recent review of the international evidence on regional banking, the 

New Economics Foundation found that, in Switzerland and Germany, the majority 

of SMEs rely on local banks (NEF 2015). In Switzerland, 80 per cent of medium firms 

and 58 per cent of small firms bank with their cantonal bank. In Germany, 75 per 

cent of SMEs bank with one of the local Sparkassen, which are publicly-owned, 

local independent banks. Though many of these banks have a public interest 

mandate, they are run like commercial banks but with a narrowed and specialist 

focus tailored to the local area. NEF’s review of the commercial viability of local, 

specialist banks found that their rate of return averaged around 10 per cent, but 

that returns were far less volatile than those of larger international banks. Local 

banks were also found to be more likely to lend for productive investment, rather