How to fix the funding gap: Where small firms can go to get their finance

Financing is the bane of the life of any small or medium sized business now, and that's a big problem for the UK economy.

Despite repeated calls on banks to do more, figures on net lending (which includes money being paid back) from the Bank of England indicate that there is only a trickle of new money finding its way into the market. That is despite the cheap money made available by the Bank. In fact its last "Trends in Lending" report found that the supply of credit from banks fell during the second quarter of the year.

A report on alternatives sources, compiled by management consultant Ares for City lobby group TheCityUK, and published yesterday, says this is a problem that needs fixing. It points out that banks still provide 80 per cent of SME (small and medium sized enterprise) financing in Europe compared to 20 per cent in the US, where the economy was proving notably stronger than Europe's before its government shutdown.

This over-reliance on banks, it says, is "a vulnerability for the wider European economy" given what happened during the financial crisis and the importance of the SME sector in terms of the jobs it provides.

The report calls for action in the UK to rectify the situation and it highlights potential sources of finance that small businesses in this country are, for one reason or another, unable to exploit.

Germany and the US, for example, facilitate direct lending - or placement - to SMEs from institutional investors which either can't or won't get involved in the UK where the market simply doesn't exist. Meanwhile the securitisation market for loans to UK SMEs - whereby packages of them can be sold off to investors freeing up capital for new lending - remains closed.

Part of the problem facing investors, ranging from wealthy individuals to pension funds, who might want to get involved in business finance is a dearth of information on businesses to which they might lend.

To address this, the report wants to see the development of a rating system (although the one provided for bigger companies and sovereigns by ratings agencies was found badly wanting during the financial crisis) plus an information exchange. The ability to access information, more than anything else, could encourage investors to tap this market, although regulators can play a role too by removing red tape that gets in the way.

Chris Cummings, chief executive at TheCityUK, says: "Given current constraints on lending, it is vital to European businesses that alternative financing solutions come to the fore to complement mainstream banking lending. It is clear that alternative finance has an increasingly important role to play.

"Closing the funding gap for smaller and mid-market companies will require a regulatory level playing field for alternative financing, recognising its value to SMEs and mid-market firms, alongside bank finance. This in turn requires the normalisation of banking markets, including addressing the impact of provision of cheap liquidity by central banks."

But the banking market isn't likely to normalise any time soon.

Regulators are pushing banks to hold more capital. While they have told banks they shouldn't seek to build up their buffers by constraining lending, their behaviour suggests that is exactly what the banks are doing.

The previous Governor of the Bank of England Sir Mervyn King became so frustrated with the situation he was even moved to write to the owner of a profitable small business supplying parts for air compressors who was left furious after he was refused a loan for a new van.

John Allan, national chairman of the Federation of Small Businesses, describes the report as "welcome". He says: "The ideas around private placements and easier access to credit information should help more firms, especially new businesses which may not have a credit history, get the funds they need.

"Alternative sources of finance, such as peer-to-peer lending or asset-based lending, need further promotion. Peer-to-peer lenders are known by almost two-fifths of FSB members, with just under half aware of credit unions, illustrating that more communication is needed if use of these sources is to be increased."

The problem is that encouraging greater provision of alternative finance for SMEs will take time.

Suren Thiru, UK economic adviser at the British Chambers of Commerce, says that while alternative finance is "important" and "should play a greater role" in financing SMEs it remains "a niche aspect of business lending". He thinks that the Government's mooted Business Bank could fill the gaping hole in SME businesses' funding needs more quickly, and says: "It could revolutionise access to finance if it was provided with the scale to succeed.

"We'd like to see an extra £9bn invested into the Business Bank over the next three years, as only then will we have a bank that is of the scale to nurture a British Google."

Loan arrangers: How Germans do it

Who's getting it right? Think Germany (again). Long renowned for its corps of successful, largely family-owned Mittelstand firms, it's also winning the battle to find sources of financing for them beyond traditional bank loans.

While the UK has no "private placement" market where companies can seek financing from institutional investors rather than banks, Germany's is thriving. The latest figures show German companies secured €13bn (£11bn) from this channel in 2012. Institutions ranging from insurance companies to investment funds – and even banks – are involved.