Commentary: Seeing risk lending in a new light

The Chancellor's in-tray is piled high with proposals for helping small businesses, and the signs are he and the Prime Minister are receptive. This is a crucial area where jobs growth will come, and where tax and other changes from the centre can have a big effect without direct pump-priming with state money.

The CBI has been pressing for larger capital allowances, higher corporation tax thresholds, new exemptions from capital gains tax and encouragement for equity finance. Small business lobbyists such as the Forum of Private Business have put forward a low-cost package of tax and administrative changes.

Brian Pearse, the chief executive of Midland Bank, has suggested a well thought-out package including a small manufacturing firms' support scheme, tax incentives, subsidised loans, encouragement to owners to retain profits within firms and a long-overdue right to interest on late payment of debt.

He also wants owners of firms to accept more outside equity and banks to encourage longer-term lending and a move away from the vulnerable overdraft, while improving their credit assessment skills.

Indeed, given the dependence of small business on the banks, in practice only the clearers, with their huge networks, can have any rapid impact.

It is stating the obvious to say that the worst problem of the recession is that many of the one-third of small firms that have net borrowings were allowed to take on too heavy a burden of debt.

A characteristic of many problem firms is that, to all intents and purposes, the debt has proved to be equity. This arises because property has turned out to be untrustworthy as security. The result is that banks have been quasi-equity holders, losing all their money as the firm goes down. They will not put their enthusiasm behind small firms until better ways of helping them are found.

The answer in many cases is not equity, which is useful but prompts the difficult question of how to make correct venture capital judgements - never really a banking strength. Instead, some of the financial engineering of the 1980s could be used to better effect, to make much more intensive use of small firm loans with equity characteristics, which gear the bank's return to profits.

Why should a highly profitable firm object to paying 10 per cent over base rate once a profit target is achieved if the loan started at 1 per cent over base when times were hard? The potential reward of financial innovation - used to good effect this time round - coupled with improved credit assessment would encourage risk lending in a way that conventional banking returns never will.