How are mid-sized SMEs affected by recent banking turmoil?

Although the downfall of Silicon Valley Bank (SVB) and Credit Suisse were caused by different factors, they serve as a reminder of the potential for contagion to spread and mushroom very quickly from seemingly regional problems into issues of global significance.

It is worth assessing, therefore, how March’s banking turmoil may impact the ability of mid-sized businesses to access new funding either via banks or through non-bank lenders such as ThinCats.

A useful starting point is to look at the business models and sources of debt capital for each type of lender.

Banks are complex businesses

Whilst the idea of a bank lending out money at a higher rate than it pays to depositors is a simple concept, the reality of modern banking is much more complex. This additional complexity has been created by banking regulators since the global financial crisis to further protect deposit holders by requiring banks to put aside more capital when lending to SMEs.

Structural risks associated with modern banks’ business models include:

• Liquidity mismatch

Banks typically hold only a fraction of the cash needed to repay their deposit holders at any moment in time. Known as “fractional banking” the balance of the depositors’ funds are lent out to business or consumers or held in instruments such as government bonds and other investments where there is potential to earn a greater return.

Some of these assets can be converted into cash more quickly than others and in some cases the bank may crystallise a loss in doing so, further eroding its financial strength. This is what happened to SVB who needed to sell investments in government debt, which had fallen in value due to rising interest rates.

Furthermore, the emergence of online banking and the speed of modern communications can quickly create herd mentality among concerned depositors leading to a classic “run on the bank” in a matter of minutes.

• Regulatory constraints

To reflect that risks vary according to the type of loan, regulators insist that all banks hold back deposits according to a ‘risk weighted asset’ (RWA) factor. Large banks have internal models signed off by the PRA, whilst smaller or challenger banks are subject to standardised rules. Overall, the rules penalise SME lending (vs mortgage or consumer lending) and larger non-asset backed lending. Banks seek to maximise their return on RWA (rather than just a simple return on assets) and this can reduce appetite for larger SME lending.

• Exposure to risks from multiple business lines

Large banks such as the UK’s big 5 (HSBC, Natwest, Lloyds, Barclays and Santander) employ tens of thousands of people across multiple business and product lines. Not only are these banks complex and difficult to manage, but the breadth of their activity means they are open to risks from their subsidiary businesses damaging trust in their core banking business. This ultimately led to the demise of Credit Suisse.

With these multiple business lines, banks tend to subsidise certain business lines from others eg lending rates may be lower because ancillary business lines eg payments, FX contribute to the overall client revenue.

• Competitive tension

The rise of the fintech sector means many business areas previously dominated by banks are under pressure from new entrants for both personal and business banking services. This additional competitive pressure is forcing banks to cut margins on historically profitable activities or withdraw services to lower value customers.

The illustration below shows just a selection of recent entrants now competing across a wide range of services offered by a typical big 5 UK bank.