The Treasury’s Optical Illusion

By Philip Young

Introduction

CYK Partner Philip Young looks at part of the Treasury’s response to the current COVID-19 pandemic.

COVID-19 has brought large parts of the economy to a crash-stop. On Monday evening, the Prime Minister effectively “locked down” the country for three weeks, with only essential public and private sector services now functioning. Some non-essential private sector businesses can continue to operate from home but many cannot.

In the course of the past two weeks, SMEs have seen their revenues either dramatically fall or in some cases cease entirely for an indefinite period.

In response to the crisis, last Tuesday, the Chancellor announced a £5m government backed loan to SMEs interest free for six months. On Friday he announced an extension of the interest free period to 12 months. This is grandly called the Coronavirus Business Interruption Loan Scheme – CBILS.

This sounds like a really good idea. On its face, it potentially keeps SMEs in troubled sectors alive, maintains employment, helps to ensure SMEs pay their suppliers, their landlords and service their debts. By funnelling money into the “real economy” it helps to maintain aggregate demand, it mitigates credit contagion in the business sector and mitigates against that transmuting into a financial crisis in the banking sector.

There’s only one small problem.

The Treasury’s plan as presently formulated doesn’t work properly, if it works at all.

According to the fine print on the British Business Bank’s website, the putative SME borrower must first apply to its/a lender and only if the lender doesn’t offer a loan on “normal commercial terms” then the borrower can in theory access CBILS. The Treasury will apparently guarantee to the lender 80% of the loan (subject to an overall aggregate limit) so the lender knows it is carrying at least 20% of the risk.

This all sounds fine in theory but scratch the surface and the illusion is revealed.

1. We are all in unprecedented times. Banks can read the writing on the wall as well as anyone. A recession is looming. Banks want to lend less, not more. They want to contract their balance sheet, not expand it. They are not going to be very enthusiastic about lending to businesses on “normal commercial terms”, especially SME businesses whose revenue streams have evaporated.

2. What are normal commercial terms at the moment? Market dislocation is everywhere. If there is such a thing as a bank’s “normal commercial terms” in this environment where a material part of the economy has been shut down, at the very least it is going to involve a high rate of interest and demands for intrusive additional security including personal guarantees.

3. Any business owner who grants a personal guarantee is essentially taking the risk of his/her business onto his/her own assets. Presently it is unclear when the current crisis will end. If, at the end of the six or twelve months, not enough cash has come in the door and the principal of the loan has been eroded, all the business owner has achieved is to have transferred the loss onto his/her own personal assets and possibly risk bankruptcy. Any sensible business owner who has never given a personal guarantee (or is sufficiently collateralised for existing personal guarantees) is not going to want to take on that risk now, in this climate.

4. Also, it is unclear how the scheme works. Assume the borrower declines whatever the bank offers by way of “normal commercial terms”. In this case can the SME borrower even access CBILS? The current language on the BBB’s website implies CBILS is not then available. This needs to be clarified urgently. If that is the case, lenders will swiftly work this out and for some borrowers will seek to leverage that “take it or leave it but, if you leave it, you die” risk to their own advantage in what they offer and to whom. After all, regrettable though it is to say it, some banks do take advantage of borrowers in distress. One only has to recall the RBS/GRG scandal as an example.

5. Similarly, it appears one of the two key eligibility criteria for entry into the scheme is that the SME must show the lender that it has a borrowing proposal that, were it not for the current pandemic, would be considered viable by the lender and for which the lender believes the provision of finance will enable the business to trade out of any short-to-medium term difficulty. This bestows on the lender the unfettered power of life or death over the SME business that approaches it for lending.

6. Alternatively, perhaps the bank doesn’t particularly want to lend all the money on its own balance sheet but still wants to earn a fee while taking a lesser risk. In this scenario the lender will decline the borrowing request knowing that it can then offer CBILS, charge a processing based fee (or equivalent) plus make money on the 20% it is risking. So this is the bank evading its own responsibility to lend, passing the risk on the taxpayer but still making money out of it.

7. Furthermore, all of this is subject to each banks’ credit control process as a borrower has to approach a bank first before being able to access CBILS. Anyone with experience of bank lending knows the process can take weeks at the best of times. Each bank has different credit control processes and as between banks these are often arbitrary. In the present climate with bank branches closed, bank staff that are ill, distracted or caring for children, etc., these processes will be even slower. The BBB’s own website acknowledges that banks’ telephone lines are “likely to be busy” and “branches may have limited capacity to handle enquiries due to social distancing” and suggests businesses try to apply via website. For good businesses who historically have not been borrowers of a particular lender it will likely take longer because even if the lender’s normal commercial terms are sensible, they will probably still involve the granting of some security (such as a debenture) and it will take time to deal with the taking of security, lawyers, etc. SME businesses that need speedy access to the loan may not find the money is available as swiftly as required to keep the wolf from the door.

8. Also, at the risk of sounding cynical, the scheme creates the risk that more unscrupulous lenders may leverage the slowness of the credit control process to force some borrowers into the “take it or leave it” position referred to above.

It is difficult to avoid the conclusion that many SME businesses are not going to get any use out of CBILS at all, in other cases lenders are being bailed out from their moral duty to lend, some SMEs may go under waiting for credit committee approval etc. and some SMEs and their owners are going to become victims of unscrupulous lending behaviour.

Ultimately, if the whole point of this scheme is to keep SME businesses from hoarding cash and to keep commerce going, it’s not very effective. This can be illustrated with contrasting examples.

Consider a SME that has historically been very prudent, has never borrowed excessively from any bank, maintains sensible cash reserves against the proverbial “rainy day” and possibly has a viable business after the COVID-19 crisis has passed. This business, which is surely the archetype for the business that CBILS should support, would ordinarily tap interest rate free money, trade as normally as possible, pay its employees, suppliers and service its existing debt. Yet the owners of this business would be ill-advised to risk personal insolvency by granting any personal guarantees and may not wish to be the victims of predatory banking behaviour. They will probably prefer to try to survive by hoarding cash tactically by making some employees redundant, paying those suppliers that they have to and trying to buy time and indulgence on existing debts and obligations, and hope for the best.

Now consider, by contrast, the SME business that is in such deep water that it is probably (but perhaps not inevitably) doomed and has nothing left to lose. This is a business where the bank does not fancy the idea of lending to it on “normal commercial terms”, i.e. where the business likely has no future and there is no further useful security that the business or its owners can offer. It is this kind of business that is most likely to obtain a CBILS facility.

Thus, the taxpayer will be supporting weaker businesses while stronger businesses are more likely to go to the wall. How is that sensible?

The issues above could potentially be fixed but there is a much smarter way to lend money to SMEs to support aggregate demand in the economy, to keep businesses afloat and to preserve jobs.

Rather than place all of this power in the hands of the banking sector, why not radically reformulate the loan scheme? Why not loan money to SMEs in a simple and effective way intended to incentivise SMEs to keep people employed and, if possible, in those few SME sectors that are expanding, incentivise them to expand their workforce? The idea is simple but effective: lend against a SME’s payroll for twelve months, interest free, with strong incentives for the borrower to maintain its pre-crisis staff. This helps to keep SMEs afloat, maintains employment and thus helps to maintain aggregate demand in the economy, assists SMEs in meeting their obligations to suppliers and helps keep their existing lenders satisfied, at least until the COVID-19 pandemic has passed. Ensuring banks play no more than an administrative role accelerates the process, avoids demands for onerous further security and mitigates the risk of unscrupulous lending activity.

Fortunately, this very proposal has been originated by Fideres Partners LLP, a leading consultancy. In an ingenious intervention, it has brought forward proposals to achieve exactly this. Fideres has set out how the existing CBILS scheme could be reformulated to work effectively, see: https://fideres.com/news/press-release-fideres-s-commentary-on-the-coronavirus-business-interruption-loan-scheme

To his credit, the Chancellor has been taking steps to try to support the UK economy in these perilous and unprecedented times. The existing CBILS programme is an optical illusion but the fundamental idea of lending to the SME sector is sound, indeed vital and necessary. It can and should be made to work. The CBILS programme should be immediately reformulated along the lines already proposed by Fideres.