The Brits’ Bureaucratic Business Banking Boost?

Between North Korea’s agricultural reforms and China’s new financial reform plans, Monday was a banner day for economic policy. The UK joined the fun, too, when Business Secretary Vince Cable announced a plan to boost small-business lending: Creating a state-backed business bank.

State-backed business (aka, development) banks aren’t a new concept. Germany’s Kreditanstalt für Wiederaufbau, established in 1948 under the Marshall Plan, provides loans to small businesses and entrepreneurs through retail banks. In 1934, FDR launched the US equivalent, the Export-Import Bank, which lends to small exporters directly and underwrites some commercial lending.

Details of the UK’s version won’t be clear till they’re formally unveiled December 5. But in his speech at the junior coalition partner Liberal Democrats’ annual conference, Cable said the government will provide £1 billion of seed money, and it hopes to attract £1 billion in private capital and raise £8 billion on primary debt markets (similar to Germany’s model). Cable suggested the bank will function as a wholesale lender, though who’ll control lending decisions is uncertain. Some reports say the bank would channel loans through some of the UK’s newer, smaller banks. Other outlets say it could bypass banks with a derivative of the peer-to-peer lending model.

Of course, it’s uncertain whether this can help boost the UK economy, which counts slow lending among its bigger headwinds. Overall loan growth continues to lag developed-world peers, and small business lending has shrunk for some time. Government programs like Project Merlin and the National Loan Guarantee Scheme have tried to address the problem without much success. The latest attempt, Funding for Lending, is in its infancy but has reportedly helped mortgage lending more than commercial lending. Cable argues these programs failed because they relied on what he calls the UK’s “broken banking system.” He claims banks are still rebuilding balance sheets post-2008, and a government bypass is the only solution.

Except that rather mischaracterizes the UK’s banking troubles. Banks’ balance sheets, while not perfect, are in better shape than he suggests. But banks are grappling with regulatory uncertainty, which lowers the incentive to lend—there’s not much point in assuming more risk now if they’ll have to make significant adjustments later on. The Independent Commission on Banking (ICB), tasked in 2010 with recommending ways to improve financial regulation, spent 15 months investigating UK banks and hinting of significantly tighter regulations. Its proposed reforms, released last September, would have given the UK some of the world’s toughest capital requirements. Banks got a reprieve when Chancellor George Osborne announced watered-down reform legislation in June, but now the BOE, which will soon assume all supervisory duties, is exploring new ways to toughen oversight—including adding the ability to set leverage ratios on a case-by-case basis.

Hence, even if Cable’s plan works as intended and small business lending increases by £10 billion over the next few years, it’s a patchwork solution at best. It doesn’t fix the banking sector’s underlying issues. A more efficient approach would be to ease banks’ regulatory burdens, giving them more incentive to lend, which would foster more sustainable improvement. Rather than replace private-sector activity, government should simply enable it.

Considering Osborne’s previous plans were private-sector focused, he likely understands this. His approval of Cable’s plan probably isn’t so much a U-turn as a byproduct of coalition politicking. The Liberal Democrats have lost significant support since joining the coalition, prompting party leader and deputy Prime Minister Nick Clegg to release a video apology for backtracking on campaign pledges (Auto-Tuned viral version available here). Meanwhile, the Labour party has surged, and the Liberal Democrats are already eyeing a potential center-left coalition with Labour in 2015. Proposing the Labour-championed development bank may be their way of cozying up to Labour and its supporters. Ditto, perhaps, for Clegg’s continued call for a wealth tax despite Osborne and Prime Minister David Cameron’s staunch opposition. Perhaps Osborne and Cameron merely agreed to the development bank in hopes Clegg et all will be mollified enough to drop the wealth tax call and opposition to labor market reforms.

Overall, while a development bank might not be the most efficient way to promote UK lending, we suppose there are worse ways for governments to compromise. Besides, with Funding for Lending and its sister program, UK Guarantees, still running, there’s still ample room for the private sector to compete.