Study backs banks' line on small firms

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BANKS are being forced to take a tough line with small businesses partly because their directors pay themselves a large proportion of their firms' earnings, according to a study commissioned by National Westminster Bank from the University of Leeds and the School of Management at UMIST.

High cash withdrawals by directors explain why banks step in so readily to monitor firms they believe are at risk, and why they demand such tight security.

The study, which suggests banks are bearing a large proportion of the risk in small firms without sharing the rewards, shifts some of the blame for current problems on to the way small firms themselves operate. It is based on a detailed five-year analysis of 110 firms in Yorkshire.

With 70 per cent of net operating income going to directors' remuneration, a bank cannot secure its loans on a firm's earnings. Instead, it has to demand personal security - such as directors' houses - which has proved a serious friction between small firms and banks during the recession.

Many of the conflicts with banks are an inevitable result of the owners' desire to find outside finance while not giving away equity, the study suggests.

Directors' decisions on whether to put their own cash into the business to expand, or alternatively to look outside for bank finance, are 'as much driven by personal wealth issues as by the performance of the firms', it says.

It finds that among the 110 firms, the bank matched pound- for-pound the amount the owners invested, with each supplying 31 per cent of total financing. Yet directors received an annual 45 per cent return on their equity while the banks were paid only 10 per cent on their loans.

Banks claim their loans to small businesses have many characteristics of equity. Yet they receive only loan interest and do not share in profits.

The study, by Kevin Keasey and Robert Watson, concludes that small firms' recent problems are partly due to the increase in bank funding in the late 1980s. It also says the firms in the survey were not charged particularly high rates for their loans, and those that borrowed tended to be faster-growing companies.

The Chancellor is due to meet the clearing banks this week to discuss loans to small firms. A Bank of England report to the Chancellor is expected to clear the banks, saying there has only been a small increase in interest margins over the past 18 months, and that this is not out of line with the increased risk.

Stephen Alambritis of the Federation of Small Businesses said: 'What we have is a credit squeeze, with banks not giving up new money to get small businesses going, or giving money to existing businesses who want to re-equip and replenish stocks.'