In Investment, Startup Management

A bank’s job is to keep savings safely locked up, not to make risky loans.

For this blog entry I’m stealing unashamedly from Les Charm of Babson College, who I saw speak last week at one of the closing sessions for the 2011 Saltire Fellowship (congratulations to all the newly graduated fellows).  He put forth a view about banks that I have long held in a very succinct way, which I will share with you here.

When banks lend money, they are lending the savings of their depositors.  Banks have promised to give the depositors their money back on demand – their survival and public confidence in the banking system depends on them keeping that promise.

Banks will lend money only where:

  • There is collateral for the loan (there is something the bank can take and sell to get its money back if the loan isn’t repaid)
  • There is a proven track record of cash flow to service the loan (usually at least one year of accounts)

This is a simple necessity for them, given that the acceptable risk on a bank loan is nearly zero.  They can stand some very small risk, which is funded by the profit that they make on each loan, but as the market is so competitive (especially in the UK and US) margins are small so necessarily risk must be small.

This is not an example of banks being evil, reckless or damaging to society – this is the very essence of banking.  What we are seeing now is not a temporary reluctance to lend, it is “business as usual” after an exceptional period.

In the good times before the current crisis, some banks got greedy and forgot these simple rules and got into huge trouble.  Some borrowers got used to borrowing money very easily without meeting these rules.  Many of them have now defaulted on their loans and are suffering the consequences.  This was the very essence of the financial crisis: it started with mortgage loans made to those without the cash-flow to repay them secured with unrealistically valued properties as collateral.  I hope it will be a long time before banks forget the rules again.

Another key point for entrepreneurs to remember is that there are fundamentally three reasons why a business wants to borrow money:

  • To fund the purchase of property or capital equipment – usually in this case the purchase will act as collateral for a loan, much like in a domestic mortgage or car loan.  In order to lend for this purpose however, the bank will still want proof of cash flow to service the loan.
  • To fund growth – When a company wants to grow beyond the Self Financable Growth (SFG) rate, cash is needed to finance cost of sales until cash is received from the customer.  In this case, profitable growth at or below the SFG rate can provide evidence of cash flow, or growth above the SFG rate that has been funded by other means (e.g. equity).  At least a year of good cash flow will usually need to be documented to provide evidence for a loan, and collateral for a loan will also be needed.  Thiscan come from the assets of the company or the founders/directors.
  • To fund losses – When a company is losing money, it is usually also losing cash.  Borrowing may prevent the company from running out of money, but a loss making company is likely to want to keep borrowing more, and is unlikely to repay the loan.  Banks will very seldom lend in this situation.

Many businesses that go to banks to borrow money are turned down – but anecdotal evidence from bankers tells us that most of these businesses are trying to fund losses, or to fund growth with no collateral or evidence of cash flow.

For the business this can seem like a catch-22.  No loan without assets and a track record, no assets or track record without a loan to get started.  The simple truth is that while businesses do need money to get going, a bank loan is seldom the right place to get it.  Money for starting up is by definition risky, and banks don’t take risk.  It’s not in their nature and nor should it be.

Most businesses get money to start up from the founders pockets or from Friends, Family and Fools.  Later, they may take money from external investors who are in the business of funding risks in exchange for big rewards.  Only once the business has a proven track record and assets for collateral should businesses start to turn to banks for finance.

Suggestions that “banks should lend more to small business”, especially from politicians, tend to ignore the reality of the purpose of banks.  If government want to stimulate loans to small business, they need to take action to make that commercially attractive and low risk to banks, such as guaranteeing the loans.  Current schemes like the Enterprise Finance Guarantee Scheme do this, but not widely enough to promote the lending government is calling for.  Perhaps I am being too cynical, but maybe calling for action from the banks in the newspapers (effectively passing blame to the banks) at a time when banks are already unpopular is easier for government than taking action themselves?

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