Small-cap lenders take off

On top of that, European banks will need to shed a further €3,400bn (£2,934bn) from their balance sheets to meet Basel III regulatory requirements through asset disposals and reduced lending. Last year, nearly 90 per cent of all deleveraging was focused on reduced lending, and the year ended on a miserable note, with bank lending to businesses falling 2.2 per cent in December – the eighth consecutive monthly decline and the worst monthly figure for nearly three years.

Stepping into the breach

That has provided an opening for a number of small companies to step into the breach to offer some good old-fashioned banking. And much-needed it is, too.

According to the Federation of Small Businesses, at the start of 2012 there were 4.8m SMEs in the UK employing 23.9m people, with a combined turnover of £3,100bn. They also accounted for 99.9 per cent of all private sector business and 59.1 per cent of private sector employment. Many of these have relatively modest financial requirements, but they need more help with the headaches of cash flow, invoices and credit guarantees. Barclays Business Banking has calculated that SMEs are currently owed more than £36bn in late payments.

So, with the retreat of high street banks and the £1bn funding gap left by ING, which was one of the UK's largest credit suppliers to SMEs, specialists such as 1pm (OPM), Ultimate Finance (UFG) and City of London Group (CIN) have burst onto the scene.

The funding gap that mainstream lenders have opened up could arguably be closed, but banks are likely to remain preoccupied with sorting out their loan books and meeting ever-more stringent regulatory reserve requirements for at least another two or three years.

And even if they try to resume SME lending on the same scale as before, by then the start-up lenders could have built up an established customer base - one that they will be keen to remind just how shabbily major lenders treated them in the past. Moreover, any bank thinking about returning to the SME market will almost certainly be constrained by a lack of expertise, and as City of London Group chief executive Eric Anstee points out, many of the teams now operating with the smaller fund providers are themselves orphans from high street banks.

With demand so strong, asset finance specialists such as 1pm can afford to implement strict lending criteria. The company specialises in providing finance for leasing, which has several attractions. For a small company looking to buy equipment, there is no big capital outlay to consider because 1pm buys the equipment and then leases it out to the customer, who then repays the cost of the equipment and interest charges over a fixed period. And, unlike a straight loan, 1pm owns the leased equipment and therefore avoids having to hold a regulatory reserve to set against the transaction. In fact, 1pm is only constrained by its ability to raise the funding.

1PM

"If we had access to more funding, we would do a lot more business," says its chief executive Maria Hampton. Even so, new business written in the six months to last November grew by 50 per cent to £3.9m, while the company's overdraft facility was increased from £350,000 to £500,000.

Ultimate Finance offers a broad range of services and is hitting all the right notes with SME customers and shareholders, with pre-tax profits up 70 per cent to £560,000 in the six months to December last year. It is also extremely well-funded, thanks to a £34m financing facility with Lloyds TSB Commercial Finance through to June 2015, and there is still £5.4m of headroom.

And while major banks seem to prefer dealing with one larger customer rather than hundreds of small ones, it is ironic that banks are lending money to the likes of Ultimate Finance so they can lend it on to people the bank doesn't want to lend money to.

The group doesn't just provide straightforward finance; it also seeks to oil the cogs of the everyday workings of a typical small company. For example, it offers an invoice discounting service, whereby SMEs can draw down cash on unpaid invoices. There is also a trade finance service that allows companies to bridge the gap in payment for imports and exports, much in the same way that trade bills were issued by discount houses 40 years ago.

City of London Group approaches SME financing from a slightly different direction, having spent some time changing from an investment company with holdings in listed and unlisted natural resources companies, to funding a series of investment platforms providing finance for SMEs and the professional services market.

The transformation is now complete, and the group sees itself operating under the traditional merchant bank model. It also offers a litigation funding service, where it will sponsor legal cases that a small company may not have the time or resources to follow through. Naturally, returns tend to be rather lumpy, as it isn’t possible to put any timing on the legal outcome of any particular case.

Support is also coming from central government through the Business Finance Partnership programme, which aims to increase the supply of capital through non-banking channels and to diversify the sources of finance. Ultimately, it intends to invest £1.2bn through these channels, matched by at least an equal amount of private sector capital.

So far, the government is investing £600m alongside £650m of private sector capital, and City of London Group has been shortlisted to manage £5m of this, which the company will match from its own resources and third-party funding. This may not sound like a lot, but with loans of as little as £7,500 making all the difference, £10m goes a long way.

Breaking through the glass wall

The outlook for smaller lenders is definitely improving. The newly created Prudential Regulatory Authority has indicated that it will be looking at the so-called 'glass wall' of regulations preventing smaller banks competing equally with the high-street names. For example, large banks use advanced methods to calculate their capital requirements on residential mortgages, while the standard method that small banks are obliged to follow could mean reserve requirements up to seven times higher.

As chairman and chief executive of Arbuthnot Banking pointed out, there are 234 banks in the UK not including building societies and overseas banks. The need isn't for more banks; it’s for a regulatory environment in which banks of any size can compete on level terms.

In a tough economic climate, there is an element of risk for potential investors in SME lending, although anyone shying away in favour of investing in a bigger and more established lender need little reminding of what has happened to some of the big banks since the credit crunch. Unlike the larger lenders who are saddled with mountainous loan books full of dubious property loans, the smaller operators are starting from a clean base. And by concentrating on small loans, the credit risk is spread further.

Moreover, the small operators are being financed by the bigger banks for effectively doing their job for them, an arrangement that appears to work well. Some of the smaller operators are only just starting to gather pace, but already the potential is being recognised – Ultimate Finance's shares have risen 50 per cent in the past six months. However, they still trade on a modest nine times forecast earnings, and there is a prospective yield of over 4 per cent too, so they remain a good way to tap into this potentially seismic shift in the SME lending landscape.

New lenders on the block