Finance for Small Businesses in Deprived Communities

Bank of England
November 2000

Domestic Finance Division ISSN 1472-661

Printed by Park Communications Ltd

Finance for Small Businesses in Deprived Communities

A First Report November 2000

Bank of England

Domestic Finance Division

GLOSSARY
BBA Community Finance Initiatives (CFI) British Bankers Association A diverse range of initiatives the aim of which is to finance businesses and social enterprises which are unable to obtain traditional sources of finance and, in certain instances, individuals within a particular community. Many also provide business support and advice. Community Loan Funds, such as the Aston Reinvestment Trust (ART) in Birmingham, provide loan finance for businesses and regeneration initiatives within local communities. Not-for-profit, co-operative organisations which encourage their members to save regularly and enable them to borrow, sometimes at lower interest rates than those charged by other financial institutions. Membership is on the basis of a common bond: for instance a common employer or living within the same community. A process whereby newly established businesses lead to closures of existing competing businesses, rather than to net additions to the stock of firms in the local economy. The provision of small or very small loans (usually below 5,000), often through Community Finance Initiatives. The New Economics Foundation (NEF) defines social banks as 'for-profit financial services providers dedicated to social or environmental objectives'. The Government's Social Exclusion Unit defines social exclusion as: "a shorthand term for what can happen when people or areas suffer from a combination of linked problems such as unemployment, poor skills, low incomes, poor housing, high crime environments, bad health and family breakdown". Financial exclusion can be seen as a part of social exclusion. Organisations which trade in the market to pursue social aims. Social enterprises are a diverse group, ranging from "ethical" and community retailing businesses through to micro-lenders. Community enterprises (or community-based regeneration organisations) seek to make sustainable improvements in the economic, social, cultural and environmental life of specific geographically defined communities. Established in 1981 by the Government to improve access to debt finance for viable businesses which are unable to obtain bank finance because of a lack of collateral or trading record, or a combination of both.

Community Loan Funds

Credit Unions

Displacement

Micro-credit Social Banks

Social Exclusion

Social and Community Enterprises

Small Firms Loan Guarantee Scheme (SFLGS)

Copies of this report are available from Bank of England Public Enquiries 020 7601 4878. For further information please contact Victoria Cleland (020 7601 4441) or Caroline Price (020 7601 4276).

INDEX

GLOSSARY .................................................................................................................................................................i EXECUTIVE SUMMARY.........................................................................................................................................iv SECTION ONE: INTRODUCTION .........................................................................................................................1 THE BANK OF ENGLAND'S INTEREST.............................................................................................1 SOCIAL EXCLUSION AND DEPRIVED AREAS................................................................................2 OBJECTIVES OF THE REPORT.............................................................................................................3 APPROACH...................................................................................................................................................4 SECTION TWO: CONTEXT....................................................................................................................................5 THE SPECTRUM OF DEMAND.............................................................................................................5 THE EXTENT OF DEMAND ...................................................................................................................8 THE IMPORTANCE OF PROMOTING BUSINESSES WITHIN DEPRIVED AREAS ...........12 SECTION THREE: SUPPORT FOR NEAR BANKABLE BUSINESSES, MARGINAL BUSINESSES, AND SOCIAL ENTERPRISES ..............................................................................................................................17 ACCESS TO EXTERNAL FINANCE ....................................................................................................17 FINANCE FOR NEAR BANKABLE BUSINESSES AND MARGINAL BUSINESSES .............21 COMMUNITY FINANCE INITIATIVES.............................................................................................22 BANK INITIATIVES .................................................................................................................................33 GOVERNMENT INITIATIVES..............................................................................................................36 FINANCE FOR SOCIAL ENTERPRISE ..............................................................................................39 SECTION FOUR: FINANCE FOR BANKABLE BUSINESSES .......................................................................41 BANK FINANCE .......................................................................................................................................41 OTHER SOURCES OF FINANCE FOR BANKABLE BUSINESSES ...........................................45 BANKING SERVICES FOR BUSINESSES IN DEPRIVED AREAS .............................................49 SECTION FIVE: THE WAY FORWARD ..............................................................................................................51 ADDRESSING THE NEEDS OF BUSINESSES IN DEPRIVED COMMUNITIES..................51 A PARTNERSHIP APPROACH ..............................................................................................................55 SECTION SIX: CONCLUDING REMARKS .......................................................................................................60 ANNEX 1 ANNEX 2 ANNEX 3 ANNEX 4 ANNEX 5 ANNEX 6 ANNEX 7 ANNEX 8 MAP OF VISITS AND AREAS ANALYSED .........................................................................61 METHOD ....................................................................................................................................62 THE EXTENT OF DEMAND .................................................................................................64 COMMUNITY FINANCE INITIATIVES..............................................................................67 FINANCE FOR COMMUNITY FINANCE INITIATIVES ...............................................68 MICRO-CREDIT SCHEMES ..................................................................................................70 CREDIT UNIONS .....................................................................................................................72 DELIVERY MECHANISMS .....................................................................................................75

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INDEX OF BOXES Reclaim.....................................................................................................................................................................6 Wellpark Enterprise Centre.............................................................................................................................1 1 Development Trusts Association ...................................................................................................................12 Credit Scoring .....................................................................................................................................................18 Aston Reinvestment Trust (ART)....................................................................................................................25 Background to Micro-Credit ..........................................................................................................................26 The Prince's Trust ..............................................................................................................................................27 BBA Micro-Credit Schemes.............................................................................................................................28 Local Enterprise Agency Loan Funds ..........................................................................................................29 Aspire Micro Loans for Business Ltd ...........................................................................................................30 North London Chamber and Enterprise Credit Union ........................................................................32 Social Banks .........................................................................................................................................................40 Enterprise Insight ..............................................................................................................................................52 Stanley Local Business Association..............................................................................................................52 1Kby2K..................................................................................................................................................................53 Hope Enterprise Centre Ltd...........................................................................................................................54 Portsmouth Area Regeneration Trust ..........................................................................................................58 Pembrokeshire Lottery......................................................................................................................................58 Salford Money Line............................................................................................................................................59 NatWest Community Bond .............................................................................................................................69

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EXECUTIVE SUMMARY
The promotion of enterprise in deprived areas has the potential to play an important role in helping to address social exclusion, by providing jobs, increasing the flow of money into local economies and increasing the availability of local services. The promotion of enterprise should not, however, be viewed as a panacea for social and financial exclusion. Displacement of existing businesses and the risks inherent in setting up in business are potential limitations of the contribution of small firms in deprived communities. There is a wide spectrum of demand for business finance from within deprived communities. Businesses in these areas will include: successful bankable businesses, near bankable businesses, marginal businesses and social enterprises. These boundaries are fluid and businesses are likely to move between them. The spectrum will also include businesses in the informal economy. The simplified diagram below identifies key providers of finance for various categories of business demand: the depth of shading indicates the extent to which the financing needs of a particular category of business could be met by each of the finance providers. Finance for Businesses in Deprived Areas: Map of Demand and Supply Channels

Traditional Finance

Community Loan Schemes

Credit Unions

Micro-credit

Social Banks

N ea rB an ka bl e

Bankable businesses in deprived areas appear to be able to obtain bank finance and other traditional sources of finance (such as leasing and factoring) on broadly comparable terms to small businesses in the UK as a whole.

iv

En S te oc rp ia ris l e

Ba nk ab le

M Bu arg sin ina es l s

 Banks currently lend 1.51 billion to small businesses in our sample of approximately 5% of postcode sectors, covering some of the most deprived areas of Great Britain: this is about 4% of total bank lending to small businesses. This compares with approximately 400 million available to CFIs in the UK. The proportions of overdrafts to term loans and fixed to variable rate loans are similar in deprived areas to those in the country as a whole, although the average lending margin (4.12%) is significantly higher than that for the general small business population (2.71%), no doubt reflecting a differential in assessed risk. There is a range of factors which might increase the risk of lending to businesses in deprived communities or businesses run by individuals from deprived communities. Risks include: lack of business experience; lack of collateral and personal equity; concentration in business sectors subject to higher failure rates; remoteness; small and localised markets; and high crime rates. Some of these factors contribute to the emergence of a group of marginal and near bankable businesses. The key challenge lies in providing technical and financial support to progress these businesses towards the bankable end of the spectrum. Community Finance Initiatives (CFIs) - in particular community loan funds and microcredit schemes - play an important role in addressing the needs of near bankable and marginal businesses, often providing business support and advice as well as finance. The sustainability and financing requirements of CFIs themselves should not be overlooked. While there are only a small number of credit unions which specialise in lending to businesses, individual members do use such finance to support their business ventures. Some social enterprises are able to raise bank finance. Others rely on community loan funds and social banks, which can support enterprises that are not initially commercially viable but that generate positive social externalities. Government support for businesses in deprived communities includes: the Small Business Service's increased focus on providing advice to businesses in deprived communities; and the establishment of the Phoenix Fund to support CFIs and to deliver a Business Volunteer Mentors Programme. These initiatives are part of a much wider regeneration programme to combat social exclusion. Many deprived areas could benefit from broad regeneration strategies - focusing on health, housing, education and infrastructure - prior to initiatives to develop sustainable businesses. The availability of appropriate business advice is, in many cases, more important than access to finance. Support agencies can provide basic business training, advice on business planning, and can enable marginal and near bankable businesses to achieve sustainability. There is currently a range of initiatives targeted at near bankable and marginal businesses, together with social enterprises. The most successful of these are characterised by a partnership approach and involve the local community. There is, however, a need to ensure a more co-ordinated approach to the development of such initiatives and to consider ways in which to achieve a more consistent national coverage. During the year ahead, the Bank will monitor the provision of finance for businesses in deprived communities. In addition to continued regional visits and analysis of quantitative data, this will include further international comparisons.

SECTION ONE: INTRODUCTION

THE BANK OF ENGLAND'S INTEREST 1.1 The Memorandum of Understanding agreed between the Bank, HM Treasury and the Financial Services Authority in October 1997 identifies, within the Bank's responsibility for the "overall stability of the financial system as a whole", a specific responsibility for the efficiency and effectiveness of the financial sector. This provides the basis for the Bank's interest and involvement in issues relating to financing arrangements for small firms. 1.2 The Bank's current work on small firm financing issues dates back to 1993, in the aftermath of the last recession. In the late 1980s and early 1990s, the banks' exposures to the small business sector had given rise to substantial losses and there was some evidence of a breakdown in communication and trust between small firms and their finance providers. The Bank published a report on "Finance for Small Firms" in January 1994, outlining the financing environment for SMEs. This was the first in a series of annual reports, the most recent of which was produced in January 2000.1 1.3 In addition to the annual report, and a regular Quarterly Report on Small Business Statistics, the Bank has published a number of special reports, focusing on issues of specific interest and concern. These include: "The Financing of Technology-Based Small Firms" (October 1996); "Smaller Exporters" (January 1998); and "The Financing of Ethnic Minority Firms in the United Kingdom" (May 1999). Access to Finance in Deprived Communities 1.4 The Government's Social Exclusion Unit was established in 1997 to consider the whole range of Government policies relevant to combating social exclusion. Subsequently, some eighteen Policy Action Teams (PATs) were formed to report on various aspects of social exclusion. Two of these PATs focused on financial exclusion: access to finance and support services for small firm start-ups and continuing enterprises operating in deprived areas (PAT 3); and access to personal financial services, including insurance (PAT 14). 1.5 The report of PAT 3 "Enterprise and Social Exclusion" was published by the Treasury on 2 November 1999. Recommendation 13 of the report was that: "the Government should invite the Bank of England to report regularly on finance for business in deprived areas (and for groups within deprived communities), perhaps as part of their annual review of finance for SMEs". The Bank accepted this new remit, which extends its existing research into issues relating to the financing of small firms. In the light of the wide-ranging nature of the issues relating to businesses' access to finance in deprived areas, it was decided to produce a report specifically on this subject, rather than including it as a section of our annual report on Finance for Small Firms. This will be the first in a series of regular assessments of the provision of finance to businesses in deprived areas.
1

Bank of England, Finance for Small Firms: A Seventh Report (January 2000).

SOCIAL EXCLUSION AND DEPRIVED AREAS 1.6 While this report focuses on issues relating to access to business finance, it is useful to consider financial exclusion and the demand for business finance in the wider context of social exclusion. The Government's Social Exclusion Unit defines social exclusion as: "a shorthand term for what can happen when people or areas suffer from a combination of linked problems such as unemployment, poor skills, low incomes, poor housing, high crime environments, bad health and family breakdown". Research by the Institute of Public Policy Research2 develops a framework for analysing social exclusion and identifies five key components: contributory factors (for example family breakdown and poor health); individuals at risk (such as lone pensioners and the unemployed); tangible problems (including low skills, poverty and a high crime environment); aspects of exclusion - in particular lack of access to goods and services; and intangible problems (such as alienation and stress). This framework provides an indication of the multi-faceted issues faced by people in deprived areas. 1.7 The present report has made use of the 1998 Department of the Environment, Transport and the Regions (DETR) Index of Deprivation, which measures the level of deprivation in an area according to twelve key indicators: Economic: total unemployment; male long-term unemployment. Low Income: income support recipients; non-income support recipients receiving council tax benefit; dependent children of income support recipients. Health: standardised mortality rates. Environment: derelict land. Education: low educational attainment; low educational participation. Crime: home insurance weightings. Housing: households lacking basic amenities; overcrowded households. A new Index of Local Deprivation was published by the DETR in August 2000, too late to be used in the research work for this report. It was based on 33 indicators, grouped into 6 "domain scores": Income, Employment, Health Deprivation and Disability, Education Skills and Training, Housing, and Geographical Access to Services. 1.8 An April 2000 report by the Social Exclusion Unit3 commented that, in comparison with the rest of England, the 44 most deprived local authority areas were characterised by: nearly two-thirds higher unemployment; mortality rates that were 30% higher; 25% more adults with poor literacy and numeracy; and two or three times the levels of poor housing, vandalism and dereliction. Other key features in these areas often included: a lack of basic services; poor infrastructure and communication networks (including few telephones); and a high incidence of crime, drugs and racism. While this report focuses on business finance rather than the wider spectrum of issues associated with social exclusion, identifying the special characteristics of deprived areas helps in understanding the challenges faced by businesses located in those areas.
2 3

Ella Joseph, A Welcome Engagement: SMEs and Social Inclusion, Institute of Public Policy Research (2000). Social Exclusion Unit, National Strategy for Neighbourhood Renewal: A Framework for Consultation (April 2000).

Causes 1.9 The causes of social and financial exclusion are complex and there are a variety of symptoms. The nature of deprivation in a particular area depends on many factors, including its history, the origin and duration of its economic problems and the particular industry or industries which have declined. Many areas have suffered following the withdrawal of key employers. Those who had worked in skilled industries were better able to find alternative employment, or to adapt their skills to self-employment, than less skilled workers. It has also been suggested during the Bank's visits that people who worked for more paternalistic employers often found it more difficult to obtain jobs, or move to selfemployment, because they had been largely insulated from the realities of the employment market. In other areas deprivation was seasonal. Remoteness or a declining population have also been highlighted as potential causes. Aspects of Deprivation 1.10 Deprivation is a complex issue. A key contrast is between rural and urban areas, but even within these areas there are differences. An important distinction which emerged from the Bank's visits is that between the inner city and outer estates. Both might experience problems associated with crime and drugs, but the outer estates are also likely to face more intense difficulties in accessing services and transport links. Inner city areas are more likely to be ethnically and socially mixed and to experience a higher turnover of people than outer estates: "The origin of these [outer] estates means that they are often socially homogeneous, and their relative lack of white-collar and skilled populations has made them disproportionately vulnerable to economic decline and rising unemployment" 4. The signs of deprivation might also be less visible in rural areas, largely because they are less concentrated. In such areas, deprivation might have resulted from a changing infrastructure and the absence of key communication networks (for instance the absence of digital telephone facilities in some areas of rural Wales), rather than the withdrawal of a large employer. 1.1 1 As well as geographical factors, this report considers a number of other issues relevant to financial exclusion. Often these relate to the characteristics of particular groups of individuals - for example the young, ethnic minorities, and people with disabilities can face special difficulties in accessing financial services. OBJECTIVES OF THE REPORT 1.12 This inaugural report aims to identify the key issues and to set a benchmark against which future progress can be assessed. The basic approach adopted is to consider whether there are any financing issues that are peculiar to, or especially important for, businesses in deprived areas compared with the small firms population in general. 1.13 In setting the scene for future work, the report considers the desire to set up businesses in deprived areas and the role which their creation can have in regenerating such areas. The main focus of the report is, however, on the availability of finance. Particular attention is given to the support and finance available to marginal and near-bankable businesses that have the potential to progress and become sustainable, bankable propositions. The report recognises that access to finance is not the only factor affecting the
4

Mark Goodwin, Poverty in the City (1995) in Chris Philo (ed) Off the Map: The Social Geography of Poverty in the UK Child Poverty Action Group.

likely success of businesses in deprived areas and it suggests other factors which might warrant further examination. The report aims to inform debate and to increase awareness and understanding among interested parties, including businesses, communities, providers of finance and policy makers. It also offers possible explanations of why some businesses in deprived areas might face particular financing needs and notes the diverse range of initiatives established to address such needs. This should help to provide a framework within which future initiatives can be considered. APPROACH Consultation 1.14 Businesses from deprived areas should not be viewed as a homogeneous group, either in terms of their characteristics or needs. Section Two identifies a number of different characteristics, for instance noting the different challenges facing businesses in inner-city and rural areas and the wide spectrum of business objectives. In order to obtain first hand information from a range of such businesses, the Bank consulted widely in the preparation of this report, for example through conducting an extensive series of regional visits. While the PAT 3 report concentrated primarily on issues affecting England, the Bank has sought to cover all parts of the UK. 1.15 An extensive series of regional visits drew heavily on the expertise and local knowledge of the Bank's twelve regional agencies, which have an important and continuing role in consulting the local business community, to identify initial contacts. Annex One identifies the areas visited. The visits covered a mixture of urban and rural areas and provided an opportunity to meet a wide range of organisations: businesses, banks and other suppliers of finance, Community Finance Initiatives, councils, credit unions, social enterprises, support and advice networks, regional government offices, intermediaries (such as accountants) and other interested parties. While the areas and organisations visited are by no means exhaustive, they provide a great range of different perspectives. Further visits will be an integral part of the Bank's continuing work in this area. Quantitative Data 1.16 There is currently little quantitative information available on the access of businesses to finance in deprived areas in the UK. The Bank has, therefore, sought to collect data on this subject. In particular, the main clearing banks have supplied data on their business customer base in some of these areas (Annex 2 provides further details of how these areas were identified). Similar data will be collected in future years, enabling us to review trends in the nature and extent of bank lending in deprived areas.

SECTION TWO: CONTEXT

THE SPECTRUM OF DEMAND 2.1 There is a wide spectrum of demand for business finance within deprived communities. It depends on factors such as the characteristics of the local area, its social composition, the nature of the business sector, the importance of social enterprise and the extent of the informal economy. Research in the United States5, for example, has highlighted the significant opportunities that exist for inner city areas to serve the central business district and other more wealthy adjacent areas. In contrast, the relative remoteness of outer estates and rural areas may result in demand primarily for businesses to serve the local market. It was also suggested during the Bank's visits that the levels of entrepreneurship vary between inner city and outer estates. Categories of Enterprise 2.2 Academics at the University of Bristol6 provide a framework by which to categorise the clients of micro-lenders (organisations such as Community Finance Initiatives which provide micro-credit). They identify three categories: those entering marginal self-employment (often life-style businesses); new or existing entrepreneurs with micro-credit needs (a mix of relatively successful life-style and more ambitious businesses); and the nearly bankable (existing micro-entrepreneurs requiring working or development capital). This categorisation can be adapted to cover a greater range of demand within deprived areas: marginal businesses, near bankable businesses, bankable businesses, and social enterprises. While the boundaries of these definitions are fluid, they provide a useful background against which to consider the differing financing needs of businesses in deprived areas. They also provide a spectrum across which it is desirable to progress businesses.

Marginal Businesses
2.3 Marginal businesses tend to be small, often due to a lack of sufficient expertise or aspiration on the part of the business owner. Their demand for finance is likely to be modest, and perhaps sporadic, due both to the limited needs of the business, and in some cases to an acknowledgement of the risks and a consequent reluctance to get into debt. Such businesses are likely to benefit greatly from basic business support and mentoring. Some businesses might be placed in this category due to the limited extent of their demand, for instance small life-style businesses with no particular desire to grow, and with very limited financing needs. Such businesses might not require formal bank finance but occasionally need extra support, often in the form of micro-credit (see page 27).

Near Bankable
2.4 Not all businesses are likely to have the characteristics necessary to attract bank finance. In some cases this might be due to factors such as lack of experience or an
Michael E Porter, The Competitive Advantage of the Inner City, Harvard Business Review, May-June, pp. 55-71 (1995). 6 Elaine Kempson and Claire Whyley, Banks and Micro-lending: Support, Co-operation and Learning, University of Bristol: Personal Finance Research Centre in co-operation with the Institute for Financial Services (2000).
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insufficient skills base. Businesses where the barriers to traditional finance are not acute and which might have the potential to access bank finance once they have received additional support (financial or technical) can be characterised as near bankable. Such businesses might be in the early stages of development and have insufficient time to realise their full potential. Alternatively, they might be constrained due to a lack of collateral or personal capital and consequently be viewed as too risky to receive bank finance in the early stages.

Bankable Businesses
2.5 As indicated by the data on VAT registered businesses reported in Annex 3, there are a significant number of established businesses in deprived areas. There are also likely to be substantial numbers of smaller, sustainable businesses in these areas. Their financing needs depend on a number of factors, for instance the industrial sector in which they operate, but might include start-up, expansion or working capital. They might, therefore, approach traditional finance providers such as banks or leasing companies. Such businesses are likely to have viable business plans, including a market for their goods/services and an ability to cover both their ongoing and capital costs. The business owners are likely to have some business acumen and the more established businesses may well have gained a track record.

Social Enterprise
2.6 The term "social enterprise" is used to describe organisations which trade in the market in order to fulfil social purposes. Social Enterprise London has identified three common characteristics among social enterprises: they are enterprise orientated and seek to be viable trading concerns; they have explicit social aims; and they have social ownership. A diverse group of organisations (including Reclaim, see box below) fall under the social enterprise banner, ranging from ethical and community retailing businesses through to micro-lenders themselves. 2.7 As a consequence of their distinct nature social businesses often have different financing needs to conventional profit maximising organisations. As well as grants, a number of social enterprises have been able to obtain loans from social banks such as Unity Trust and Triodos Bank (see box on page 40), which specialise in meeting the needs of such organisations. Although social enterprises are commonly regarded as a separate business group, the distinction is in practice less clear.

Reclaim
Reclaim is a not-for-profit social enterprise based in the North of Sheffield. It focuses on the employment and training of people with learning disabilities, and achieves this aim through a recycling business which specialises in both consumer and industrial plastics. Individuals with learning disabilities are offered jobs such as sorting products prior to recycling and hence make a valuable contribution to the environmental and commercial activities of Reclaim. Reclaim was established in 1990 and is a registered charity as well as a company limited by guarantee. It currently covers approximately 50% of its costs from trading income, with the remainder being met by environmental and job creation grants. It is looking to increase trading income significantly over the next few years. Reclaim has recently obtained a significant loan from the Local Investment Fund to purchase a new granulating machine. This could help to increase the commercial viability of the enterprise. 6

2.8 The above categorisation is not exhaustive and its boundaries are fluid. Its simplicity does, however, provide a useful background against which to consider some of the key elements within the wide spectrum of demand. It is also important to recognise the extent of the informal economy in some deprived areas.

The Informal Economy

2.9 The distinction between the formal and informal economies is often imprecise. In areas with high levels of social exclusion, informal forms of economic activity are often widespread. The nature of informal activity can range from marginal labour carried out whilst receiving benefits to full scale businesses that remain informal due to the perceived costs of becoming legitimate, through to large scale criminal activity7. There is potential for many firms which operate in the informal economy to move into the formal economy: such businesses could be viewed as having latent demand for business finance.

Demand for Micro-Credit

2.10 Many self-employed, sole traders and micro-enterprise owners will require very small loans, for instance to buy basic tools. Those entering self-employment will tend to start on a very small scale, but a lack of personal savings might well require that finance be raised from external sources. A number of business advisers who were consulted during the Bank's regional visits referred to their clients needing to borrow sums of as little as 50. These small sums might be to finance start-ups, or for the provision of development and working capital. Short term demand for working credit can be met informally through forms of personal credit such as credit cards, although their availability might be limited in deprived communities. 2.1 1 It is more likely that the financing requirements of these businesses will be met by banks or through specific micro-credit schemes. Micro-credit schemes, often delivered through Community Finance Initiatives, provide very small loans (usually below 5,000), to businesses that are unable to access mainstream bank finance because they are "considered to be a very high risk and/or very costly to serve in commercial banking terms"8. 2.12 There are also wide variations in the scale of demand for micro-credit and this in turn is reflected in the various types and models of micro-credit available. In addition to providing small amounts of finance to riskier businesses, micro-credit can be attractive because it offers frequent contact with the lender and sometimes techniques such as group lending, (see page 29) which can facilitate the development of trust and help to address the "cultural gap"9. For instance, the peer group lending model employed by the Women's Enterprise Employment & Training Unit (WEETU) in Norwich has been adopted in order to address the perceived needs of WEETU's female client base. Micro-credit might also be preferred by those businesses that do not have an affinity with the banking sector. The role of micro-credit is discussed in more detail on pages 27 to 30.
7 8

K Whitefield, Notes on the Informal Economy (2000). Op cit, Elaine Kempson and Claire Whyley (2000). 9 Andrew Leyshon and Nigel Thrift, Lists come alive: electronic systems of knowledge and the rise of credit-scoring in retail banking, Economy and Society, Vol. 28, No. 3, pp. 434-466 (1999).

The Needs of Different Communities 2.13 There has recently been an increasing recognition that both the extent and nature of demand for business finance vary in relation to different groups within a community. Despite recent increases concern has, for example, been raised over the low number of businesses that are owned by women10. This is reflected within the UK in the establishment of Community Finance Initiatives specifically targeting women entrepreneurs, such as WEETU, and the establishment of a Women's Unit within the Cabinet Office. 2.14 Other groups which are often seen to have specific demand characteristics include the disabled, ethnic minorities and different age groups. The particular characteristics and needs of ethnic minority businesses have been the subject of numerous studies11 and a special report in 1999 by the Bank of England12. The Bank's report compared the experience of ethnic minority firms with that of small firms in general and suggested that some ethnic minority groups perceived access to finance as disproportionately difficult for them compared with other groups. It has been widely recognised that certain ethnic minority groups, especially those of Asian origin, exhibit a high propensity for self-employment13 and more recently, research in the UK by Barclays Bank has highlighted the different propensities of ethnic and white businesses to demand bank finance14. Further work is being carried out on these issues, for instance a longitudinal survey, mapping the progress of a sample of businesses over two years. Less research has been conducted on issues affecting other groups, for example the over 50s, although initiatives such as PRIME (Prince's Initiative for Mature Enterprise) are directly targeted at helping people in this age group to set up in business. 2.15 The effect of the social composition of an area upon demand is illustrated by reference to a longitudinal study during the 1990s15 which showed that demand for the DHP Enterprise Ltd self-employment scheme in North Derbyshire varied depending on the local unemployment profile. There was a strong positive effect on demand for the scheme when unemployment among women and among those in the 25-44 age group was high; conversely, high unemployment in the under-25s age group had a strong negative effect on demand. The authors suggest that lack of interest in the self-employment option by this group may be explained by a lack of the necessary human capital and/or financial resources. It is also important to consider the composition of the labour market. THE EXTENT OF DEMAND 2.16 Assessment of the extent of demand for business finance within deprived areas is hampered by a lack of data and research. The most common method of attempting to infer demand has been the examination of VAT registration data. Annex 3 analyses such data and suggests that there is a negative relationship between deprivation and enterprise at the
Personal Finance Research Centre, Micro-lending for Enterprise in the UK, PFRC Working Paper (1998). Alicia Herbert and Elaine Kempson, Credit Use and Ethnic Minorities, University of Westminster: Policy Studies Institute (1996). 12 Bank of England, The Financing of Ethnic Minority Firms in the United Kingdom: a Special Report (May 1999). 13 Op cit, PFRC (1998). 14 Barclays Review, Ethnic businesses - an emerging economic force, Barclays Bank (2000). 15 Marc Cowling and Rachel Hayward, Out of Unemployment, University of Birmingham: Research Centre for Industrial Strategy (2000).
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local/unitary authority scale. The more deprived an area, the less entrepreneurial activity appears to take place in that area. 2.17 Annex 3 illustrates that nearly half of the fifty most deprived local/unitary authorities appear within the bottom quartile in terms of VAT registration and deregistration rates in England. Despite the problems associated with VAT registration and deregistration as a proxy for demand (for example it excludes informal business activity and companies that fall below the threshold level), data in Annex 3 support the intuitively plausible conclusion that deprived areas are characterised by lower levels of business activity than less disadvantaged areas. This could suggest that there is a lower level of demand for establishing businesses in deprived areas, or that existing demand is not being as fully met in such areas. Potential Barriers to Demand for Business Finance 2.18 There are a number of deep-rooted reasons why the level of measurable enterprise appears to be lower in deprived areas. Adequate housing and access to basic goods and services are among the essentials necessary to create a stable and supportive environment in which individuals can consider entering self-employment. Maslow's theory of a hierarchy of needs16 suggested that it is only when individuals have sufficient "hygiene factors" (such as food and housing) that they will seek to address higher order needs (such as job satisfaction). It is likely that in those deprived areas where it is difficult to access basic goods and services, the level of enterprise will be lower. A number of other potential barriers to enterprise are discussed below.

Motivational Factors
2.19 The Bank's regional visits highlighted a considerable diversity in the extent to which individuals in deprived communities seek to establish new businesses. Evidence suggests, for example, that there may be greater demand within ethnically diverse inner city areas than in some of the isolated outer estates. Business advisers also point to the significant obstacles in translating an interest in starting a new business into actual demand for finance and the establishment of a sustainable business. Of particular importance is what has motivated an individual to seek self-employment. In many cases, self-employment might be viewed as a last resort and the potential business might lack sound proposals and hence be likely to fail. It is likely that those who start a business through choice are more likely to succeed and consequently have a greater demand for business finance.

Culture
2.20 Cultural factors play a significant role in determining the extent of demand for finance. Long term unemployment and experience of deprivation can often breed a culture of social exclusion, creating a substantial gap between those living in deprived areas and the wider business world. In certain deprived areas it is not uncommon for families to have experienced three generations of unemployment, thus impacting on their aims and aspirations. A report on deprivation in the North East of England, for example, highlights concern "about children being socialised into 'the culture of the street' rather than of the workplace"17. The socially excluded may also have a fear of bureaucracy, formality and
Maslow A H, Motivation and Personality, Harper and Row (1954). Churches Regional Commission in the North East and the North East Employment Forum, Building Bridges to Employment in the North East (2000).
17 16

institutions. Many are also wary of getting into debt. A recent survey, prepared by IDK Consult on behalf of Wester Hailes Representative Council (Edinburgh), found that 15% of the 512 residents surveyed agreed with the statement "I do not trust banks". In addition, 24% of those surveyed agreed with the statement "Banks do not cater for people like me". The research indicated that a group of between 8 and 10% of those surveyed would consider starting a business, yet did not trust the banks or believe that the banks catered for their needs. Similar findings are evident in recent work by the Personal Finance Research Centre (Bristol University) on attitudes within Bristol's Barton Hill estate. 2.21 Conversely, cultural factors may also have a positive effect on demand. In particular, certain ethnic groups may be characterised by a culture of self-employment and entrepreneurship. Asians, for example, have established thriving small business communities within many deprived areas, such as those we visited in Leicester.

Benefit Payments
2.22 During the Bank's regional visits, the benefits system was cited as a potential deterrent to setting up in business. A number of business advisers explained that they encourage individuals to consider the opportunity cost, in terms of lost benefit, of starting a business. In some instances, individuals needed to earn an income in excess of 16,000 per annum from a business venture to compensate for loss of benefit income. The turnover required, together with the associated risk, was perceived to be a significant barrier to establishing a business, and in some cases was believed to drive businesses to enter the informal economy. 2.23 The potential impact of the benefits framework is being considered by the Social Enterprise Zone (SEZ) - a pilot project in East London led by the Newham-based charity Community Links. The SEZ seeks to create an environment in which to generate and test ideas for using resources more effectively. The SEZ is working at the local level and suggests that micro-finance could make a bigger impact on deprivation if the tax and benefits systems actively encouraged and supported people seeking to use self-employment as a route off benefits. Issues such as income fluctuation in the first year of trading, and the ability to build up assets for the business without having benefits withdrawn after saving above a certain amount, are being addressed.

Support and Advice

2.24 The importance of cultural factors means that training, advice, mentoring and positive role models are all vital to developing demand within deprived areas. The success of institutions such as the Prince's Trust (see box on page 27) and some local business support agencies - for example the Portobello Business Centre in West London - is commonly attributed to their role in identifying clients with the appropriate motivation, boosting confidence, enhancing human and social capital, providing mentoring and reducing the cultural gap. 2.25 It has, however, been suggested by a number of business advisers that businesses in deprived areas are likely to require up to two and a half times more guidance and support than other businesses. If there are inappropriate support mechanisms, perhaps because of a lack of funding or a shortage of business advisers who understand the specific issues facing businesses in deprived areas, the level of demand is likely to be stifled. Social enterprises tend to face particular difficulties in accessing appropriate sources of advice, because few 10

business advisers are aware of their specific needs. As highlighted in the PAT 3 Report18 "too often, services are seen as inaccessible or unapproachable by people in deprived communities; provider agencies are often seen as part of the social mainstream, with little relevance to those who feel excluded" - it is important to ensure that support and advice networks are able to target people in deprived communities and those which face particular financing needs. The Wellpark Enterprise Centre (see box below) is an example of a business centre that has adapted to address the specific needs of a particular community. While there is a range of enterprise centres across the UK, Wellpark is notable due to its holistic approach to supporting and nurturing a very targeted group.

Wellpark Enterprise Centre

The Wellpark Enterprise Centre was established in the East End of Glasgow in 1996. Wellpark provides support, advice and assistance for women seeking to establish or develop a business. Wellpark offers a number of managed workspace units - their success is demonstrated by the fact that the current premises are being expanded to meet demand. Services offered by the Centre are delivered through three mechanisms: the Enterprise Development team; the Business Development team; and the Resource Centre. The focus of the Enterprise Development team is to provide advice and support for women planning to establish a business. The Business Development team seeks to help female business owners to develop their businesses. Finally, the Resource Centre provides women with access to a wide range of business information sources such as directories, journals and management books as well as computers and other services. More generally, the support services provided by the Enterprise and Business Development Teams include: business skills training; business planning and market research support; start-up courses for women looking to develop their ideas and business skills; assistance with business health checks and development plans; individual and group business counselling; network events for businesswomen; and organising marketing and PR events. As well as such support services Wellpark offers a group lending based micro-credit scheme.

Latent Demand 2.26 There is believed to be a considerable level of latent demand to establish businesses within deprived communities. Research by IDK Consult, on behalf of the Wester Hailes Representative Council (Edinburgh), reported that 26% of the 512 local residents surveyed agreed with the statement "I would start my own business if I had the money". In some circumstances demand will grow in response to adequate mentoring facilities and the availability of finance; in other cases more deep-rooted regeneration will be necessary. Development trusts are community-based organisations, often involving partnerships between local authorities, local communities and sometimes the private sector, which seek to promote social and economic regeneration within local areas. Many are members of the Development Trusts Association (see box below).

18

Policy Action Team Three, page 8 (1999).

11

Development Trusts Association

The Development Trusts Association (DTA) is an independent membership organisation, formed in 1992. Its mission is to promote sustainable economic, social, environmental and cultural regeneration by supporting the efficiency, effectiveness and growth of development trusts. The DTA has over 300 members, of whom 200 are community enterprise organisations, and operates throughout England, Wales and Northern Ireland. DTA Wales was formed in 1999, and the DTA is now working to develop a parallel network in Scotland. The DTA pursues its aims by: serving the needs of member trusts encouraging and advising on the creation of new development trusts promoting development trusts and their achievements advocating on behalf of development trusts at regional, national and European level.

THE IMPORTANCE OF PROMOTING BUSINESSES WITHIN DEPRIVED AREAS 2.27 As highlighted on page 2, deprivation is typically associated with low levels of employment and low purchasing power. The promotion of businesses in deprived areas can play a role in addressing this problem by providing jobs and increasing the flow of money within the local economy.

Job Creation
2.28 New business establishment provides employment both for the owner-managers and employees of those businesses. Small and micro-enterprises are an important source of employment and the promotion of such businesses within deprived communities offers the potential to provide new opportunities and jobs. Creation of businesses in deprived areas will most directly help to reduce social exclusion if the businesses employ local people. Mark Goodwin, writing in the context of urban deprivation, has argued that "the open nature of most urban labour markets means that those jobs which have been created in deprived places have rarely gone to the urban poor who live there"19. During the Bank's regional visits, Camden (North London) was cited as an example of an area where many of the retail businesses established were believed to be run and owned by people from outside the Camden area. Other research, however, has suggested that small and micro-enterprises are more likely than larger concerns to employ local people20. It has also been suggested that there are significant competitive advantages, for example in terms of crime reduction and market penetration, in employing local people within businesses in the inner city21. 2.29 The promotion of business within deprived areas can also have indirect job creation benefits. Individuals entering self-employment for a period or participating in selfemployment training schemes are more likely subsequently to gain employment. The
19

Op cit, Mark Goodwin (1995). Op cit, Ella Joseph (2000). 21 Op cit, Michael E Porter, (May-June 1995).
20

12

experience can provide important business and working skills as well as self-confidence, making it easier to enter the formal labour market. That said, although there is evidence to suggest that even failed self-employment can often have a beneficial impact on the possibility of gaining future employment, the negative consequences of reluctant recruits being pushed into self-employment can be significant22.

The Provision of Local Services

2.30 New businesses can also provide basic local services such as core retail facilities. The lack of such services significantly adds to the difficulties of the people within these areas and in some circumstances might result in the emergence of what Ella Joseph23 refers to as "as food deserts". Indeed geographical access to services is one of the six main demanding level indicators of the DETR's new Index of Local Deprivation. 2.31 The promotion of new businesses can also help to reverse the vicious circle of deprivation. The reopening of shops and the occupation of previously vacant and rundown commercial property helps to generate a more positive environment, boosting the confidence of businesses and the community. The development of a virtuous circle of growth, local confidence and a more positive image lies at the heart of regeneration success stories and attempts to address the problems facing deprived areas seeking to break out of the spiral of decline. Research has stressed the importance of businesses in deprived areas looking beyond their local market, seeking to service adjacent, more affluent areas24. By servicing such markets businesses have the potential to bring wealth into a local area, through the increased buying power of the company and its local employees.

Regeneration
2.32 By attracting money into the local economy, creating jobs and providing services, the establishment and growth of businesses can have a significant impact not only upon the material, but also on the social and cultural fabric of an area. The establishment of a critical mass of businesses can go a significant way towards the regeneration of an area and the reduction of social exclusion. It has been suggested that SMEs, particularly those owned by local people, are better placed than larger companies to promote regeneration and improve social capital25: "SME owner-managers, with a small and clearly definable geographical community, are more likely to display true commitment to their area and have detailed knowledge of how to add value there." An oft-cited example of what can be achieved by the establishment of a thriving small business community is that of the Southside area of Chicago. In the 1970s the area was commonly perceived as a slum to be, but through the establishment, inter alia, of a highly successful community development bank - South Shore Bank - offering loans for small and micro-businesses, the area has been successfully transformed. 2.33 Drawing on the US experience, Michael Porter has argued that inner cities represent a significant and relatively untapped market. Despite the low income levels, the population density of such areas "translates into an immense market with substantial purchasing power". Porter continues that, "The most intriguing attribute of the inner city market is its potential to be a leading indicator of major nationwide trends"26. Although the scale, context and geography of
22 23

Claire Whyley, Risky Business, University of Westminster: Policy Studies Institute (1998). Op cit, Ella Joseph (2000). 24 Op cit, Michael E Porter (1995). 25 Op cit, Ella Joseph (2000). 26 Op cit, Michael E Porter (1995).

13

deprivation within the UK is clearly different from that of the United States, the promotion of business activity within deprived areas provides opportunities to access new markets and to develop new products and services. A Cautionary Note 2.34 While the promotion of businesses in deprived areas can have a number of positive impacts on local people, several studies (discussed below) have stressed that business establishment on its own should not be viewed as a primary tool for tackling deprivation. A recent study27 of micro-finance in Britain argues that "self-employment and micro-enterprise do not tackle the underlying structural causes of poverty and social exclusion". It suggests that selfemployment and micro-enterprise should not be seen as an alternative to higher employment. Other writers claim that any form of employment, whether in small and microenterprises or in larger, more established businesses, should not in itself be regarded as a panacea for overcoming social exclusion. Authors of one recent paper point out that: "Many sectors of society may never be employed in economic activity and other aspects of social inclusion need to be addressed including education, policing, housing, transport and infrastructure. It is debatable whether business ownership can contribute significantly to overcoming the structural conditions that contribute to social exclusion"28. 2.35 In addition to these general observations, there are also a number of specific issues which need to be taken into account when considering business establishment and selfemployment as a partial solution to deprivation.

Displacement
2.36 Displacement, whereby newly established businesses lead to closures of existing competing businesses, rather than net additions to the stock of firms in the local economy, is often cited as a concern when promoting new businesses. An International Labour Organisation (ILO) study suggests that displacement is a particularly acute problem in the UK29. Displacement is likely to be most prevalent within mature, low-growth, easy entry markets. Evidence from the Bank's regional visits suggests that a large proportion of business establishment in disadvantaged areas takes place within such markets, for instance taxi firms and other small-scale service industries. In general, the ease of entry into such markets is facilitated by limited capital and skill requirements. Several academic studies30 have highlighted the adverse effects that displacement can have on individuals, and on the local economy. 2.37 While displacement is likely to be an important factor in some circumstances, particularly where the market place is very limited (such as a small rural village), this will not always be the case. Competitive micro-enterprises operating in mature markets, such as food

27

Ben Rogaly, Thomas Fisher and Ed Mayo, Poverty Social Exclusion and Micro-finance in Britain (1999: 51-52). Robert Blackburn and Monder Ram, Social Inclusion and Small Firms: A Cautionary Note, Paper presented to The Institute of Small Business Affairs Small Firms Policy Forum on Social Exclusion, Association of Chartered and Certified Accountants (7th June 2000). 29 International Labour Office, Micro-finance for Self-employment: Enterprise creation by the unemployed (2000). 30 See, in particular, Robert Blackburn and Monder Ram (2000), op cit.
28

14

production and printing, can provide an important source of jobs and income for deprived communities, as highlighted by a number of Nottingham-based businesses consulted during the Bank's visit to the East Midlands. There are also instances where clustering of a large number of similar businesses can be a factor which might reduce displacement: the success of the sari shops in Leicester's Belgrave Road is in part due to the fact that the area has built a reputation as a supplier of such products.

Suitability of self-employment
2.38 Small businesses are viewed as inherently risky, having a higher probability of ceasing to trade than large firms31. Evidence has shown that nearly half of all small businesses close within the first three years of trading32. It is essential that individuals are aware of, and in a position to bear, such risks. Many business advisers regard the provision of advice on such risks as important and do not encourage business start-ups that are unlikely to be successful. 2.39 Success in self-employment and business ownership is difficult and is often associated with a particular set of business and personal skills, such as self-confidence, self-belief and motivation. A lack of viable alternatives can often be the main motivation for people living in deprived areas to enter self-employment. Research shows that many such 'reluctant recruits' either quickly drop out of self-employment, or become 'plodders' rather than ambitious business owners33. There are also many people from deprived areas who will actively choose self-employment over employment and who will have considerable talents and the potential to succeed. However, in such cases there is not always the degree of access to business advice and support which is needed to augment basic skills in preparation for a successful conversion to self-employment. 2.40 A common characteristic of social exclusion is low formal educational levels, and low levels of knowledge of financial services. These can create substantial problems in running a business. For instance, a certain level of numeracy is required for bookkeeping and financial planning, and a good level of literacy is needed for the production of marketing and business plans. Many of the socially excluded will also lack experience of commerce, and may lack specific organisational and business skills. The importance of such human capital factors is borne out in the findings of the ILO study34. 2.41 As noted above, there is a tendency for new businesses within deprived areas to be established in easy entry, mature markets. Such sectors often provide only limited opportunities for growth, are very competitive and characterised by low profit margins35. It has been suggested that businesses in such markets may well remain marginal and micro in scale with a precarious hold on the market place36. Increased self-employment cannot necessarily be regarded as an indicator of an improvement in material and social well being.

DTI, Business start-ups and closures: VAT registrations and de-registrations in 1999 (2000). Bank of England, Finance for Small Firms: A Sixth Report, page 21 (January 1999). 33 Claire Whyley (1998); Robert Blackburn and Monder Ram (2000). 34 Op cit, International Labour Office (2000). 35 Ibid. 36 F Macdonald, Welfare Dependency, the Enterprise Culture and Self-Employed Survival; Work, Employment and Society, Vol. 1 1, No. 3, pp. 431-447 (1996).
32

31

15

Consequently, Blackburn and Ram have argued that "business ownership and small employers both contribute to social exclusion, as well as inclusion"37. Summary 2.42 There are many potential benefits in promoting enterprise within deprived communities. The most notable are likely to be increased job creation, increased purchasing power and enhanced provision of local services. At the same time most studies suggest that there are clear limitations to the contribution which small firms alone can make to the alleviation of deprivation.

37

Op cit, Robert Blackburn and Monder Ram (2000).

16

SECTION THREE: SUPPORT FOR NEAR BANKABLE BUSINESSES, MARGINAL BUSINESSES, AND SOCIAL ENTERPRISES

ACCESS TO EXTERNAL FINANCE 3.1 The availability of appropriate forms of finance is important to the success of all firms, at any stage in their development. While small firms, in aggregate, have in recent years become markedly less dependent on external finance (only 39.5% of small businesses sought external finance between 1997-9938, compared with 65% in the 1987-90 period39) it is important that viable firms which do require external finance are able to access it on appropriate terms. The availability of external finance, from the earliest stages of business development, is likely to be especially important to firms in deprived communities, where business owners are less likely to have their own savings.

Personal Capital
3.2 Data from Barclays Bank40 suggest that the average start-up costs in 1999 were 17,680 and that 60% of start-up businesses used personal funds as an initial source of finance. Personal savings and finance from family and friends are, therefore, potentially important sources of business finance. However, many people from deprived areas who wish to establish a business do not have savings on which to draw. This is particularly true of those who are seeking to move from unemployment to self-employment. Furthermore, in many instances family and friends will face similar difficulties and it will be difficult to draw on them as a potential source of finance.

External Finance
3.3 The NatWest/SBRT Quarterly Survey of Small Business in Britain41 asks survey respondents to select, from a list of fourteen options, the most important problem facing their business. Access to finance is typically one of the lowest ranking problems - in June 2000 just 1.3% of respondents cited access to finance as the most important problem, ranking it eleventh out of 14 factors. However, the process of raising finance can still be difficult for many small firms and it was in recognition of this that the Bank's current work on small firm financing issues began in the early 1990s. Since the Bank's first annual report on Finance for Small Firms was published in January 1994, many structural changes have occurred, improving the provision of finance to small businesses. These changes have in part enabled finance providers, most notably banks, to overcome some of the key barriers and risks involved in supplying finance to small businesses. Sections 3 and 4 consider the variety of sources of finance that are available to businesses in deprived areas. There is, however, little research to illustrate the proportions in which these sources might be used by such businesses: in particular it is difficult to assess the extent to which such businesses will be able to benefit from trade credit.

38

ESRC Centre for Business Research, Cambridge, British Enterprise in Transition 1997-1999 (2000). Small Business Research Centre, University of Cambridge, The State of British Enterprise (1992). 40 Barclays Bank, Research Review - Setting up in Business (February 1999). 41 The Small Business Trust, NatWest/SBRT Quarterly Survey of Small Business in Britain, Volume 16 Number 2 (June 2000).
39

17

Lending Decisions 3.4 Bank managers consider a wide variety of factors when making lending decisions, based on the need to make prudent loans which will not adversely impact on the interests of their depositors and shareholders. Some bank managers are set targets based on a minimum value of loans that they need to make during a given period. Their levels of bad debts and default rates will also be monitored. These factors will motivate bank managers to lend to viable propositions when they arise. 3.5 In assessing the potential viability of the business a bank manager will consider the business plan and the track record of the business/business owner. Decisions will be made based on the bank manager's knowledge and expertise and might in some circumstances, especially for the smallest loans, include information obtained through credit checks and credit scoring techniques. In its evaluation of a business plan, the lender's main concern is that the business will fail and default on outstanding commitments. Statistics on closure rates42 show that small firms have a higher probability of ceasing to trade than large firms and are, therefore, regarded as more risky.

Credit Scoring
Credit scoring has been most widely adopted by providers of finance to the personal sector, but is gradually also being used as one of a range of tools by some financial institutions providing business finance. The "Guide to Credit Scoring 2000"43 provides the following definition of credit scoring: "Credit scoring measures the statistical probability that credit will be satisfactorily repaid. It is based on the fact that it is possible, using statistical techniques, to predict the future performance of applicants with similar characteristics to previous applications (either to the credit grantor itself or groups of credit grantors)." The introduction of credit scoring has helped to improve the quality of the banks' loan books and has increased the consistency in approach. In addition to reducing the subjectivity involved in lending decisions, credit scoring can reduce the costs in making such decisions and greater objectivity can provide greater confidence in lending to more marginal proposals. The latter point is particularly important at the smaller end of the market where, as highlighted by the PAT 3 report, transactions costs may act as a barrier to lending. Despite these advantages, concerns were raised during the Bank's regional visits that credit scoring might disadvantage those living in deprived areas. One area of concern was that the factors included in credit scoring might discriminate against people living in deprived areas. The credit score is likely to include information regarding factors such as inclusion on the electoral roll, county court judgements (CCJs), residential stability and previous credit history - the latter being one of the most important elements. However, the "Guide to Credit Scoring" states that "credit grantors will

42 43

Ganguly P, UK Small Business Statistics and International Comparisons (1985). The "Guide to Credit Scoring 2000" has been drawn up by a range of organisations in the credit industry including the British Bankers Association, the Building Societies Association, the Council of Mortgage Lenders, the Consumer Credit Association and a number of credit reference agencies.

18

not refuse credit solely on the grounds of place or area of residence". Credit scoring should not, therefore, result in applicants being refused credit solely because they come from a deprived area, although postcode data might be one of the factors included in the overall score. However, the inclusion of data on CCJs might, if relevant to potential business activities and if combined with other negative evidence, affect substantial numbers of people in deprived areas. In many circumstances a bank manager will consider the credit score information in light of his own experience: this might be particularly relevant in a closely-knit community where the bank manager knows many of the residents and can revert to character lending - for instance in the Western Isles. The extent to which credit scoring is used in decisions to lend to businesses in deprived communities, and the likely impact of its inclusion, are areas which would benefit from further research. 3.6 The PAT 3 Report identified three key factors which might result in small firms finding it difficult to access external finance - asymmetric information, high monitoring costs, and higher objective risk - and suggested that they were often accentuated in the case of businesses in deprived areas. This section considers a number of factors which might explain why some businesses from deprived areas are more risky than their counterparts in the general small business population. Potential Barriers to Raising Finance

Asymmetric Information
3.7 Information asymmetries, giving rise to moral hazard and adverse selection, are believed to be a significant feature of small business finance because there is typically less market information available than for larger firms. Adverse selection arises if debt providers such as banks find it difficult to discriminate between good and bad risk companies and react by increasing the price of debt to all potential borrowers. This can discourage all but the highest risk borrowers and might result in certain institutions deciding not to lend at all in such circumstances - a form of credit rationing. The economic literature suggests that moral hazard may occur because the entrepreneur when raising finance has an incentive to increase risk, since he/she benefits fully from any associated additional returns, but might not suffer disproportionately if the loan has not been fully secured. Issues arising from information asymmetries are not restricted to lending in deprived communities, although it has been suggested, for example in the PAT 3 Report, that they might be accentuated within them.

Availability of Collateral
3.8 Finance providers have a duty to protect their depositors/shareholders against the risk of lending to a business. Taking security provides some reassurance to the bank that, if a business is unable to repay a loan/overdraft, there is a means by which some or all of the money can be recovered. Granting security can also provide evidence of a business owner's commitment to the business proposal. Some banks will not require collateral for small loans and others maintain that security is a second order factor in lending decisions, citing the role of the Small Firms Loan Guarantee Scheme (SFLGS) in cases where there is insufficient collateral44. However, evidence45 suggests that there are occasions when collateral shortages can indeed constrain the level of business starts. There may, therefore, be a limited number of potential businesses that are constrained by lack of collateral. In many deprived areas,
44 45

Bank of England, The Financing of Ethnic Minority Firms in the United Kingdom (May 1999). Black et al, House Prices, the Supply of Collateral and the Enterprise Economy, Economic Journal , Vol 106, No 434 (1996).

19

property values are low (anecdotal evidence from a visit to Salford suggested that the value of some properties had fallen by 80% over the past few years), or the potential business owner lives in rented accommodation: there is in consequence limited security available. In Northern Ireland, property values were perceived to be more volatile, making it less likely that banks would take property as security. The absence of security can also pose problems for Scottish crofters having security of tenure, but without legal ownership of the land or property (for instance in the Western Isles). Furthermore, anecdotal evidence suggests that, even if they do have personal assets, individuals from deprived communities are often very reluctant to agree to provide security or personal guarantees.

Availability of Equity
3.9 In addition to providing some recourse to the bank if a business fails, collateral can act as a signal of the business owner's commitment to, and belief in, the business proposal. Such signals may help to overcome problems of asymmetric information. Banks may also look for a capital injection from the business owner to improve gearing ratios. Banks typically prefer to invest in ventures where some of the costs have been met by the owner: businesses with higher levels of debt are more likely to encounter problems. The availability of personal capital is likely to be limited in deprived areas, where the entrant to selfemployment will typically have been unemployed or working in low wage employment (the latter was cited to be a problem in Wales) and will in many cases have been unlikely to have accumulated personal savings.

Crime Rates
3.10 Many, though by no means all, deprived inner-city areas are characterised by high crime rates. This is likely to be reflected in high insurance costs and the need to purchase security systems, thereby increasing the cost base. Businesses in deprived areas with high crime rates will not only find it difficult to attract customers but also to recruit labour. Survey evidence cited during one of the Bank's regional visits indicated that high crime rates had led a number of businesses to consider leaving a particular city. Overall, it seems likely that the high crime rates in deprived areas will reduce the potential viability of businesses.

Remoteness
3.1 1 Certain areas might be viewed as excluded due to their remoteness from mainstream infrastructure and services. This can also have an impact on the viability and growth prospects of businesses located in those areas. The factors affecting businesses in Harris and Lewis in the Western Isles illustrate some of the key issues faced by business in remote areas: limited market place; high distribution costs, affecting both inputs and outputs; restricted labour market; lengthy delivery times; and the time commitment necessary for visiting company representatives. These problems are very real and can have a notable impact on the viability of a business, although they need not invariably mean that a business operating in a remote area is unlikely to be as successful as one which operates in a cluster. Geographical isolation is also evident in urban areas, such as East Manchester, where the lack of infrastructure or the presence of natural barriers can reduce the perceived accessibility of an area. Issues relating to a poor communications network (for example, frequent electricity outages in the Scottish islands and poor mobile phone network coverage in the north of Scotland) can impact adversely on the ability of businesses to operate effectively.

20

Sectoral Distribution
3.12 As noted in Section Two, firms in deprived areas tend to cluster in sectors of the economy where start-up and exit costs are low, and historic failure rates are high. Such sectors include retail, catering, and taxi firms. Such businesses are often less attractive to lenders due to higher default risks, regardless of the area in which they are based. Furthermore, many of these businesses are in sectors, such as retail, which are excluded from the SFLGS.

Skills and Experience

3.13 As outlined on page 15, many people from deprived areas turn to self-employment as a last resort. As a consequence, they might not possess the entrepreneurial skills which are likely to be necessary if their businesses are to thrive. Furthermore, many will have limited work experience, particularly regarding business skills, and will have had few local role models to follow. They are also likely to lack the track record that many banks believe to be an important indicator of success. Networking is important in the business world, and businesses in deprived areas are unlikely to have opportunities to benefit from these informal support structures. Furthermore, anecdotal evidence suggests that there is a reluctance to approach business advisers to assist in the development of the necessary basic business skills. If not suitably addressed, these factors are likely to reduce the viability of these businesses.

Small and Localised Markets

3.14 An important element of any business plan is the projected demand for the good or service, because any business with an insufficient potential customer base is unlikely to be viable. Many businesses initially serve the local market place and these local markets can be limited, and in some cases very small. In the Western Isles, for instance, there is a population of just 28,000: this is a natural constraint for retailers and service providers. In addition to limited local markets, deprived areas are often characterised by low disposable incomes; this further limits the ability of the business to grow. A business owner in Plymouth noted, during the Bank's visit, the difficulties that her tailoring business had experienced following the contraction of naval-related employment in the area, and the subsequent need to rely on the local population. FINANCE FOR NEAR BANKABLE BUSINESSES AND MARGINAL BUSINESSES 3.15 As illustrated in Section Four, the banks extend a significant amount of lending, on commercial terms, to businesses in deprived areas. But there are businesses in the nearbankable or marginal categories which will, by definition, be less able to access bank finance. These might be adversely affected by a number of the potential barriers to raising finance that are outlined above: the need for further business skills and experience or the constraints of operating in a limited market place are likely to be particularly pertinent. Many such businesses will require a gradual introduction to the business world and access to finance. It is these businesses, which with appropriate financial and technical support have the potential to become bankable, that are the key focus of this section. Section Four suggests that there is a range of finance available for bankable businesses regardless of the area in which they are based: the challenge lies in nurturing marginal and near bankable businesses to reach this stage. 21

3.16 A number of the key sources of finance for marginal and near-bankable businesses are considered below. While the diverse range of sources is impressive, there is evidence to suggest that these sources lack coherence and that geographic coverage is patchy. A key feature of the initiatives is that they adopt innovative approaches to overcome the potential problems in lending to marginal and near bankable businesses. Their techniques can range from alternative methods of assessing and managing risk (for example, group lending as described on page 29) to the provision of technical support and advice. COMMUNITY FINANCE INITIATIVES

Introduction and definitions

3.17 The term Community Finance Initiative (CFI) covers a diverse range of initiatives aimed at providing alternative sources of funding for businesses and social enterprises and, in certain instances, individuals, within a particular community. The New Economics Foundation includes credit unions, community loan funds, micro-credit organisations, mutual guarantee societies and social banks under the broad heading of CFIs - these organisations are discussed below. While diverse in their remits, CFIs have two key functions, viz

"to provide the catalytic capital resources or means of risk reduction to secure the involvement of mainstream finance in enterprise development; and to provide the means of widening economic opportunities for marginalised individuals, businesses and communities".46
Some are quasi-commercial, others are purely social. Many will be run as businesses, although most will have objectives which are non-commercial, such as regenerating depressed local economies or encouraging entrepreneurial activity among a particular social group. In addition to offering financial support, many CFIs also provide ancillary support and training services. CFIs also differ in terms of their own funding structure: some aim to generate enough income to cover their operating costs, while others will be more reliant on grant finance.

Target Audience
3.18 Those CFIs which support enterprises tend to focus on those businesses that have been unable to access commercial lending. Their target audience includes start-up businesses with the potential to become viable, existing businesses with the potential to grow and social enterprises. Within this group the propositions are likely to range from the near bankable to the marginal. Some CFIs will target, through different schemes, each of these areas of demand while others might concentrate on one. A number of the larger CFIs, such as Investors in Society, Aston Reinvestment Trust (ART), the Local Investment Fund (LIF) and the Industrial Common Ownership Fund (ICOF) focus primarily on large near bankable deals. At the other end of the scale are smaller organisations offering small loans to marginal businesses, such as the Women's Employment and Enterprise Training Unit (WEETU) in Norwich and Aspire Micro Loans for Business Ltd in Belfast. The first group of CFIs can broadly be described as community loan funds, while the second comprises mostly specialist micro-credit providers. 3.19 The target audiences of CFIs are typically rather different from those of the banks, in that they focus on those who are unable, or in some cases unwilling, to seek bank finance. CFIs also make an important contribution by developing markets and hence creating additional demand.
46

Calouste Gulbenkian, Investing in Social Enterprise Development (1989).

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The Role of CFIs

3.20 CFIs aim to support businesses and enterprises within a given community, both through the provision of finance and, in some cases, advice. The nature of the available funding varies across CFIs, and ranges from grants to loans at above-market rates of interest. While there is a short-term attraction in grants, there is evidence to suggest that they do not provide businesses with the financial discipline that can enable them to progress to more commercial sources of finance. A number of potential enterprises are likely to seek other (possibly lower cost) sources of finance, for example grants, before approaching a bank. There is also concern that public, or subsidised, investment is capable of crowding out or displacing existing private sector investment and reducing the level of bank activity. Furthermore, there is a danger that the provision of grants to new businesses might place viable loan-financed businesses at a competitive disadvantage. As well as being associated with greater discipline, loans from CFIs can provide a business with the confidence to borrow, at a later date, from a commercial lender. The provision of loan finance also increases the longevity of a fund: if money is recycled it can benefit more businesses. Such arrangements are often referred to as "revolving" funds. 3.21 Some CFIs, particularly micro-credit funds, charge above market rates of interest. In the case of Aspire, the APR on initial loans, in autumn 2000, was 19.5%, reducing for repeat customers. One rationale for this approach is a belief that micro-credit should provide a bridge to mainstream commercial lending and that above-market rates of interest will deter those who are able to attract bank finance. Furthermore, above-market rates better reflect the cost of making a large number of small loans. Research on traditional finance providers suggests that credit rationing by quantity rather than price can exist due to problems of moral hazard and adverse selection, and due to fears that the "market" rate would be so high as to affect adversely the lender's wider reputation. If this is correct, it may be possible to argue that, by charging above-market rates, CFIs are actually closer to the real "market" rate in a particular area. Even above-market rates are likely to be more attractive than the financing terms offered by the moneylenders to which some small businesses turn. Furthermore it has been suggested47 that small businesses view access to finance and a good relationship with a finance provider as more important than the level of interest charged. Anecdotal evidence from micro-credit schemes further supports the proposition that businesses are prepared to pay more for a financial product which is tailored to their specific needs. 3.22 CFIs are often established to meet specific local needs and, because of their ad hoc development, there is no definitive list of all CFIs in the UK. The New Economics Foundation has, however, listed some of the key CFIs (see Annex 4). It has been estimated48 that CFIs serve approximately half a million people and have over 400 million of capital (240 million of which is with credit unions). While a proportion of this finance will support the personal sector, the impact on the business sector can also be significant. Furthermore, a key benefit of CFIs is their ability to leverage additional funding from a range of other sources, including the banks. For example, between its foundation in 1996 and March 1999, the Emerging Business Trust committed 4.5million to businesses in deprived areas of Belfast but was able to leverage in an additional 19.5 million of further public and private sector funding.
Bank Of England, Finance for Small Firms: A Sixth Report (January 1999). Mayo E, Fisher T, Conaty P, Doling J and Mullineux A, Small is Bankable: Community Reinvestment in the UK (November 1998).
47 48

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Ancillary support measures

3.23 In addition to the provision of finance, a CFI might offer support and training, sometimes on a fee-paying basis. Good professional relationships between lenders and borrowers, together with hands-on monitoring and support where needed, will tend to improve the viability of target businesses and thereby reduce default rates among borrowers. Specific courses, aimed at improving the key management skills of customers, are also used, for example by WEETU. 3.24 That such support can have a positive impact on success rates is illustrated by the high survival rate of Prince's Trust supported businesses. Around 60% of such businesses survive beyond the first three years of trading, compared with just under 50% for the small business population as a whole. Furthermore, many CFIs will stipulate that borrowers must be monitored on a continuing basis, to ensure that the loan is being used appropriately; this again helps to build financial discipline. Technical assistance is believed to be important to the success of CFIs in the US; it has been suggested that in certain circumstances a CFI will spend up to a year advising a business and refining a business plan before funding is awarded.

Special Features of CFIs

3.25 A key perceived advantage of CFIs is that they can be more flexible and quicker than banks in their ability to identify, and respond to, real needs within their communities. The fact that they are often based within the community means that they are more likely to have an approach to business finance reliant on personal relationships and trust as well as one which is focused on the particular needs of the community. A CFI is likely to understand the area it supports and be well placed to make lending decisions. In some instances borrowers will be keener to ensure that they repay a community scheme than a traditional bank. 3.26 A number of practitioners have expressed a desire to see both their own organisations and the businesses they support becoming part of the mainstream. In particular there is a desire to demonstrate that there is a role for banks in funding social enterprises. Many CFIs believe that they demonstrate to the banks how to extend the boundaries of what is bankable. It has also been suggested that the CFIs' experience could ultimately lead to cost savings for the banking sector, especially in turning non-bankable businesses into viable propositions for the banks. There may also be greater scope for banks to lend to businesses in conjunction with CFIs. 3.27 CFIs, therefore, have an important role to play in supporting near bankable and marginal businesses and social enterprises. There are, however, a number of issues regarding the sustainability and the financing requirements of these organisations. These are discussed further in Annex 5.

Community Loan Funds

3.28 Community Loan Funds are defined for the purposes of this report as funds which make loans towards the larger end of the CFI scale (usually above 5,000), but which still have a specific geographical target area. They are often managed by staff with banking experience and might receive funding from a variety of sources including EU structural funds, other grants and commercial loans. Like other CFIs, they will still offer "gap" funding where applicants have been refused mainstream bank credit. They face many of the same 24

cost constraints as banks, although because they are not funded purely commercially they are able to absorb more of the transaction costs involved in lending to small firms. It is not unusual for community loan funds to take collateral, although this will depend on the nature of the business being financed.

Aston Reinvestment Trust (ART)

Aston Reinvestment Trust was established in 1995 and formally launched in the summer of 1997. ART emerged from the work of the Aston Commission. Established in the 1980s, the Aston Commission examined ways to promote the regeneration of the deprived areas of Aston and Newtown in Birmingham. ART is run as a mutual society providing loans at commercial rates to small businesses and social enterprises, not only in Aston and Newtown but throughout the whole of Birmingham. In order to qualify for a loan the person or organisation in question has to have already been turned down by a bank. Since 1997 ART has lent in excess of 700,000 and has raised capital of 1.3million. Capital is raised from both the public and private sectors: Barclays Bank, NatWest, the City of Birmingham and the Charities Aid Foundation are among the organisations that have provided particularly strong support. Default provisions currently stand at 8% of total funds lent since launch. ART operates a number of lending schemes, aimed at addressing different needs. Although ART provides loans for start-ups, to date demand has been greatest for working or development capital. As such ART has concentrated its efforts on servicing already established small and micro-businesses and on providing finance for social enterprises.

Micro-Credit Organisations
3.29 Micro-credit can be defined as the provision of small loans (usually significantly less than 5,000), often to businesses unable to access mainstream bank funding. The customers of micro-credit organisations tend to range from the marginal self-employed to the near-bankable, many of which will be micro-businesses. As noted above, microbusinesses in deprived areas may be higher-risk due to their small size, lack of collateral, the marginal, mature markets in which many operate and the significant information asymmetries that often exist between a micro-enterprise and a lending organisation. The provision of small loans to micro-enterprises can also be very costly. The administrative cost of providing a small loan is often similar to that of providing a much larger loan and this, coupled with the other risks associated with small businesses, can bring into question the profitability of offering micro-credit. Nevertheless, as a recent report on micro-credit stresses, it is important to recognise that many commercial banks do make micro-loans: "The loan profile of the National Westminster Bank, for example, shows that it is, arguably, the biggest 'micro-lender' in the UK" 49.

49

Op cit, Whyley C and Kempson E (2000).

25

Background to Micro-Credit
Micro-credit in the modern sense has its origins in development initiatives in Southern Asian countries during the 1970s. One of the most prominent of these was the Grameen Bank in Bangladesh which was established in 1976 to extend small loans for enterprise to women living in deprived rural areas. Micro-credit offered a lower cost route (compared with traditional grant funding) to making a major impact on society's end-users and the micro-businesses which sustained them. The Grameen experience inspired a number of similar initiatives world-wide and has its own Foundation based in the US and large-scale fund-raising and public relations activities. The leading micro-credit initiative in Europe is Fundusz Mikro in Poland, which since inception in 1994 has made over 15,000 loans to small businesses, with a default rate of less than 5%. The three main design features of the programme are interest rates which are above market rates, rate discounts for lending guaranteed by a group of businesses, and a technique involving the extension of loans for increasing amounts (otherwise known as "stepped" lending, see page 30). Furthermore, Fundusz Mikro has a rigorous risk assessment process, which involves close contact with the businesses and which is designed to reduce the probability of default. Estimates from the World Bank suggest that there are over 7,000 micro finance institutes in developing countries. These serve over 16 million customers and have a combined turnover of approximately $2.5 billion. The industry is thought to be growing at 30% per annum50. 3.30 Collateral is rarely sought from micro-credit borrowers, because of the high costs of taking a charge on limited security, together with the usual transaction costs of making and monitoring loans. Micro-credit is therefore particularly applicable to businesses operating in deprived areas and communities, where lack of collateral can be a barrier to raising conventional credit. It is widely accepted that successful micro-credit programmes do not merely provide finance, but also benefits in terms of training and skills development. One argument drawn from the international experience of micro-credit initiatives is that, in order to be successful, organisations need to be specialised to benefit from the essential "economies of scale" involved in managing large numbers of small, but very similar, loans. 3.31 Most micro-credit programmes, in common with other business orientated CFIs, offer significant business support services alongside their lending activities, mainly because these have been shown greatly to improve repayment rates. The balance between support services and lending is likely to favour support if a programme's focus is on poverty alleviation. If financial exclusion of businesses is regarded as a graduated state, with the marginal selfemployed at the bottom of the scale and established businesses at the top, any micro-credit programme can realistically only hope to cover part of the ground through its various activities. This is one of the major criticisms of micro-credit: that it cannot bring the "poorest of the poor" into the financial mainstream.

50

Aspire, Microfinance News, Volume 1, Issue 1 (Autumn 2000).

26

3.32 The flexibility and speed of decision-making characteristic of micro-lenders are based on the centrality of relationship banking. Evidence has shown that transaction costs, rather than high interest rates, is the key issue for micro-entrepreneurs. Micro-lenders have sought to overcome the problems of information asymmetries by placing a high emphasis on traditional relationship banking. Frequent face-to-face contact with micro-entrepreneurs, as well as the employment of other techniques such as peer group lending, promotes the development of trust and local knowledge, thereby reducing information asymmetries and the cultural gap51. It is the creation of such a trust-based relationship and understanding which allows the micro-lender to be flexible and to make quick loan decisions. Nevertheless such a relationship can only be forged at a cost and this is reflected in the high operational costs and the low levels of sustainability of micro-lending organisations52. 3.33 The economic objectives of micro-credit include creating and saving jobs, assisting with the creation of businesses, and improving business survival rates over time. There is also an expectation that, under the right conditions, carefully targeted micro-credit programmes can effectively create markets in deprived communities. While this may allow the eventual return of traditional finance providers, such as banks, to the area, and markets integrated into the wider community, it may also facilitate a self-supporting social economy, largely independent from the world outside. In both cases, the additionality created by micro-credit may be substantial, especially from a regeneration perspective. The current popularity of micro-credit among international agencies and charities suggests that it may be a more effective delivery mechanism for public or charitable funding than traditional grant finance, especially in terms of the number of jobs created or preserved.

Micro-credit in the UK
3.34 The largest programme in the UK has been the Prince's Trust (see below), which is funded by a combination of public sector performance contracts - principally with the Department for Education and Employment (DfEE) and the European structural funds together with private sector funding from companies, trusts and individuals. It is directed at the marginal self-employment end of the micro-credit market. In 1997 Barclays, Lloyds TSB, HSBC and NatWest together provided a 6 million syndicated loan, matched by the DfEE.

The Prince's Trust

The Prince's Trust was established by the Prince of Wales in 1976. Since 1983, its Business Division has provided finance and mentoring to 40,000 young people to support them in business initiatives. It has helped develop over 35,000 businesses, around 60% of which were still trading after three years (as noted earlier, a higher survival rate than for SMEs in general). An additional 5,000 young people have benefited from the support of the Prince's Scottish Youth Business Trust. The Prince's Trust offers assistance to unemployed or "underemployed" people who are aged between 18 and 30 and unable to access traditional forms of finance. It is able to offer a range of support, including: a low interest loan of up to 5,000, test marketing grants, grants for special circumstances and a business mentor during the first three years of trading. There are over 7,500 Prince's Trust volunteer business mentors, and they play
Leyshon A and Thrift N (1999), Lists come alive: electronic systems of knowledge and the rise of creditscoring in retail banking Economy and Society, Vol. 28, No.3, pp. 434-466. 52 Op cit. Kempson E and Whyley C (2000).
51

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an important role in providing ongoing business advice and helping to raise the confidence levels of young business owners. While the Prince's Trust and the Prince's Scottish Youth Business Trust do not focus exclusively on deprived areas, their assistance does extend to assisting young people in deprived areas. The Prince's Trust is also involved in a number of initiatives to target areas of disadvantage - for instance the Trust aims to support 235 young unemployed people in Tyneside into business in the four years to 2004. The banks have been longstanding supporters of the Prince's Trust. In addition to offering preferentially priced loan facilities under the scheme, banks have provided a significant amount of sponsorship and help in kind. A further contribution is through the provision of volunteer mentors: this enables bank staff to develop and understand the challenges faced by start-ups in deprived areas. There are, for instance, currently over 100 Barclays' Small Business staff acting as volunteer mentors. Furthermore, a number of bank staff sit on boards of local Prince's Trust offices or act as panel members, and banks have seconded staff to the Prince's Trust. A number of banks have also sponsored the production of promotional leaflets for the Trust - for example, Barclays funded the publication of the Prince's Trust Start-up Kit. 3.35 While the Prince's Trust, together with the Prince's Scottish Youth Business Trust, services the whole of the UK, most micro-credit schemes focus on a small community. There are, in consequence, many areas which do not benefit from the presence of a micro-credit scheme. A recent report by for the Institute of Welsh Affairs has highlighted that there are only a limited number of micro-credit schemes in Wales53.

BBA Micro-Credit Schemes

Research undertaken by the BBA54 in 1998 showed that its members had provided 8 million of capital towards the establishment of micro-credit initiatives in the UK. Total funding for these schemes was estimated at 24 million, although both figures are believed to be underestimates. The banks' involvement has also been non-financial, through the provision of credit officer personnel, mainly through secondment programmes. NatWest, for example, provided a full-time member of staff to help establish the Local Investment Fund. The BBA report covered 62 different micro-credit schemes that were supported by the banks (see Annex 6). While the list may not be exhaustive, and some of the schemes may have ceased to operate, the report provides a useful overview of the range of initiatives. Nine of the schemes provide maximum loans of 3,000 and just 25 make loans in excess of 10,000: the majority are, therefore, targeted at the smaller end of the market. The schemes, which are run in partnership with other organisations, most commonly local authorities, Training and Enterprise Centres and Business Links, are targeted at a combination of start-ups and established businesses. Over half of the listed schemes are supported by HSBC, and six schemes include joint support from a range of banks. Many schemes provide support and advice in addition to finance.
Blewitt, Institute of Welsh Affairs, Small Loans for Small Businesses: Developing Micro-credit in Wales (July 2000). 54 BBA, Micro-credit in the UK (1999).
53

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Methods
3.36 A number of different micro-credit mechanisms have been employed internationally, but the most successful programmes have used pilot schemes to test the effectiveness of different models in a given environment before the start of live operations. Street UK, for example, is planning to run several pilots to test a number of parameters linked to potential loans, including interest rate levels, repayment periods, different population groups, group or individual lending and the type of delivery organisation (existing voluntary organisations or dedicated branches). Street UK is a new micro-credit initiative in the UK modelled on the successful Fundusz Mikro programme in Poland. It hopes to start operations shortly in a handful of deprived areas around the UK and will be targeting Britain's 500,000+ microentrepreneurs. Some 3.5 million has been raised for the initiative so far in the form of grants and loans from commercial banks, but it is hoping to raise a further 10 million over the next 4 years through a share issue.

Local Enterprise Agency Loan Funds

In addition to offering support and advice to small businesses, many Enterprise Agencies run loan funds - for example, the Grimsby and Cleethorpes Area Enterprise Agency Ltd, Project North East, Solihull Business Enterprise Ltd and Tyneside Economic Development Company Ltd (TEDCo). The National Federation of Enterprise Agencies recently undertook an informal survey of 19 Enterprise Agencies with loan schemes. In the previous twelve months, 383 loans had been made, totalling nearly 2.7 million. In addition a further 5.2 million had been leveraged in from other finance providers. The majority of loan funds set the minimum loan at 500, but East London Small Business Centre provided loans for as little as 250. Interest rates ranged from base minus 2%, to plus 10%. Interestingly some 438 loans were offered but only 383 were accepted.

Minimising default rates

3.37 It has been suggested that successful micro-credit programmes are associated with default rates which are lower than those of the traditional banking sector55. These low default rates are achieved mainly through the assessment skills and ongoing support of loan officers. The emphasis on personal, tailored service does mean that micro-credit is generally a labour-intensive, and therefore high cost, delivery mechanism. Several methods, however, have been developed in the international context to bring down costs as well as default rates. There is some scepticism, however, that micro-credit organisations will be able to achieve similar results in the UK: only eight of the 62 bank-supported schemes had default rates of less than 7%56. The level of default rates, together with examples of good and bad practice, is an area that would benefit from further research.

Group lending
3.38 The principle of group lending is that individual loans are dependent on the repayment record of the group as a whole: if one member defaults on a payment, no further loan will be made to any member until the position has been rectified. The Full Circle Fund run by WEETU in Norwich is a UK example of a group lending micro-credit scheme, with the added characteristic that members of the group participate in lending decisions (this is known as peer group lending). Fundusz Mikro in Poland opted for a mixed approach which
55 56

Conaty P & T, Micro-credit for micro-enterprise, New Economics Foundation (1999). Op cit, BBA (1999).

29

gives the entrepreneur the choice between borrowing as an individual at a higher rate or borrowing with up to 4 guarantors/co-borrowers at a lower rate. Fundusz Mikro have a target to lend 80% of funds to groups and only 20% to individuals, an objective also written into Street UK's business plans. In fact, Street UK plans to run a number of pilots with various interest rate differentials between the two types of lending, until it finds the correct one to achieve this target.

Stepped lending
3.39 Stepped lending involves making a series of loans, usually in increasing amounts, with the extension of a new loan depending on the repayment of the previous one. The advantage of this system is that it enables borrowers to build up a credit record gradually, and so the lending base of a micro-credit programme can be extended without undue risk. A potential disadvantage is that stepped loans might not provide the amount which the borrower may want, or even need. In such cases chances of survival may even be impaired by the small amounts of available finance. However, in many stepped lending schemes businesses take out loans which are below the maximum threshold - for instance Aspire (see box below) have a maximum limit of 5,000 for the first loan, but the average loan size is 3,400.

Aspire Micro Loans for Business Ltd

Aspire was launched in Belfast on 1 February 2000. It specialises in providing flexible finance for the self-employed or businesses with less than 10 employees, within the Greater Belfast area. Aspire has adopted a number of techniques aimed at reducing the level of defaults, which should in turn improve its chances of attaining sustainability. It targets for profit businesses that have been established for at least 6 months and sets a 5,000 and 9 month limit on initial loans. In addition, loans are repaid by direct debit and as at end August 2000 97.75% of loan repayments were less than a day late. Aspire's performance during the first seven months of trading has exceeded its own targets. Between February and August Aspire invested over 100,000 across 27 small and microenterprises.

The Role of Credit Unions

Introduction
3.40 Credit unions are co-operative organisations which encourage their members to save regularly and then enable them to borrow. Although the movement embraces individuals from a broad spectrum of society, successful credit unions can help to alleviate financial exclusion. Most credit unions focus on providing financial services to individuals, but a small number specialise in business lending, and there is evidence that many more have been indirectly exposed to business lending, through lending to individual members who subsequently use the finance to support their business ventures. While they are most likely to attract businesses which are unable to raise commercial finance, they will also be able to offer support to bankable businesses. It is important to recognise that credit unions can only support those individuals, or businesses, which have previously saved with the credit union and might, therefore, be inaccessible to some of the most needy.

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3.41 The credit union movement in Great Britain has historically been much smaller than in other countries such as the US, Canada or Ireland. The Association of British Credit Unions Ltd (ABCUL) represents 476 credit unions with a total of approximately 250,000 members; there are also approximately 200 additional credit unions with an estimated further 20,000 members which do not belong to ABCUL. Credit unions in Great Britain currently involve only about 0.5% of the adult population; the equivalent percentages for Ireland, the US, Australia and Canada are 45%, 30%, 20% and 16% respectively57 (Chart 3.1). The penetration of credit unions in Northern Ireland is much higher than in Great Britain, with nearly as many members in the province as in the rest of the UK. Most of these are from the Catholic community, where membership levels are closer to those in the Irish Republic. Further details of the particular challenges facing the UK credit union movement are contained in Annex 7. Chart 3.1 Credit union membership as a proportion of the population

45%

30%

20% 16%

1% Ireland Source: HM Treasury USA Australia Canada UK

The relevance of credit unions to business finance

3.42 Business finance is not considered an immediate priority for the British credit union movement, whereas larger credit unions in the US, Canada or Ireland are considered to be significant small business loan providers. The two main reasons for this reluctance are that business lending is perceived as inherently associated with greater risk than personal lending, and that the small scale of most British credit unions makes that greater risk unacceptable. The Welsh Co-operative movement, in its recently published credit union development plan58, argues that support and advice, perhaps via links with the existing business support network, could help to mitigate some of the risks of lending to businesses. The additional risk is compounded by the fact that business loans are often larger than personal loans, hence putting them beyond the reach of smaller credit unions.
57 58

HM Treasury Credit Unions Taskforce, Credit Unions of the Future (1999). Wales Co-operative Centre, Development through partnership - a strategy for credit unions in Wales 20022005 (1999).

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3.43 There are consequently only a handful of credit unions in Britain which specifically target businesses as a customer group. These include: the North London Chamber and Enterprise Credit Union (see box below), Dalston City Business Credit Union, the First Welsh Business Credit Union and the Federation of Small Businesses Credit Union, originally established in Cumbria but hoping to become a national network. Research for the European Commission59 has shown, however, that occasional business finance is much more widespread, with a third of credit unions surveyed by the researchers reporting that they had made loans to assist members to establish or expand their business. The existence of lending to businesses via individual members is illustrated by the experience of the Llandudno and District Credit Union: this was founded in 1996 and by the end of 1999 had made 20 business related loans, totalling 45,00060.

North London Chamber and Enterprise Credit Union

The Credit Union was founded in 1994 as the North London Chamber and Enterprise Credit Union Ltd, with membership of the North London Enterprise Club as a condition of membership. The common bond was widened in 1996 to cover all member businesses of the North London Chamber of Commerce. Specifically, membership is now open to owners, partners, directors and employees of businesses that are members of the North London Chamber of Commerce, which includes employees of the London Borough of Enfield, a member of the Chamber. Current assets total 264,000 and membership stands at 518. The Credit Union has made over 220 loans to date totalling over 400,000. A significant proportion of lending is to small firms headed by owner-managers from ethnic minority groups. Dividend payments on savings are currently 5% per annum and members are generally able to borrow up to 5 times the value of their savings once they have been saving regularly for 3 months.

Mutual Loan Guarantee Societies

3.44 In September 1997 the Co-operative Bank and Unity Trust expressed a commitment to financing Mutual Loan Guarantee Societies. MLGSs allow small firms to pool savings into a common fund that can be used as security against loans. They typically increase the amount that targeted firms can borrow by between 20% and 50%, providing crucial management support in preparing loan applications and business planning. They have been extremely active in continental Europe where they have advanced over 50 billion in loans to small firms. The Co-operative Bank agreed to provide scheme members with favourable lending terms of around 2% below normal rates, a reduction of around 70% in banking charges and preferential savings rates. Eight pilot schemes were developed by the National Association of Mutual Loan Guarantee Societies and local partners, such as Business Links, although they have yet to progress fully. The Alternative Credit Market 3.45 It is by its very nature difficult to collect hard data relating to the number of people who are reliant on the alternative credit market. Research from the University of Bristol61
Lynch and Haidar, The social responsibility of credit institutions in the EU - UK Country Report, (1997). Blewitt, Small Loans for Small Business: Developing Micro-credit in Wales, Institute of Welsh Affairs (July 2000). 61 Kempson E and Whyley C, Extortionate Credit in the UK, Department of Trade and Industry (2000).
59 60

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suggests that approximately 1-2% of the population use moneylenders. While the majority of such lending goes to the personal sector, some businesses, particularly in the early stages or those operating in the informal economy, also borrow from moneylenders and incur high rates of interest. During the Bank's regional visits we noted a high incidence of pawnbrokers and cheque cashers in a number of the most deprived areas. While these are most frequently used by personal customers, there is again anecdotal evidence that they are also used by a number of small businesses. 3.46 In addition to the high rates of interest associated with such borrowing, utilisation of the alternative credit market can act as a barrier to transition into the formal credit market. Credit scoring and track records are increasingly important in bank lending decisions. It is, however, difficult for individuals who have regularly made payments to moneylenders to gain recognition for this track record under formal credit scoring techniques. BANK INITIATIVES 3.47 Bank involvement in deprived areas is not limited to the provision of traditional banking services. The banks have, in recent years shown a greater interest in these areas, and are acknowledging their potential as emerging markets. NatWest, for example, has established a Community Development Banking Unit, with the specific aim of developing a better understanding of the financial needs of disadvantaged communities and markets, and Barclays has recently increased the size of its Social Banking team. Furthermore, there is an increasing level of bank expertise in these areas, and Policy Action Teams 3 and 14 included banking representatives with this specialist knowledge. 3.48 The banks participate in a number of initiatives intended to promote financial inclusion. Many such initiatives are targeted primarily at personal customers, while others are likely to have an impact on both demand for, and supply of, finance for businesses in deprived areas. The latter are aimed at promoting and supporting those businesses which the banks would not normally finance and in nurturing latent demand. This section highlights some, but by no means all, of the types of initiatives in which individual banks are involved and that will support marginal and near bankable businesses.

Bank Support for Community Finance Initiatives

3.49 The banks are active supporters of various CFIs and have in some instances been integral to the formation of a particular CFI. NatWest, for example, was a founding partner of the WEETU/Full Circle Fund (Norfolk) and the Aston Reinvestment Trust (Birmingham). NatWest's innovative approach in this field was also demonstrated by its leadership in the development of the national pilot for the Local Investment Fund. Lloyds TSB was a founding sponsor of the Portsmouth Area Regeneration Trust (see box on page 58). 3.50 The banks are also involved in the ongoing activities of CFIs, for instance the Cooperative Bank is a lead sponsor of the Local Investment Fund initiative in the North West. Barclays currently provides a secondee and financial support to ART. NatWest, in conjunction with the DETR and the Development Trust Association, has run a series of seminars over the past two years to inform local authorities of the potential role of CFIs and asset based development.

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3.51 In addition to offering support and advice to Salford Community Ventures Ltd established to develop the innovative ideas of Salford residents into initiatives that create long term employment opportunities - a representative of the Co-operative Bank has been appointed Chair of the Board. The Co-operative Bank also supports the 450,000 Bolton Business Ventures Challenge Loan Fund through an interest free loan, to supplement funding secured from the local Council and European Regional Development Fund. Cooperative Bank representatives sit on the Management Board and also on the Appraisal Panel which grants individual loans to businesses. The fund is aimed at high-risk business startups, within targeted areas of Bolton, that would not normally receive funding from banks. 3.52 NatWest has launched a range of Regional Community Finance Funds and the NatWest Community Bond (see box on page 69), to provide funds for community projects in disadvantaged areas which are unable to receive adequate commercial funding. NatWest also supports a number of initiatives, such as the Centre for Employment and Enterprise Development, through the NatWest Charitable Trust. As outlined above, the banks are also important supporters of the Prince's Trust.

Micro Loan Schemes

3.53 The banks also support a number of soft loan schemes. The range of support includes: a financial contribution to the fund; discounted pricing arrangements; and lending decisions made by a panel of representatives from the local community. Barclays, for example, is currently involved in nine such schemes, including the Mid Suffolk District Council Business loan scheme and the Bolton Security Loan scheme. Midland Bank commissioned research published in 199462 which found that soft loan funds provided a worthwhile additional source of finance for small firms. While additionality was found to be low, as most firms surveyed were sound businesses which would probably have obtained conventional finance, displacement was also found to be limited, but only because of the selectivity of the fund managers concerned.

New Deal
3.54 The British Bankers Association has taken the initiative to foster links between banks and the New Deal for Communities pathfinder areas63. By September 2000, seven of the seventeen areas had already entered a dialogue with the banks. For instance, Lloyds TSB, whose small business team is based in Bristol, sits on the management committee of the Bristol Pathfinder New Deal Area.

Research Activity
3.55 The banks are also supporting a range of research projects which are aimed at increasing the understanding of issues facing those with particular financing needs, such as ethnic minority firms and women in business. Barclays, in conjunction with the National
Robert Blackburn, James Curran and Martina Klett-Davies, Soft Loan Schemes and the Finance Gap: An Evaluation Study, Small Business Research Centre (1994). 63 The New Deal for Communities (NDC) initiative was launched in September 1998 as part of the Governments response to the Social Exclusion Units report: Bringing Britain Together - a national strategy for neighbourhood renewal. The focus of NDC is on the regeneration of specific deprived areas, delivering resouces through local partnerships. The creation of 17 pathfinder NDC areas was announced early in 1999 and another 22 areas were invited to bid for funding under the second round of the programme in November 1999. Funding for each of the area NDC partnershipis expected to range between 20-50m.
62

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Federation of Enterprise Agencies, is currently undertaking a two year study to track the survival and growth of small businesses that benefit from training courses run by the Enterprise Agencies, against those businesses that do not receive such support. Lloyds TSB sponsored the annual Ethnic Minority Business Conference in September 2000. The Conference provided a forum to further understanding and promoted the needs of ethnic minority businesses. The BBA, DTI and the Bank of England have jointly funded a longitudinal research project (due to be published in Spring 2002), examining the financing needs of ethnic minority businesses.

Seminars
3.56 Barclays' Small Business Teams hold an extensive seminar programme to discuss ways of promoting economic regeneration. The seminars are particularly relevant to those at the pre-start-up and start-up stages and cover issues such as: starting in business; women in business; business planning; online banking; and marketing. Over 1,000 such seminars were delivered during 1999 and it is envisaged that a similar number will be run during 2000. 3.57 In conjunction with the National Federation of Enterprise Agencies, Barclays runs a nation-wide Start Right Seminar Initiative aimed at those people who are considering selfemployment. The Spring seminar programme covered training and advice on topics which were important to the start-up market. Over 200 events were organised during Spring 2000, and a further 200 are planned for the Autumn. In addition to promoting the events in Barclays branches and Enterprise Agencies, the bank has targeted Job Centres, Prince's Trust offices, libraries, regeneration departments of local councils, local redundancy counselling groups, colleges, business schools and Chambers of Commerce. HSBC also offers an extensive seminar programme, often delivered in conjunction with business groups, aimed at providing practical business advice - for instance on how to increase sales and how to finance the credit gap.

Financial Literacy and Money Advice

3.58 As noted above, demand for finance can be affected by a suspicion, or lack of understanding, of the banking sector. Basic financial literacy can help to increase confidence in dealing with a bank and might, therefore, assist some of those entering selfemployment for the first time. The banks individually, and through the British Bankers Association, support a number of initiatives to promote financial literacy, both among school children and adults. The BBA's report, Promoting Financial Inclusion64, provides further details of such initiatives. 3.59 Money advice organisations, for instance Money Advice Scotland, are targeted at those people who are in financial difficulties and who would benefit from independent advice. Evidence65 suggests that one in six people will be deterred from using a bank account after having encountered financial difficulties. The lack of a bank account would have an adverse effect on the majority of businesses, and previous financial difficulties could impact on the ability to raise finance in the future. The banks acknowledge the importance of advice and provide financial support to a number of money advice services. During 1999
64 65

British Bankers Association, Promoting Inclusion: The Work of the Banking Industry April (2000). Kempson E and Whyley C, Access to Current Accounts, BBA (August1998).

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banks contributed over 2.3 million to money advice agencies66 and a number provided support in kind. The banks67 also sponsor the National Business Debtline, which was launched in July 2000 and offers confidential and independent telephone advice to microbusinesses which experience financing difficulties. GOVERNMENT INITIATIVES National Strategy for Neighbourhood Renewal 3.60 A key theme during the Bank's regional visits was the difficulty of considering access to business finance in isolation. There were many other underlying factors that need to be in place - for instance, good infrastructure, low levels of crime, and basic education - if businesses are to start up and prosper. Various aspects of the Government's regeneration programmes are likely to have an impact on the propensity to enter self-employment and the viability of businesses in deprived areas. 3.61 In autumn 1998 the Social Exclusion Unit published a report68 analysing the problems facing deprived neighbourhoods. It set out two key goals: to bridge the gap between the poorest neighbourhoods and the rest of the economy; in all the poorest neighbourhoods, to have common goals of: lower long-term unemployment and worklessness; less crime; better health; and better qualifications.

3.62 Following this report, 18 Policy Action Teams were established to consider the various aspects of social exclusion. The key findings were brought together in a consultative document in April 200069 and details of how these issues will be taken forward are due to be announced in autumn 2000. The initiatives are likely to focus on four underlying principles: thriving local economies; engaging the communities; improving services; and promoting leadership and joint working. 3.63 The Government is developing a coordinated approach to address issues relating to social exclusion: many of these will impact on the barriers, perceived or real, to providing finance for businesses in deprived areas and perhaps indirectly increase both the demand for, and supply of, finance for such businesses. This section of the report focuses on some of the key aspects of Government policy which are aimed specifically at promoting businesses in deprived areas, many of which are likely to assist marginal and near-bankable businesses and move them towards the more bankable end of the spectrum. The Small Business Service 3.64 The need for appropriate support and advice is vital to business success. This is particularly true of businesses in deprived areas where there are fewer role models and informal business networks. Marginal and near-bankable businesses in particular are likely to need high quality basic business advice if they are to progress to the bankable end of the scale. For such businesses, advice needs to be easily accessible and of consistent quality. Evidence from the Bank's visits suggested that many individuals from deprived areas were
British Bankers Association, Promoting Financial Inclusion: The Work of the Banking Industry (April 2000). Bank of Scotland, Barclays, Co-operative Bank, HSBC , Lloyds TSB, NatWest and Royal Bank of Scotland. 68 Social Exclusion Unit, Bringing Britain Together: A National Strategy for Neighbourhood Renewal (1998). 69 Social Exclusion Unit, National Strategy for Neighbourhood Renewal: A Framework for Consultation (April 2000).
66 67

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likely to be apprehensive of formal business advisers, thus increasing the importance of support services being approachable. The Small Business Service (SBS) has an important role in providing a coherent and consistent business support network. 3.65 The Government published its consultation document on the SBS in June 1999 and the SBS began operating as an Agency of the Department of Trade and Industry in April 2000. It will become fully operational in April 2001. The main responsibility of the SBS is to ensure that the interests of small firms receive a higher priority and greater influence within Government. The SBS states three key objectives:

"To act as a voice for small businesses at the heart of Government. To simplify and improve the quality and coherence of Government support for small businesses. To help small firms deal with regulation and compliance, and to ensure that the interests of the small business sector are properly considered in future regulation."

3.66 In addition to these key tasks, the SBS aims to "promote enterprise across society and particularly in under-represented and disadvantaged groups"70. Many of the groups awarded the new Business Link franchises have made specific reference to their commitment to assisting businesses in disadvantaged areas. A key feature of the SBS will be the single gateway for business advice: enabling businesses to access an extensive range of information via the internet or the telephone. This could be particularly important for businesses in rural areas, which face logistical issues in accessing traditional sources of support, and it could also be beneficial to business owners who are wary of approaching formal advisers. The Phoenix Fund 3.67 The Secretary of State for Trade and Industry announced a national Phoenix Fund, designed to encourage entrepreneurship in disadvantaged areas, in November 1999. The 30 million Fund has four key elements, which together aim to help businesses in deprived areas by providing assistance to intermediaries, most notably business support providers and Community Finance Initiatives. The four elements of the fund are: the Challenge Fund, the Development Fund, Loan Guarantees and a pilot network of volunteer mentors.

The Challenge Fund

3.68 The purpose of the Challenge Fund is to provide capital support to Community Finance Initiatives, which would then in turn offer support to businesses in disadvantaged areas. Bidding guidelines for those CFIs which wish to apply for funding from the Challenge Fund were issued on 7 June 2000. Some 3 million was made available for the first round of bidding, the closing date for which was 1 September 2000, and CFIs were asked to supply competitive bids for the funding. The guidelines suggested that innovative approaches, which demonstrated a likelihood of successfully addressing social exclusion in specific areas, were the most likely to receive support in the initial round. Further details are available at www.businessadviceonline.org/press/cfibid.asp.

70

Small Business Service, The Vision, SBS promotional leaflet.

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The Development Fund

3.69 The Development Fund is designed to support innovative ideas on how to promote enterprise in deprived areas. The bidding guidelines, which were published on 8 August 2000, indicated that funds would be made available to support new ideas and to promote the development and spread of best practice. The fund has a budget of 12.6 million over three years and is restricted to organisations in England. The bidding period for Round One applications ran from 1 September to 31 October 2000. Further details are available at www.businessadviceonline.org/press/devbid.asp.

Loan Guarantee Scheme

3.70 In addition to the Challenge and Development Funds, the Phoenix Fund offers a guarantee element to assist those CFIs that wish to borrow from the banks. Under the proposals, a CFI would borrow money from a bank and on-lend within the community, servicing the bank loan with the funds obtained from their client's repayments. However, if a shortfall were to arise, for example if the CFI had to reschedule a loan for a client, the CFI would be able to claim from SBS to meet the shortfall owed to the bank. Guidelines for CFIs wishing to utilise the loan guarantee scheme were published on 7 June 2000.

Business Volunteer Mentors Association

3.71 Appropriate support and advice is vital to the success of any business, and as demonstrated by the success of the Prince's Trust, close one-to-one mentoring can be of particular value. Mentoring can play an important role in deprived areas, where the business owner might be reluctant to approach a more formal support service. 3.72 Some 3 million from the Phoenix Fund has been made available to support a pilot Business Volunteer Mentoring Association initiative, in conjunction with the National Federation of Enterprise Agencies (NFEA). The initiative, which aims to provide mentoring advice to pre-start, start-up and micro-businesses, particularly those in deprived areas, is based on the American SCORE (Service Corps of Retired Executives) model. A key element of the scheme is to provide volunteers with a training and induction programme to support them in their role and to increase the confidence of those whom they advise. The pilot, which aims to recruit 1,000 volunteer mentors, is due to run until March 2001 and if successful will be extended across the country. New Entrepreneur Scholarship Scheme 3.73 The Chancellor also announced in the March 2000 budget a New Entrepreneur Scholarship Scheme, to draw on the expertise of local business schools in providing business support in deprived areas. Three pilot schemes are taking place (Manchester, Cornwall and Greenwich) in 2000/2001 with the full launch scheduled to take place in September 2001. The Manchester pilot is managed by the Manchester Metropolitan Business School, working closely with various interested parties, including the Prince's Trust, New Deal agencies and enterprise agencies. It aims to provide a six-month part-time business development programme for new entrepreneurs in disadvantaged areas of Manchester. It is anticipated that in providing extensive assistance to a number of small firms, a group of successful businesses will emerge to act as role models for other businesses in the area.

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New Deal for Self-Employment 3.74 We referred above (page 10) to the difficulties faced by those who wished to move from the benefits system into business. Anecdotal evidence suggests that people might be deterred from setting up in business, because benefit payments are likely to stop even before the business has started to trade. Many contacts during the Bank's regional visits noted that the Enterprise Allowance Scheme, before it was withdrawn in 1995, had played a useful role in assisting businesses through this transitional stage. 3.75 The Self-Employment option of the New Deal for Young People (NDSE) was introduced on 1 June 1998 as a mechanism to overcome the problems of transition. NDSE provides, over a six month period, a weekly allowance equivalent to benefit income plus 15. Applicants attend awareness and counselling sessions designed to assess their commitment to setting up a business, and to help draw up a business plan. Once an acceptable business plan has been prepared, successful applicants will receive help and training for 6 months while setting up the business. Support from training providers will continue to be available for up to 2 years after the NDSE option has ended. 3.76 At the end of the first 10 months of operation, in May 1999, the New Deal had helped 740 claimants towards self-employment, 108 of whom were trading independently. At the end of June 2000, the equivalent figures were 2,199 and 448 respectively. These figures need to be compared with the 9,864 referrals to the NDSE basic awareness session and the 145,000 young people helped into some form of employment, either unsubsidised or otherwise. The Social Investment Taskforce 3.77 The Chancellor announced on 9 February 2000 the establishment of the Social Investment Taskforce. The Taskforce, which is an initiative of the UK Social Investment Forum, the Development Trusts Association and the New Economics Foundation, is chaired by Ronald Cohen of Apax & Partners. The Taskforce, which reported in October 200071, had three main areas of interest72: Consider the case for social investment and financing in regeneration and community economic development. Identify ways in which obstacles to the further development of these initiatives may be overcome. Test models for the future development of social investment.

FINANCE FOR SOCIAL ENTERPRISE 3.78 There is still considerable scope to increase awareness and understanding of social enterprises. Many such enterprises believe that they are inhibited because neither banks nor business advisers fully understand their remit, structure or needs. Similarly there is scope for social enterprises to increase further their understanding of the services offered by

Social Investment Taskforce, Enterprising Communities: Wealth beyond Welfare, http://www.enterprisingcommunities.org.uk (2000). 72 UK Social Investment Forum, Chancellor Announces Social Investment Taskforce, Press Release (9 February 2000).
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banks. Initiatives such as Social Enterprise London's development of a website to outline the role of social enterprises, and the Social Economy Forum for Scotland, are important in overcoming such information shortages. It is possible that if banks were to develop further expertise in social enterprises, they might be able to benefit from a potentially profitable, and growing, market. The Salford School for Social Entrepreneurs is piloting a course, which it is intended should be run nationally, to identify, support and encourage entrepreneurial skills in those who wish to work in social enterprise. The development of such programmes might further increase the number and viability of social enterprises in the UK. 3.79 Some social enterprises will have financing needs that are very similar to the small firms population as a whole and will use traditional bank finance. A number have been able to obtain loans from social banks, such as Unity Trust and Triodos Bank (see box below). Where there are large social benefits, others might require grants or subsidised loans. It has been suggested by practitioners that many social enterprises could not survive without grants. Many CFIs have an important role in supporting social enterprises and some, for example Investors in Society, have policies of supporting social enterprises, albeit ones which can demonstrate economic viability. The Aston Reinvestment Trust, for instance, has developed a new Key Loan Fund, with support from the European Regional Development Fund, targeted at voluntary sector organisations and community enterprises.

Social Banks
Social banks are defined by the New Economics Foundation as for-profit financial service providers dedicated to social or environmental objectives. The market leader, Triodos Bank, started in the Netherlands and established in the UK in 1995. Unity Trust is another example of a social bank, which was established in 1984 by the trade union and co-operative movements in the UK. Triodos provides financial services to enterprises which are of social, environmental or cultural value. Both banks provide account services for the charitable sector. In 1999 Triodos provided 1,974 loans amounting in aggregate to 145 million; the average loan made by the bank is, therefore, just under 74,000, which means that it is able to support some of the larger social enterprises.

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SECTION FOUR: FINANCE FOR BANKABLE BUSINESSES

BANK FINANCE Bank Data 4.1 This section draws on data submitted to the Bank by those banks with significant exposures to the UK small business market: Bank of Scotland, Barclays, Co-operative, HSBC, Lloyds TSB, NatWest and Royal Bank of Scotland. These data relate specifically to their small business lending activity (defined as accounts with an annual debit turnover below 1 million) within some of the most deprived areas in England, Wales and Scotland. Annex 2 explains the method adopted by the Bank to identify these areas, based largely on the 1998 DETR Index of Local Deprivation, and subsequently translated into postcode sectors. To ensure the inclusion of the highest possible proportion of the most deprived areas - while also achieving coverage of all of the regions - the data covers approximately 5% of postcode sectors. References to "deprived areas" in this section relating to quantitative data collected from the banks will refer to those postcode sectors selected using the methodology. 4.2 In order to provide a benchmark, bank involvement in these areas is compared with their activity in the small business market across Great Britain73, drawing on BBA data74 and data submitted bilaterally to the Bank75. These data sets define a small business by annual account turnover of up to 1 million. It is, however, important to appreciate that a significant number of businesses, operating both in the formal and informal economy, use their personal accounts to service their business needs. It is, therefore, difficult to gain a clear picture of the extent of bank finance of businesses in deprived areas. 4.3 At the end of June 2000, there were 134,000 business current accounts and 52,900 business deposit accounts in the sample of deprived areas (see Chart 4.1). The number of business current and deposit accounts in deprived areas equate to 4.5% and 4.6% respectively of the total of business bank accounts for Britain as a whole reported to the Bank. This is broadly the proportion of accounts that might be expected if the distribution of businesses was equal across all postcode sectors. It is, however, unlikely that businesses are equally distributed, and care is needed in interpreting such information. The postcode sectors used in this report are highly concentrated in urban areas and hence might be expected to have a greater density of businesses: it would be useful in future reports to examine more carefully urban and rural lending patterns. As shown in Annex 3 there is a negative relationship between enterprise and deprivation: hence we might expect the number of business accounts to be lower in deprived areas. Furthermore, the number of businesses with bank accounts is likely to be considerably higher than the above figures suggest, as many small business owners use personal accounts for business purposes.

Data for Northern Ireland were not collected for this report, but might be included in future years. Bank of Scotland, Barclays, Clydesdale, Lloyds TSB, HSBC, NatWest and Royal Bank of Scotland. 75 Abbey National and First National Bank, Bank of Scotland, Barclays, the Co-operative Bank, Lloyds TSB, HSBC, NatWest and Royal Bank of Scotland.
74

73

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Chart 4.1 Number of Accounts, Overdrafts and Loans in Deprived Areas as at 30 June 2000

Source: Bank of England

4.4 Although a proportion of 4.5% of business current accounts and 4.6% of business deposit accounts in deprived areas may, therefore, appear encouraging, it is difficult to draw firm conclusions. We are, however, able to make comparisons of the proportions of lending and the facilities available. The ratio of deposit accounts to current accounts was similar across all areas of the country: there was approximately one deposit account for every 2.5 current accounts. 4.5 At the end of June 2000, bank exposure to small businesses in deprived areas stood at 1.51 billion compared with 39.4 billion total bank lending to small businesses. The proportion of total bank lending extended to businesses in deprived areas is therefore just under 4% of total lending: this is not far short of the proportion of business bank accounts held in these areas. While it is difficult to make clear comparisons without details of the size and sectors of businesses in these areas (all of which will have differing financing needs), this suggests that businesses in deprived areas with business current accounts are likely to be able to obtain similar levels of finance to their counterparts in the rest of Britain. Furthermore, in areas where there is a preponderance of subsidised loans and grants, eligible businesses are likely to apply for these ahead of bank finance, possibly in some circumstances crowding out mainstream bank lending.

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Chart 4.2 Value of Overdraft and Term lending in Deprived Areas as at 30 June 2000

Chart 4.3 Value of Overdraft and Term lending: Overall Data as at 30 June 2000

Source: Bank of England, BBA

4.6 At end-June 2000, some 71% of lending to small businesses in deprived areas was term lending, with the remaining 29% overdraft (Chart 4.2). These proportions are identical to those for total bank lending (Chart 4.3). This suggests that businesses in deprived areas are able to access the same forms of bank finance as small firms more widely and that they are able to benefit from the greater stability associated with term loans. Similarly, the proportions of fixed and variable rate lending were comparable, with ratios of 33:67 and 35:65 in deprived areas and the whole of Britain respectively (Chart 4.4). This again suggests that similar products were made available to businesses regardless of the area in which they were based. Chart 4.4 Proportion of Fixed and Variable Rate Lending: Deprived Areas and Overall Data as at 30 June 2000

Source: Bank of England, BBA

4.7 The maturity profile of the loans is, however, very different with businesses in deprived areas typically having shorter loans. Around 52% of businesses in deprived areas

43

had loans of less than five years, compared with 37% across the whole of Britain (Chart 4.5). There are a number of demand and supply-side factors which might explain the shorter maturity profile. Anecdotal evidence from the Bank's visits suggested that many businesses in deprived areas were reluctant to accumulate debt. It is, therefore, possible that when it was necessary to borrow their preference was to make the debt as short term as possible. On the supply side, the risks associated with some businesses in deprived areas might encourage banks to insist on a shorter repayment period. Chart 4.5 Maturity Profile of Term Loans: Deprived Areas and Overall Data as at 30 June 2000

Source: Bank of England, BBA

4.8 The average margins charged by individual banks on their lending to businesses in deprived areas were weighted by lending volume, and give an overall mean margin over base rate for small business loans of 4.12%. This compares with 2.71% for lending to the small business sector across Britain as a whole. The higher margin is likely to reflect the higher perceived risk, due for instance to a lack of experience or business support, associated with lending to some businesses in deprived areas. Data received from the banks on default rates was not sufficiently consistent to present industry figures in deprived areas. However, the limited information that was available suggests that default dates in deprived areas could be over 3 times as high as those for the country as a whole, indicating the increased risk of lending in deprived areas. Small Firms Loan Guarantee Scheme 4.9 Lack of security has been highlighted as a potential barrier to the ability of businesses in deprived areas - where property prices are low or where the business owner lives in rented accommodation - to raise bank finance. The Small Firms Loan Guarantee Scheme (SFLGS) was established in 1981 by the Government to improve access to debt finance for viable businesses which are unable to obtain bank finance because of a lack of collateral or trading record, or a combination of both. It has an important role to play, therefore, in supporting those businesses which are categorised as near bankable for either reason, as well as established businesses which wish to expand.

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4.10 Established firms attract guarantees for up to 85% of the loan and are charged annual premiums of 0.5%, while new business lending receives guarantees for 70% of the loan and attracts an annual premium of 1.5%. The maximum loan provided under the scheme has increased over time and in 2000 stands at 250,000 for established businesses and 100,000 for new businesses. The maximum loan term is 10 years. 4.1 1 The most recent DTI figures show that, in the six months to September 2000, 2,297 loans were guaranteed under the scheme, with a cumulative value of 129 million. 21% of the loans went to new businesses, with a total value of 27 million. The largest number of loans (49%) were for amounts of less than 30,000, although these loans accounted for 18% (22.3 million) of the total value of the loans made. During the same six month period, NatWest provided the largest proportion of finance under the scheme (29.77 million), followed by Lloyds TSB (25.8 million), Barclays (24.9 million), and HSBC (19.3 million). A range of other approved lenders extended the remaining 29.4 million. 4.12 The SFLGS is a useful mechanism for assisting collateral-constrained small businesses, and has a potentially important role to play in supporting businesses in deprived areas. There is, however, a belief among certain segments of the small business community that greater use could be made of the SFLGS. A 1999 survey by the British Chamber of Commerce76 found that 87% of respondents felt that the Government could do more to assist small businesses, and 35% of these thought that easier access to the SFLGS would be beneficial. Anecdotal evidence from the regional visits suggests a number of reasons for what was perceived to be an under-utilisation of the scheme: the minimum loan of 5,000 was too high for many businesses in deprived areas; large amounts of paperwork deterred banks and small businesses from pursuing SFLGS loans; the guarantees were not large enough to cover the high risks involved in lending to businesses in deprived areas; and many businesses in deprived areas were in sectors such as retail which are excluded from the scheme. 4.13 The PAT 13 report on the provision of retail services called for the removal of retail firms from the list of excluded activities and for the introduction of higher guarantee levels for businesses in deprived areas. Higher guarantee levels, however, have been introduced in the past - in the form of the inner city variant of the SFLGS - but resulted in high levels of displacement and low take-up. The reason for the inclusion of retail in the original list of excluded activities was the high displacement associated with it. The Government announced in June 2000 that David Irwin, the Chief Executive of the Small Business Service, is to lead a review of the SFLGS. OTHER SOURCES OF FINANCE FOR BANKABLE BUSINESSES 4.14 While traditional bank finance remains the most important source of external finance for small businesses (Chart 4.6), there are a range of other potential sources of finance which are in some circumstances more appropriate. These forms of finance might be accessed by many bankable businesses.

76

British Chambers of Commerce, Small Firms Survey: Finance (1999).

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Asset-Based Finance 4.15 Research by the ESRC Centre for Business Research77 suggests that, after bank finance, asset-based finance is the most commonly used source of external finance for SMEs in general. Chart 4.6 Sources of external finance for SMEs 1997-99

Source: ESRC

Asset-based finance includes leasing, hire purchase and a range of other products. The finance and leasing industry has grown over recent years (with business finance reaching over 20 billion in 1997 and 1998) as more businesses seek greater flexibility in the range and sources of their external finance. Research by the Small Business Research Trust78 estimated that 36% of small businesses used hire purchase and leasing in 1999, compared with 32% in 1991. 4.16 Anecdotal evidence from the Bank's regional visits suggests that leasing was viewed by many businesses operating in deprived areas as a particularly useful source of finance. A leasing company has the security of the asset which is leased, hence mitigating issues relating to lack of the business owner's collateral or equity. It was, however, noted that leasing companies undertook credit checks and that this could, in some circumstances, cause difficulties for people living in rented accommodation. Leasing was generally seen as a viable, and often used, alternative source of finance for those businesses operating in deprived areas that need to purchase computers or small scale manufacturing plant.

77 78

Op cit, ESRC Centre for Business Research (2000). NatWest/SBRT, Quarterly Survey of Small Businesses in Britain (June 1999).

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Factoring and Invoice Discounting 4.17 Factoring and invoice discounting79 provide businesses with access to finance against their outstanding invoices. Depending on the type and size of business, factors and invoice discounters will immediately advance to their clients between 75% and 85% of the value of invoices. The remainder of the finance is transferred to the business after the invoice has been paid, less the charge for the service (approximately 1-2%) and the interest payment. This type of finance assists a firm's cashflow because it is sales-based. 4.18 Factoring and invoice discounting are particularly appropriate for small growing firms and for exporters unable to draw on further overdraft facilities. They can enhance cashflow and reduce the problems caused by late payment. Invoice discounting is typically only offered to businesses with a turnover of 1 million and above. Most small businesses, therefore, will use factoring. This enables the business to outsource its financial management controls. However, anecdotal evidence from the Bank's visits suggests that this deters businesses in deprived areas, which are typically very wary of losing control. 4.19 Factors and Discounters Association (FDA) figures, covering more than 95% of the market, show that the factoring and invoice discounting industry has grown rapidly over the past decade, with volume growth averaging 20% per annum. Research by the Small Business Research Trust, sponsored by NatWest80, found that 4.6% of small firms using bank finance in 1999 also made use of factoring and invoice discounting. Although this is a small number, the proportion of small firms that use factoring and invoice discounting has more than doubled since 1991, when just 2% of small firms made use of this type of finance. The SBRT research also found that larger firms are far more likely to use this form of finance than smaller firms. No firms with fewer than five employees used factoring or invoice discounting, while more than 15% of firms with more than 50 employees did use these types of finance. 4.20 It has not been possible to collect factoring data by postcode sector, but there is no evidence to suggest that access to factoring is particularly difficult for businesses from deprived areas. It was, however, suggested on the Bank's visits that many businesses were deterred by the high perceived costs of factoring. There is further scope to inform businesses in these areas of the potential of factoring and in particular to allay fears regarding a loss of control. Equity Finance 4.21 The Bank's January 2000 publication "Finance for Small Firms: a Seventh Report" included a special section on "Equity Finance", covering both the formal venture capital/private equity market, and the informal business angel market. ESRC research81 has

Factoring is the purchase by the factor and the sale by a company of book debts on a continuing basis, usually for immediate cash. The sales accounting functions are then provided by the factor who manages the sales ledger and the collection of accounts under the terms agreed by the seller. The factor may assume the credit risk for accounts within agreed limits (non-recourse), or this risk may be retained by the seller. Invoice discounting is the purchase by the discounter and the sale by a company of book debts on a continuing basis (occasionally selectively) for immediate cash. The sales accounting functions are retained by the seller, and the arranged facility is usually provided on a confidential basis. Credit protection can also be provided if required. 80 NatWest/SBRT, Quarterly Survey of Small Business in Britain (June 1999). 81 ESRC Centre for Business Research, Cambridge, Enterprise in Transition (2000).

79

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indicated that venture capital accounted for just 1.3% of external finance for SMEs in the period 1997-9 and noted that this could be due to a range of demand and supply-side factors. 4.22 The anticipated loss of control, arising from the dilution of the owner-manager's equity stake, is thought to be a key factor deterring small businesses from seeking equity finance. A recent survey by Manchester Business School82 highlighted this issue. Respondents were asked to grade those problems that they perceived to be associated with raising external equity finance. Loss of control was their greatest fear. Anecdotal evidence from the Bank's regional visits suggested that this was likely to be even more pertinent for businesses from deprived areas. There was a feeling, for instance among business advisers, that many people were keen to maintain their independence and that those people who were wary of approaching banks would be even more suspicious of institutions which wished to take an equity stake in their business. Some businesses in deprived areas are "life style" businesses, where entrepreneurs enjoy the flexibility of independence and are motivated by factors other than financial gain, and hence do not wish to be pressured into growth. 4.23 A number of intermediaries, for example in East Anglia, explained that they had considered the establishment of a venture capital fund but decided against progressing the idea, anticipating low demand. The Glasgow Regeneration Fund operates a venture capital fund but has made just four equity deals in seven years. 4.24 Despite the constraints there are some businesses from deprived areas that will wish to seek such finance. Some businesses will be able to raise finance from formal venture capital funds. There are also a small number of venture capital funds that are aimed specifically at certain communities and areas. For instance, UK Steel Enterprise was established in 1975 to promote enterprise creation and regeneration in former steel areas, and has invested 60 million in over 3,800 companies. The Creative Advantage Fund, a joint initiative by West Midlands Arts Limited and Birmingham Venture Capital Limited, aims to provide small-scale capital investments to fast developing creative industries in the Objective 2 area of the West Midlands. It provides seed capital, starting at just 5,000 and the maximum investment size is 130,000. The Fund is aimed at commercial businesses and can provide a valuable source of equity capital. 4.25 The Government announced on 23 June 200083 its commitment to invest up to 10 million, on a matching base (giving an initial target fund of 20 million) for a community venture capital fund targeted at promoting venture capital investment in low income areas. The Social Investment Taskforce has been asked to consider a suitable structure for such a fund.

82

Poutziouris, Chittenden and Michaelas, Manchester Business School, The Financial Development of Smaller Private and Public SMEs (1999). 83 H M Treasury News Release, Chancellor Gordon Brown Calls for Enterprise for All (23 June 2000).

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BANKING SERVICES FOR BUSINESSES IN DEPRIVED AREAS 4.26 The traditional branch remains an important delivery channel for banks providing services to personal and small business customers. However, as illustrated below, its importance is declining as alternatives are developed. The rationalisation of traditional bank branches has been significant throughout the 1990s, both in the UK and internationally. BBA figures84 show a 29% reduction of bank branches between 1989 and 1999. At the end of December 1999 there were just over 12,000 bank branches (excluding agencies, sub-branches and self-service branches). However, at the same time as branch rationalisation, there has also been rapid growth of new, high-technology delivery channels. These changes are discussed in further detail in Annex 8.

The potential impact of rationalisation on small firms in deprived areas

4.27 A recent literature review on behalf of the Financial Services Authority85 suggests that the pattern of branch closures has not been even and that it has been concentrated in deprived urban areas. In some instances, this has resulted in what has been termed86 "financial desertification", whereby certain areas are left with no financial services. It follows that businesses in deprived areas are more likely to be affected by branch closures than the small firms population as a whole. This is likely to increase the time they devote to visiting banks and may in some cases result in individuals carrying large amounts of cash through high crime areas: mention was made during the Bank's regional visits of some business owners having to use public transport when depositing large sums of cash. Research by the Personal Finance Research Centre at the University of Bristol87 has examined how personal and small business customers meet their banking needs if they are not near to a bank branch. Although only 7% of urban small businesses are more than a mile away from their nearest branch, some 15% of rural businesses are more than 4 miles away. Only 1 1% of these firms, however, claimed that it was difficult to reach their branch, with the selfemployed who worked from home, and small retailers, the most adversely affected. 4.28 Remoteness from a bank branch might also impact on the ability of banks and small businesses to build relationships. Business owners and potential business owners in areas where there are no bank branches may be less confident in approaching a bank. Furthermore, businesses will be less likely to visit bank managers if this necessitates a significant journey. Several businesses, particularly those based in rural areas, have expressed concern that they feel remote from their bank manager and decision-makers.

British Bankers Association, Promoting Financial Inclusion: The Work of the Banking Industry (April 2000). Kempson E, Whyley C, Caskey J and Collard S, In or Out? Financial Exclusion: a Literature and Research Review, Financial Services Authority (July 2000). 86 Thrift N and Leyshon A, in Rossiter (ed.) Financial Exclusion: can mutuality fill the gap? New Policy Institute (1997). 87 Kempson E and Jones T, Banking Without Branches, British Bankers Association (January 2000).
85

84

49

4.29 The rationalisation of branches and the development of new delivery channels, however, have also had a number of more positive effects. Many small businesses will have benefited because some of the remaining branches have become more specialised and focused on the needs of small business customers. Some of the newer channels are undoubtedly more convenient for small businesses - for example, many are available 24 hours a day. However, small businesses need to have the IT capability to take advantage of some of these new channels, and the new channels need to provide adequately for the continuation of relationship banking. Businesses in deprived areas are the least likely to have some access to the appropriate IT and communications infrastructure necessary to take advantage of such developments. Even small businesses with extensive cash-handling requirements may be less adversely affected than in the past inasmuch as longer opening hours of the remaining branches reduces their need to travel during their own key business hours.

50

SECTION FIVE: THE WAY FORWARD

ADDRESSING THE NEEDS OF BUSINESSES IN DEPRIVED COMMUNITIES 5.1 The evidence we have assessed suggests that bankable businesses in deprived communities face similar issues, when raising finance, to their counterparts in more affluent areas of the country. A frequent theme, particularly among business advisers, during the Bank's regional visits was that the majority of viable businesses were able to raise finance. Banks lend nearly 40 billion to the small business sector, 1.5 billion of which goes to some of the most deprived areas of the country, and are therefore an important source of finance for many small businesses. Simply to achieve their own lending targets, banks are likely to support those businesses that they perceive to be viable, regardless of the area in which they are based. 5.2 While there is no evidence of discrimination according to area or of different lending criteria being applied, there are a number of factors - for instance lack of security or personal equity - which might reduce the probability of potentially viable businesses in these areas raising finance. Anecdotal evidence suggests that the number of otherwise viable businesses rejected on the basis of these constraints is small. However, there is a range of reasons why businesses in deprived areas might be perceived by finance providers to be less viable. Looking forward, it is, therefore, important to concentrate on how to support the businesses which might initially appear to be marginal but which have the potential to progress and to become bankable. Some of the key issues which need to be addressed - the promotion of enterprise, appropriate support and advice, effective banking relationships - to enable the migration towards successful and sustainable enterprises in deprived areas are outlined below. Promoting Enterprise

The Business Environment 5.3 As is true more generally, a stable macro-economic environment is important to the success of business in deprived areas. But deprived areas also have more specific needs in creating an environment in which enterprise can flourish. Many require broad regeneration strategies - focusing on health, housing, education and infrastructure. In addition to private sector and EU funding mechanisms, national, regional and local government all have an important role to play. Issues relating to regeneration are outside the scope of this report, although their impact on the demand for, and supply of, finance for businesses in these areas should not be under-estimated. Promotion of Entrepreneurship 5.4 As highlighted throughout this report, an initial step in promoting entrepreneurship in deprived areas is to address a number of cultural issues and to provide individuals with the confidence to set up in business. The Norwich Enterprise Agency Trust (NEAT) ran a series of entrepreneurial roadshows during 1999, to alert individuals to the potential benefits of starting a business. Following the roadshows, NEAT found a substantial increase in demand for their business start-up course. In supporting such initiatives, the banks might attract profitable customers. The Enterprise Insight initiative aims to promote entrepreneurship on a nationwide basis, including in deprived areas.
51

Enterprise Insight The British Chambers of Commerce, together with a range of partners including the Institute of Directors, the Confederation of British Industry, Shell LiveWIRE, Young Enterprise and the Prince's Trust launched in spring 2000 a joint venture called Enterprise Insight (EI) (www.enterpriseinsight.co.uk). The aim of EI, which acts as an umbrella organisation, is to promote a culture of enterprise across Britain, with a particular focus on deprived communities. There are two core strands to EI: the Ambassadors Programme and the Enterprise Insight Forums. The Ambassadors Programme involves the development of a database of entrepreneurs willing to act as enterprise ambassadors. The initiatives have a potentially important role in promoting the possibilities associated with entrepreneurship, especially in deprived areas. Assistance from within the community 5.5 While roadshows have an important role to play in promoting entrepreneurship, they are unlikely to appeal to those who lack the confidence to approach potential business advisers and finance providers. There is an important role for community based initiatives, where potential business owners are able to discuss issues with those to whom they can more easily relate. The New Entrepreneur Scholarship Scheme (see page 38) could in time promote levels of confidence by providing role models from within the communities. In the meantime business advisers need to demonstrate a willingness to become more closely involved in communities, for instance by visiting the estates. The Villages and Community Enterprise Company Ltd in Stoke-on-Trent, for example, regards the creation of businesses in deprived housing estates as an important element of its remit. There is also a role for local business clubs to promote business within deprived areas, although their existence is at present unevenly distributed across the country. Stanley Local Business Association The Stanley Business Association is one of six Business Associations, which between them have over 400 member businesses across Liverpool. The Stanley Business Association covers a number of deprived areas in Liverpool. In addition to offering a range of free information, through the INFO POOL, the Association has an important role to play in promoting networking between local businesses.
Support and Advice 5.6 The valuable role that the provision of good quality business support and advice can play in establishing and maintaining viable businesses was a recurrent message throughout the Bank's regional visits. This was in line with a key theme of the PAT 3 report namely "the importance of combining help with access to finance with suitable training, advice and support". A large number of those business advisers who were consulted during the Bank's visits commented that people from deprived areas are likely to require more business support and advice than their other clients, in part due to the lack of local role models and the need to build confidence. 5.7 Support and advice is available through a wide range of organisations, although in some instances the wide choice can be a disadvantage. Local Enterprise Agencies have played an important role in supporting businesses from deprived areas, as they focus on the 52

small end of the market. The Small Business Service (see page 36) has also stated that it views the promotion of enterprise in deprived areas as integral to its role. Project North East is an example of a support agency which already places a strong emphasis on the importance of building relationships with businesses in deprived areas. 5.8 In order to overcome the initial reluctance of businesses to accept training and advice, some initiatives link the provision of finance to attendance at courses. For example, the Enterprise Company in the Western Isles will only make grants and loans available to those who have participated in a number of courses. 5.9 The success of the Prince's Trust (see box on page 27) is believed to be partly a consequence of the provision of mentors to each of the businesses. The Prince's Trust concept has been extended, through PRIME, to those who are over fifty but there have been calls to extend the scheme to cover all age groups. The Phoenix Fund contains a business mentoring element (see page 38), but there is also a role for more community-based mentoring. One such example is the Manchester Caribbean Business Association's mentoring scheme to support Caribbean businesses in Mosside and Hulme.

1Kby2K PricewaterhouseCoopers, in conjunction with the Prince's Trust and the Prince's Scottish Youth Business Trust, launched a Millennium initiative to support 1000 disadvantaged young people with a business idea by the end of 2000 - hence 1Kby2K. Furthermore, PWC has undertaken to support a number of outreach workers for three years. Their work will focus on the identification of young people from deprived inner-city areas and rural backgrounds. Managed Workspace
5.10 Start-up businesses face a number of practical challenges in their early months of trading. Access to affordable premises can be a major factor in determining the initial viability of a business. The provision of managed workspace can help to address many such challenges, and the number of units is increasing: for example, further spaces are currently planned in Sheffield and a number of centres, for instance the Hope Enterprise Centre in Wigan, are currently expanding to meet demand. Enterprises Agencies have played an important role in providing such workspace. In 1998 Enterprise Agencies owned, or managed, over 2800 units of managed workspace - covering 1.4 million square feet. The national coverage of managed workspace is patchy and often relies on an organisation responding to a perceived local need, rather than a coherent approach. 5.1 1 In addition to providing affordable (sometime subsidised) workspace, the most successful schemes tend to offer a range of other services, including: good security; the ability to take "rent-holidays"; a fixed rent that includes electricity, rates and other variable costs for which a business might initially find it difficult to budget; on-site business advisers; and a strong network with other businesses. Such an environment is likely to improve the success of businesses and hence their ability to attract finance. Hope Enterprise Centre Ltd is an example of a managed workspace that offers an holistic approach. Many other schemes will provide a less comprehensive range of services. 53

Hope Enterprise Centre Ltd Hope Enterprise Centre Ltd, Wigan, has 25 small offices/workshops which provide a supportive environment for new businesses. It offers subsidised rents together with flexible repayment terms and notice periods - measures aimed at alleviating some of the burdens that affect, and in some instances deter, start-up businesses.
The Centre offers an extensive business support facility, intended to reduce some of the pressures of running a business. The presence of a resident business adviser is beneficial to many occupants, and the informal nature of this arrangement can help to address cultural barriers associated with approaching business advisers. Other services include: a reception desk and secretarial support; security systems; catering; and facilities for the disabled. The units vary in size, allowing businesses to grow while remaining in the same supportive environment. Current occupants cover a wide range of businesses including: a computer graphics business, a children's clothing manufacturer, a dog grooming parlour and a security company. Demand for the units is high and the Centre is undergoing its third phase of expansion. Banking Relationships

Business Advisers 5.12 Anecdotal evidence suggests that in communities where business advisers have built up a strong relationship with banks, the financing prospects for local businesses are improved. Such relationships might be formal (for instance the main banks in Norwich support NEAT's business start-up programme and provide successful participants with a subsidised loan) or more informal. Business Connect Wrexham has over time developed a good relationship with most of the local banks, to such an the extent that a bank will refer a client to the business adviser as soon as there is an indication that the business might experience difficulties. The Portobello Business Centre (PBC) arranges for banks to visit PBC's premises to talk to clients, helping to allay the initial fears of businesses who are reluctant to approach banks, for whatever reason. Such initiatives can be mutually beneficial: they increase the business adviser's understanding of what a bank is looking for and the bank manager can become more reliant on the business adviser's assessment of the business. There is scope to develop further such relationships and perhaps to consider a formal role for such intermediaries, for instance in using their knowledge of clients to inform banks and thus reduce the bank's transactions costs. Businesses 5.13 Relationship banking is still important to many small businesses and recent evidence suggests that relationships between banks and small businesses have improved significantly over the last six years. This reflects the initiatives taken by banks in recent years to ensure that relationships with small business customers have been either maintained or, if necessary, rebuilt. The banks have placed increased emphasis on training their relationship managers to understand the specific issues faced by small businesses. Examples of specialised managers include healthcare, high technology, legal and ethnic minority business experts. It is likely that many of the lessons learned in improving general banking relationships could be focused on addressing the particular needs of businesses and social enterprises in deprived areas.
54

5.14 Businesses in deprived areas, particularly those that do not have a natural affinity with the banking sector, would benefit from a greater understanding of how banks operate. Explanations of lending criteria, and reasons why loan applications have been rejected would be appreciated and might help to improve confidence when dealing with banks. Similarly this could increase the banks' understanding of the needs of the business and the environment in which it operates.

Collateral and Personal Equity 5.15 The absence of adequate collateral, as noted, is a potential barrier to some businesses in deprived areas raising finance. The Small Firms Loan Guarantee Scheme (see page 44) is intended to support businesses with neither collateral nor track records but with viable business plans and which meet the criteria of the scheme. While the SFLGS is potentially very useful to businesses in deprived areas, many are unable to access the scheme as they require loans below the 5,000 minimum threshold or operate in sectors which are excluded. There is also scope to increase the level of awareness and utilisation of the scheme. There are a number of non-banks, for example the London Enterprise Agency, which lend under the scheme. Inclusion of non-bank lenders might encourage more borrowers by attracting those who might not have had the confidence to approach banks, and could also make it easier to put together packages of finance - for instance involving loans and grants.
5.16 The lack of personal equity can be a barrier in cases where banks' risk assessment systems preclude providing 100% of a project's cost. Partnerships between banks and CFIs can help to overcome this problem, with each organisation financing part of the project and hence sharing the risk. The Aston Reinvestment Trust (ART) is just one example of banks and CFIs working together to support a project: the injection of ART's money can give a bank greater confidence in the proposal (ART will typically invest considerable resources in assessing the viability of the business) and the bank will not be exposed to the full risk of the project. In turn, the bank's involvement enables ART to spread its limited funds to support a greater number of businesses. There is scope further to develop such partnership approaches. 5.17 Joint investments with CFIs, or providing finance for a project which is part grantfunded, does not, however, address the issue of the need for the business owner to show commitment to the proposal. In the absence of a financial contribution, it might be possible for a business owner to demonstrate commitment through having participated in a suitable training course. This is a concept which needs further research. A PARTNERSHIP APPROACH 5.18 This section has outlined a number of innovative approaches to addressing the particular needs of businesses in deprived areas. It has also highlighted examples of some of the many successful initiatives that are currently in existence. A comprehensive list of such initiatives is not, to our knowledge, available although a co-ordinated national approach to the development of such initiatives could be helpful. 5.19 Many initiatives have arisen from the local identification of need and coverage is often limited. There are advantages in developing initiatives locally and ensuring participation by the community at an early stage. However, this can lead to duplication of 55

effort and a fragmented approach. There is a role for the Small Business Service and for Regional Development Agencies to co-ordinate initiatives within their regions and to ensure that information is made available. In some instances national approaches would be desirable, in particular for sharing best practice, increasing information flows and facilitating benefits from economies of scale. The Prince's Trust is an example of a successful national initiative that has flourished, through the development of regional offices and a strong local presence. In a similar vein, the Local Investment Fund, a national organisation, is establishing community loan funds in the regions and is working closely with the Regional Development Agencies and the private sector to bring itself closer to the community clients it seeks to serve. 5.20 A further area which is likely to benefit from a more co-ordinated approach relates to access to European funds, which can also be used to promote enterprise within deprived areas. The Aston Reinvestment Trust (ART), after lengthy negotiation, was able to secure European funding to support a pilot project to help social enterprises and there may be further lessons to learn from their experience. On a larger scale, organisations in Cornwall and Wales are considering how best to utilise the money which is available through their Objective 1 status. Representatives of the Merseyside Special Investment Fund have provided assistance based on their own experience as an Objective 1 area. 5.21 There is also scope for the promotion of intermediaries to co-ordinate the work of the community and commercial sectors. There are instances where scepticism or lack of understanding of the banks and other private sector organisations on the part of communities might hinder the development of new approaches. The Social Enterprise Zone (see page 10) is an example of a partnership approach to test new ways of working. It suggests that public, private and voluntary organisations all need to be involved. The Importance of Community Finance Initiatives 5.22 There are a number of initiatives by the public and private sectors which can help to increase the potential viability of businesses in deprived areas and move them to the bankable end of the spectrum. CFIs can play an important role in providing the necessary support and advice and, by co-ordinating packages of finance and devoting time to nurturing the business, in developing bankable propositions. 5.23 However, the evidence also suggests that many such businesses are unlikely to be commercially viable and others will continue to require alternative forms of finance. In some circumstances, for instance social enterprises where there are positive externalities (such as strengthening local markets), additional support may be both necessary and desirable. While commercial criteria do not normally reflect such social returns, there are a range of CFI's to support these enterprises - both in terms of access to finance and the provision of support and advice. In the absence of such externalities, however, it is not the role of the public sector to facilitate the provision of finance to businesses unlikely to be commercially viable, regardless of whether they are located in affluent or deprived areas. 5.24 An increased understanding, particularly of the needs of social enterprises, is also important and it might result in an additional group of enterprises receiving bank finance. However, it will in many cases also be necessary to address issues such as: meeting the transactions costs of micro-loans; providing time and expertise to develop workable 56

business plans; ensuring the close monitoring that is often needed, particularly in the early stages; and in some instances providing subsidised interest rates. CFIs can help to address these needs, and may act as a stepping-stone to traditional finance for those businesses which have thus far found it difficult to build a relationship with a bank. The Development of Community Finance Initiatives 5.25 CFIs have a valuable role to play in supporting businesses in deprived communities. In acknowledgement of their importance, the Scottish Executive and a number of senior bankers undertook a Study Trip to the US, to consider the role of CFIs there and how they are financed. As a consequence of this trip the Scottish Executive is creating a joint public/private loan fund offering loan finance and technical assistance to support the social economy in Scotland. The Social Investment Taskforce has also devoted considerable time to understanding the potential of CFIs, and a number were also covered during the Bank's regional visits.

Private Sector Involvement 5.26 If they are to become sustainable, and hence able to continue to provide support , CFIs will themselves need sufficient capital. A number of elements of the Phoenix Fund (page 37) aim to support the financing of CFIs, but the available funds are limited. The banks have provided support (for example: secondees, finance for the CFI, or through joint lending to businesses) for some CFIs, for example Barclays is a long-term supporter of the Aston Reinvestment Trust, and Lloyds TSB has recently supported the Portsmouth Area Regeneration Trust. There is a question about whether, and under what circumstances, the contribution of banks and other private sector organisations to CFIs could be further extended.
5.27 The PAT 3 report suggested the introduction of tax incentives to encourage banks to enter into partnerships with CFIs. NOP research relating to NatWest's Community Bond indicated that twice as many people were likely to be interested in purchasing a bond if fiscal incentives were available. Such incentive schemes and corporate tax credits to encourage charitable giving and investments for reinvestment are among those considered by the Social Investment Taskforce. In addition the PAT 3 report recommended that the "Government (SBS) should run an award scheme for innovation and excellence in the banking sector in serving deprived communities." Such initiatives are likely to have a positive impact, particularly if extended to organisations outside the banking sector. It has also been suggested that the US Government's approach of combining obligations (for instance the Community Reinvestment Act), and incentives (including the Bank Enterprise Award Scheme and the Community Development Finance Institutions Fund) has increased the level of support for CFIs. It is, however, possible that the incentives alone would be sufficient. 5.28 The Housing Finance Corporation and the Local Investment Fund, in conjunction with the New Economics Foundation, are working to develop a new financial intermediary to promote community regeneration. The intermediary would raise private and public sector funding on a wholesale basis: this could then be on-lent to individual CFIs. This could add coherence to the fundraising process, reduce duplication and enable CFIs to devote more time to supporting businesses, and less to boosting their own finances. The intermediary is also likely to be well placed to access finance from quasi-public sources such as the European Investment Bank. In addition it has been suggested that the intermediary's role could extend to ensuring the quality of those CFIs to which it on-lends. 57

Personal Sector Involvement 5.29 Individuals and the local community are also a potential source of finance for CFI's. The Sheffield Employment Bond, for example, encourages individuals to buy bonds to support new jobs within the area and it includes a revolving small business loan fund. While such initiatives are currently limited, the Portsmouth Area Regeneration Trust (PART) has adopted a similar mechanism and there are plans to extend the PART formula to other areas of the UK. The potential role of private shareholders is considered in a recent report produced by the Forum for the Development of Community Based Financial Institutions88. The Pembrokeshire Lottery is a unique, but successful method of increasing the availability of business finance within deprived areas. Portsmouth Area Regeneration Trust The Portsmouth Area Regeneration Trust was launched in July 2000. It is based in Portsmouth and provides support to individuals and families throughout south-east Hampshire. A key objective is to provide finance to personal and business customers from disadvantaged and low-income groups who might otherwise resort to alternative credit markets.
PART receives funding from a number of sources, including: the Single Regeneration Budget, Lloyds TSB, Portsmouth City Council and Portsmouth Housing Association. In addition, there are a large number of community partners (for example the South East Hampshire Enterprise Agency) and it is hoped that finance will be raised from individuals within the area. PART has issued a share prospectus, providing an opportunity to purchase 1 shares and encouraging applicants to buy at least 250 shares. Shareholders will be able to withdraw their funds, subject to certain notice periods and availability at the time. Although they will be not receive a financial dividend, many will be attracted by "a social dividend", conditional on improvements within the community. PART hopes, through this innovative financing scheme, to raise 100,000 in the first year. In addition to providing an additional source of finance, investment by the community can increase the standing of PART within it and address some of the cultural barriers that might deter potential borrowers from approaching a commercial organisation. PART's literature emphasises that it is "rooted in the communityowned and managed by local people".

Pembrokeshire Lottery The Pembrokeshire lottery has been running since 1993, providing an innovative source of finance for businesses in the area. Individuals who subscribe 1 per week are entered into a weekly draw, the winner of which is awarded 2000. The surpluses from the draw, 760,000 by Summer 2000, are invested in local businesses.

88

K Drayson, B Paterson and J Powell, Investing in People and Places (2000).

58

5.30 Furthermore, schemes where members of the community are involved from an early stage are typically the most successful. Salford Money Line is an example of an initiative which is being developed in accordance with this principle. Partnership with the community has been viewed as paramount: members of the community have been closely involved in preparing the promotional literature. While the Salford Money Line is a one-off initiative, the concept is one which, if successful, is likely to grow in popularity.

Salford Money Line The Salford Money Line is being established to support individuals and businesses in the Salford area, which encounter difficulties in raising finance from more traditional sources. The scheme has a number of innovative aspects, such as repayment holidays in December, and aims to assist personal and small business customers. The scheme, which will take the form of a business in which local people can buy 1 shares, hopes to be fully operational by mid-2001. It has in its formative stages placed great emphasis on a partnership approach and on involving the local community. Partners include: Barclays Bank, the City Council, the University of Salford and a number of local Housing Associations. This consultative approach should assist Salford Money Line's ability to meet the needs of the local community, by providing finance to businesses in a way which seems non-threatening and which might encourage them to progress to more commercial banks in time.

Information Sharing 5.31 CFIs tend to be local organisations, established to meet the particular needs of the community. Many of their approaches are innovative and take considerable time to develop. While relationships between CFIs are good, there is perhaps further scope to promote best practice amongst CFIs and to benefit from economies of scale, particularly in the research stage. The Development Fund element of the Phoenix Fund will assist in such developments, as will the continued input of organisations such as the Local Investment Fund in disseminating their expertise on a national basis. Furthermore, the SBS, via the Phoenix Fund, is financing the provision, through seminars and via the Internet, of training for CFIs. A pilot course will be launched in January 2001 and the training will be made available nationally later in the year. There are also tentative plans to establish a trade association for CFIs. This could play a valuable role in the promotion of best practice.
Summary 5.32 The establishment of sustainable enterprise within deprived communities can play a vital role in rejuvenating the areas in which they are based, creating jobs and stimulating general economic activity. In addition to benefiting the individuals within these areas, it will reduce the level of support required from the Government and increase the customer bases for organisations, such as banks, servicing the area. The way forward preferred by many of those we have consulted is a partnership approach. The public, private and voluntary sectors all have specific contributions to make and the main challenge ahead is the development of joint projects and working methods that are mutually beneficial as well as effective in tackling deprivation.

59

SECTION SIX: CONCLUDING REMARKS

Key Findings 6.1 This report is the first in what is intended to be a regular series of assessments of the provision of finance to businesses in deprived areas. As it is an inaugural report, it has aimed to set the scene and identify some of the key issues affecting businesses, and potential businesses, in deprived communities. 6.2 The Bank's regional visits formed a crucial part of the research for this report and the Bank is most grateful to all of those who took the time to explain the issues relevant to their particular communities. Although the issues, and their severity, varied between communities and regions, a number of common themes arose. Most importantly, the availability of finance was seen to be just one of a range of issues which needed to be considered in promoting business in deprived communities and was for many far from the greatest problem. A multi-faceted approach is essential to address the underlying problems, and to improve the economic and social environment so that businesses can survive. Access to finance has a role to play as part of such an overall regeneration programme. 6.3 Bank lending to businesses in deprived areas (as covered by the Bank's data collection exercise) stood at 1.5 billion at the end of June 2000. The types of financial products appeared to be used in similar proportions to small businesses in Britain as a whole, with the exception that term loans were of shorter maturity and subject to somewhat higher margins, reflecting the greater risks attached to businesses in deprived areas . 6.4 There are, however, a number of businesses and enterprises that rely on noncommercial sources of finance, especially those which require micro-credit. There are already a number of innovative initiatives, some supported by the banks, which make a valuable contribution to the promotion of enterprise in deprived communities. There is scope to benefit from best practice among the range of CFIs and to build partnerships to improve their sustainability. Successful initiatives tend to offer more than finance, and include a range of practical support and advice. Access to appropriate forms of support and advice is vital for business owners and the self-employed in deprived areas. The need for business support was viewed by many as more important than finance. The Year Ahead 6.5 The Bank will continue to monitor developments relating to the financing of businesses and social enterprises in deprived areas. We will undertake a further series of regional visits. This will enable us to assess the progress made by some of initiatives referred to in this report, and provide the opportunity to speak to some organisations we were unable to visit this year. 6.6 It is important to have realistic expectations of progress given that, as this report has made clear, there is no single initiative or policy action which would address all of the issues. We shall, however, be reviewing new initiatives, the success of existing ones, and the types of partnership which are formed. We will also collect further quantitative data relating to bank exposure to the relevant markets and we shall be looking at the development of CFIs and the actual and potential contribution of the Small Business Service. 60

ANNEX 1: MAP OF VISITS AND AREAS ANALYSED

Map of BoE Visits and Geographical Distribution of Postcode Sectors Analysed

Stornoway

Glasgow

Newcastle Londonderry Gateshead

Belfast Bradford Leeds Wigan Liverpool Caernafon Wrexham Portmadog Birmingham Tregaron Merthyr Tydfil London Cardiff Bristol Portsmouth Bedford Luton Manchester Salford Stoke-on-Trent Sheffield

Norwich March Lowestoft

Plymouth

Over 50 10-49 1-9

Visits carried out by Bank staff* *Many visits included meetings which involved representatives from surrounding areas

Portsmouth

61

ANNEX 2: METHOD
Introduction In monitoring access to finance for businesses in deprived areas, it was important to obtain data on banking services in a number of areas defined as deprived. The Bank has collected such data, on a confidential basis, from the banks on a regular basis as part of its ongoing monitoring of small business finance. Considerations of comparability meant that the heads of data collected for the subset of deprived areas were broadly similar to those normally collected for Great Britain. Of particular relevance to the wider interest in the Bank's work is the broad equivalence between a bank's deposit-taking and lending activities in given areas. Selection of Areas

Data sets used

The data sets used in the course of the research were obtained from the London Research Centre (LRC), acting on behalf of the DETR, National Statistics and from the Scottish Office. The LRC was sub-contracted by the DETR to distribute the 1998 Index of Local Deprivation (ILD) at ward level for England and has produced a similarly based index for Wales. The Scottish Executive provided us with a publication by the Scottish Office89 giving details of the Scottish Area Deprivation Index (SADI). Postcode data, including both lists of full postcodes and of postcode sectors, were supplied by National Statistics.

Initial constraints
The main difficulty faced in selecting areas was that banks were constrained as to the geographical basis on which they could provide data, while the ILD and the Welsh Index were computed on the basis of administrative districts and wards only. A number of options were suggested to the banks during consultations about the quantitative exercise for the report. The provision of data on the basis of sort code areas was deemed to be unworkable because of the difficulties in matching these to areas classified as deprived according to the ILD. The provision of ward-based information, optimal given the basis of the ILD deprivation information, was not an option for a number of the banks who were not able, within the time allotted and using available resources, to map geographical markers on their accounts data to administrative wards. This process of elimination left the provision of data by postcodes as the best option acceptable to all those required to provide data. However, the use of full postcodes was deemed to be impracticable because of the numbers involved. There are over 2 million postcodes operational in the UK and even selecting only 2% of wards translated into over 60,000 postcodes. A further difficulty is that full postcodes are not purely geographically based and are subject to continual changes by the Post Office. Postcode sectors were deemed to be the best compromise, being easily derived from, and not subject to the same

89

K Gibb et al., Revising the Scottish Area Deprivation Index, The Scottish Office Central Research Unit (1998).

62

degree of change over time as, full postcode data. The issue then was finding a way to transpose ward-based ILD data to postcode sectors. A further reason to use postcode sectors was that these were the basis on which the Scottish deprivation index was compiled.

Translation method
The decision was made to focus on the most deprived 2 per cent of wards in England and Wales separately, and the resulting list of 173 English and 19 Welsh wards was sent to National Statistics for translation into both full postcodes (List 1) and postcode sectors (List 2). As postcode sectors are far from contiguous with administrative wards, it was necessary to obtain a third list from National Statistics, listing all full postcodes within the postcode sectors in List 2. It was also necessary for this third list to map full postcodes to administrative wards. The main problem in going from one basis to the other was that a selected ward could be divided between a number of postcode sectors, some of which were likely to be far from deprived, especially in urban areas. It was therefore necessary to devise a method for reducing the impact of the translation process in changing the deprivation profile of the areas selected. Each of the wards in the English and Welsh deprivation indices were given a percentile ranking depending on their relative rank within the index. This meant, for example, that the most deprived 2% of wards had percentile rankings of either 0 or 1. Using the ward markers in List 3, each full postcode in that list was given a corresponding deprivation index percentile ranking. It was then possible to produce an average percentile ranking for each postcode sector. Two conditions were applied for postcode sectors from List 2 to be selected. Firstly, the average percentile ranking score for postcodes across the sector needed to be less than 5. Secondly, there needed to be at least 1 postcode within the sector which was located in a ward classed as one of the 2 per cent most deprived according to the indices.

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ANNEX 3: THE EXTENT OF DEMAND

The best-fit line in Chart 1 suggests that there is a negative relationship between deprivation and enterprise at the local or unitary authority level90. The more deprived an area, the less entrepreneurial activity appears to take place. The Chart shows the DETR's 1998 deprivation score plotted against VAT registration data (a proxy for the level of enterprise) for each of the local authorities in England, excluding the City of London and the Isles of Scilly which both have very low population levels. Use of VAT data does, however, have limitations. The lowest spatial scale at which data is available is the local authority. Deprivation is often concentrated at a much smaller scale than the local authority level, so the typical unitary authority will include both deprived and wealthy wards. Furthermore, the smallest companies, regardless of area, will not appear in the VAT data as they fall below the threshold level and informal business activity will not be registered in this data. Chart 1 The relationship between deprivation and enterprise (1998)
0.0350 Enterprise Indices (New VAT registrations in 1998 divided by existing VAT stock, per 10,000 adults)

0.0300

0.0250

0.0200

0.0150

0.0100

0.0050

0.0000 0 10 20 30 40 0 Deprivation Score (1998) Source: DTI, DETR

Bearing these caveats in mind, the negative relationship between deprivation and entrepreneurial activity appears to be clear-cut in the case of the fifty most deprived local authorities according to the DETR's 1998 index. Chart 2 shows the distribution of these
90

The best-fit line was produced by ordinary least squares regression analysis of the effect of deprivation on the level of enterprise creation. The analysis produced a negative co-efficient statistically different from zero at the 1% significance level. The fact that the co-efficient is negative confirms our instinctive hypothesis that there would be a negative relationship between deprivation and enterprise. An R Square figure of 0.156301 suggests that approximately 16% of the variation in the levels of enterprise can be explained by the deprivation indices.

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fifty local authorities in terms of VAT registrations and deregistrations relative to the rankings of all the local authorities in England in 1998. It illustrates that nearly half of the fifty most deprived local authorities appear within the bottom quartile in terms of VAT registration and deregistration rates in England. Interestingly, a significant minority of the most deprived local authorities exhibit rates which place them in the top quartile of registrations and deregistrations. Previous research has shown that many of the local authorities associated with high VAT registration and deregistration rates are in London. The geography of London illustrates the problems associated with using data based on the local authority level for measuring business activity within deprived areas. Deprived areas within London are often located in close proximity to very prosperous areas and areas with high business establishment rates91. Chart 2 Ranking of 50 Most Deprived Districts in terms of VAT Registrations and Deregistrations
60% 50% % of Most Deprived Districts 40% 30% 20% 10% 0% Lowest 25% 50% 75% Highest 25% VAT Registrations/Deregistrations Ranking Registrations Deregistrations

Source: DTI, DETR

Chart 3 shows the distribution when those London local authorities appearing in the list of the fifty most deprived areas are removed92. This illustrates that the London local authorities constitute the overwhelming majority of the most deprived local authorities with higher VAT registration and deregistration rates. When the London data are removed, virtually all of the most deprived local authorities have rates in the bottom half of all local authorities in England. Around two-thirds of the most deprived areas, excluding London, lie within the bottom quartile of registration and deregistration rates.

Greater London Enterprise, New Directions - Sustaining London's Communities, Greater London Enterprise: The Social Economy Framework for London (2000). 92 Op cit, Policy Action Team 3 (1999).

91

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Chart 3 Ranking of 50 Most Deprived Districts in terms of VAT Registrations and Deregistrations (Excluding London)
80% 70% % of Most Deprived Districts 60% Registrations 50% 40% 30% 20% 10% 0% Lowest 25% 50% 75% Highest 25% VAT Registrations/Deregistrations Ranking Deregistrations

Source: DTI, DETR

Despite the problems associated with VAT registration and deregistration as a proxy for demand, the above data supports the intuitively plausible conclusion that deprived areas are characterised by much lower levels of business activity than less disadvantaged areas. This could suggest that there is a lower level of demand for establishing businesses in deprived areas, or that existing demand is not being as fully met in such areas.

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ANNEX 4: COMMUNITY FINANCE INITIATIVES

The following table of CFIs has been prepared by the New Economics Foundation Aspire Micro Loans for Business Limited Aston Reinvestment Trust Black Country Mutual Guarantee Society Business Debtline Cambridge Housing Society CEED (Charity) Ltd Charities Aid Foundation, Investors in Society Citylife Community Enterprise in Strathclyde Co-operative Housing Finance Society East London Small Business Centre Ecology Building Society Elephant Jobs Enterprise Ventures Ltd Envolve Glasgow Regeneration Fund Greater London Enterprise Hackney Business Venture INBIZ (South) Ltd Industrial Common Ownership Finance Local Investment Fund Merseyside Special Investment Fund National Association of Mutual Guarantee Societies North London Chamber and Enterprise CU PRIME Prince's Trust/Prince's Scottish Youth Business Trust Sheffield Co-operative Ventures Street Cred Street UK Sustainable Strength, Birmingham Settlement Triodos Bank Women's Education Enterprise and Training Unit Wellpark Enterprise Centre Belfast Birmingham Willenhall Birmingham Cambridge Bristol National Cambridge Glasgow London London Keighley London Preston Bath Glasgow London London Thornton Heath, Surrey National National Liverpool National London National National Sheffield London National Birmingham National Norwich Glasgow

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ANNEX 5: FINANCE FOR COMMUNITY FINANCE INITIATIVES

Evaluation of CFIs The New Economics Foundation is currently carrying out research on evaluation methods with the ultimate aim of disseminating best practice in the UK. It is hoped that accreditation of programmes by some formal approval of their performance measurement processes could help their fund-raising efforts. Traditionally the economic impact of development finance programmes has been measured in terms of the number of transactions and possibly the number of jobs created or preserved. However, it is also important to consider measures of self-sufficiency and financial performance. Other measures could include the amount of additional funding levered in from other providers, the number of businesses established, and the impact on business survival rates. The social impact of programmes is generally difficult to assess. The University of East Anglia has developed a social impact assessment system for WEETU's Full Circle Programme, which it has piloted over the last year. This involves obtaining feedback from participants at every stage in their development. However, any qualitative evaluation process focusing on the acquisition of "soft skills" by participants is likely to be costly and time-consuming. Financing Issues for CFIs A key issue for CFIs is the sustainability of their organisations: the ability to cover their operational costs with revenue generated from their lending activities and fee-based services. This is commonly defined as operational sustainability and is different from financial sustainability, which would require programmes to meet their capital costs as well. While the former is theoretically achievable for well-run programmes focusing on "nearbankable" enterprises, the latter is likely to be very difficult even for these programmes. The main factor likely to deliver operational sustainability in the medium term is scale. Extending operations rapidly to generate high lending volumes is probably the quickest way for organisations to cover the fixed costs of loan portfolio administration. This route does, however, imply a large capital injection from the outset. Fundusz Mikro in Poland was able to follow this path thanks to a $24 million grant from the Polish-American Enterprise Fund. Its domestic sister organisation Street UK is currently following a more gradual development path as it is hoping to raise 10 million over 4 years through a share issue aimed at small investors. This is closer to the main alternative route to sustainability, which is to wait until each new branch of a micro-credit organisation has become self-supporting in its own right before opening a new one. Many of those dependent on grant finance now acknowledge the need to become selfsustaining. A favoured route to achieving this goal is to scale up activities, both in terms of fund size and geographical area of operation. ART, for example, has expanded its operations to the whole of Birmingham. A number of organisations are currently exploring the possibility of borrowing from banks on favourable terms as the best means of scaling up activities, given the increasing difficulties in obtaining grant finance.

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CFIs face particular difficulties when seeking finance. There are understandable concerns about the viability of organisations which generally focus on businesses which have failed to secure bank finance. Furthermore, many of the organisations are new and so have not had time to build up a lending record. Whether CFIs have the structures and policies in place which can underpin sustainability over the medium and long term is another key concern of potential finance providers. The difficulty for CFIs to obtain finance from institutional investors was one of the main reasons for the launch of the Phoenix Fund's Community Finance Challenge Fund. Another approach to funding has been to solicit "socially responsible" investment from philanthropic individuals. The Sheffield Employment Bond and NatWest's Community Bond are innovative examples of such an approach.

NatWest Community Bond

NatWest launched its Community Bond in January 1999. The bond, which is based on the Socially Responsible Bank Account offered by the Vermont National Bank, provides a new financial instrument to raise additional resources to promote community initiatives. The bond invites NatWest customers to invest a capital sum, of between 500 and 250,000, for a fixed term in one of eleven bonds - choosing between each of the nine English regions, Scotland or Wales. In addition to depositing capital to be on-lent, bondholders are encouraged to choose a lower rate of interest than the published savings rate. The difference between their chosen rate and the advertised rate is donated to the relevant regional Community Finance Fund. Each Community Finance Fund has been established as a company limited by guarantee with registered charity status and will lend, often at near commercial rates, to local projects. The loans will target schemes where they will help to develop capacity and administrative strength, with the ultimate aim of making the projects bankable. In order to maintain the interest of bondholders and to highlight the importance of their support, they will receive newsletters, updating them on the progress of their regional fund. The first round of investments will be targeted at micro-credit and social investment initiatives, many of which will relate to deprived communities.

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ANNEX 6: MICRO-CREDIT SCHEMES

The following list includes those micro-credit schemes listed in the BBA's report "Micro Credit in the UK: An Inventory of Schemes for Businesses Supported by Banks". The report was published in 1999 and records the situation as at the end of 1998. Sussex Development Fund Surrey Development Fund Partners for Growth (Medway) Port (Partnership Opportunities Regeneration in Tilbury) Chelmsford Soft Loan Scheme Boston Borough Council Loan Fund East Lindsay Small Business Loan Fund (Lincolnshire) North Kesteven Small Business Loan Scheme (Lincolnshire) Midland Bank Gainsborough Regeneration Fund (Lincolnshire) Peterborough Soft Loan Scheme Mid Suffolk Business Loan Scheme Menta Good Practice Small Business Club (Suffolk) Norfolk and Suffolk Small Business Initiatives Business Expansion Loan (Norfolk) Full Circle Fund (Norwich) Leeds & Bradford Enterprise Loan Scheme Falchion Fund (Darlington) Business Grants and Loan Schemes (Stockon-on-Tees) Cleveland County Loan Fund Business Link Teeside Fund Sunderland Midland Investment Loan Enterprise Schemes (SMILES) Midland Bank/South Tyneside Loan Fund North Tyneside City Challenge Rowan Start Up Fund (Northumberland) Rowan Fund (Northumberland) Coventry & Warwickshire TEC Start-up Capital Loan Scheme Wolverhampton Enterprise Fund Solihull Start-up Soft Loan Scheme Sandwell Development Loan Fund The Arrow Fund Loan Scheme (Birmingham) Business Link Birmingham Enterprise Soft Loan Schemes A and B Business Link Birmingham Enterprise Soft Loan Scheme C Walsall Small Business Loan Fund Aston Reinvestment Trust (Birmingham) Shropshire Business Growth Scheme - Start-up Shropshire Business Growth Scheme - Existing Business Manchester Lend Scheme Oldham Business Development Loan Fund Normidtec (Warrington) Cheshire Seedcorn SRB Challenge Loan Fund (Bolton) 70

Bolton Business Loan Fund Bolton Business Ventures Loan Fund Helliwell Business Loan Fund (Bolton) Blackburn Borough Council Soft Loans Scheme Merseyside Task Force Merseyside Community Loan Fund Barrow Regeneration Loan Fund Wyre Forest District Council Young Enterpreneurs Fund (Bristol) Midland Bank/Great Western Commerce & Enterprise Low Cost Loan Scheme (Wiltshire) London Business Growth Fund Enterprise Link Loan Fund (West London) Beta 2000 Business Loan Scheme (SW London) Solotec Midland Bank Growth Loan Fund (South London) Credit Unions Scheme (Scotland) Dumbartonshire Enterprise Fund Glasgow Regeneration Fund Business Shop Dundee Investment Fund Investors in Society (UK) Local Investment Fund (England) Ismaili Business Acquisition Scheme (UK)

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ANNEX 7: CREDIT UNIONS

Structural issues Recent research by John Moores University93 has highlighted a number of structural problems faced by the credit union movement in Britain. It draws a key distinction between community-based and work-based credit unions94, the former comprising the great majority by number (85%) but with the latter holding over 70% of total assets. The research confirmed its original hypothesis that many smaller, community-based credit unions were failing to develop into organisations which could provide a real financial service to a significant proportion of the population. A key reason for the slow pace of development was the prevailing perception of credit unions as community and personal development vehicles, rather than community businesses capable of offering a professional service to increasing numbers of customers. This impacted on the ambitions for growth and the perceived need for professional training and staff. Out of 348 community-based credit unions in England and Wales at the time of the research, only four were labelled as self-sufficient and economically viable, according to a classification developed by the Birmingham Credit Union Development Agency. The research also highlighted "volunteer burn-out," where onerous responsibilities were borne by certain members in each credit union. This form of self-management is of special importance to the prevailing co-operative ethos in the movement today, but does present challenges for the performance of specialist functions, for example that of credit officer. Lending decisions are taken by the Credit Committee or Investment Board, invariably consisting of members. This can result in potential conflicts of interest if, for instance, an individual was called upon to decide whether a neighbour should receive a loan. The John Moores research regarded the employment of staff, either full-time or part-time, as a key condition for credit union development. A number of credit unions have mentioned the need to overcome the reputational problem that they are perceived as a "poor person's bank". This can deter the savers who are essential to the viability of the organisation. Regulatory framework The current regulatory framework for credit unions is defined by the Credit Unions Act 1979, as amended by the Deregulation Order of 1 September 1996. Credit unions are registered and regulated by the Registry of Friendly Societies and are subject to a number of core constraints. Membership is limited by the common bond based on place of residence, membership of an association, employment by a particular employer or in a locality, or following a particular occupation. In 1996 a new common bond of living or working in a particular locality was added to the list. For example, membership of the Cardiff Chamber of Commerce is the common bond among members of the First Welsh Credit Union. Deposits are limited to 5,000, subscribed in the form of 1 shares. Interest payments on deposits are not allowed, but dividend payments can be made up to 8% per annum of the value of the

93

Liverpool John Moores University, Towards sustainable credit union development, (1998). Community-based credit unions are based on a common bond related to place of residence or membership of an association, while work-based ones use an employment-type common bond.
94

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shareholding. In practice such payments are rarely above 3% and new credit unions may even pay no dividends at all in the initial years. Loans may be made to members of up to 5,000 in excess of their shareholding: although this low borrowing threshold (a maximum of 10,000) might deter certain businesses, it may also represent an important source of micro-credit finance. Interest on loans may not exceed 1% per month on the declining balance (12.68% APR) and loans are repayable over 2 years if unsecured and over 5 years if secured. In November 1998, the Government proposed a number of measures designed to lift some of the restrictions of the Credit Union Act 1979, in order to encourage growth of the credit union movement and to reinforce its focus on the provision of financial services to those currently financially excluded. The main thrust of the proposals was to introduce greater flexibility in credit unions' funding arrangements, product and service offerings and membership criteria. The changes would remove the current 5,000 limit on membership; allow longer repayment periods for loans; allow credit unions to borrow from external sources in addition to their existing powers to borrow from banks and other credit unions; enable them to offer fee-earning additional services (including bill payments); and allow the association-type common bond to be combined with any of the others. The counterpart to this proposed increased flexibility is that regulation of credit unions would in future be entrusted to the Financial Services Authority. The primary legislation is now in place in the Financial Markets and Services Act, which received Royal Assent on 14 June 2000 and which is due to take effect in due course. However, it is estimated that the full new regulatory regime for credit unions will not be in place until the first half of 2002, when the process of consultation with the movement will have been completed and all the necessary secondary legislation implemented. It is anticipated, however, that certain key changes (such as the extension to loan repayment periods) will be made by Statutory Instrument before this date. The removal of the membership limit of 5,000 is part of the primary legislation95, but will not be effective until the later date. Conditions for further development The Treasury's Credit Union Taskforce Report of November 1999 indicated that changes to the regulatory environment and the lifting of restrictions would not in themselves stimulate the desired wide-scale development of the movement in the UK. Research into other, more successful, movements around the world suggested that a key element in their expansion was the presence of a central services organisation to promote as well as support credit unions through the provision of a range of back-office functions. A draft business plan for a Central Services Organisation (CSO)96 drawn up by the Royal Bank of Scotland, the Co-operative Bank and ABCUL was published in September 2000. Funding of the business plan was provided by all the major banks and building societies, together with the Post Office, MBNA and the Coal Fields Regeneration Trust. The key assumptions of the draft business plan rely on ambitious growth plans. It assumes that credit union membership over the next 6 years will grow to 1.5 million and that the movement will have extended over 1.3 billion in low cost credit (up from a base of 144
Schedule 18 of the FSMA supersedes the relevant clauses of the Credit Unions Act 1979 (subsections 6.2 to 6.6). 96 ABCUL, Achieving Financial Inclusion Through a Sustainable Credit Union Movement: Draft Business Plan for a Central Services Organisation (2000).
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million in 1999), if the CSO starts operations from 2002. Estimates indicate that 20 million will be needed for the CSO over a 5-year period. Such growth is likely to be affected by a range of factors such as the scope of the proposed Universal Bank, and the popularity of basic bank accounts. Research on the credit union movement in the US suggests that the number of credit unions has been falling for the last 30 years, from a high of 29,000 in 1969 to around 1 1,000 in 1996. The main reason for this apparently sharp decline has been the large number of mergers and acquisitions in the US movement. These mergers often occur for strategic growth reasons, rather than as a defensive measure. The average size of US credit unions has grown accordingly, enabling them to offer a wider range of services than before, which in turn attracts greater numbers of members. Membership has consequently grown significantly over the period, even in the face of greater competition from an increasingly deregulated financial services industry. Lessons from the US are difficult to apply directly in the UK for a variety of cultural, environmental and regulatory reasons. However, it does appear that consolidation of the movement in the US has facilitated its expansion, through the operation of economies of scale and improved ability to make technology investments.

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ANNEX 8: DELIVERY MECHANISMS

Changes in Delivery Mechanisms
As referred to on page 49, there has been a significant programme of rationalisation of traditional bank branches, both in the UK and internationally. The changes in delivery mechanisms have been driven both by demand-side factors, reflecting a desire on the part of personal customers for greater convenience in banking, and supply-side forces, through which banks are striving to serve customers more efficiently and at lower cost. Significantly, recent research by the Personal Finance Research Centre97 showed that 70% of small businesses visit their branch at least once a week, and 97% visited the branch to pay in money. Utilisation of bank branches varied greatly between sectors with those in retail and catering being the greatest users. To the extent that the banks recognise these needs, there seems likely to be a limit to the extent to which traditional branches can be replaced by alternative delivery mechanisms. According to the BBA, there were 1 1,557 ATMs in December 1988, of which 935 were situated away from branches. This figure has risen significantly and at the end of 1999 reached approximately 26,000, some 6,000 of which were situated away from branches. Kiosk self-service centres (which allow customers to withdraw money and deposit cheques and in some cases cash) have also reduced the need for some small firms to visit branches, and there are a even a small number of mobile bank branches. The further development of these networks may help to reduce small business reliance on traditional bank branches, although future take-up might in part depend on the level of charges.

Telephone and Internet banking

Telephone banking is also becoming more attractive to some smaller firms, which value the service outside normal working hours. The major clearing banks all offer telephone banking services to their small business customers and Girobank operates 'Girobank Direct', a telephone banking service specifically developed for smaller businesses. Furthermore, the major clearing banks have now all either established business banking Internet services or are in the process of doing so. A survey by the Small Business Research Trust (SBRT), sponsored by NatWest98, found that 79% of small businesses now use computers. Internet access and use is also increasing rapidly. Nearly half of small businesses (47%) had access to the Internet in 1999, compared with 14% in 1996. These rapid increases are encouraging in terms of the potential for small businesses to be able to access services such as PC and Internet banking.

Post Offices
The Post Office has been offering a basic corporate and personal banking service for a number of years, through the Alliance and Leicester (incorporating Girobank). In addition, Barclays, Co-operative Bank and Lloyds TSB's personal customers are currently able to use

97 98

Kempson E, Jones T, Banking Without Branches, BBA (January 2000). NatWest/SBRT, Quarterly Survey of Small Business in Britain (March 1999).

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the Post Office network to make deposits and withdrawals. Co-operation with the Post Office could be a way for banks to lessen the impact of branch closures, especially in rural communities, on both personal and business customers. There are current plans to introduce a Universal Bank, using the Post Office network to provide basic bank accounts for personal customers. Although the number of Post Office outlets has fallen in recent years, there were still nearly 19,000 Post Offices in the UK at the end of 1999, well above the total number of bank branches.

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