Proposals to stop another banking crisis are missing the point

One of the best-established associations in economics is between financial development and growth – countries with well-developed financial systems grow faster.

The reason for this is that evolved financial systems – which include banks and financial institutions, as well as legal and regulatory frameworks – are simply better at servicing companies’ financial needs. Countries with such systems display strong growth, particularly in sectors where external financing is important, such as some high-tech industries. Countries with poorly developed systems tend to be dependent on industries that do not require much external financing, such as retailing.

Banking systems are therefore critical to the growth of economies, but not all systems are equally well suited to all forms of growth.

Typically companies go through a life cycle where they are dependent on owner and family sources of finance in their initial phase, heavily reliant on bank finance in the next stages and turn to market sources of finance only once they are well established. Banks are therefore vital to the successful transition of firms from start-ups to small- and medium-sized enterprises.

At the beginning of the 19th century, the UK had one of the world’s most successful banking systems. It financed the industrial revolution and created a manufacturing industry that was “the workshop of the world”. This system has gone, and with it the industry that depended on it. What we have lost is a system of local banking that financed emerging enterprises and offered them the relationships that now exist in almost every country other than the UK.

The reason it disappeared is that local banking is fragile and exposed to the decline of its neighbouring industry. Repeated banking crises in the 19th century prompted policies aimed at protecting the monetary system by merging smaller banks to form larger, safer ones. So banks got bigger, less local, then headquartered in London and ended up doing everything but funding SMEs. The one type of local banking that remained was building societies, and a significant reason for our preoccupation with home ownership rather than enterprise is that the local institutions exist to fund our housing, but not our companies.

Financing of industry has been a concern of British governments since the beginning of the 20th century, and this has resurfaced recently in concerns about short-termism. A consultation by the Department for Business, Innovation and Skills considered whether the UK financial markets, the financial institutions and executive incentives encouraged firms to focus unduly on short-term performance rather than long-term development.

But the problem starts much earlier than that. There is a fundamental shortage of finance in the UK that runs from venture capital finance for start-ups, through bank funding for SMEs to long-term capital for large organisations. The issue of bank finance for SMEs is particularly relevant now, partly because the financial crisis has focused attention on the failure to provide this and partly because current reviews of the UK financial system offer a valuable opportunity for the government to address the problem.

The trouble is that the focus is not on fixing the financing of industry, but on the immediate issue of avoiding another failure of the banks. For example, the ideas being discussed by the Independent Commission on Banking in terms of isolating retail from investment banking may or may not resolve concerns about stability. But they will not ensure that British banks provide sufficient financing for SMEs, and therefore do not adequately assist the development of our next generation of major corporations.

What is needed? A key feature of local banking and the most successful SME banks around the world is their long-term corporate relationships and their industrial as well as financial expertise. They offer a degree of support for the long-term development of companies that comes from an understanding of their borrowers’ businesses and a commitment of capital in the sectors and locations in which they are based.

It is difficult for banks that operate in international capital markets and freely move resources to the most profitable locations around the world also to provide the degree of commitment that local relationship banking demands. More seriously, the exposure of banks to the fortunes of local industries makes them vulnerable to failure – and regulators and central bankers are therefore reluctant to accept the instability that such banking can entail.

The significance of local relationships in banking is similar to the importance of local networks in the development of entrepreneurial and venture capital finance. The success of Silicon Valley in financing high-tech ventures in large part revolves around the mentoring and networking role performed by experienced entrepreneurs for the next generation. They provide an important intermediary function as general partners between financial institutions and upcoming entrepreneurs.

Without such local intermediaries, the financial institutions in New York would perceive few fundable investments (much like the financial institutions in London) and entrepreneurs in California would be underfunded (as their counterparts in the UK are).

The successful growth of UK enterprise therefore critically hinges on both institutional changes in the way in which banks structure corporate lending and on the response of regulators to these developments. We have a golden opportunity to initiate such changes, but at present there is little evidence that this will happen. If it does not, we will continue to wonder why we have one of the largest financial systems in the world with one of the worst records of financing promising new businesses.

The writer is Peter Moores dean and professor of management studies at Saïd Business School, University of Oxford