Britain needs more venture capitalism ­– not a state bank

Allister Heath
HERE is a simple question. What do you think would do more to help the provision of finance for small firms? Vince Cable’s new state bank, which will begin its operations in 18 months’ time, or a radically improved tax system to improve the provision of equity financing and venture capital? In other words, is the problem too little debt – or too little equity?

You may say I’m missing the point and that both are a problem. Perhaps. But the truth is that debt financing will always be harder to come by for start-ups than equity. Small businesses are extremely risky. Most go bankrupt quickly. Few (other than one-person bands) are still in business after five years. Only a small proportion go on to make it big.

The chances of a lender losing all of its money is very high, which means that either small business lending becomes a mortgage in all but name – with directors’ homes used as collateral – or a prohibitively high interest rate needs to be charged. Equity makes much more sense: the capital provider is still likely to lose their cash, but also stands to benefit from a potentially huge upside.

Of course, some projects are easier to understand than others. A successful restaurant may wish to borrow more to expand; the decision to lend it some funds may be less risky than lending to a brand new entrant. Perhaps critics are right to say that banks need to become better at picking the right projects to which to lend – though I’m sceptical that there used to be a golden age. Banks relied on locally based managers, of course, rather than centralised systems, which would have helped in some cases – but many modern start-ups are highly sophisticated, and the kind of scale and specialism required to gauge their viability means that the old model is obsolete. If it is hard for veteran venture capitalists to assess the chances of a small business, it will be nigh on impossible for mainstream retail banks to get it right.

If it is true that plenty of good projects go unfinanced, the real solution is to allow more banks to enter the market to pick up such opportunities. However, not only is the government making this extremely difficult by refusing to grant new licences to new entrants but regulators have increased capital requirements for small business loans, dramatically reducing their profitability.

Astonishingly, it is therefore government policy to reduce the availability and increase the cost of small business lending. The government’s refusal to address its own self-defeating policies is the reason why it now wants a state-backed bank. I’m willing to bet that it will end in a frenzy of politically motivated bad loans and misallocated capital, as is always the case with state-directed banks. Poor taxpayers will end up subsidising rich entrepreneurs.

It would make more sense for the government to boost equity investing in start-ups. Current schemes are too complex. Abolishing capital gains tax entirely would help, for a start, by boosting returns to successful investors. Eventually, Britain must become more like America, with a far greater and more diverse army of VCs financing new firms. Once again, the government’s plan is the wrong answer to the wrong question.

It was great to see a full-length BBC2 TV programme on Friedrich von Hayek, one of the greatest economists of the twentieth century, last night. Had politicians listened to his ideas on the business cycle, they would have realised that excessively easy money always leads to bubbles and, eventually, to economic implosion.