Project Merlin has to avoid mistakes of past

Stuart Fraser
LAST week, George Osborne announced to the House of Commons that the four largest UK banks – HSBC, Barclays, RBS and Lloyds – have finally signed up to what has been dubbed project Merlin.

There is no doubt this agreement is good news if it starts to rebuild the banks’ relationship with the government and wider society.

However, some of the stipulations regarding lending to SMEs – £190bn must be lent to businesses this year, £76bn to smaller businesses – give cause for concern.

Of course lending to SMEs is important; they will a key driver in economic recovery and must be given every opportunity to succeed and grow.

Moreover, banks can only make a profit if they lend money to a range of borrowers. The interest rate charged and the conditions of the loan vary with the bank’s analysis of the degree of risk taken by making the loan.

If a bank forgoes making a profit by declining to lend then it either views the inherent risks as too great, or it has more than adequate balance sheet exposure to that type of business.

After the crisis, the banks were rightly criticised for adopting an overly relaxed attitude to lending and a failure of risk management in their quest for ever-increasing profits, resulting in huge losses that nearly caused a financial meltdown.

It also became clear that SMEs were overly reliant on bank lending as a source of finance and did not have sufficiently robust business models to weather a sudden and unexpected change in circumstances.

And yet we are now faced with the situation that banks are being coerced to lend to businesses they have already rejected as too risky or as not having a sustainable business plan, and to encourage SMEs to take on more debt.

This conflict was highlighted when the Chancellor announced that the level of lending under project Merlin is significantly higher than the level banks had originally been considering.

Project Merlin also stipulates that “chief executives of each bank, along with relevant business area leaders will have their pay linked to performance against the SME lending targets.”

This again creates a perverse incentive we witnessed in pre-crisis times. Management were paid to meet quantitative lending targets with little thought on the quality of the lending.

If you were successful you pocketed the bonuses and hoped you were promoted before the defaults started to come in, leaving it to your successor to sort out.

We must be careful not to repeat the mistakes of the past.

Stuart Fraser is the Policy Chairman at the City of London Corporation