Credit Crunch on Small Firms in the UK Finance Essay

The seriousness of every recession has always started with financial distress in a number of sectors of the economy (Bernanke et al, 1991).Without doubt the financial environment in the United Kingdom and the rest of the world has witnessed a dramatic down turn facing what the financial experts and the economist call "credit crunch". Ding et al (1998) quoted the Council of Economic Advisors (1991) that credit crunch is "a situation in which the supply of credit is restricted below the range usually identified with prevailing market interest rates and the profitability of investment projects". It can also be defined as an abrupt fall in the accessibility of loans and other types of credit from banks and capital markets at given interest rates. "The reduced accessibility of credit can result from many factors, including an increased perception of risk on the part of lenders, an imposition of credit controls, or a sharp restriction of the money supply".( www.teachmefinance.com ).

After the September 11 attack in the U.S, the Federal Reserve decided to cut interest rate to as low as 1% in June 2004 to ease the monetary policy (Allen, 2007) .This resulted in a boomed economy and availability of cheap credits. Not surprisingly this began to encourage more people into the housing market in search for capital growth. Most of the borrowers were lower income earners and the banks in the United States were willing to lend to people falling into this group, which in the past might be considered too risky. This gave birth to what the financial experts call 'sub-prime lending market'. "Interest rates hit rock bottom in America in 2004 at just 1 per cent, but in June that year they began to rise. As interest rates jumped, US house prices started to fall and borrowers began to default on their mortgage payments sparking trouble for us all" (www.timesonline.co.uk ). The birth of "sub-prime crisis" came to light due to high rate in home repossessions, soon this problem in the U.S started to have impact on other countries. Arnold Jones of the economics magazine analysed this and said "the problem was, these mortgages had been pooled together and sold as 'mortgages backed securities' to international banks across the globe".

Early last year, U.S investment Bank Bear Stearns, admitted losing $1.6bn to mortgage debts since the financial market's internationalization, this effect got into Europe and saw the French bank, BNP Paribas admitting being exposed to debts. Soon, speculations began and other large banks started calculating their financial exposure and risk. Investors in the stock market soon began to liquidate their equity in the banks; this led to 'liquidity crisis. Since the financial market is operating internationally, a plummeted share index in an economy facing a crisis, especially the advanced countries (U.K and the U.S) will have ripple or a resultant effect in the markets around the world. The interbank lending became a risk, since no bank is sure of how the borrower is exposed in the crisis infested market.

Due to this crisis the open relationship once enjoyed by small businesses and their local bank managers has began to crumble, resulting in banks being more selective over who they loan money to. The firms who eventually get loans have to pay interest rates in excess of 10 percent and are required to provide about 50 percent equity. An acquisition on these new terms became much harder. Banks now see small businesses as more of a risk -and because they can't meet all the criteria now required by the bank, they struggle to borrow. Some small business now resort to using director's pension as part of the collateral for the bank loan, since they don't have major assets to secure the loan; for example Team Leyland International (TLI) . "The FSB, which represents about 210,000 UK firms, added that there was a broader concern that small businesses would not be able to afford to expand"(www.bbc.co.uk ). This raises cause for alarm as the job security of employees working in small firms is affected as their jobs are becoming less secure. This has hit some small firms so hard that they had no other choice but to liquidate. It has also caused a reduction in the pay of some of these employees, causing a ripple effect on the cost of living in general; hence making things a lot tougher (as payrolls are cut back but expenses still remain at the same rate). Another way small firms are affected is; the fact that some bigger firms now also finding borrowing more expensive and are unable to secure loans themselves, hence these bigger firms are not able to provide funds for investments in small businesses. As a result of this, smaller firms that supply goods and services to bigger firms are affected inevitably. Although some banks have reorganised their lending policy to fit the state of the economy, some still maintain their policy, for example NatWest reports that "Our lending criteria is based on a number of factors, competitive pricing and the customer's ability to repay being paramount," he said. 'These are consistent principles and remain unchanged by recent market conditions. Any lending decision is made on a case by case basis'" (www.bbc.co.uk )

Research Purpose

The aim of this proposal is to shed light on whether and to what extent small businesses are currently suffering from the credit crunch. Also, the research aims to know what other options are being explored by small businesses to cope with the obvious threat of the credit crunch. Although researchers have studied various effects of the credit crunch on small businesses, there seems to be little emphasis on other means by which small businesses can raise funds to sustain their existence. This is one of the major areas that my proposed research would investigate as reflected in my research question.

Research Questions

Are small firms liquidating and could the credit crunch be the major reason for the unprecedented rate of liquidation of small firms?

How has the credit crunch affected the demand of the products and services of small firms?

What options are small firms exploring in order to be salvaged from the current economic crisis?

Hopefully, the research would be able to provide answers to these questions satisfactorily and present a scientific understanding of the core issues relating to the current literature in this field.

Concepts & Theory

Small businesses employ the bulk of people in the UK but are the most vulnerable to economic shocks. Governments rarely give small companies the credit they deserve, failing to understand their contribution to the economy and therefore failing to protect them by easing the regulatory and tax burdens they face. In a recent publication, Robertson (2009) warned that many high street banks already disregard the immediate challenges faced by SMEs when it comes to applications for funding, and despite the U-turn by the Bank of England to pump money in to the economy, many banks are still imposing even stricter lending criteria that owners and managers simply can't meet. He however stated that banks are not the only option for SMEs who are looking for means to boost their financial stability, and that many now opt to work with providers of alternative, more flexible funding, such as invoice finance (ibid). In studying the impact of credit crunch on businesses Wei et al (2002) stated that the main results of the study showed that the credit crunch had a sweeping negative impact on businesses particularly small-sized banks and enterprises. Also, Bernanke and Gertler (1995) argued that when the economy is hit by a negative shock, there exists a shift in demand or supply. They (ibid) included that on one hand, the corporate sector may be demanding less credit because fewer investments are undertaken; on the other hand, it could be that banks are less willing to lend and, therefore, charge higher interest rates or decline more credit applications. For instance, both increases in the cost of borrowing and credit rationing is likely to lead businesses and households to shelve some investments or current expenditures for which funding is no longer available or has become too costly (ibid).

Bernanke, B.S. et al (1991) argue that during a period of credit crunch, lenders become reluctant to lend either because of funding problems stemming from disintermediation, or because regulators have urged credit restraint. The reluctance to lend may also stem from the lenders' own balance sheet weaknesses (capital constraints) and their reassessment of borrowers' average credit quality. Although credit crunches are often deemed as a primary supply phenomenon, it is difficult to disentangle supply from demand effects since some of the same factors that reduce the willingness to lend may also restrain the desire to borrow (ibid). Wei Ding et al (1998) adds that this is most applicable in a situation of monetary tightening when the external finance premium (that is, the difference in cost between funds raised externally and funds generated internally to the firm) is likely to increase, thus increasing the cost of borrowing. At this point of uncertainty and soberness, characterised by a protracted and tight monetary policy needing high real interest rates, the authors suggest that efforts of small business owners' may appear inappropriate for restoring market confidence. Therefore, it would be desirable for policy makers to consider alternative policy instruments that do not place further stress on the banking sector and on its lending to the corporate sector (ibid).

Bruno (2009) referred to the work of Weston (1996) which showed the existence of a strong negative link between bank size (in terms of asset and bank capital) and the supply of credit to small businesses, arguing that, compared to smaller financial institutions, large banks in terms of capital tend to devote proportionally less of their assets to small businesses. Thus, credit allocation and the impact of a capital crunch on firms' investment are highly dependent on banking system heterogeneity (ibid). The argument during the 1990 recession (which is still relevant in the current situation) was that: with respect to credit terms other than the interest rate, the Opinion Survey on Bank Lending Practices reports a tightening of credit standards during 1990 that appears about normal for a recessionary period. But the question is: How normal can a credit regulatory policy that leaves small businesses unable to operate be? I hope that my research will be able to answer this inescapable question in the unexplored thinking of small business managers.

Bruno (2009) stated that if a capital shortage has reduced bank lending below its economically desirable level, this raises two possible concerns for public policy. First, if bank lending is cut back, bank-dependent borrowers, such as some small businesses, may find it more difficult or costly to obtain credit. This additional burden on bank-dependent borrowers will be viewed by many people as inequitable; it may also be inefficient for the economy in the long run if, for example, it is true that small businesses play an important role in developing product and process innovations. He stressed the abundance of subjective evidence suggesting that at least some small borrowers have suffered from the reduction in bank lending during credit crunch situations. Moreover, in principle, reduced bank lending arising from a capital shortage could dampen economic activity, affecting both aggregate demand and aggregate supply. The potential aggregate supply effects are straightforward: by limiting access to working capital, reduced lending could force firms to shed workers and delay investment plans, reducing output in both the short and long run (ibid).

Research strategy and design

My proposed research will apply a qualitative approach which provides a detailed account of what goes on in the setting being investigated (Bryman and Bell 2007). My major source of data collection is primary data, but at certain stages secondary data would be indispensible to my research; this would include company documents, newspaper articles, reports, and other sources of secondary data. The research design will follow a case study approach. Two small firms would be used as case studies and this would help generate an intensive, detailed investigation of my proposed research. The strength of this design was stressed by Knights and McCabe (1997) as allowing the researcher to combine several methods rather than relying on a single approach. The case study design, like every other design has its short comings which is revealed in the inability for most cases to have external validity or generalizability (Bryman and Bell, 2007)

Methodology

The methodology is aimed at connecting the research question to the data. I intend on using a semi-structured interview as my data collection method. I will be interviewing the managers of small firms to know the extent to which their businesses have been affected by the credit crunch. Questions such as: what number of workers have been laid off and made redundant? To what extent has the crisis affected the demand of goods and services of their businesses? and more would be asked to ascertain the practical effect on the business as revealed by the respondents. My interview will be designed in such a way that the outcome will answer my research questions. Hence Bryman and Bell (2008) suggests that there should be no need in asking questions that do not relate to the research questions. This method would be of benefit to my research as it would give me the opportunity to probe complex questions. According to Bryman and Bell (2003), Semi structured interviews leads to the interviewer having an 'interview guide'; this is a list of specific questions intended to be asked. As beneficial as this method is, it has some short comings, such as the possibility of bias answers and misunderstanding of question by the interviewee. The study population for my research are small firms in U.K, and the sample for the case study would be two selected small firms in the city of Hull. I will ensure that the process of my data collection would be objectively selected to avoid a biased sample. According to Bryman and Bell (2002, 83) "a biased sample is one that does not represent the population from which the sample is selected".

Data Analysis

Data from the interview would be recorded with a tape recorder and then transcribed for analysis. To analyse the data systematically and rigorously, I intend on classifying the data into meaningful categories derived from concepts and theories; in order to develop a structure to aid further analysis. Then I would engage in a selective process to reduce and rearrange my data into a more comprehensive form by the use of charts and graphs. To supplement this, I would make use of summaries (which is an analytical aid providing additional contextual information) to highlight the key points that occurred in the interview such as; the comments and non-verbal communications made by the interviewee, and anything that occurred that might affect the essence of the data collected. I intend on implementing the grounded theory procedure of the inductive approach which involves the building of an explanation around the core theme that emerge from the data (Saunders 2007)

Validity

Winter (2000) argued that although the traditional criteria for validity find their roots in a positivist tradition, anchored on empirical conceptions such as universal laws, evidence, objectivity, truth, deduction, fact, mathematical data etc; there exists a dichotomy between validity in quantitative research and qualitative research. However, Winter (2000) went ahead to quote Warin (1997) that validity and reliability are tools of essentially positivist epistemology. In this research, I shall ensure validity by selecting relevant data and avoid misleading questions in the process of data collection. This is because, in every research, "the greatest threat to validity is wrong choice of language and presentation of irrelevant data" (Maxwell, 1992, 287- 288). The validity of my research will best be determined internally. Internal validity (or molar causal validity) as distinct from eternal validity, erases the confusion normally presented in treating validity as unspecific (Campbell 1986).

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