Saturday, 14 April 2012

Debt and Equity financing

Vince Cable wants to help Small and Medium-Sized Enterprises (SMEs) get funding, so naturally he set up a taskforce to consider what might be done.  The report they've come up with is eminently well-suited to its likely fate, which is filing in the round one.  Frances Coppola ably dissects its absurdities.

One problem for SMEs in getting access to corporate debt markets is that the costs of estimating their credit risk would be too large for the size of bond issue involved.  Credit rating agencies are pointless for sovereign debt, where all the information required is readily available to investors, useful for large enterprises, but too expensive for SMEs.  Securitization of mortgages got round this difficulty by pooling mortgages and then slicing the pools into tranches: that all ended in disaster because the quality of mortgages fell as lenders no longer had to hold them to expiry, and because high correlations of default made the best-quality tranches much less secure than investors (and ratings agencies) supposed.  The report recommends an "Aggregation Platform" to bundle and securitize SME loans: this would have the same problems as bundling mortgages, but default correlation would be higher and recovery rates much lower.  And no investor is going to make the same mistake again, nor even the ratings agencies, at least not yet.

The report notes that
The Taskforce has sought to estimate a level of finance that would be required by businesses. This requirement could be met with retained earnings or equity, but the analysis focuses on how much additional credit is likely to be needed.
Why not encourage equity investment instead of exploring divers unsound proposals for making borrowing easier?  The report doesn't say.

Let's at least stop using the tax system to discriminate against equity investment.  That means allowing dividends to be paid out of gross earnings, as is debt interest.  We can get some of the money back by taxing dividend income at the same rate as earned income.


  1. Not quite on topic, but bearing in mind this and the Frances Coppola comment, why is it so difficult to establish a money market type fund that genuinely takes some risk off banks (which recent history suggests might be a Good Thing) but where investors know and accept that they are taking a bit of a punt for higher returns?

  2. There have already been many attempts over the years to encourage equity investment - venture capital trusts, Investors in Industry etc., plus all the film financing wheezes. So there might not be much mileage in further trying to stimulate the public appetitie for equity investment in SMEs.

    On the other hand, your proposal to re-synchronise the tax regimes for dividend income and "earned" income seems sensible. I am not sure why Gordon Brown ever abandoned it, although it should be noted that the previous government had already weakened the link in, I believe, 1993 when, for the first time the rate of advance corporation tax was set at a different rate, 22.5%, from the income tax rate on dividends of 20%, thus discriminating against basic-rate taxpayers.

    I would be in favour of treating, for corporation tax, dividends in the same way as interest. It would be good to see whether the Modigliani-Miller theorem actually works in practice - and help to stop the squealing from the ill-educated that there is no intellectual rigour whatsoever in economics.

    For income tax, the treatment of interest and dividend income should also be equalised - getting rid of that 20% notional tax on certain types of deposit account, as well as tht 10% on dividends. Otherwise you risk creating another of those weird anomalies that already abound in the ridiculously over-complex UK tax code.