03/10/2011 06:49 BST | Updated 03/12/2011 05:12 GMT

Lending for Growth - a Conference Priority?

George Osborne is renowned for his sense of political timing. His proposal of an inheritance tax cut in 2007 is widely credited with preventing Gordon Brown from calling an early election while Labour still led in the opinion polls. Perhaps now, with business lending still in the doldrums and the ink still wet on the report of the Independent Commission on Banking, he'll take the chance to announce measures to improve the flow of credit to the UK's businesses. What are his options?

Let's first of all consider the problem he is trying to solve: bank lending to small businesses continues to shrink, according to the most recent figures from the Bank of England, despite banks making available some £20.5 billion in finance to small businesses as a result of the Project Merlin agreement with the government on lending. Banks argue this is purely because of reduced demand for loans: businesses are nervous about future sales, so don't want to take on new debt. Business organisations such as the British Chambers of Commerce disagree, and say that creditworthy businesses are being refused loans, or only offered them on prohibitive terms.

At the same time, Sir John Vickers's independent review of the banking system has called for strict ring-fencing between retail and wholesale banking activities, together with increased capital requirements, rules that some commentators fear will constrain lending further. The Vickers report also called for greater competition in banking, although without going into detail about how to achieve this.

The Chancellor has several options at his disposal to meet this challenge. They are best thought of in two categories: big, systemic changes that aim to reshape the system, and smaller, more incremental ones that aim to create the right incentives for lending.

When it comes to systemic changes, several proposals have been mooted. Some seem unlikely: Adam Posen of the Bank of England's Monetary Policy Committee, and David Blanchflower, a former MPC member turned left-wing journalist, have both proposed the establishment of a state bank to lend to small businesses. This is not unheard of internationally: Germany's Kreditanstalt for Wiederaufbau is one such, while the United States Small Business Administration does much the same by guaranteeing small businesses lending operations. But it is unlikely we will hear much about this today: it seems out of keeping with the mood of austerity, and would be unlikely to play well at the party conference.

Another big-picture proposal, also proposed by Adam Posen, is easing capital adequacy rules for small business lending, so that banks would have to hold less equity against their business loans. With banks' return on equity for business loans a relatively unattractive six to eight per cent, reducing the equity cushion required could make lending more attractive to banks. But again, this may be stymied by opposition from the Treasury and financial regulators, who are nervous of allowing what they see as politically driven exceptions to the banking rules.

Perhaps the most palatable macro option is to offer a government guarantee to some types of small business lending, such as bonds issued by smaller firms. The principle is already established, in the form of the government's Enterprise Finance Guarantee scheme, which guarantees bank business loans. Extending this could help encourage more direct borrowing by businesses, perhaps along the lines of razor manufacturer King of Shaves' 2009 retail bond issue.

When it comes to the micro-landscape of business lending, there is one goal that the Chancellor will be focused on: competition. Increasing competition in the banking sector has been an interest of the Chancellor's team since their days in Opposition. The demerger of 600 Lloyds TSB branches under Project Verde is a start. And new entrants like Handelsbanken But the real question is how to encourage new entrants that can transform the business lending market like price comparison sites changed the insurance business, or Wonga reshaped the unsecured loans market.

One option here involves deregulation. The idea of deregulating financial services to encourage innovation may seem odd or even crazy after CDOs and CDSs brought down the world economy. But several new providers of debt argue the regulatory regime for small lenders discourages new entry. Securing a banking licence, for example, can take over a year. Peer-to-peer lenders like Funding Circle and Crowdcube, which allow savers to loan money directly to small businesses, could benefit from a light-touch regulatory framework for small new providers. By encouraging new models of finance, this could make the system more robust rather than less. The Chancellor may also want to look at tax-breaks for new businesses, such as the Enterprise Investment Scheme and the Enterprise Management Incentive, neither of which are available to financial services start-ups.

Another option is to help businesses shop around for loans. Businesses like Funding Options have called for greater transparency on the terms of business lending: for example, a requirement by banks to state a clear interest margin, arrangement fee and termination fee for lending. These kind of measures are unlikely to be transformative, but have the advantage of minimal direct cost for government with the possible of long-term benefit.

A final option is to encourage more businesses to tap the credit markets directly. Few UK businesses other than the largest issue their own bonds, and no liquid market exists for them. The Treasury has been looking into how to encourage more medium-sized businesses to issue bonds, and how to make a market in them. The real question is how to encourage investor interest in what is, for the time being, an unfamiliar asset class. Tax breaks may be off the table for the time being, but some sort of government guarantee scheme for directly-issued debt would certainly spur demand.

What, then, can we hope for from the Chancellor today? At the very least, it seems likely that he will underline the importance of getting business lending flowing. But there's some hope that we won't have to wait until November's autumn statement for a more definitive move on bank lending. Britain's businesses are watching.