Britain's risk-wary banks are reluctant to lend to small firms or pass on cuts in interest rates, according to government-commissioned research that points to a lack of supply rather than demand as the main brake on transactions.

Banks have clashed with policymakers and regulators over the reasons for scant flows of credit to small and medium-sized enterprises, seen as vital to Britain's economic recovery, arguing that firms lack confidence to borrow and invest.

A study by the National Institute of Economic and Social Research (NIESR), the country's leading macroeconomic think-tank, published on Monday said subdued demand for finance and pressures on banks to shrink balance sheets played a role.

But it suggested lenders' excessive distaste for risk was a key factor.

"It's the aftermath of the credit-driven boom followed by a banking crisis which has led to a shift to risk aversion," said Philip Davis, one of the authors of the paper.

He said banks over-reacted to lax pre-crisis lending practices, noting that a typical SME was now less likely to obtain a loan than in 2001-04, a period the researchers consider "normal" in contrast to the "easy money" of 2005-07.

"In the boom, credit conditions are relaxed too much and then in the downturn credit conditions are tightened too much," he said.

The paper summarises research prepared by NIESR for Britain's Department for Business, Innovation and Skills, whose minister Vince Cable has regularly criticised banks and called for more action to boost business lending.

Additional factors constraining credit flow to SMEs include high margins on loans to the sector, with banks wielding greater monopoly power over smaller firms, while large companies have the option of borrowing via bond issues, the researchers found.

This suggests that "banks have to some extent taken advantage of the lower base rates to profit from SME lending," they wrote.

When the economy's prospects - and so the risk of defaults - are hazy, banks are particularly wary of lending to smaller firms as they are perceived as less stable.

Furthermore, "they have lower reporting requirements, have less need for formal reporting structures and are subject to less outside monitoring by equity investors," the paper said.

Source: THT