Financing Up: Why Levelling Up requires purpose-driven finance

There is widespread agreement that the UK government’s agenda to ‘level up’ the country is important for addressing regional disparities in people’s circumstances, yet how the financial sector creates inequality is a topic that has been little discussed.

Can we level up with the banking system we’ve got?

New analysis by Finance Innovation Lab Senior Fellow Christine Berry and CEO Jesse Griffiths aims to fill that gap. Looking at how the UK’s unusual banking system creates regional inequality they argue for a new policy approach that combines purpose-driven regulation with targeted initiatives – drawing on what already works here and in other countries – that would facilitate the growth of the UK’s purpose-driven, shareholder banking institutions. These consist of Community Development Finance Institutions (CDFIs), credit unions, ethical banks and building societies, and emerging mutual banks – and they could provide a significant boost to small and medium-sized enterprises (SMEs) and households around the country.

How do SMEs fit into the levelling up picture?

Providing over 60% of private sector employment, SMEs are widely recognised as the lifeblood of local economies. As such, they’re essential to the success of the Levelling Up agenda. However, with a funding gap of £22 billion, the financial system doesn’t support them to grow and thrive. Research has found that pre-Covid, only 2–5% of UK bank lending went to SMEs. And there was a geographical imbalance, with around one-third of all bank lending to these businesses concentrated in London and the South East and just 13% of all bank lending going to the most deprived areas.

The dominant shareholder banking model has a tendency to specialise in activities with economies of scale and centralisation – thereby excluding SMEs – and their ownership and governance structures mean lending will be directed to more profitable activities. These are features that contribute to the unequal distribution of lending and side-lining of SMEs.

And what about households?

If the Levelling Up agenda is a success, its benefits will be felt at the household and individual level. But this requires a functioning relationship between banks and individuals that benefits all. With approximately 1.2 million people remaining unbanked, access to bank branches declining, and the rapid growth of household debt, that relationship needs attention.

Even prior to the pandemic and the current cost of living crisis, the Bank of England warned of a “spiral of complacency” around personal debt. In 2021 the number of households struggling with large debts rose by a third, to around 10% of households. As many as 10 to 12 million people have limited options for accessing credit from a mainstream bank, and so resort to the commercial high-cost credit sector. This exacerbates poverty in deprived communities, with high interest rate payments draining already scarce resources.

The potential of purpose-driven banking

Purpose-driven banking institutions have social and/or environmental purpose embedded in their mission, which then translates into operating structures and practices. Compared with the dominant big banks, such ‘stakeholder banks’ have been proven to maintain larger branch networks, lend more to small businesses, produce more consistent and less volatile returns, have safer business models with higher loan quality, and help reduce regional inequality.

For individuals, this means affordable credit options are widened and often combined with support such as money advice and access to benefits, which further builds people’s financial resilience. Many purpose-driven finance institutions also support SMEs that are unable to access mainstream credit; in 2021 94% of SMEs that received loans from CDFIs had already been turned down by another lender.

A step-change is needed to enable these services to become accessible to all, and we can look to many other countries to see this working. For example, ​​the German banking system consists of a network of local public savings banks and co-operative banks, alongside big commercial banks. This system has been credited with closing Germany’s regional divisions, and particularly in supporting small businesses in the country’s most deprived regions.

The UK can also take inspiration from the US Community Reinvestment Act of 1977, which requires banks to demonstrate they are channelling a minimum level of funding to low-income neighbourhoods. If they are not willing to lend themselves, they must provide support to local purpose-driven institutions, which assume this role.

Banks for levelling up

The UK has a major opportunity post-Brexit to rethink the role of its financial system in supporting the wider economy, and in particular the development of its regions. This needs to include taking the opportunity to ensure regulation elevates financial inclusion objectives and supporting regulators to focus on promoting the interests of the country as a whole. We know what works in other countries: purpose-driven financial institutions rooted in and accountable to local communities. Enabling such institutions to flourish in the UK would mean the financial system could become a major driver of levelling up, rather than a barrier.

Read the full report here.