Britain needs a vibrant credit market

The outcry was predictable. When the controversial instant loan company Wonga announced that it was moving into lending to small business, there was a string of complaints about how it was going to charge struggling new enterprises sky-high rates for the cash they need to keep them afloat.

But the anger was misplaced. There are few industries that need fresh thinking as much as lending to small businesses. The City has lost interest, if it ever had any. The high-street banks are in full-scale retreat. The government has produced endless enquiries and initiatives, all of which have produced precisely nothing. Wonga's small business loans may not be perfect, but if it shakes up the industry and creates a more open, flexible market, it will have done something valuable.

Business lending is potentially a big opportunity for online lenders. Having come from nowhere with a fresh approach to personal lending quick and easy but expensive too Wonga is hoping to do the same thing in commercial loans. Companies and partnerships will be able to borrow money very fast. Loans of up to £10,000 will be available initially, and the charges will start at 0.3% a week. The interest, of course, is going to add up over a year. But Wonga isn't looking to lend for long periods of time. Its loans are designed to last for a few weeks or months.

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There is certainly space in the market. Small businesses have found it hard to borrow money in Britain for a long time, but since the credit crunch lending has fallen off a cliff. According to research last November by the Federation of Small Businesses, there was a 24% fall in successful loan applications by small firms in the last year. More than half of those that applied for an overdraft and 43% of those applying for a loan for the first time last year were rejected. Figures from the Bank of England show that lending to small business is falling by 3% a year.

The government knows there is a problem and has been trying to get the banks to lend more. Project Merlin aimed to set targets for small business lending by the high-street banks, although there is little evidence so far that very much of it has got through. In the budget the chancellor, George Osborne, launched a £20bn National Loan Guarantee Scheme to try and get more money into the sector. It has even been suggested that the Bank of England should lend to small business directly rather than just buying gilts via quantitative easing.

Yet none of it seems to do much good. In reality, the banks are repairing their balance sheets and don't really want to lend to anyone. The government doesn't have the expertise or the infrastructure to get involved in lending to small companies; and the Bank of England would hardly know who it should lend to and who it shouldn't.

Yet this should be a thriving industry. Companies like Wonga are criticised for making borrowing money too easy, and there is some justification in that. Britain has been on a huge debt binge, with people borrowing way too much money to fund lifestyles they couldn't really afford. A study last week by the National Institute of Economic and Social Research found that by 2007 the poorest households were spending 40% more than they earned. That was crazy they should never have been allowed to borrow so recklessly. If anything we should be making it harder to get personal loans, not easier.

But business lending is not like that. There are usually quite legitimate reasons to borrow short term; stock has to be paid for before it can be sold, customers don't always pay on time and advertising often has to be paid for before it brings in any sales. So companies need to borrow money for a few months to keep their cash flow ticking over.

At the same time, there is a lot of money out there looking for a home. Interest rates on savings accounts are pitiful. The equity markets look set for another summer battering. The bond market is a bubble waiting to burst. Many savers haven't a clue where they can put their money and earn a respectable return with a decent level of safety. Many small companies are quite happy to pay 10% or more for short-term finance. The banks have lost interest, but many investors will think that is a pretty good deal. The trick is to find a way of bringing them together.

Wonga is not the only answer. Companies such as Funding Circle and ThinCats, which connect firms and lenders directly, may well be able to do a better job. So might some of the newer banks expanding into Britain Sweden's Handelsbanken, for example, specialises in providing an old-fashioned service to small companies.

However, what Wonga can do is shake up a market that has become moribund. It is a measure of how far the City has drifted away from being a genuine financial centre for the British economy that it has shown so little interest in finding innovative ways of reviving small business lending. Britain needs a vibrant credit market. If Wonga helps create that, it will have done the country a big favour.

This article was originally published in MoneyWeek magazine issue number 589 on 18 May 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.