Small and medium-sized enterprises (SMEs) form the backbone of the economy, yet they are regularly underserved by the current financial services market. In a system dominated by large commercial banks, primarily serving large corporate clients, SMEs are calling out for a new alternative. The National Institute of Economic and Social Research’s (NIESR) recent report, Alternative Commercial Lending to the SME Market, has found SMEs want a new system built on relationship-based lending, which can help to generate SME growth in all parts of the UK. The report demonstrates the vital role mutual financial services and CDFIs can play in filling this market gap and achieving the Government’s growth mission to restore economic development to all parts of the UK.

At present the business lending system relies heavily on commercial banks operating a centralised banking system where lending is based on credit score and risk-based models to assess lending opportunities. This leaves many SMEs —who may not fit neatly into these credit models—struggling to access the financing they need to grow.

Relationship-based lending focuses on developing a business relationship between the lender and the funding recipient. This model allows lenders to build up a comprehensive understanding of the SME’s business model, goals, and the challenges it faces – enabling them to make informed decisions on whether to lend.

This model is at the heart of the mutual financial services and CDFIs sector. The mutual financial sector focuses on delivering effectively for their members, which own the mutual institution. Their operations are typically characterised by building strong relations with customers – which enables them to assess business need and risk effectively before lending. As NIESR states mutuals aim to “promote their region’s economic and social development” as part of their relationship based lending decision making.

NIESR’s international evidence suggests that decentralised banking systems have a strong track record when it comes to supporting SMEs. The success of co-operative and mutual banks in countries like France, Germany, and Sweden shows that these models can not only compete with traditional commercial banks but often outperform them, particularly during financial crises. In France, co-operative banks control more than 50% of the SME lending market, and research has shown that these institutions have been more effective in helping SMEs, particularly during economic downturns. In Germany, co-operative banks form one of the three pillars of the German banking system and play a key role in regionalised SME lending. Germany’s co-operative banks have a rising share of SME lending – approximately 22% market share – the same as private lenders. Both the French and German systems are characterised by their relationship-based approach which supports long-term investment and growth by SMEs and a stabilising approach to lending.

The decentralised, relationship-based model of these mutual financial institutions allows them to stay more connected to the communities they serve, often operating on a regional basis – offering a level of understanding and flexibility that large commercial banks cannot match.

The UK’s SME sector plays a vital role in driving economic growth and development, but too many businesses are underserved by the current lending market. A move toward relationship-based lending, through mutuals or CDFIs, could provide SMEs with the tailored financial support they need to thrive. The Government could review the case for working towards developing a new network of relationship-based mutual and CDFI financial institutions to meet the needs of the UK’s SME population in all regions of the country.