The Financial Regulation of Small Firms

The financial regulation of small firms

Jane Pollard, Centre for Urban and Regional Development Studies and School of Geography, Politics and Sociology, Newcastle University NE1 7RU

Simon Down, Institute for International Management Practice, Anglia Ruskin University, Cambridge CB1 1PT

Paul Richter, Newcastle University Business School, NE1 7RU

Abstract

The paper draws on ESRC funded research with 14 high growth SMEs in two regions in the UK. The research comprised three waves of ethnographic observation and interviews to understand firms' everyday practices of understanding and adapting to different forms of regulation, formal and informal, perceived and real. Our findings explore the regulatory and constitutive effectsof the activities of various financial intermediaries that provide our sample firms’ working capital. The findings are significant in policy terms in a UK context where much academic and policy discourses about regulation are redolent with notions of “burdens”, of firms being constrained by regulations designed with larger businesses in mind. We argue that literatures in economic geography, concerned with production networks, and those in management, concerned with regulatory ‘burden’, need to devote much greater conceptual and empirical attention to a more relational analysis of the production-finance interface in order to understand the role of firms in regional economic growth.

Key words: economic geography, regulation, financial networks, small firms.

Introduction

There are longstanding debates about how best to support the growth of small and medium sized enterprises (SMEs). One particular area of concern is whether such firms - viewed as crucial for the UK and its regions’ economic and social well being – are overly constrained by regulations, or, more common in popular discourse, ‘red tape’ (Federation of Small Business 2011, Fletcher, 2001). The received wisdom of ‘business burden’ and ‘cost-compliance’ research and much political rhetoric is that the burden of regulatory compliance for small firms is too high (Baldwin, 2004) and that regulation is ‘an enemy of enterprise’ (Wheeler, 2011). More recent research on small business regulation, however, suggests that the effects attributed to regulatory compliance on firm growth are exaggerated (Edwards et al., 2004 ; Kitching et al., 2013; Carter and Mason, 2009); while regulation does mean higher direct and administrative compliance costs for SMEs (Carter et al., 2009), it is often accepted as a necessary part of doing business and can enable as well as constrain firms (Kitchinget al., 2013). Carter et al. (2009) suggest that if we are concerned with the fate of SMEs then there are other forces that ‘impinge on the vitality of the small business sector’ (2009, p. 277) that warrant further research.

This paper identifies one such force – namely the power of financial intermediaries - that is profoundly shaping the vitality of small firms. To develop this argument, we draw on ESRC funded research (details to follow) on small firms’ understanding and adaptation to regulation. We argue that literatures in economic geography, concerned with production networks, and those in management, concerned with regulatory ‘burden’, need to devote much greater conceptual and empirical attention to a more relational analysis of the production-finance interface in order to understand the role of firms in regional economic growth.

The paper is organised as follows. Section 1 considers key elements of debate in management literatures on the health of small firms and discusses three key shortcomings of these literatures. Section 2 outlines some key silences in economic geographical literatures concerned with firms’ performance. Section 3 describes the research project undertaken and section 4 focuses on the regulatory and constitutive influences of financial intermediaries.

1: The regulation of small firms

Policy debates about economic growth in the UK are marked by a strong desire to support small firms and, more broadly, to support a culture of entrepreneurialism that can spawn innovation, commercialization and employment creation. In understanding how regulation affects small firm growth, we synthesise literatures from economic geography, management and entrepreneurship studies to argue that such debates have rested on three major deficiencies.

First, much of the debate has been narrowly focused on discourses about whether regulation is a ‘burden’ and a constraint on firm growth. The first and now standard critique of ‘business-burden’ and ‘cost-compliance’ analyses are that they are over-simple snapshots (at best) of firm behaviours. Edwards et al. (2003:70), for example, moved beyond conceptualisations of regulation as a ‘burden’ by stressing the often indirect impact of employment regulation and arguing that,

‘the law often exerts effects less by direct impact and more by “casting a shadow” over existing relationships mediated by the internal structure of the firm and its position in the market.

Research has also shown that there is sometimes a low awareness of regulation within small firms and a wide range of responses (Vickers et al. 2005) to ‘dealing’ with it, including various forms of resistance and compliance, contingent on business resources and market contexts (Blackburn et al. 2005). Small firms will also often adopt what Blackburn et al. (2005:16) term ‘a cultural predisposition of objecting to regulation’.

The second problem with these literatures has been their reliance on an under-problematised, overly homogeneous conception of ‘a small and medium sized enterprise’. This stance has often led policy debates towards a ‘one size fits all’ approach that looks at the impact of regulation on a mythical ‘typical’ firm. We address two related facets of this under-specification that stand out. First is the analytical privileging of the small firm as a unit of analysis, and often it is an aspatial and acontextual firm that features in much of the small firm literature (Jones et al. 2000, Pollard 2003, Jones and Ram 2007, Ram and Jones 2008). An important re-conceptualisation here is to draw on economic-geographical literatures that view firms as material territorialized and relational constellations of actors, interdependencies and practices (Storper, 1995; Dicken and Malmberg, 2001; Pike, 2007), in which learning, the accumulation of knowledge and rules and norms shape expectations, beliefs and decision-making in conditions of uncertainty. By ‘relational’, we refer to processes,

through which network[1] linkages are established, sustained, and reorganised over time and space by the power struggles between, and the social networking strategies of, business people located in a diversity of places or regions (Murphy, 2012: 211).

As such, firms are living entities that do far more than process transactions costs (Currah and Wrigley, 2004); firms are hybrid, fluid and always combine motion and fixity.

A second important element of our re-contextualization addresses the lack of empirical research that captures the dynamism of firms’ understandings of and responses to regulation. Although recent research (Kitching 2006; Blackburn et al. 2005; Edwards et al. 2004; Vickers et al. 2005) suggests that regulatory effects are not uni-dimensional, much of this research relies on ‘snapshots’ of firms that are unable to distinguish between ‘young’ and ‘mature’ responses, and fails to capture the unintended consequences of regulation on smaller firms (Blackburn et al., 2005). Previous ‘business-burden’ and ‘compliance-cost’ studies have tended to rely on the self-reported effects espoused by owner-managers and have over-emphasised perceived negative effects (Kitching 2006). As small firms are constellations of complex social, economic, legal and spatial relations this approach simplifies the effects of regulation, especially when both short and longer temporal perspectives are considered. Thus, the same contextual factors described above apply to the temporality of regulation in the small firm sector: it is not just the ‘life-cycle’ of the emergence and maturity of the regulations that need to be assessed, but the temporal contexts of the broader economic environment.

Third, our dynamic, relational conception of the firm allows us to explore its location in heterogeneous networks of suppliers, customers and other intermediaries and, in so doing, addresses a third weakness in prevailing literatures. Much work on regulation sees the state as the key actor in designing and enacting regulation, with attendant focusing on things like the UK’s ‘red tape challenge’; regulation is seen as something emanating from government that is ‘done’ to small firms. If we accept that regulation encompasses an assemblage of alliances, influences, actors and practices in extended and dynamic production networks, then regulation can be conceived much more broadly as ‘all mechanisms of social control – including unintentional and non-state processes’ (Baldwin et al. 1998: 4). Relatedly, such an approach pushes us to consider wider territorialized divisions of labour, financial and power relations that shape firm behaviours (see Pollard 2003).

These three interventions lead us to conceive of regulation as a process of interaction between heterogeneous agents in territorialized social, economic and cultural contexts that shape firms’ competitiveness, owner/managers’ awareness of and disposition to regulation (which may be mediated by gender, class and ethnicity). Thus, how small businesses internalise and respond to, for example, the redefinitions of work, age and tax that accompanies regulatory change, is not simply a product of regulation per se, but also territorialized social, economic and cultural contexts of firms. As such, this approach also allows us to explore the everyday micro-social practices of firms and understand their constitution and expression of wider macroeconomic forces (see also Jones and Murphy, 2011).

2: The finance of small firms

A second body of work we interrogate here has long recognised that firm size complicates the provision of external finance (Kalecki, 1937); small firms often face difficulties securing external finance because they are less able than large(r) firms to finance themselves from retained earnings (Macmillan Committee, 1931; Bolton Committee, 1971; Storey, 1994; Bank of England, 2002). Most economic-geographical treatments of firm finances, however, have focused on how firms access external funds, especially those from venture capitalists and business angels (Mason and Harrison, 1999; Mason and Harrison, 1995; Mason and Harrison, 1996; Mason and Harrison, 1997; Martin et al., 2002). With few exceptions (see Clark and Wrigley, 1995; 1997; Pollard, 2007; Pike and Pollard, 2010; Pollard, 2003), analyses of production networks, including highly influential literatures on global production networks (GPNS) (Coe et al., 2004) proceed from the assumption that firms’ capital structures are in place, rather than interrogating their formation and how, in turn, such financial relations shape firm behavior.

For all the insights of economic sociology that have made their way into economic-geographical research, for example the concern with the social and cultural embeddedness of economic behaviours and institutions, the importance of networks and power relations and how these affect economic institutions, these concerns have not filtered through to analyses of the flows of money that support firms and production complexes. The financial architectures of these networks, institutions and behaviours go unnoticed courtesy of the assumptions of both classical and neoclassical economics; that money is simply a neutral facilitator for the exchange of the ‘real stuff’ of an economy and that money merely represents, rather than creates, inequality (Dodd 1994, Pollard 2003).

Pollard (2003) illustrates how the productivist leanings of Marxian political economy - so influential in economic geography since the 1970s - slowed engagement with issues of circulation and consumption. Moreover, political economy, in addition to its legacy of privileging production, is much stronger at macro-level description than it is at delving into the micro-foundations of economic and social co-ordination, most especially issues of allocation and distribution (Sayer, 1995; Storper, 2001).

More recent literatures in economic geography (see Jones and Murphy 2011:374) have developed practice-oriented approaches that view economies as,

more than simply sets of social relations driven by class, patriarchy, or other forms of structural power; they are instead amalgams of materials, performances, structural factors, and cognitions whose particular time-space constitution is contingent on the agency of actors and is thus open to improvisation and accident.

We thus conceive financial intermediaries, firms and corporations, and their assets, as produced and reproduced, discursively and materially, in webs of territorialised financial (and other) relations and practices. On this score, there are a number of geographies of firms’ financial networks to consider. For example, a firm’s assets are irretrievably grounded in real space-time in the bricks and mortar of their factory buildings or laboratories that act as collateral against which they can secure loans. Beyond the firm and its assets, and despite all the globalising tendencies of finance, there remain significant national differences in financial markets (Christopherson, 2002; Zysman, 1983), and, relatedly, in forms of corporate governance. On a regional scale too, firms operate in financial networks that shape their access to and terms of credit. In Becattini’s(1990: 47) discussion of Marshallian industrial districts, the local bank was described as,

an organism born and bred in the district, that is very closely linked with local entrepreneurs (and often with other local social and political lobbies.

Nevertheless there is evidence that such localised forms of firm finance have been eroded from two directions. First, banks in the US and UK have consolidated functions and removed lending authority from branches and become much less reliant on local knowledges(Leyshon and Pollard, 2000). Second, SMEs may increasingly find themselves operating in or at the edges of increasingly global production networks that expose them to international financial networks and performance metrics.

Flows of credit involve not only capital, but also the workings of networks of agents who seek out, control and manage those flows and who do so through participating in networks of peers and customers while operating their businesses according to normalised practices and conventions. Thus, literatures in accountancy and elsewhere in the social sciences have illustrated the socially constructed and spatially uneven norms and practices of accountancy, audit and credit rating (Leyshon and Thrift, 1999; Power, 2003; Sinclair, 2005). For Power (2003: 385), the micro-rituals of audit practice are about ‘impression management’ and the progressive ‘purification’ of the messy reality of economic and financial practice for external consumption. As an important part of a firm’s ability to signal its worth to financial institutions, firms have little choice but to conform to the required financial reporting recognised by banks, accountants and other financial intermediaries.

In essence, our argument is that while innovation, learning, and other facets of economic co-ordination have long been understood as geographically rooted, socially constructed achievements, firm finances are still treated as a silent partner in understanding the growth of small firms and, in turn, their roles in regional economic development.

3: The research project

In what follows, we report on results from an ESRC funded project that ran from December 2009 to June 2012. This research was designed as a response to calls for a richer, contextually sensitive understanding of small firms’ responses to regulation. We employed a longitudinal, qualitative analysis of the processes by which firms understand and respond to regulation in different sectoral and geographic contexts in order to complement existing statistical-based surveys and more recent theoretical syntheses that have been achieved in studies of small firm employment relations (Edwards et al. 2006). The project was designed to build on the above advances by explicitly connecting spatiality and regulation in the study of smaller organisations, specifically by producing qualitative and longitudinal analyses to understand wide-ranging and longer term effects of regulation, including unforeseen effects of regulation (Blackburn et al. 2005) and sectoral, temporal and spatial variations in firm behaviour (see Edwards et al. 2003:74, Ram and Jones 2008). Three specific concerns were addressed in the project. First, by taking process and context seriously, we moved away from a ‘one size fits all’ approach that looks at the impact of regulation on a ‘typical’ firm. Second, we interrogated the temporality and life cycle of regulatory initiatives, following Edwards et al. (2004:250). Our research method allowed us to explore different forms of regulation with different temporal ‘cycles’ and immediacy of response implications and to see varied acceptance and resistance behaviours that developed. Third, the research challenged the analytical privileging of the small firms as a unit of analysis and instead focused on the situated, relational and embedded characterisations of the firm’s production networks.

The project investigated 14 smaller firms in the environmental services, film and media, bio-business and security sectors in two regions of the UK, the North East and the East Midlands (see Table 1). This sectoral emphasis was a response to previous research into small firms and regulation (Edwards et al.,2003) which suggested that some over-researched areas (e.g. restaurants and clothing) should be avoided. Various other factors have influenced the choice of sectors, including orientation to growth. Whilst there is no reason to suppose that all three sectors will have growth-oriented firms, the bio-processing industry clearly epitomises a high-innovation high-growth orientation. The security sector is perceived as less dynamic in this regard. The firms were also selected to emphasisecontrasts in their regulatory approach within sector and the range of regulation sensitivity. We chose firms in the same sectors across two regions to highlight pertinent spatial differences in sectors as they related to economic performance and cultural attitudes to entrepreneurship. Thus the sectors and regions were chosen to ‘illustrate different conditions and circumstances’ (Edwards et al. 2003: 12) relating to the full range of regulation.

In addition to the collection of secondary material, the research team undertook three phases of non-participant observation and in-depth unstructured interviews of managers, employees and external network relations. This longitudinal approach allowed us to confront the complexities of relationships between small firms and regulation, to gain access to the informal and implicit and to incorporate and capture change over time, and to enable reflection on hypothetical possibilities and alternative paths. Though observation and everyday causal conversation typified significant aspects of the research effort, we also undertook 82 interviews with firm staff and other regulatory intermediaries in order to understand how the impact of particular regulations were perceived over time. Other actors interviewed included intellectual property consultants, landlords and venture capitalists, as well as more general regulatory actors such as civil servants and regulators from local authorities, the Environment Agency, Health and Safety Executive, the Better Regulation Delivery Office (BDRO) and the National Institute for Health and Care Excellence (NICE).