The Rise of the Alternative Lender

Standard Chartered, HSBC, Lloyds and RBS have all withdrawn from the SME sector in the UAE. Is this an indication of problems in the UAE SME sector? Absolutely not. It is an indication of troubled global banks and a flawed banking strategy.

Understanding the issue, and the opportunities that it presents, requires an understanding of the common attributes of these four banks and their failures. The starting point is that all of these banks are known as strong commercial banks catering exclusively to retail and corporate clients for most of their 150 to 270 year history.

Then along came Wall Street, its investment banks and fat deal fees. Mortgage backed securities, collateralised loan obligations, foreign exchange futures, interest rate derivatives. Fast talking MBAs backed by deep thinking PhDs. Black Scholes equations, Ito’s lemma, Gaussian copula functions and stochastic calculus. Easy as taking candy from a baby. What could go wrong?

As these four venerable commercial banks piled into a business that they did not, could not, understand let alone govern, they became so blinded by potential profits that they ignored the very real risk lessons happening to their peers.

Without a doubt the Barings Bank debacle was the clearest alarm signal. Barings was a merchant bank, the precursor to today’s investment banks. This means that Barings supposedly had a better understanding of the capital markets than the commercial banks. In 1995 at the ripe old age of 200 years Barings collapsed due to the unauthorised trading of a single employee and the banks inability to manage its internal operational risks.

Why the commercial banks did not heed this warning is unclear. Why they thought that it made sense to change focus from what they know best, lending, and instead focus on what they don’t know, investment banking and capital markets, is also not clear. What is clear is that they should not be surprised that they had no ability to manage their own operational risk in these areas and in particular with their LIBOR and FX dealers.

This brings us to the opportunity. The commercial banks have, in their wisdom, decided to continue to focus on the business lines that destroyed massive value for them and to withdraw from what has been their traditional strength. Four of the major players have left the UAE SME market. They are also leaving the SME sector in many other frontier and emerging markets. This has created a massive gap in the market, and a massive gap means a massive opportunity.

The gap, of course, is not just in the SME sector but in all sectors that the withdrawing banks serviced. The first to benefit from this withdrawal will be the local and regional commercial banks that will step in to service their traditional clients: corporate and retail. The SME sector, already under serviced, will have the gap widen further and provide an opportunity for astute investors to convert opportunities so rich that they will pay off handsomely for decades.

The exact competitive landscape is not clear but what is clear is that it will not be the commercial banks who take advantage. The current alternatives include smaller specialist banks, non-bank lenders, peer to peer operations also known as crowd source funding, and a massive scale up of vendor financing.

Specialist banks are usually banks conceived as conventional commercial banks that never reached the scale to be able to compete with the bigger banks in their preferred markets of corporate and retail and therefore had to find other markets to service. These banks are highly regulated and are legally able to attract deposits, the cheapest funding one can get. The challenge is in restructuring the bank to be aligned with a new vision.

Non-bank lenders are usually regulated as well, but since they rarely take deposits, or at least not retail deposits, their regulatory overhead is less. This allows them to be more nimble than a full blown bank but the offset is usually more expensive funding.

Peer to peer lending networks are intriguing but as yet untested commercially or legally, especially in the region. Disintermediation makes for a powerful appeal, and clients, both borrowers and depositors, disillusioned with the banking system may in the end flock to a non-bank solution.

Let the games begin.

Disclosure: The author is involved in various credit related initiatives.

You may also be interested in: The Characteristics of an Alternative Lender.

This article was originally published in The National.