In November, news broke from the UAE Banks Federation that banks in the UAE would face losses of Dh5 billion to ­Dh7bn for the year on SME-related lending. A small sum from an asset point of view, but a considerable amount from a profit point of view. Worse, it heralded the beginning of a contraction in the economy.

But something didn’t sit right. Oil was hovering between US$65 and $50 per barrel last year, well above levels that might trigger an economic contraction. It was only in August that oil prices dropped below $50 per barrel to $30, a price that heralds tougher economic times.

It took a little digging to find that the Banks Federation’s statement qualified that the losses were not triggered from operating losses but that the credit bureau, after being launched, allowed banks to understand that parts of the SME sector had borrowed from multiple banks without disclosing it. From the banks’ view, these particular SMEs had been dishonest and so the banks cut their credit lines, causing the overleveraged SMEs to fail.

The good news is that the UAE banking sector is not in trouble and this is supported by a recent statement from Fitch, the ratings agency. The banks will also remain strong if oil stabilises at about the $60 level. But what can the banks do to prepare themselves for a long period of oil at $30 and below?

First some definitions. A bank’s balance sheet typ­ically comprises three elements: liabilities, assets and equity. Liabilities are what fund the bank and usually compromise customer deposits, money market loans – which are both short term – and financing loans, which are usually sold to groups of banks and have a longer ­tenor. Assets are simply the loans that are made, the bulk of this side of the balance sheet and are long-term investments and balances held with commercial and central banks. Equity is shareholder money and simplistically sits as a buf­fer to protect the creditors that provide the liabilities.

Back to our hypothetical scenario planning. The first issue for any bank is the liability side, funding. The loudest warning was made by National Bank of Abu Dhabi late last year as to the large customer deposit withdrawals by the government. Other withdrawals can come from the retail sector as people draw down savings or leave the country as they are laid off. If liabil­ities plus equity drop below assets, that is a huge problem.

How can this gap be closed? Or how can a bank prepare for it? The first thing to realise is that if the economy is contracting then the need for customers to borrow will also contract. This means that the real issue is how fast liabilities contract relative to assets. The first corrective issue for banks is therefore to pare back credit lines approved in the good times to better match today’s environment. This includes reducing loans made. The second is judi­cious use of capital reserves. Most banks in the UAE hold reserves well above the regulatory minimum, usually held as investments and commercial and central bank deposits. This cushion should provide ample support for the well-run bank to bring assets down to match liabilities. However, might we see further exits of foreign banks?

Now that we have taken a layman’s look at a bank’s balance sheet let’s move on to the income statement. If the above scenario pans out then banks will be under-leveraged relative to their equity and so even if they get the same returns on their assets (ROA), their return on equity (ROE) will be much lower. Investors care about ROE far more than ROA as it affects share price.

To improve ROE, banks have to either increase risk or shift assets geographically to markets that provide better risk-reward ratios. The former proposal, increasing risk, basically means moving assets away from the government entities and towards corporate and retail customers – reverse government crowding out, if you will. Of course, this is unlikely to happen as who wants to upset the government?

So the other way to raise ROE is to invest the bank’s excess cash through the treasury and international financial institutions divisions in geographies with better risk-return ratios. With energy costs down by 70 per cent, pretty much most markets around the world will be doing well soon.

There is a third option. Be ultra­conservative and tell your shareholders to expect a lower ROE.

This article was originally published in The National.