How can government acclimatise lenders to SMEs?

Over the past six months leaders in the banking sector have announced that SME owners and managers were departing the UAE with their companies in trouble and defaulting on their loans.

The implication was that the SMEs were in trouble because of a contraction in the economy.

However, the banks clarified that a portion of the defaults was because of banks getting a clearer picture of the SMEs’ borrowings thanks to the UAE’s Credit Bureau, and then calling in or not rolling over credit facilities – although there was no clarity on what percentage of the defaults were because of banks behaving in this manner.

There was also no clarity on whether the numbers mentioned in terms of SME defaults were gross or net – did the banks subtract out the value of the collateral and provisions already booked?

To their credit, the banks came together and developed a framework, the “mini bankruptcy law”, that is supposed to discourage banks from acting prematurely against SMEs and instead to try to work out a more effective solution by talking to the other banks involved as well as the SME.

Although seeing the banks work together to stave a wholesale rout in the SME sector, considered strategic by the government, is quite salutary it is disappointing to see the SME sector take yet another hit.

As the SME sector is strategic to the government, which not only talks about it but also has developed institutions to help its growth such as the Khalifa Fund and the Dubai SME 100, then how might the government work to better develop private sector lending to SMEs?

There are more than 50 banks in the UAE, which has a population of about 9.5 million, the majority of whom are blue-collar workers.

With that much competition one would expect that the lenders, both banks and non-banking financial institutions, would be forced by competitive pressures to expand into every sector, including SMEs. But this is not the case.

There are at least three ways that the government can incentivise lenders into lending to SMEs.

The first is to guarantee the principal of SME loans. This approach has been used the world over to help shepherd banks into lending to parts of the economy they might initially be wary of.

Guarantees, of course, create a moral hazard, in that if the lender has nothing to lose then they might lend recklessly, wasting government money and lending to the wrong SMEs.

The idea would then be to create some level of risk, such as a co-pay or a deductible on, say, the first 10 per cent loss.

Other moral hazard busters include charging for the guarantee – in other words, credit insurance. Or some combination of the above.

This can lead to lenders familiarising themselves more thoroughly with the SME market before taking the plunge of lending without guarantees.

The second way governments can incentivise lenders is extrapolated from the 50-plus banks surviving in a relatively small economy.

The only answer as to why competitive pressure has not culled this number is that the government supports lenders through outsize deposits, possibly at below-market rates, and huge loans for infrastructure development, possibly at above-market rates.

If this conclusion is true, then the government can steer this lucrative business to banks that are more attuned to its policy objectives. If one such objective is developing the SME sector, then government business can be steered to those banks supporting such an objective.

The third way is through education.

As I have written in detail in previous articles, SME lending is different from large corporate lending. A real-world example is a board member who was not used to the volatility in non-performing loans demanding that the credit risk be decreased by lending smaller amounts.

The unintended consequence is that the client demographic moved sharply to small SMEs.

To understand why, consider an SME that wants to purchase a piece of equipment for Dh1 million. It does the company no good to be offered a loan for Dh200,000. So it doesn’t take it. Only a smaller firm with smaller needs would be interested in such loans.

The problem with sliding down the size curve is that although any individual loss is smaller, the probability of loss increases tremendously. This can lead, and has led, to large losses at a portfolio level.

This is why erroneous thinking with regard to the SME market needs to be corrected.

This article was originally published in The National.