No easy solution for the problem of SME lending gap

According to the International Finance Corp, SMEs in the UAE represent 90 per cent of total businesses. As a total percentage of GDP, the estimates for rich Mena countries are at approximately 51 per cent contribution from SMEs with employment contribution at 62 per cent. Paradoxically there is an SME credit gap in excess of US$260 billion in Mena, with only 4 per cent of outstanding loans in the UAE awarded to SMEs. This points directly to the main challenge facing SME sector growth.

As the governments across the region and in the UAE in particular seek to bolster the critical SME sector, the question arises what can be done to help this sector flourish. Public sector support, such as the Khalifa Fund and Dubai SME, provides equity funding, incubation, business planning and other services to Emiratis. Private sector initiatives are predominantly private equity and venture capital firms that include Middle East Venture Partners, looking at younger companies, and Cedar Bridge, focused on SMEs in the growth phase, as well as a multitude of other firms. Legislation has recently been enacted to further develop the SME sector. What is missing is addressing the debt financing gap of 4 per cent current outstanding loans to SMEs relative to estimates of greater than 50 per cent contribution by SMEs to the economy, according to a 2012 IFC presentation.

To understand the urgency of the matter, assume a conservative 50 per cent of GDP due to SMEs, with 4 per cent of loans. This means that the rest of the economy, 50 per cent, is leveraged by 96 per cent of loans. This implies an incredible efficiency in terms of use of capital by SMEs which are able to match, or beat, the rest of the economy which is so highly leveraged. Trying to understand the exact effect of improving the debt financing of SMEs to say 40 per cent from the current 4 per cent is futile, but it is blindingly clear that the result will have a significant and sustainable improvement in GDP growth.

What efforts are there to improve debt financing for SMEs? Regulatory changes have been enacted with more on the way. The recently launched Emirates Development Bank has guidelines to provide 10 per cent of its loans to SMEs, a vast improvement over the current 4 per cent market level, but far short of the SME sector’s 50-per-cent-plus contribution to GDP. Furthermore, there is an offsetting development in the withdrawal of at least three global commercial banks from the UAE’s SME loan market.

In the private sector the calls for SME support by banks have been consistent for years. The problem is that there has been no real action as clearly shown by the abysmal 4 per cent statistic of loans to SMEs. So are the banks being dishonest in their announcements? This is unlikely and it is much more likely that the intent exists but that there are challenges to SME lending that the banks are finding difficult to overcome. Although the banks do not announce these issues, it is not difficult to recognise what the issues are.

Starting at the first step, individual SME loans are much smaller than loans to conglomerates, government and government related entities and large family businesses. This means that originating such loans to match the portfolio size of large customers takes much more manpower, a cost that might be difficult to justify unless the bank changes its business model, at least with respect to SMEs.

The next step is due diligence on the application. Again, this will be completely different than a bank’s current large clients who have well staffed finance departments and up to date technology. SMEs do in time evolve to such levels of sophistication but most will not be able to provide the documentation in the form that banks require. This challenge can also be overcome only with a change in the business operating model for lending to SMEs.

The most difficult challenge for a bank is when an SME application reaches the risk department. Banks set up to look only at risk at this point will simply view SMEs as too risky regardless of return. Even with sophisticated risk based pricing models, a risk culture used to only AA credit ratings will choke on a BB credit rating. As one cannot have two cultures residing in the same entity, the above problem can be resolved only by creating a new risk culture in a separate entity.

In the final analysis it seems unlikely given the challenges outlined and the historical evidence that banks will fill the SME credit void, it would simply take too much in business model and risk culture changes especially as banks are currently making outstanding profits. The incentives are all against improved bank lending to SMEs as evidenced by the large and consistent credit gap.

This is not to say that there is no solution. The answer has to do with recognising that fund providers and fund users are sitting at different points on the risk/return curve and that the solution to this asset-liability matching problem lies in credit structuring.

Stay tuned.

Sabah Al Binali was formerly vice chairman of Gulf Finance, a UAE SME lender, and chairman of Gulf Installments, a Saudi SME lender

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