The Credibility Gap

Why won't Middle East banks lend money to small businesses, and can anything be done to change their minds? Published in Bloomberg Businessweek, 18 March 2015

Pity the entrepreneur running a small business in the Middle East who wants to borrow some money. He probably won’t have a bank account, particularly if he is working in the grey economy, but even if he does he will almost certainly have no loan or overdraft arrangement. According to the World Bank, just 20 per cent of small- and medium-sized enterprises (SMEs) in the Middle East and North Africa have a loan or line of credit. In most Middle East countries, SMEs account for between 20 and 40 per cent of private sector employment—a percentage that is significantly higher if the grey economy is included.

Instead of helping small businesses, banks across the region tend to focus their lending towards large corporate customers and the public sector. “The banks in Jordan are big, well-capitalised and they’re not willing to take a lot of risks,” says John Yancura, chief executive officer of Finca Jordan, a microfinance company. “There is some lip service to SMEs and small business lending in Jordan, but a lot of bank lending is to government.”

This approach is prevalent throughout the region, according to figures from the International Finance Corporation (IFC), an arm of the World Bank. Loans to the SME sector account for just 12 per cent of all bank loans in the Levant and North Africa, it says. The figure is even worse in the GCC, where SME loans make up just 2 per cent of all bank loans.

A survey carried out last year by the Dubai Economic Council found that just 11 of the 18 banks it asked did any lending to the SME sector. Of those, five of them said SME lending made up less than 10 per cent of their total loan book. But while the absence of SME finance appears to be most pronounced in the Gulf, the need for change is widely recognised elsewhere too. “Banks [in Egypt] are not fulfilling their role, which is to match-make the excess supply of cash with where it’s most needed,” says Wael Ziada, managing director and head of research at Cairo-based investment bank EFG Hermes. “They’ve been lending to a sovereign, which has almost zero risk of default. That has resulted in a lot of bankable companies being pushed outside the system.”

Instead of persuading a bank to lend money, a small company may be able to borrow from another business or individual  swapping post-dated cheques or promissory notes in return for the cash. The cost of doing so is often extremely high, although the fact that SMEs can still afford to go down this path is a sign of just how profitable many of them are.

“The SME sector is phenomenally strong,” says Sabah al-Binali, a former vice chairman of Gulf Finance Corporation, the SME lending arm of Dubai-based Shuaa Capital. “If they can pay rates of 15 per cent and remain highly profitable that shows you how strong they are.”

Ziada agrees, saying that if the banks took a closer look at the SME sector they would almost certainly discover some attractive lending opportunities. “Egypt is a country where you have companies that are resorting to financing at a 30 per cent interest rate,” he says. “If someone is financing his working capital at a 30 per cent interest rate how much do you think he’s earning a year? His return must be above 40 or 50 per cent.”

But if SMEs are such good credit risks, why are banks still not lending to them? The reasons vary from case to case, but among the most frequent problems is that SMEs often lack the audited accounts and other paperwork that banks require to evaluate them as a credit risk. Doubts over the amount of security that a bank will receive in return can also dissuade them from lending, particularly in a place like Dubai with a high turnover of expatriates. Such issues mean that SMEs are less credible in the eyes of the banks.

Another reason is that the loan an SME might want is often too small to be interesting for banks. According to Al-Binali, the main problem is not that banks are unwilling to risk their money with SMEs, but that it just doesn’t make sense for them to do so. “It’s not so much that the banks are risk averse, it is just that they cannot innovate,” he says. “There isn’t a massive increase in risk [in lending to SMEs], it’s just a different risk and it requires a different approach. Business development is different, client acquisition is different and how you manage the risk is different. You really need an entrepreneurial approach, which in a larger institution is rarely found.”

Whatever the reasons, there is no doubt that finance is lacking and there is a lot of pent-up demand for more credit across the region. According to the IFC, the credit gap for SMEs in the region is around $260-320 billion, more than in any other emerging market region.

There are of course options available to address the problem. Tax breaks and other regulations could perhaps be tweaked to encourage more lending. Other forms of funding could also be encouraged, ranging from microfinance institutions to crowdfunding platforms, angel investment networks and venture capital funds. Many of these provide a useful service in more developed markets but are still in their infancy in the Middle East.

Arguably governments could also do more directly. There are some government initiatives to help entrepreneurs. For example, the Saudi Industrial Development Fund provides guarantees on bank loans to SMEs under its Kafalah programme. But the funding provided varies from year to year and still depends on banks agreeing to the loans in the first place. In 2014, the amount lent under the programme dropped 76 per cent to 572 million rials ($153 million) as banks tightened their lending criteria. That compares with a 12 per cent increase for total bank credit last year to 1.25 trillion riyals, according to Saudi central bank data. In the UAE, the Khalifa Fund for Enterprise Development provides funding to SMEs across the emirates, as well as providing finance in other markets—in November it agreed to provide $200 million to Egypt’s Social Fund for Development to support projects there.

Ziada suggests that if Egypt could attract higher levels of foreign direct investment (FDI) that would lead to higher savings rates which could, in turn, lead to more lending to SMEs. “Savings equals investment,” he says. “In a country like Egypt with a very low GDP per capita the savings levels are anaemic. You have 10-15 per cent of GDP in the form of savings, so that’s as much investment as you get. Hence the tremendous importance of getting FDI into the country because this is where you start creating a larger pool of money. The multiplier effect would result in more savings being available to SMEs and that would start a virtuous circle.”

None of these options offer a quick fix, but if a way can be found to boost lending to SMEs then there are some obvious potential benefits, both for those directly involved in lending and borrowing and for the economy as a whole. Across the region, governments are desperately trying to create more jobs and to diversify their economies. The SME sector is one of the obvious areas where jobs could be created and where economic diversification is most likely to happen. That ought to offer enough incentive for regional governments to do more to boost lending to SMEs.