Attractive lending margins, a growing and stable economy and easy liquidity have only encouraged increasing competition and a lack of innovation in the small and medium-sized enterprises (SME) lending business among banks.

Liquidity and capital are both cheap and available in plenty, and attractive returns on equity are possible, without true innovation. One area in which these characteristics have manifested themselves — in an entirely undesirable manner — is that of SME business loans, the type that is doled out based on so-called cashflows and debt service coverage ratios.

There has been an explosion in the size of the SME business loan market in the last three years or so. RAK Bank, perhaps the only bank with a clear niche focus, was a market leader in this business for several years.

However, in the recent past, numerous banks have waded into this space attracted by high returns, an easy-to-launch product, high front-end fees, marginal and low level screening requirements and so on. The non-too-serious barriers are the number of employees involved (especially the sales team), time taken to build a portfolio (as individual loan sizes are small), portfolio protection (granularity, i.e., the larger the number of small loans comprising a portfolio, the better the spread of risk) and the frauds that are involved.

These are all manageable and hardly insurmountable.

Now the question becomes is the apparently limitless demand for these loans — a banker told me business loans outstanding total Dh10 billion — driven purely by the needs of business for growth? Our work with SMEs over the past four years clearly reveals what banks already know, that it is most certainly not.

We have seen dozens of financial statements and have had innumerable discussions with SME owners, who, off the record, tell the truth. Armed with doctored financial statements, bank account statements studiously beefed up with fake and “round tripping” transactions (which increases the turnover of the company), an owner can easily and quickly raise a business loan.

And this has been proliferating to a dangerous extent. Some end-uses we have come across are the following.

* Business loans are a substitute for capital.

* A loan raised in one company becomes the equity seed capital for another venture. Clearly the new venture has additional risks and a gestation period, thus exposing the mother company to serious risk.

* Loans are taken out to finance real estate purchases, very often in the borrowers’ home countries. Real estate returns cannot possibly service these levels of interest costs.

* Loans are taken out to finance losses and cover holes in the books or to finance the repayment of other loans. With absolutely no control or desire (or indeed the ability) to monitor the end-use of loans, business owners are running amok in increasing the indebtedness of their companies.

The list is endless and remarkably creative.

A small example can be revealing. We have seen recently a company, which turns over Dh40 million annually, load up on business loans of Dh8 million. Now, roughly speaking, a company like this should have a balance sheet size of around Dh16 million funded roughly by Dh8 million to Dh9 million of equity and the remainder by trade credit.

This company did have Dh9 million in equity, Dh8 million in loans and Dh3 million to Dh4 million in trade creditors. This extent of funding is simply not required, so it can mean only one or two or both of two things: the level of equity shown is a fake or the company has been loading up on loans to finance losses.

When we pressed the owner for answers, he admitted that business had dried up in the past six months (he was in the fur business, selling largely to Russian tourists) and that he had no cashflows whatsoever, and was taking loans to repay others.

This is not the exception and the number of companies in similar situations is alarming. It is almost certain that 2015 will witness an increase in loan delinquencies in the portfolios of the major players.

Worse still, companies will borrow from the new players to repay the old, so delinquencies will become spread between more banks misleading the main players into believing that their portfolios are actually behaving well, when in reality, the parcel is being nicely passed between banks.

The writer is the Managing Director of Vianta, which works with SMEs in raising bank finance.