The business of SME banking has become decidedly more risky over the past five years. Having been in the UAE for 22 years with three banks, I can confidently say that I have never seen a more lethal environment for SME lending.
It is now, in an harsh macroeconomic environment, that the poison that has infected this business so deeply and tellingly. It is not a conundrum easy to resolve or even mitigate. This is because the issue facing us is not one of economics, the environment, geopolitics or any external factor. It is one of ethical turpitude.
What does this mean? A few examples will suffice to illustrate the issue.
One is a fairly common lack of adherence to agreements in the SME space — both written and oral. There is an almost indifferent attitude to any sort of obligation being fulfilled. SMEs in most industries think nothing of delaying payments, asking for last minute discounts, delaying deliveries and so on as matter of routine, default behaviour.
This plays havoc with financial planning and profitability for recipients, including lenders.
Another issue is the widespread malpractice of doctoring financial statement submitted to banks, robustly aided by pliant and unscrupulous audit firms.
Other Information also is subject to widespread falsification and what is presented to banks is tailored to what they want to see. Lenders cannot constantly second-guess the veracity of the information they receive, but this is what it has come to pass now.
This has not been beyond the pale of banks too, some of which have behaved erratically, and in astonishingly narrow self-interest during hard times faced by their clients. This, regrettably, has resulted in a crisis of confidence of no small measure.
The reasons for this rather dire situation are many and complex. Cultural norms, lack of relevant oversight, reluctance to seek legal redress, sheer avarice, intent to fraud ... the list goes on. However, one must accept that it is what it is. So what does this mean for SMEs with regard to access to bank finance?
A serious implication of these developments over the past few years is the current (and fully justified) fear that banks face in lending to the SME space. This is partly because the business has indeed become more dangerous, but also because banks unfortunately now will be required to play a more aggressive, indeed intrusive role, in assessing the risks involved in lending to SMEs.
Risk managers in banks know what to do. However, informal discussions with senior risk executives reveal an astonishing fact — that most banks are unwilling to spend the money in enhancing due diligence and risk assessment activities, citing profitability pressures! Another sorry example of short-term thinking.
The old ways will not work any more. In our daily work involving both SMEs and banks, we observe this change in attitude in banks, but have not yet witnessed a concomitant and significant change in underwriting (risk assessment, essentially) methods.
Second, they have not done very much to seriously question the quality of employees that are charged with soliciting and underwriting business. Our own experience coupled with the incessant flow of complaints from our SME clients evidences the fact that most relationship managers in this space are woefully short of adequate skills to assess risk, leave alone proactively advise clients on financing.
Given the paradigm shift in the SME lending environment, here are a few things banks will need to do in taking a more visceral approach to SME risk analysis.
First, banks need to augment the testing of the financial health of SMEs as a fairly large percentage of the financial statements prepared by borrowers (and audited) are suspect. This can be done by a detailed audit of the processes, controls and study of original source documents of borrowers. Audit firms are supposed to comment on processes, if found wanting. I have yet to see an audit report that has done this.
Second, additional due diligence on the business model and on the genuineness of the counterparties that borrowers deal with, is a pressing requirement. SMEs more often than not, describe to naive and inexperienced bankers, a business model that is desirable to banks.
Third, banks need far more insight of their clients, processes, competence of their people, business continuity plans (if any), checks and balances and financial discipline. Recently, a bank had commissioned us to conduct a comprehensive study on these aspects as well as the financial health of a large company and the results were truly shocking. The report was as shocking to the bank as to the owner.
Happily, a collaborative attitude resulted in the company undertaking a major overhaul.
Fourth, banks need to start conduct more exhaustive checks on owners in their home countries. This can be done online as well as vide agencies. In our work with banks, we have been able to identify defaults, serious legal cases and so on, that owners here are involved in, back in their home countries. This can also include a more robust check on owners’ true personal net worth — owners tend to inflate their net worth in statements, because they well know that banks do not verify the same.
This list could be far longer and beyond a point, the checks and analytics required could reach impractical levels and become completely unfeasible for banks. A push back from borrowers can certainly be expected.
A paradigm shift on one side of the fence has happened. Now it’s time for change on the other.
The writer is the Managing Director of Vianta Advisors.