The "lose-lose" game of Entrepreneurs & Banks in the UAE

Disclaimer: the views and opinions in this post are entirely mine and do not reflect those of the institution I work with or clients I advise and consult for.

"Is this just the tip of the iceberg"? 

The CEO of a mid-sized company in the UAE put that question to me a few weeks ago.

We had been discussing the recent systemic wave of defaults on loans by mid-sized companies in the UAE, and the knee-jerk reaction of most banks, which exacerbated the situation.

What's been happening since early 2015 is this:

1- A slowdown in consumption in the UAE led to many small and medium-sized businesses (SMEs) missing their "promised" target financial performance.

2- Most of these SMEs are highly leveraged (carrying a large amount of debt), primarily from local banks.

3- A small percentage of those SMEs saw their business slow down to the point of missing 1 or 2 interest payments.

4- In response, UAE banks "pulled lines" (asked for immediate repayment) on entire loans given to "similar" businesses.

5- SMEs now had a major problem: it's not like the money from loans was sitting under their mattresses: they had used it to buy inventory and make investments. It was virtually impossible to "immediately" repay loans.

6- The owners of these companies had often given personal guarantees to the banks to secure those loans, so they were "personally" liable to repay those loans.

7- The penalty of defaulting on a loan in the UAE? Prison.

8- So many of them, fearing jail, just left the country, leaving companies, employees, inventory and irate banks behind.

9- Banks started to freak out, which caused them to "pull loans" from healthy businesses, because they "might" struggle.

10- Those "healthy" businesses now had the same problem: banks wanting "immediate" payments.

11- As a result, those "healthy" businesses suddenly became "unhealthy", and joined their "unhealthy" brothers.

12- And so the cycle continues.

So: "Yes, I believe that we haven't seen the worse of it yet", I answered.

A Fundamental Flaw in the Bank-SME Relationship

It all has to do with: limited upside with unlimited downside.

Let me explain:

Suppose I come to you and say: I will ask you a "general knowledge" question.

- If you answer correctly, I will give YOU $10.

- If you answer IN-correctly, YOU will give ME $50.

Do you see the problem here? If you get it right, you win $10, but if you get it wrong, you lose $50!

Your "downside" is 5x your upside!

Absolutely nobody in his/her right mind would play at this game, right?

Wrong! That's exactly what banks in the UAE are doing!

In fact, that's exactly what both banks AND SMEs are doing!

Let me elaborate:

From the perspective of the bank

You are a bank in the UAE:

- You lend AED5m to an SME for 5 years.

- You charge 7% interest.

- You get a personal guarantee from the owner.

- You have the right to "pull" the loan at any time for any reason (standard in these contracts - crazy right?!).

Year 1: everything is great. You get your 7% interest and 1m repayment.

Year 2: everything is still good. You get 7% interest and 1m repayment.

If everything continues well, you will eventually, by year 5, get your AED5m back + interest.

So your BEST CASE scenario is: your money back + 7% interest. 

But what if things changed?

Year 1: everything is great. You get your 7% interest and 1m repayment.

Year 2: everything is still good. You get 7% interest and 1m repayment.

Year 3: uh oh. Trouble. Borrower is in trouble, can't repay the loan or interest.

Your WORST CASE scenario is: you lose interest AND YOUR MONEY.

My point: the bank has "limited upside", but "unlimited downside": if things go great, you get your interest. If things go badly, you could lose your entire money!

RESULT: bank panics, threatens to put the owner in jail, owner runs away, can't run the company, company collapses, both parties lose.

From the perspective of the borrower

Same scenario as above: you're the company who has borrowed AED5m for 5 tears at 7% interest.

That loan is "crucial" to your business: without it, you can't grow as fast as you want to, and your competitors might pull ahead in the market.

BEST CASE scenario: your business continues to do well, you repay the bank. The loan didn't "transform your company into a giant", but you did well. 

Now imagine a scenario where things start to get difficult: market slows down, you can't sell as many products as you had hoped. Cash flow starts to get tight, and you miss an interest payment. 

The Bank freaks out, comes to you and says: PAY ME NOW!

Except that you can't, and you know that. So, afraid of jail, you run away.

WORST CASE: you lose everything and you're a "criminal".

Again: the company has "limited upside", but "unlimited downside": if things go great, your business does "well", if things go badly, you end up in jail, lose everything, and be branded a criminal.

RESULT: bank panics, threatens to put the owner in jail, owner runs away, can't run the company, company collapses, both parties lose.

Conclusion 1

There is a fundamental flaw in the Bank-SME relationship in the UAE which will cause pain for everyone and stifle growth in entrepreneurship: 

When things are going WELL, the GAINS of both the bank and the SME are LIMITED.

When things are going BADLY, the LOSSES of both the bank and the SME are UNLIMITED.

Both banks and companies are saying: "yes, I'll play this game where I get $10 if I'm right and lose $50 if I'm wrong!".

In Part 2 , I provide some suggestions to both banks and SMEs on how to manage risk better to at least partially hedge against their own fragility.

Tony

#neversettle