Closing the SME Credit Gap

In last week’s article this column laid out the case that the current SME credit gap, estimated by the IFC to be at least USD 260 billion in the MENA region, could not be closed using currently available tools and institutions. There is an argument to be made that the potential exists to close the gap as the SME sector’s contribution to the UAE’s GDP is in excess of 50% and its share of total loans is only 4% thus implying that the massive supply-demand imbalance has driven loan pricing to extremely attractive levels relative to risk. It is important to note here that it does not matter what the risk is as long as the return more than compensates for it.

The first step is understanding how to build a risk culture that is relevant to lending to the SME sector. There are several key differences to risk as it relates to traditional large corporate lending by banks. The first of these is quality and quantity of information. A large proportion of the SME sector either consists of companies that have several decades of profitable business but do not have detailed financial statements or the auditor is not known and trusted by banks, or they are young companies that have just started operations or only have a few years of financial results. This immediately makes the standard tools used by banks unhelpful in understanding the risks involved.

A second issue is that quite often banks will lend to SMEs but not in the amounts that the company needs. This leaves the SME in the unenviable position of seeking to increase their debt funding but can only offer junior debt to lenders. Junior debt is in effect the second class citizen of debt as the original lenders, who have senior debt, are legally protected to have their loans repaid first before any junior debt holders. Junior debt is usually not palatable to banks but the idea does contain the seed for a potential solution.

If SMEs have junior debt to offer and banks do not have much appetite, then the question becomes what type of lender, or investor, would be interested in junior SME debt? This is too easy of an opportunity to have been missed by the financial sector: if there exist enough investors interested in investing in this debt the market would have easily connected them. Since there are no investors at that risk/return point there could be two or more at other risk/return points and by splitting the debt the same way again into senior and junior pieces the problem may be solved.

As an example, consider an SME that wants to borrow AED 100,000 and furthermore that the market rate for this is 12% p.a. If there are no investors interested in the 12% rate and associated risk, this loan can be split into two loans, loan A, the senior loan, and loan B, the junior loan. If the two loans are made to be the same size at AED 50,000 and loan A always gets paid back first then loan A will receive 6% p.a. and loan B will receive 18% p.a. Loan A will be very low risk since 50% of the total loan can be impaired and loan A will still be repaid 100% of principal since loan B investors will take the first AED 50,000 loss. This is why loan A pays only 6% and would probably be attractive to banks and other low risk investors. Loan B on the other hand is much higher risk and might be interesting for sophisticated equity style investors especially with an 18% coupon.

Although the arithmetic might seem a bit onerous the underlying idea is simple: you can take something that is at one risk level, decompose it to two other investments with different risk levels and corresponding returns. The decomposition of risk is not restricted to two new risk levels, any number of decompositions are possible if there is market demand.

This methodology of decomposing risk is central to improving the efficiency of asset-liability matching in the market. The more closely that a financial intermediary is able to match the risk they want to sell to the risk profiles of fund providers the greater the probability of success and the economy as a whole becomes more efficient.

Financial tools also provide an answer to the first issue, lack of data on a per company basis. Although single company data might not be available, data on the SME sector and various of its sub-sectors is available. Portfolio construction models, well developed and used in various markets such as listed equities, can be used to replace the need for single company data which is unavailable with sector data mimicked by portfolio statistics.

This shows that one promising direction to close the SME credit gap is to understand that traditional commercial bank tools are inadequate for this particular sector and to borrow finance tools from other areas.

Previous article: The SME Credit Gap in the Middle East.

A version of this article was originally published in The National under the title: How to go about closing the SME credit gap.

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