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Banks in Saudi Arabia have traditionally enjoyed a cozy relationship with prominent family-owned businesses in the country. The practice of so-called name lending — extending credit based on the reputation and standing of a company’s owners rather than on a rigorous examination of its financial health — is prevalent, not surprising for a culture that prizes deference and discretion over transparency. Bankers were only too happy to do business on such an informal basis while the economy was booming and global liquidity was abundant.

Today, however, a stunning corporate scandal involving two of the country’s most prominent family-owned conglomerates — Saad Group and Ahmad Hamad Algosaibi & Brothers — has shattered the industry’s complacency. The two companies have traded stinging allegations of financial misconduct in dueling lawsuits in Western courts, with AHAB accusing Saad and its chairman, Maan al-Sanea, of defrauding it of $10 billion. Both companies have defaulted on debts, which bankers estimate total as much as $22 billion, and the Central Bank of Bahrain has placed their Bahraini banking subsidiaries into administration. The Saudi Arabian Monetary Agency, the country’s central bank, has frozen the personal bank accounts of al-Sanea.

This unprecedented airing of financial allegations involving onetime pillars of the Saudi business establishment has sent shock waves throughout the country and across the Gulf region and prompted calls for radical reform of the way business is conducted. Dramatic improvements are needed in corporate governance and transparency to give investors a true picture of the health of companies. And lenders need to look beyond mere reputation and perform rigorous credit analyses before making commitments.

“There will be a regional impact” from the scandal, says Shayne Nelson, CEO for the Middle East and Africa at Standard Chartered Bank. “Banks will need to become more sophisticated in their lending, and good governance will have to prevail.”

The incident has dealt a blow to a Saudi economy that was already suffering from the decline in oil prices over the past year. Jadwa Investment, a Riyadh-based investment firm, recently reduced its forecast for the country’s economic output this year — by half a percentage point to a decline of 1 percent — because of concerns about the health of family businesses and an expected tightening of credit to the sector. “Bank lending decisions will now be driven by credit officers rather than relationship managers,” says Paul Gamble, head of research at the firm.

The ramifications also extend across the Gulf region, where authorities were already struggling to deal with the fallout from the global credit crisis and a collapse in local property markets. Authorities in Kuwait, Qatar and the United Arab Emirates have intervened to prop up their banking sectors over the past year, following the collapse of several Kuwaiti finance houses and a sharp decline in real estate values in Dubai and other markets.

The Saudi banking scandal is, on one level, a family affair. Al-Sanea, a Kuwaiti-born former Air Force pilot, is married to the daughter of one of the three founding brothers of AHAB, a company with interests in banking, construction, shipping and bottling. He worked at AHAB’s remittances subsidiary, Money Exchange, for two decades even as he was building up his own Saad Group. Al-Sanea made a splash on the global financial scene two years ago when he bought a 3.1 percent stake in London-based banking giant HSBC Holdings. Earlier this year, Forbes ranked him as the 62nd-wealthiest person in the world, with a worth of $7 billion.

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