A softening in the United Arab Emirates' economy has led to a surge in small and medium-sized businesses defaulting on debt, dragging on banks' performance and highlighting the need for a new bankruptcy law.

In a country where a bounced cheque risks landing the issuer in jail, there have been hundreds of recent cases of expatriate business owners fleeing the country, or "skipping", with unpaid debts, banking sources say.

Others who remain have defaulted on debt and in some cases been arrested. Bankers estimate the total amount of defaults in the past three to four months at 3 billion-4 billion dirhams ($817 million-$1 billion), up significantly from a year ago.

SMEs contribute 60 percent of UAE's gross domestic product but banks have long seen them as risky, partly because of their sometimes poor accounting standards.

However, they proved profitable customers in recent years as the local economy boomed - a situation that has reversed this year as a slow global economy and weak oil prices dampened government and consumer spending. Some SMEs are also struggling amid choppy commodities markets, especially traders of rice and other foodstuffs, as prices have fallen.

"Banks are panicking and are recalling loans or stopping lending," said a banker, citing the launch late last year of the country's credit bureau as an added factor.

The bureau collates credit histories for consumers and companies dating back to October 2012, exposing for the first time the extent of customer indebtedness across the banking system.

Analysts and bankers say a new bankruptcy law, under planning since 2009 and expected to include decriminalising the issue of bounced cheques, is needed.

"It would help in loan restructuring, thereby reducing the amount of provisions banks will have to take, while improving valuations across the sector," said Chiradeep Ghosh, banking analyst at Bahraini investment bank SICO.

Government officials often cite the risk of jail as important in helping guarantee payments, but many bankers disagree, saying it encourages debtors to flee the country, rather than stay and try to resolve their debts.

World Bank data appears to back up their claims. Secured creditors in the UAE only receive 29 cents on the dollar from an insolvent firm at the end of insolvency proceedings. That compares with an average of 72.3 cents on the dollar for high-income countries in the OECD.

DRAFT LAW

The UAE Banks Federation (UBF), a lobby group, aims to submit a white paper to the central bank next month urging the government to push through the bankruptcy law, according to banking sources.

The cabinet approved a draft law in July but it still needs the support of the Federal National Council, the country's legislative body, and the president.

During the UAE's financial crisis of 2009 deteriorating credit conditions spread from small traders to larger, government-linked companies. That culminated in state-owned Dubai World requesting a debt standstill on $25 billion of obligations in 2009, a move that triggered a global markets sell-off.

Analysts see little risk of the current crisis escalating to that point, at least for now. The larger companies are much leaner and less indebted than in 2009, while the global backdrop is healthier.

Still, smaller banks are suffering. United Arab Bank swung into the red in the third quarter after setting aside 466 million dirhams to cover soured debt. Other banks with significant exposure to the same field - RAKBANK, Union National Bank, Commercial Bank of Dubai and National Bank of Fujairah - all increased provisions in the first nine months of the year.

UAE banking shares have slumped more than 16 percent this year, according to the Thomson Reuters UAE Banking Services Index.

EFG-Hermes analysts warned last month that defaults by SMEs could even start to pressure profits at larger banks with more corporate-oriented loan books like National Bank of Abu Dhabi and Emirates NBD (ENBD) in the fourth quarter.

"We have taken a conservative approach on lending and have operated increased surveillance from 2014 on this sector," a spokesman for ENBD said.

The bank has seen an increase in skipping by SMEs, mainly around sectors such as commodities trading, and that has led to a "marginal" increase in impaired loans, he said.