Lower loan yields to hurt UAE banks’ profitability from Q3

A teller at a bank in Dubai. During the first two quarters, most UAE banks maintained strong asset growth. Image Credit: Gulf News Archives

Dubai: Two rounds of interest rate cuts combined with slow loan growth is expected to reflect on the interest rate margins and banking sector profits in the third quarter, while a part of the margin squeeze is expected to be offset by strong growth in non-interest income streams, according to banking sector analysts.

The Central Bank of UAE implemented two rounds of rate cuts in the third quarter following rate cuts by the Federal Reserve in July and in September.

In a rising interest rate environment, banks have the option reprice their loans to higher rates while deposit rates rise remains negligible, resulting in improved interest margins for banks. As the rates drop, the difference between deposit rates and lending rates shrink faster applying pressure on loan yields of banks, impacting their profitability.

“Rate cut is credit negative for the UAE banks because it will reduce the net interest margins (NIMs) as gross yields earned on loans will decline more than funding cost paid on deposits,” said Mik Kabeya, an analyst with Moody’s.

While the impact of the second round of rate is likely to be visible on the profit and loss accounts in the fourth quarter, analysts said banks will face pressure on profitability in the third quarter too as net interest income accounts for a significant share of total revenue of UAE banks. For the whole of 2018, interest income accounted for 70 per cent of the total revenue.

During the first two quarters of this year most UAE banks maintained strong asset growth and profitability. However, a recent analysis of second quarter results of UAE banks by Alvarez & Marsal (A&M) showed the overall operating income across the sector improved marginally from Q1 2019, largely driven by consolidation activity in the sector as the merger of ADCB with Al Hilal Bank and UNB completed in the spring.

“The top ten UAE banks reported steady performance in top line during the second quarter of 2019 but well below the 2018 average of 5.6 per cent, against a backdrop of reduced economic growth. For the remainder of 2019, we expect margins to remain under pressure due to the rate cut,” said Asad Ahmed, Head of Financial Services, A&M.

Inevitable repricing

Analysts say banks will be forced to lower rates on their floating rate corporate and government loan books that will reflect on their profitability. “The repricing will primarily reflect the fact that 75 per cent of UAE loan books as of June 2019 comprised corporate and government sector loans that typically carry floating rates that reset predetermined intervals,” said Kabeya.

The impact of lower interest rates on profitability of UAE banks will vary across the sector, depending on the level of loan book exposure to corporate and government borrowers and on the funding side, the level of dependence on current and savings account deposits (CASA).

Analysts said banks with the highest proportion of corporate loans and highest proportion of CASA deposits are likely to suffer the most. While the UAE being a highly competitive market, corporates would seek lower rates and on the funding side there is little scope for reducing the rates on CASA deposits as the rates already are negligible. According to Moody’s 52 per cent of UAE banks’ funding as of July comprises of CASA deposits.

Creeping rise in NPLs

A slow but steady rise in non-performing loans linked to the real estate and construction sectors too are expected to add pressure on banking sector profitability.

“UAE banks are increasingly at risk of deteriorating asset quality due to a weakening domestic property sector, with real estate prices more than 20 per cent below their 2014 peak,” Fitch Ratings said in a recent note.

Moody’s expect the UAE banks’ NPLs to raise to about 5.5 per cent (of total loans) this year compared to 4.8 per cent as at the year-end 2018.