Riding the crest of a wave

Banks had an exceptional run in 2005.

It was undoubtedly a spectacular year for banks in the UAE, one they might wish they could pocket and save in case of rainy days ahead. According to the Emirates Bank Association, quoting the Central Bank, the banking system's total assets rose by more than 40 per cent in the year, while profits jumped by more than 100 per cent.

The general trend was set and underpinned by an extraordinary economic environment of high, stable oil prices, generating huge liquidity and an expansionary business outlook, not only in the UAE but across the GCC region. Oil prices averaged $50.7 (Dh186.22) ( Opec basket) for the year, compared with $36.1 (Dh132.60) in 2004 and the mid-$20s in 2000-2003.

Such sustained government spending and deposit flows not only created a platform for a higher lending trajectory but was bound to lead to a broader, and eventually rampant, bullishness.

Beyond the great capacity of the government to pursue projects based on hydrocarbon revenues, the UAE is the country (in the GCC) most oriented to private sector activity, creating a strong multiplier effect. This was witnessed most obviously in an extension of the building boom and lending to construction and real estate, particularly across Dubai's crane-strewn skyline.

Even so, there were evolutionary, structural forces at work in the financial sector as a whole, further exaggerating these economic effects.

Specifically, the UAE's local stock exchanges (Abu Dhabi Stock Market and Dubai Financial Market) surged enormously during the year, sparking a speculative investment fever that threatened to turn into something of a malady. Their influence impacted banks' performances like one giant non-recurring item, given their exposure - both directly and indirectly - to this temporal momentum. This aspect of 2005 seriously skewed the sector's numbers, leading in a circular way back to stretched valuations on bank stocks themselves.

Expert speak

Regional brokerage EFG-Hermes explained the mechanics of these phenomena in simple terms in its year-end research. The banks benefited from buoyant equity and real estate markets in a number of ways: ( i) the revaluation of financial and physical assets, (ii) higher brokerage revenues through higher volumes (despite the regulatory imposition of lower fees), (iii) newfound asset management fees, particularly in relation to performance, (iv) the IPO (initial public offering) frenzy, with many companies 'going public', and the banks "clear beneficiaries", both from the interest on their financing and subscription fees, and from fee income related to the process itself.

Such was the springboard from these factors that earnings generally showed faster growth than assets, with a high proportion of non-interest income, reflecting 'one-off' gains. There were many examples of IPOs being oversubscribed in multiples of hundreds (e.g. Aabar Petroleum, Dana Gas), and banks enjoyed windfall returns.

Rapid development

The rapid development of the UAE economy and its financial system has promoted an overhaul of the banking business. As margins for traditional commercial and corporate services have narrowed, the banks have reached beyond their usual domain.

In 2005, both interest and non-interest income gained ground. Rates rose steadily against the (necessary) backdrop of rising US rates (given the dirham-currency peg). On the basis of a high share of non-interest-bearing deposits, the banks could take advantage of widening spreads. At the same time, however, competition in this area has become intense, squeezing margins.

Retail banking has grown quickly, with a broad-based expansion in consumer finance, including consumer durable and auto financing, credit card and mortgages, as well as lending for share investments.

Fee income has been enhanced particularly by treasury activities, corporate and project finance, advisory business, structured finance, asset management, fund management and Islamic banking, and property development and management. The prospect of such income diversity has been advanced by the progress of the DIFC, in its first full year, making considerable headway in attracting big-name financial institutions.

As increased levels of financial sophistication emerge, capital market products permeate the banking landscape and the scope of investment banking opportunity rises. An increasing requirement for equity and bond issuance has arisen, part of the GCC trend towards economic liberalisation and development, in which DIFX intends to provide a regional gateway for larger investors and issuers to pool liquidity. In this emerging environment, the scope for private equity activity has also grown.

The banks' other significant preoccupation in terms of business line is Islamic services, where the market is developing maturity, growing beyond niche status. Whereas significant ground has been covered in terms of market share - for instance in current and savings accounts - and expectations of further expansion are high, there nevertheless remain concerns in terms of educating consumers, harmonising operating methods, and the incorporation of Sharia-compliant investments into global financial regulatory standards.

Overall, it is a scene in which domestic banks have decided not only to focus locally, but in some cases also re-focus locally as the scope of business opportunities in the UAE and surrounding countries grows. At the same time, foreign banks have become increasingly interested in a region where investment is more lucrative than anywhere else. While their anticipated arrival is a WTO-related pledge and therefore on a reciprocal basis, the reality is that for the moment their presence is felt mostly in the free-zone confine.

Extra funding

It is also a system whose growth has to be fed by extra funding, particularly in light of historical maturity mismatch and developing liquidity tightness, for instance loans/deposits rising beyond 80 per cent and in many instances beyond 100 per cent. A series of capital-raising exercises has been witnessed in readiness for further growth, Union National Bank's rights issue (which raised Dh2 billion) and $1.5 billion EMTN programme providing a characteristic example. Increasingly heavy funding requirements for long-term, flagship and industrial projects in the region further requires banks to access medium-term international financing to meet that demand.

The top five banks in the UAE (by assets) all posted profits in excess of Dh1 billion on a substantially increased asset base.

National Bank of Abu Dhabi produced a storming performance, its assets total reaching Dh83.7 billion (+48.5 per cent), and net profits Dh2.58 billion (+126.8 per cent). Though often identified as conducting lower-yield, government-related business, its increased focus on investment banking and asset management gave it a significant boost.

Emirates Bank Intl jumped to second position in terms of assets, with Dh59.4 billion (+54.4 per cent), also generating faster profit growth (+78.2 per cent) to Dh1.73 billion. Whilst demonstrating broad growth in revenues on the back of well-diversified activity, including Islamic business, its growth too was sparked by excited stock market conditions.

Strong showing

Abu Dhabi Commercial Bank performed strongly in third spot with total assets surging to Dh57.5 billion (+49.7 per cent), and profits soaring (+140.0 per cent) to Dh1.92 billion. It too rode the market exuberance by way of fees and commissions. Its restructuring and re-branding strategies of the past couple of years appear to have paid off.

National Bank of Dubai has maintained a conservative stance as regards the volatile lines of business, losing ground accordingly in the headline data. It dropped to fourth in terms of assets, which grew relatively modestly to Dh51.4 billion (+27.7 per cent), with profits slower still (+18.9 per cent) in reaching Dh1.10 billion. Despite aiming to expand, its relative prudence translated into non-participation in lucrative IPO business.

Mashreqbank showed fairly rapid accumulation of assets (+43.2 per cent) to Dh45.7 billion, but much faster growth in net profits, the only other bank apart from NBAD to break Dh2 billion, at Dh2.01 billion (+143.8 per cent). It was propelled enormously by equity-related non-interest income, and the general dynamism of the private sector and UAE economy.

It was not just about the top five, however. Other banks made a significant impression. In sixth and seventh places in terms of assets, Dubai Islamic Bank and Union National Bank also grew by over 40 per cent. First Gulf Bank continued its powerful run, with a 100 per cent rise in reaching eighth spot. These three also recorded net profits of over Dh1 billion.

Still, few expect the experience of 2006 to match the previous year, although First Gulf Bank (first out of the blocks, and the only one to do so at the time of writing) indicated continuing, extraordinary buoyancy, with net profits in the first quarter up by over 250 per cent year-on-year. Liquidity is not lacking in the system, as oil prices have averaged over $60 (Dh220.39) in the year so far, while US-led interest rates have sustained their upward path.

Some take the view that huge profits might still be seen as incoming revenues are invested. There is no shortage of ambition in terms of projects planned. The consumer market too is still growing. Banks may continue to benefit not only from strong oil and non-oil economies - with oil prices staying high - but also lending at moderately higher interest rates, and with deposits of their own in FX also yielding better returns.

The Abu Dhabi banks especially may continue to show stronger asset growth, on the back of capital increases, with a more aggressive outlook owing to the greater number of investments in the federal capital in coming years.

Yet, evidently there are risks attached. Towards the end of last year, Moody's referred to much of the sector as "increasingly exposed, directly and indirectly, to the overheating property and equity markets, with real estate prices and equity valuations that have grown sharply to unsustainable levels". A price correction, which is what has been seen in the intervening quarter, would adversely affect profitability and asset quality.

Banks will also be under pressure from a number of sources, such as regulatory restrictions imposed on IPOs (and extending credit to potential subscribers) in reaction to excessively volatile market activity, besides the curtailment of brokerage commissions. The requirement of Emiratisation in employment practice may also adversely impact cost bases.

Deeper issues

There are deeper issues that are also being addressed. Rating agencies such as Standard and Poor's have warned in the past about poor disclosure, concentration risk, non-performing assets, and the moral hazard associated with an assumed interventionist policy of the Central Bank. Senior figures within the industry have recognised the need for a sounder basis for investor confidence, with an emphasis on corporate governance, market discipline and transparency.

Thus the welcome given to an advisory agreement signed last December with International Finance Corporation (an arm of the World Bank) to support corporate governance reforms, intended to put UAE on the same standing as many developed countries.

Moreover, a new UAE banking law is expected this year, with a background of pending implementation of revised Basel II accord recommendations, and ongoing preparations for GCC's proposed monetary union.