Dubai: The profitability of the UAE’s banking sector in 2018 and 2019 is expected to improve steadily on the back of better asset yields resulting from higher interest rates and the ongoing recovery in loan quality, analysts have said.

According to rating agency Moody’s, loan performance will stabilise over the next 12 to 18 months.

“Our forecasted stable problem loans/gross loans ratio reflects our expectation that the recovering economy and a resilient performance by large borrowers will offset problem loan formation among small and mid-sized businesses and individual borrowers,” said Mik Kabeya, assistant vice-president at Moody’s.

Moody’s expects problem loans to range between 5 to 5.5 per cent of gross loans by the end of 2019. Problem loans declined to 5.1 per cent in June, from 5.5 per cent at the end of 2017, as a result of a conservative approach adopted by large banks upon adoption of new IFRS 9 accounting standards in January 2018.

Nevertheless, the problem loans ratio of UAE banks remains high compared to GCC peers whose non-performing loans (NPLs) range between 1.9 per cent and 5.8 per cent.

Year-to-date bank results broadly confirm that banks have either fully provided for the problem loans linked to the small and medium enterprise (SME) sector and or deleveraged substantially from their exposure to troubled segments of business.

With economic growth starting to pick up again on the back of higher oil prices and production, as well as increased government spending in Abu Dhabi and higher infrastructure spending in Dubai in preparation for Expo 2020, banks are seeing a revival in credit demand from corporates, government and government-related entities (GREs), overall retail loan growth remains anaemic.

A recent forecast by Institute of International Finance (IIF) has pegged the sector-wide loan growth above 6 per cent. The 12-month increase in credit was 3.7 per cent, thanks to an improvement in lending to the corporate sector, and 8.4 per cent for deposits in September 2018.

“The acceleration in deposit growth was mainly due to the substantial increase in government deposits in the banking system. The recent central bank’s credit sentiment survey points to rising credit growth,” said Garbis Iradian, Mena chief economist at the IIF.

While loan demand largely driven by corporate sector is improving the interest income of banks, Moody’s expects that solid corporate loan performance will balance delinquencies among small businesses, with consumer loan performance at large corporate borrowers seen remaining resilient.

“Ongoing resolution of legacy impairments, including from Dubai-based public-sector bodies and large corporates, will limit problem-loan formation in this segment. Household loan performance will continue to weaken, however, as subdued employment and wage growth, combined with a higher cost of living, constrain borrowers’ repayment capacity,” said Kabeya.

Analysts expect slow, yet, steady improvement in UAE banks’ profitability, driven by higher loan yields and shrinking provisions. Moody’s expects profitability to improve slightly over the next 12 to 18 months, with net income at around 1.6-1.8 per cent of tangible banking assets.

“Rising interest rates will increase banks’ gross yields as they gradually re-price their loan books. Loans to the corporate and government sectors, which typically carry floating rates that reset at predetermined intervals, account for the bulk [74 per cent as of June 2018] of UAE banks’ loan books,” said Kabeya.

Although the currency’s peg to the dollar keeps the local currency interest rates going up with US rate hikes, Moody’s analysts believe that improved local liquidity resulting from higher oil prices will moderate competition for deposits and so ease funding cost pressure.