Banking at the sharp end

The Gulf economies have shown unique resilience in the face of the prolonged global financial turmoil and the regional political instability. As an extension of these economies, the banking systems in these countries have withstood challenging times.

The International Monetary Fund has forecast the GCC's GDP growth to reach 7.8 per cent this year as increased oil production is expected to stabilise global oil supplies in the face of supply disruptions elsewhere.

This big surge in government spending supported by strong oil prices forms a basis for the Gulf's sustained economic stability. The region now enjoys the unique distinction of having improving growth prospects even in the face of elevated global economic uncertainty.

Yet, despite such strong macroeconomic fundamentals, the banking systems in the six GCC countries face varying levels of uncertainties linked to asset quality, asset growth and profitability, according to banking industry analysts and rating agencies.

Among the Gulf banks, analysts say the UAE banks face maximum pressure on all these parameters. "UAE banks are yet to experience the peak in their NPLs — to 8.4 per cent, on our estimates for 2011 — and will have to adjust to stricter regulatory measures mainly on consumer lending and fees," says Mohammad Hawa, banking analyst with Credit Suisse.

Rating agency Moody's has said it expects the average NPL ratios of the UAE banks to peak above 10 per cent this year, from 8.3 per cent in 2010 and 4.9 per cent in 2009. Moody's expects the $10 billion (Dh36.7 billion) debt restructuring by Dubai Holding to significantly contribute to this year's NPL levels.

"Dubai-based banks typically have high exposures to Dubai's government-related entities (GREs), and we consequently expect NPLs to peak in 2011 at around 6-8 per cent in Abu Dhabi and 11-14 per cent in Dubai," says Khalid Howladar, Vice-President — Senior Credit Officer, Moody's.

Comparative ratios

Among the UAE banks, analysts expect National Bank of Abu Dhabi to have the lowest NPL ratio at 3.2 per cent in 2011 compared to 2.3 per cent last year. Emirates NBD is expected to have the highest NPL ratio, at 14 per cent compared to the NPL ratio of 10 per cent last year. Its provisions coverage on impaired loans improved in the second quarter to 55 per cent from 45 per cent at the end of the first quarter.

"We remain conservative in our estimate of NPLs, and expect the total provisions for the year to be in the range of 13-14 per cent of the total assets," said Surya Subramanian, Chief Financial Officer, Emirates NBD in a conference call.

Credit Suisse expects the recent Central Bank tightening of lending rules and fee structures to affect non-interest income growth in the UAE, declining to 3.8 per cent year-on-year in 2011, compared with growth of 4 per cent in 2010.

Further afield, among the GCC banking systems, rating agencies and analysts believe that Saudi Arabian banks have perhaps the most unrealised potential in terms of profitability and asset growth. (See accompanying article on page 13.)

Qatari and Saudi banks continue to exhibit high asset quality, with 2010 NPL ratios of 1.7 per cent for Qatar and 2.4 per cent for Saudi.

"The profitability of Saudi banks stems from a unique combination of factors," said Standard & Poor's (S&P) credit analyst Nicolas Hardy in a report. "They operate in a supportive operating environment because of high oil prices and the backing of a cash-rich government."

Funding remains one of the key strengths of Saudi banks, with deposits constituting around 88 per cent of non-equity funding at end-2010. "A significant portion of the deposit base was unremunerated at end of the first quarter of 2011, ensuring very low-cost funding for most banks," wrote Mahin Dissanayake, an analyst with Fitch.

Fitch expects those banks to remain highly profitable in 2011. The average NPL ratio for Fitch-rated Saudi banks was around 2.9 per cent at end-2010, down from 3.4 per cent at end-2009.

Loan impairment

The default of the two large Saudi corporates, Saad and Algosaibi groups, in 2009 represented the single largest challenge for Saudi banks during the global financial crisis, and corresponding loan impairment charges continued to adversely affect the profitability of a number of banks in 2010.

Analysts say banks in Saudi Arabia are likely to reduce the amount of NPLs this year as lending and deposits are picking up in the largest Arab economy. "We do not expect a deterioration of asset quality in Saudi banks," said S&P's Hardy. "The ratio of NPLs may fall to 3 per cent from 3.2 per cent."

The banks significantly increased their reserve coverage levels in 2010 and, as a result, rating agencies such as Moody's and Fitch expect the impact of legacy loans on performance to fade in 2011. At the same time, low private sector demand for loans and shrinking margins will constrain profit growth.

The strong funding profile of banks and relatively low dependence of market funding is seen as a key strength for Saudi banks.

But a conservative stance prevails.

"The banking system is flush with liquidity. But lending is yet to take off. We feel supply, demand and structural factors are responsible for the slow pace of loan growth in Saudi Arabia," John Sfakianakis, Chief Economist of Banque Saudi Fransi, told Gulf News recently.

The new mortgage law that is likely to be announced this year is expected to become a major driver of credit growth in Saudi Arabia's banking sector.

Meanwhile, Qatari banks remain insulated, analysts believe, from regional and global economic volatility. Qatar has been the most active among GCC countries in its support of banks through a variety of measures, including liquidity support, and $6 billion of purchases of equity stakes and problem-asset purchases.

"We expect that NPLs have peaked in 2010 at around 4 per cent. With projected GDP growth of approximately 15 per cent per year and the additional ($65 billion) stimulus of infrastructure investment for the 2022 football World Cup, local banks will continue to benefit substantially from government-driven economic activity," said Moody's Howladar in a report.

Despite a perceived peaking of NPLs in 2010, analysts see potential risks in the asset quality of Kuwaiti banks. Kuwait's investment companies accounted for around 11 per cent of lending at year-end 2010. Such firms are a key NPL driver, as the leveraged business models of these diverse institutions collapsed amid funding mismatches and rapid asset-price declines.

Oman has a small and relatively insular banking system, with robust domestic performance. Moody's believes Omani banks' NPLs peaked at around 5 per cent last year, and they have strong capitalisation levels.

Despite the economic recovery across the GCC since 2010, asset quality challenges are expected to persist in banking sectors across the region owing to vulnerabilities arising from concentration of exposures to regional conglomerates, lack of diversification opportunities and a lag in reporting NPLs due to underdeveloped corporate governance standards in the region (see box on page 7).

Funding issues

Structural asset-quality issues will continue to limit the GCC banks' credit strength, and constrain many of their individual stand-alone ratings. The chances of these banks securing external funding will remain tough, apart from those instances of those banks with significant government ownership and those in Saudi Arabia, Qatar and Oman with their inexpensive deposit base.

Overall, the region's banks seem to have learned some hard lessons from the financial crisis. Evidently, the focus on balance sheet repair over the past two years has led to massive deleveraging and stricter provisioning. More prudent lending and stricter regulatory requirements are expected to secure the balance sheets against potential risks.

Additionally, barring a few exceptions, the banks in the Gulf are well capitalised, with very strong regulatory capital ratios, significantly above the minimum requirements. For example, the majority of banks in the UAE have regulatory ratios above 15 per cent, and in many cases exceed 20 per cent. The UAE's regulatory minimum requirements, at 12 per cent, are already high compared with those in the rest of the world — above the minimums in the Basel III proposals.

Indeed, with the strong equity base that many of these banks have, their comparatively high proportion of Tier-1 capital gives them additional systemic strength compared to other banking systems in the world such as Europe and the US where there tend to be high compositions of Tier-2 capital instead.

Government support

The strong net asset positions of GCC governments and their willingness to support banks in the event of a crisis make the regional banking systems not so susceptible to systemic risks, according to rating agencies.

Despite the recent political turmoil in the Middle East and North Africa, including Gulf countries such as Bahrain and Oman, S&P believes that most sovereigns and by extension banks will continue to remain isolated from the regional political turmoil.

However, analysts say Bahrain may be an exception, as political unrest affects the economy and banks' operating conditions, besides an excessive exposure to the real estate sector impacting asset quality.

"System-wide metrics announced by the Central Bank of Bahrain show that about one third of the loans of Bahraini banks are linked to this riskier segment. The price correction in Bahrain, as in Dubai and Kuwait, has been weakening banks' financial profiles," says Goesksenin Karagoez, a rating analyst with S&P.

But Bahrain still has the well-established reputation and infrastructure to remain a strong regional hub. "We think if the political situation remains stable, the authorities should be able to convince investors that Bahrain remains a key financial centre for the region," said Emmanuel Volland, a credit analyst with S&P, in a report.

In the UAE S&P analysts say the banks have structurally strong operating performance with funding support from the authorities and GREs, while the operating environment is supported by the country's emergence as the new financial hub of the region.

A common weakness of the Gulf financial system, according to analysts, is that banks across the region have only limited opportunities for diversification, with concentrated assets and liabilities.

"The UAE is the only country to achieve a strong measure of economic diversification, and this ongoing process has so far taken decades. As such, high corporate concentration and a narrow economic base dominated by energy and real estate-related businesses will remain enduring features of the local banking systems," wrote Khalid Howladar, Vice-President — Senior Credit Officer, in a Moody's report.

Corporate governance issues continue to plague asset quality in the GCC. Governance is still relatively weak in the GCC, with a high incidence of related-party lending and some limited disclosure, but this is improving following some large local defaults.

The rating agencies say that not all loans with embedded losses have been identified and classified as non-performing, and these reporting lags will cause problems in accurately assessing the extent of problems.

Analysts say GCC banking systems continue to face borrower concentrations as businesses are dominated by large state- and family-owned holding companies. These large conglomerates have an extensive network of businesses, often with movement of funds between them. Thus, while some exposures may appear diversified from a sector perspective, they can still be concentrated in terms of borrowers.

In Saudi Arabia, the Saad and Algosaibi defaults highlighted concentration risks, with approximately $20 billion of exposure distributed across 80 or so banks.

The writer is Deputy Business Editor, Gulf News.