Collage Banks
Image Credit: Guf News/Pixabay

Why have the profits of UAE banks declined last year? Since 2020 has been the year of the coronavirus, much of the blame should go to the COVID-19 pandemic. But even before the virus arrived, the global economy was passing through turbulence. The pandemic made a bad situation worse. And the fallout impacted the UAE too. That’s reflected in the banks’ balance sheets.

The sharp decline in the 2020 earnings of UAE banks is hardly a surprise. The economic environment was indeed challenging, and it’s expected to persist this year too. So the profitability will remain under pressure.

That pressure was evident in last year’s balance sheets of the top three banks. First Abu Dhabi Bank (FAB), Emirates NBD, Abu Dhabi Commercial Bank (ADCB) and Dubai Islamic Bank (DIB) together account for more than 65 per cent of banking assets in the country. The three have reported a significant reduction in profit in 2020, while small and medium-sized banks have reported net losses.

The results weren’t unexpected. By the end of the third quarter, it was evident that the top banks were headed for significantly lower profits or even losses.

Alvarez & Marsal’s analysis of the top ten banks’ third-quarter results in mid-November had shown that UAE banks have been facing challenges in both interest and non-interest income streams. That’s coupled with a significant decline in asset quality (loans’ risk of default), forcing them to take large provisions (buffers) against loan losses.

“We expect the economic conditions in the UAE and the region generally to remain challenging in the near term, which would likely limit credit and earnings growth and also result in higher non-performing loans (NPLs),” said Asad Ahmed, managing director and head of Middle East Financial Services of Alvarez & Marsal.

Although many banks recovered some of their profits from the second quarter, most continued to face a considerable decline in net interest margins (NIM, which is the difference between interest revenue and interest paid). This is due to several factors such as the shift to the marginal cost of funds-based lending rate (a kind of benchmark to set lending rates), and an all-time low interest rate.

How bank profits affect the economy

A healthy banking system is vital for economic growth as it helps money grow. Banks maintain the wealth of others and invest them as loans to create more money. So, confidence in the banking system is essential to increase funds through savings and channel them to investments. This ultimately helps the national economy grow.

Poor economic growth can lead to a rise in bad loans that self-perpetuate weak lending and weaker economic growth. A weak banking system won’t have the confidence of depositors, leading to insufficient funds for investments.

The UAE banking system is supported by a robust regulatory framework. The fall in UAE banks’ profits in 2002 is largely cyclical and linked to low global interest rates and weak economic growth.

How do banks make money?
In the simplest of traditional banking operations, banks accept deposits at lower rates and lend at higher rates, making a margin that constitutes the bulk of its profits.
A commercial bank is where most people do their banking. They make money by providing loans and earning interest from loan products such as mortgages, auto loans, business loans, credit cards and personal loans. Customer deposits provide banks with the necessary funding to make these loans. These days, bond issues also are used to raise capital.
Banks also make money through non-interest income such as fees, commissions and service charges: monthly account maintenance charges, minimum balance fees, overdraft fees, non-sufficient funds (NSF) charges, safe deposit box fees, and late fees. Many loan products also contain processing fees in addition to interest charges.
Large banks that combine investment banking (banks that create capital for companies, governments and other entities) and wholesale banking with the retail business have additional fee income sources. Much of their revenue comes from arranging funds through capital market activities such as initial public offerings, bond/sukuk issuances arranging loan syndications and trade finance.

Why low bank profits were not a surprise

Analysts were not off the mark in their forecast. While the three systemically important domestic banks’ net profits declined in the range of 15 to 60 per cent, some banks posted losses.

Image Credit: Ahmed Ramzan/Gulf News

The UAE’s largest bank, First Abu Dhabi Bank (FAB), reported a group net profit of Dh10.6 billion for 2020, down by more than 15 per cent from Dh12.5 billion in 2019.

Profitability was lower year-on-year, reflecting unprecedented market conditions, record low interest rates and the pandemic-driven economic slowdown, resulting in lower revenue and higher impairment charges or provisions against loan losses.

Image Credit: Ahmed Ramzan/Gulf News

How Emirates NBD battled the challenges

Emirates NBD reported a net profit of Dh7 billion, a decline of 52 per cent largely driven by higher provisions and no repeat of the gain on disposal of Network International shares in 2019. The bank’s operating profit declined 29 per cent mainly due to lower interest rates and transaction volumes, coupled with higher impairment allowances. The impairment charge of Dh7.93 billion was 65 per cent higher than the previous year.

“Emirates NBD’s strong balance sheet, coupled with the ongoing ability to generate operating profit, enabled the bank to successfully deal with the unforeseen challenges in 2020,” said Hesham Abdulla Al Qassim, vice-chairman and managing director of Emirates NBD.

Image Credit: Gulf News Archive

What’s the ADCB surprise?

Abu Dhabi Commercial Bank (ADCB) surprised the markets with a better than expected results considering the large provisions taken on its exposures to NMC and Finablr Groups. ADCB’s net profit of Dh3.8 billion is 27 per cent lower than the Dh5.24 billion in the previous year.

“In testing times, ADCB has drawn on its strengths — a robust balance sheet, disciplined governance and a high-performance culture — to navigate the complex issues raised by the global pandemic, softening global economic activity and low oil prices,” said Khaldoon Al Mubarak, chairman of the board of ADCB.

Net impairment charges were Dh3.99 billion, significantly higher than the previous year reflecting the challenging macro-economic environment and huge provisions taken on NMC Health Group, Finablr and associated companies.

The National Bank of Ras Al-Khaimah (RAKBank), a prominent lender with significant exposure to small and medium enterprises and retail customers, has reported a full-year consolidated net profit of Dh505.4 million, down by Dh589.9 million or 53.9 per cent over the previous year.

Why some banks reported losses

Banks reporting losses is a rare phenomenon in the UAE, barring a few exceptional circumstances in the past, such as the global financial crisis. The past year also needs to be classified as exceptional due to the economic impact of COVID-19.

Mirroring the difficult operating environment, a few banks have posted net losses. Emirates Islamic reported a net loss of Dh482 million. Emirates Islamic’s 145 per cent lower net profits (net loss) stemmed from the lower rates, a decline in non-funded income due to the slowdown in the economy and an increase in impairment allowances.

The total income of Dh2.1 billion fell by 22 per cent, and funded income margins were lower by 52 bps due to lower profit rate environment.

“Despite these challenges, the bank’s balance sheet remains healthy and growth-oriented with the headline financing to deposits ratio at 87 per cent. With an increase in business activity in the last quarter of 2020, we have accelerated our sales momentum across our retail, and wholesale segments,” said Salah Mohammed Amin, Chief Executive Officer of Emirates Islamic (the Islamic financial institution of the Emirates NBD Group).

While Mashreq, one of the leading financial institutions in the UAE, reported a net loss of Dh1.3 billion in 2020 compared to Dh2.1 billion profit in 2019, National Bank of Fujairah (NBF), another prominent bank with significant small business client base, reported a net loss of Dh475.3 million compared to the profit of Dh552 million in 2019. The bank’s operating income of Dh1.4 billion is 18.9 per cent lower than the Dh1.7 billion in 2019.

“Margin compression, recessionary trends across global economies and depressed economic activity with the persistence of COVID-19 caused the drop in income,” the bank said in a statement.

20210214 Bank Results
Image Credit: Seyyed Llata/Gulf News

Why bank profits plunged in 2020

The profitability of UAE’s leading banks declined in 2020 mainly due to the low interest rate environment, flat loan growth and significant rise in loan loss provisions.

Squeeze on net interest margins

Globally, low interest rates impact bank profits because of lower net interest margins.

The UAE and other GCC countries track the US interest rates because their currencies are pegged to the dollar. In March the US Federal Reserve slashed the targeted interest rates to 0 to 0.25 per cent from a previous target range of 1 per cent to 1.25 per cent. The Fed is committed to maintain rates close of zero for at least next two years as part of its monetary policy efforts to lift US economic growth. GCC countries move their interest rates in tandem with the Fed to keep their currency pegs stable against market bets.

What’s Net Interest Margin?
It’s a bank’s income from interest. A bank/financial firm earns money from credit products like loans and mortgages: that’s interest income. At the same time, money is paid as interest to holders of savings accounts and its other sources of funding: that’s interest costs.
Net interest margin (NIM) is the difference between the net interest income and net interest costs (or cost of funds). Expressed as a percentage, the NIM is a key profitability indicator. A positive margin suggests a profitable operation, while a negative figure implies poor investment efficiency.

How low interest rates impact banks

A low interest rate environment like the current one reduces banks’ net interest margin and profitability. A major attributing factor is the maturity mismatch between assets (loans) and liabilities (deposits).

While repricing loans, especially when the floating rate contracts happen every quarter, interest outgo (paid out) on term deposits is stickier. It results in a loss on interest yield from loans.

In other words, banks are forced to stick to higher rates on term deposits and other forms of fixed rate funding while they will be compelled to cut lending rates, especially on large corporate loans. This is either because of floating rate loan contracts and or simply because the bank is willing to take a margin cut to retain high-quality corporate customers in its portfolio.

Why loans failed to generate income

Demand for loans (credit demand) at retail and corporate levels has been affected last year, resulting in overall poor credit growth (low single digits).

Why is there no demand for credit? The pandemic and contraction in many sectors have forced corporates to postpone of capital expenditures. This has led to a lower loan demand from businesses.

What about retail loans? Shutdowns, job losses and salary cuts in the private sector are to blame for the poor demand for retail loan products such as personal loans, auto loans, mortgages and credit cards.

There’s a flip side too. When the loan demand declined, banks tightened their lending norms to guard against rising loan losses and higher provisions. This is attested by the credit sentiment surveys of the Central Bank of UAE.

How high operating income affects profits

Last year, banks launched massive cost reduction efforts by reducing branches, headcount, and overheads to combat the pandemic’s fallout. Despite all this, the UAE banks’ operating costs continued to remain high.

So the cost-to-income (C/I) ratio of leading UAE banks increased, as reduced operating income more than offset cost-efficiency measures.

What’s cost-to-income ratio?
The cost to income ratio is used to gauge the efficiency of an organisation by comparing the operating expenses of a bank to its income. The lower the cost to income ratio, the better the bank’s performance.

How bad loans affect banks’ profits?

Non-performing loans (NPLs) or bad loans have been a significant factor in lowering the UAE banks’ profits in 2020. Bad loans are a manifestation of the deterioration in asset quality and provisions have to be made to cover that, leading to reduced profitability. How does that happen?

A non-performing loan (NPL) is a borrowing defaulted by the non-payment of the scheduled payments. An NPL is an impaired loan, since the bank is unable to collect the payments.

Banks set aside an allowance to cover uncollected loans and loan payments. This is called credit loss provision. These provisions affect the profitability in the immediate quarter as impaired loans are considered losses. The UAE banks have been taking significant loan loss provisions in the last three quarters resulting in lower profits in 2020.

Why UAE banks will face more risks?

Banks in the UAE are bracing for more turbulence later this year. Because they are likely to face an increase in NPLs in the second half of the year. Why would there be more bad loans?

The Central Bank’s decision to extend the Targeted Economic Support Scheme (TESS) until June 30, 2021 provides temporary relief to certain sectors, in terms of loan deferrals. But bank balance sheets remain exposed to considerable credit risks as these deferred or restructured loans could become NPLs in the third quarter. At the end of the deferral period, there could be a sizeable increase in NPLs for the banks, if the economy fails to recover.

Image Credit: Seyyed Llata/Gulf News

What’s the outlook for banks this year?

The UAE banks are expected to face a much lesser volatile operating environment in 2021 compared to last year. However, the lingering impact from 2020 will continue to pressure profits and asset quality (strength of a loan against default), according to bankers and analysts. The recovery from the impact of pandemic will be gradual in 2021, according to rating agency Standard & Poor’s.

Banks’ asset quality is likely to deteriorate and the cost of risk will increase as they start recognising the impact of 2020’s shockwaves. Plus, the Central Bank of UAE (CBUAE) will lift its forbearance measures (stimulus) gradually in the second half of 2021.

Due to the low interest rates, banks’ profitability will remain low and a few banks are likely to show losses.

“We expect GDP growth to recover in the UAE this year from the sharp recession of 2020 triggered by the COVID-19 pandemic and low oil prices,” said Mohamed Damak, senior director and global head of Islamic Finance at S&P. “However, we think the 2020 shock will continue to reverberate through the economy and banking sector.”

Despite the expected boost to growth from the Expo and a recovering hydrocarbon sector, S&P forecasts the GDP to return to the 2019 level only by 2023.

A host of factors such as the continuing margin compression (less returns) from low interest rates, the likelihood of more bad loans are expected to keep the bank profits flat.

Flat loan growth and profits

Since risk factors from 2020 persist, market expectations remain tepid with the International Monetary Fund (IMF) forecasting 2021 GDP growth of just 1.3 per cent in the UAE following a contraction in excess of 6 per cent last year.

While margin compression is expected to abate for banks, there is little scope for expansion as Fed rates are set to remain near zero per cent in 2021 and 2022.

S&P expects gross lending growth to accelerate slightly when banks recycle the Central Bank’s Dh50 billion liquidity support to help clients navigate choppy waters. The Expo and borrowing by the government and related entities will support lending growth.

Corporate borrowing is likely to improve only marginally because some of the deferred capital expenditures in 2020 may be executed this year along with refinancing of existing debt.

“Loan growth is expected to reach mid to low single digits and provisioning to remain elevated. As such, we expect aggregate banking revenues and net income to remain broadly flat year on year in 2021,” Bank of America Merrill Lynch (BoAML) said in a recent analysis.

How reforms will spur growth

While the overall outlook remains cautious, BoAML analysts say several factors will provide a fillip to earnings through a more optimistic economic outlook, stronger loan growth and lower provisioning costs. Analysts pin their hopes on the recent announcements on 100 per cent foreign ownership of businesses, socio-economic reforms and new residency and citizenship rules. These are likely to result in significant foreign direct investments (FDI) that could boost the economy and loan demand.

NAT 210118 DHA VACCINE-211-1611670098856
Emirati Abdullah Majid Khalfan Bin Thaneya getting Pfizer-BioNTech COVID-19 vaccine at Zabeel Primary Health Centre. Photo: Virendra Saklani/Gulf News

How vaccine will impact the UAE economy

The development of several highly effective vaccines against COVID-19 is important to the UAE and its economy. The country’s vaccination drive is in full swing, with around 5 million doses already administered.

BoAML analysts believe the vaccine provides a realistic chance for reviving the travel and tourism sector (including higher attendance at the Expo), and trade could rebound more strongly than anticipated.

Strengths and weaknesses of the UAE banking sector

The UAE banks have strong capital buffers and liquidity and can rely on state support in the event of any structural risks. However, banks continue to face challenges from asset quality pressures, shrinking coverage ratio for bad loans and concentration of exposure to the real estate sector.

The power of capital buffers

Capital ratios (against risk-linked assets) in the UAE are among the highest in the region. The average CET1 [common equity tier 1] stands at 13.4 per cent while the average CAR [capital adequacy ratio] stands at 16.6 per cent. Leverage is low as well, with equity to assets at 12.1 per cent on average.

In March, the central bank allowed banks to tap up to 60 per cent of their capital conservation buffer currently set at 2.5 per cent of risk-weighted assets. The four domestic systemically important (D-SIB) banks used up to 100 per cent of their D-SIB buffer.

Liquidity is sound and stable

Liquidity in the banking system remains sound and stable. As loan growth remains subdued around 5 per cent, the system loan to deposit (L/D) ratio (the amount of loans granted against the amount of deposits in per cent) has stabilised around 95 per cent for the last 2-3 years. Like all GCC countries, state deposits in the system are high at 19 per cent of the total, providing cheap funding for banks. The Central Bank of UAE’s comprehensive Targeted Economic Support Scheme (TESS) has boosted liquidity in the banking system, to soften the pandemic’s fallout.

Funding structure is strong

UAE banks’ funding structure benefits from a strong core customer deposit base and limited reliance on external funding. The overall deposit growth fell in 2020, as some corporates had to use their deposits to cover operating costs amid reduced revenues. At the same time, government and cash-rich public sector entities deposited extra cash in the banking system.

Deposits by individuals (retail deposits) continued to increase despite significant job losses, as they prioritised saving over spending. UAE banks benefited from a Dh50-billion free liquidity injected by the central bank and a relaxation of regulatory liquidity ratios (measure of a bank’s ability to convert its assets into cash) in 2020. As of September 2020, almost one-quarter of UAE banks’ assets were in liquid form.

Strong state support

The government is expected to continue to support the major banks in the UAE. The UAE authorities provided support in the form of additional capital and liquidity to its banks in 2008-09 also, in the wake of the global financial crisis.

Loan risks on the rise

While the UAE has experienced a low growth environment since late 2014, asset quality (loan’s risk against default) pressures have been muted until late 2019. However, pressures have accelerated since then due to a weak macro environment (the overall economy) combined with the COVID-19 outbreak starting from March. As a result, non-performing loans increased by around 60 per cent year on year as of September end.

Bad loans coverage declines

As of September, the average NPL (bad loans) ratio stand at 5.8 per cent while Stage 2 loans (see box on IFRS 9) represent another 7.9 per cent of the loan book. NPL total coverage has deteriorated materially to 78 per cent at the end of September compared to 113 per cent a year ago. Bank managements are bracing for more pressures in 2021 to sustain higher cost of risks.

Image Credit: Ahmed Ramzan/Gulf News

Exposure to real estate

Exposure to the construction and real-estate sectors is quite high across the banking system. It’s about 20 per cent, but as high as 25-30 per cent at some banks. With the real estate prices under pressure collateral values of many real estate exposure are expected to shrink further warranting additional provisions.

How IFRS 9 is impacting bank profits

Dubai: The adoption of International Financial Reporting Standards (IFRS 9) by UAE banks from January 1, 2018, impacts banks’ profits through the way loan impairments are recognised, and provisions are made.

IFRS 9 sets out rules on how banks should classify and measure financial assets and financial liabilities, including the recognition of impairment. In the standard that preceded IFRS 9, the “incurred loss” framework required banks to recognise credit losses only when evidence of a loss was apparent.

Under IFRS 9’s expected credit loss (ECL) impairment framework, banks must recognise ECLs at all times. This should take into account past events, current conditions and forecast information. Bank also must update the amount of ECLs recognised at each reporting date to reflect changes in an asset’s credit risk. It is a more forward-looking approach than its predecessor and will result in more timely recognition of credit losses and a likely increase in NPLs.

Stages of loan loss recognition under IFRS 9

Under the ECL framework, impairment of loans is recognised under three stages. Under the general approach, an entity must determine whether the financial asset is in one of three stages to determine both the amount of ECL to recognise and how interest income should be recognised.

Stage 1 is where credit risk has not increased significantly since initial recognition. For financial assets in stage 1, entities are required to recognise 12-month ECL and recognise interest income on a gross basis – this means that interest will be calculated on the gross carrying amount of the financial asset before adjusting for ECL.

Stage 2 is where credit risk has increased significantly since initial recognition. When a financial asset moves to stage 2, entities must recognise lifetime ECL, but interest income will continue to be recognised on a gross basis.

Stage 3 is where the financial asset is credit-impaired. This is effectively the point at which a loss has been incurred. For financial assets in stage 3, entities will continue to recognise lifetime ECL, but they will now recognise interest income on a net basis. This means that interest income will be calculated based on the gross carrying amount of the financial asset less ECL.

Rating agency Fitch expects UAE banks’ asset quality to deteriorate as payment holidays expire and not all borrowers can weather the downturn. This is particularly true in real estate, contracting, retail, aviation and hospitality sectors.

The agency expects a spike in Stage 3 loans under the IFRS 9 reporting classification. “Stage 3 loans could rise to 6.5 per cent of gross loans by end-2021 from 4.9 per cent at end-2019, which would be well above levels reached during the last oil price shock in 2014-2016, said Redmond Ramsdale, Head of Middle East Bank Ratings at Fitch.

“In addition, increasing restructuring and extension of support measures until end-H1-21 masks the true increase in Stage 3 loans.”

Stage 2 loans ratios vary across UAE banks and are not yet fully comparable. But some have reached 20 per cent and above, indicating the potential for high asset quality pressure.

How to read bank results

Here are a few commonly used banking and accounting terms used in reporting bank results and their meanings in simple language. All the explanations are purely in the context of a bank’s balance sheet.

Interest income

Interest income is the amount paid to a bank to lend its money or let another individual or entity use its funds.

Non-interest income

Non-interest income comprises all other income streams of a bank such as fees and commissions including deposit and transaction fees, insufficient funds (NSF) fees, annual fees, monthly account service charges, inactivity fees, cheque and deposit slip fees, and so on.

Floating and fixed rate loans

A floating interest rate is an interest rate that moves up and down with the market rate. It can also be referred to as a variable interest rate because it can vary over the debt obligation duration. This contrasts with a fixed interest rate, in which the interest rate of a debt obligation stays constant for the duration of the loan’s term.

Asset quality

Loans are assets of a bank. Asset quality is a measure of the likelihood of default of a loan or lease. It’s also a measure of its marketability. It is a measure of the price at which a bank or financial institution can sell a loan or lease to a third party.

Impaired loans and non-performing loans

There are several terms used loosely to refer to a problem loan. These terms range from delinquent loans, under-performing loans, defaulted assets, impaired loans, restructured loans, troubled debt, non-accrual status, non-performing loans, write-offs, provisions, loss allowances etc.

Some of those terms have very specific legal, accounting and/or regulatory meaning in the applicable jurisdiction. The practitioners informally use others in the financial services industry.

The key distinction between the terms impaired and non-performing is that impairment is an accounting term (affecting how problem lending is reported in financial statements) whereas non-performing is a regulatory term (affecting how problem lending is treated in prudential regulatory frameworks). In the UAE, IFRS 9 applies to the regulatory treatment of a bank’s asset quality.

Loan loss provisions

A loan loss provision is an income statement expense set aside as an allowance for uncollected loans or non-performing loan. This provision is used to cover different kinds of loan losses such as non-performing loans, customer bankruptcy, and renegotiated loans that incur lower-than-previously-estimated payments.

NPL ratio

NPL ratio is a percentage of the bank’s non-performing loans to total loans. It is calculated by dividing total NPL by the total amount of outstanding loans in the bank’s portfolio.

NPL coverage ratio

The coverage level of potential losses stemming from NPLs is measured by the ‘NPL coverage ratio’, which essentially is the loan loss reserves set aside by banks against the NPL volumes accounted in their balance-sheets.

Margin compression

Margin compression means input costs rise faster than the prices received from the sale of products, leading to decreasing margins. In the case of banks, it refers to lower interest income compared to its interest costs.

Marginal cost of funds

For banks, the marginal cost of funds refers to the increase in financing costs due to an increase in funding costs.

Cost-to-income (C/I) ratio

The cost to income ratio is one of the key efficiency ratios used to gauge a bank’s efficiency. It is used to compare the operating expenses of a bank vis-à-vis its income. The lower the cost to income ratio, the better its performance.

Capital Adequacy Ratio

The capital adequacy ratio (CAR) is a measurement of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposures. The capital adequacy ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems worldwide.

Tier 1 common equity ratio

Tier 1 common capital ratio is a measurement of a bank’s core equity capital, compared with its total risk-weighted assets, signifying a bank’s financial strength. Tier 1 common capital excludes any preferred shares or non-controlling interests.

Systemically important financial institution (SIFI)

A systemically important financial institution (SIFI) is a bank, insurance, or other financial institution that the regulators determine would pose a serious risk to the economy if it were to collapse. A SIFI is viewed as “too big to fail” and imposed with extra regulatory burdens to prevent them from going under. A SIFI label brings more scrutiny and additional regulations.