Banking: A fistful of dollars

14 June 2002

'Neither a borrower, nor a lender be,' Polonius famously advised his son in Shakespeare's Hamlet. The counsel may have been sage, but the playwright was clearly no banker. There have been times when some of the heads of the Gulf's financial institution were not regarded as bankers either, but given the vibrant performances of most regional players, this is clearly no longer the case.

Oil, interest rates, competition and integration. These were the key words for the banking sector in 2001. As the annual MEED survey (see pages 33-38) of the community shows, those banks plugged into the right markets in the right way reaped the rewards last year and those that were not got burned. In 2001, the winners outnumbered the losers but, significantly, the number of losers is growing. If this trend were to continue - and there is every reason to think that it will - it could force some radical rethinking at some of the smaller and less effective financial institutions in the region. Equally, the current winners cannot afford to rest on their laurels: they might have the right formula now, but this is not to suggest it will always work.

For the moment, most of the region's bank chief executives can sleep easy. Of the 68 financial institutions covered in the MEED survey, 48 - or 71 per cent - posted increased earnings last year. Perhaps more impressively, eight banks grew their profits by more than 50 per cent, 15 by more than 25 per cent and a very healthy 25 by more than 15 per cent. Clearly, there were plenty who got the equation right in 2001.

There were also those that didn't. Four banks posted out-and-out losses, the highest number in the last five years of MEED surveys. It is no coincidence that two of them - Bahrain International Bank and BMB Investment Bank - were investment banks heavily exposed to the turmoil of volatile international markets. The importance and the danger of integration with the global financial community continues to be a controversial debating point.

Equally, it is no surprise that the other two, National Bank of Oman (NBO) and Majan International Bank, both operate in the troubled Omani market. A combination of aggressive lending, weak credit control, a crashed stock market and comparatively poor asset quality has forced an escalation in levels of provisioning and debt write-offs that has seriously eroded profitability. NBO and Majan might be the only two Omani banks to report losses, but most of the others had painful experiences: BankMuscat saw net profits drop by 52 per cent, Oman International Bank's earnings fell more than 80 per cent and Oman Arab Bank's slipped 11 per cent. Bank Dhofar Al-Omani Al-Fransi was alone in improving its earnings last year and the local Omani banks as a whole generated aggregate profits of only $24 million in 2001. Times have been hard and while there are some that hope for a recovery this year, there are signs that not all the poisonous bad debt has been drawn.

None of the other five GCC markets gave their banks such a comprehensively hard ride, but that didn't stop another 11 banks reporting declining profits. In the case of regional heavyweights such as Gulf International Bank and Arab Banking Corporation (ABC) - two of the five largest banks in terms of assets - much of the downturn stemmed from their exposure to difficult conditions on international markets. ABC, in particular, was rubbing shoulders with global giants such as JP Morgan Chase in the crowd of Enron Corporation's creditors and provisioning for this had a direct impact on the bottom line. ABC was not alone, Al-Rajhi Banking & Investment Corporation also found itself with about $100 million-worth of exposure to Enron when the balloon went up.

Among the other financial institutions that struggled last year were a number of those most intimately locked into international capital markets. Investcorp, the flagship of regional investment banking, had its second difficult year on the bounce, mainly the result of illiquid and depressed markets restricting exits from private equity investments. United Gulf Bank and TAIB Bank, both Bahrain-based investment banks, also saw profits tumble.

Just how this evidence will be used in the ongoing debate over regional banking strategies will be determined by who holds the floor. Some will argue that the domestic markets are inherently more stable, that these markets should be ring-fenced and protected, that banks should be restricted in their exposure to volatile global markets and that there are clear benefits in isolationism. The proponents of this will be accused of having short memories and being shortsighted.

The opposite view is that the Gulf's financial services sector has a very uninspiring future if it refuses to integrate itself into the greater global financial community. While much of this argument revolves around the need to develop better products and provide improved services, there is an underlying, less frequently deployed but possibly more compelling, case.

As the MEED surveys have shown, the GCC's banking community has grown considerably faster than the regional economies. Strong oil prices in recent years have generated substantial capital inflows and a significant proportion of this has filtered down onto the balance sheets of the local banks: liquidity levels have - with the clear exception of Oman - spiralled upwards. In each of the last five MEED surveys, aggregate customer deposits have grown faster than loans, and while much of the surplus in major markets such as Saudi Arabia is soaked up through the issue of government debt, there is a growing pool of money looking for a home.

The result has been a fundamental shift in the psychology of balance sheet management. The days when the best bankers were adept at handling the liability side of the balance sheet are passing and the era of asset management has arrived. Not only does this force the region's bankers to develop new skills and learn new tricks, it also raises important questions over the depth of regional markets and the availability of strong investment opportunities.

Capital accumulation within the regional banking sector is in danger of outgrowing investment outlets and, against such a backdrop, it is not surprising that capital flows into other markets are on the increase. The case for the integration of the regional banking community into the global system grows stronger as each petrodollar filters down to the banks' balance sheets.

This is not to suggest that most of the banks are not in rude good health. Benefiting from the region's comparative isolation from the global flows of hot money, and the protectionist walls thrown up around some of the GCC's key markets, most of the regional banks have performance ratios to boast about. Of the 67 banks included in this aspect of the MEED survey, more than 24 generated returns on year-end assets (RoAs) in excess of 2 per cent and 54 had RoAs of more than 1 per cent. Perhaps more impressive, nine of the 67 had returns on year-end equity (RoEs) of more than 20 per cent - they are the envy of most international banks - and 22 had RoEs greater than 15 per cent.

Significantly boosting the isolationists' case are the aggregate market returns. There are those that claim it is no coincidence that the two banking sectors most effectively sealed off from foreign competition - Saudi Arabia and Kuwait - on aggregate generated the best RoEs (see left). Whether or when full alignment with World Trade Organisation accords will force change and deregulation remains to be seen. But in the meantime, those believers in the 'it ain't broke, so don't fix it' theory will continue to crow.

But they might be cut short. There is good reason to expect that the soaring profits of the one-market, domestically focused banks might not be repeated this year. Last year, the well-managed banks were able to widen their lending margins as a string of interest rate cuts were made. This year, the low-and-stable interest rate environment gives them much less room for manoeuvre and, in the context of growing competition, it can be assumed that margins are being squeezed. Add to this the uncharacteristically high - in global terms - reliance on non-interest bearing deposits and the chances of another boom year look slim. There are dangers inherent in making forecasts, but it is unlikely that 71 per cent of the financial institutions covered in next year's survey will have grown their profits.

One of the reasons for this is a continued dependence on interest income. Considerable lip service has been paid in recent years to the need for a greater diversification of banks' revenue streams. It has not been matched by action. As a sample of some of the leading banks in each of the GCC markets shows, the reliance on net interest income continues to be heavy (see left). When margins are wide, net interest income is good fuel for the bottom line, but it will always be volatile and carry greater risk than more stable fee and commission income. The table suggests that the banks in Kuwait, Bahrain and the UAE have been more successful in developing non-interest revenues, but it remains an issue for all the region's banks. Perhaps Polonius had a point after all when he warned against lending.

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