Since the start of 2013, banks in the Middle East and North Africa (Mena) region have been preparing to meet the exacting capital and liquidity standards of the Basel III regulations. Released by the Basel Committee on Banking and Supervision, the regulations were the global banking communitys response to the financial crisis of 2008.
For the most part, [regional banks] do not need to go to the market to raise new capital
Khalid Howladar, Moodys Investors Service
Unlike many of their Western counterparts, regional banks have not been forced into repairing tarnished balance sheets as a result of ill-judged exposures to sub-prime assets. Whereas Western banks held too little capital to protect against unexpected losses, banks in the Mena region for the most part, are well capitalised, highly liquid and sufficiently provisioned against non-performing loans.
Qatar, for example, boasts a capital adequacy ratio of 19 per cent, well ahead of the minimum requirements of the Basel III norms. This is not just a reflection of the regions wealthiest economies in-built advantage; Lebanons capital adequacy ratio stands at 11.8 per cent, ahead of the 10.5 per cent ratio required by the Basel committee by the end of 2014.
GCC banks have capital levels that are strong relative to developed market banks, says Khalid Howladar, senior credit officer at US ratings agency Moodys Investors Service, based in Dubai. Basel III significantly hits existing hybrid capital, but most capital in the Gulf is composed of high-quality common equity that makes for a strong buffer.
In addition, Gulf banks in general are largely profitable, with decent margins that provide strong internal capital generating ability.
For the most part, they do not need to go to the market to raise new capital, they can fund growth through internal generation, says Howladar. This leaves them in quite a good position for the incoming Basel III regulation on capital.
|GCC capital adequacy ratios (percentage)|
Nonetheless, under regulatory pressure, regional banks will spend the next five years with a renewed focus on ensuring their balance sheets are as de-leveraged as possible in order to comply with Basel IIIs capital and leverage ratio requirements.
That focus will inevitably have an impact on the staple activities of banks, notably lending to projects. One of the starkest impacts of the Basel III process has been on the regions project funding market, with large Western banks withdrawing from the region. This is, in part, an effort to meet the stricter capital and liquidity standards laid out by the Basel committee.
There has been widespread concern that Basel III capital norms could lead as US ratings agency Standard & Poors (S&P) warned to a drying up of long-term finance to Gulf projects from European lending institutions. Gulf and other Middle Eastern project lenders did not suffer the same capital and liquidity challenges. Their lack of size and inability to access long-term funding sources, however, has left the project market bereft of commercial lenders able to commit to large, multi-tenor deals.
This has created a need for new capital-boosting instruments, with growing calls for the use of project bonds and sukuk (Islamic bonds) in the region.
Despite their robust capital buffers, local banks in particular, the sharia-compliant institutions still need to recalibrate their risk-weighted assets to comfortably clear Tier 1 capital thresholds. This has prompted some significant innovations, with a reach-out to capital market instruments that help to diversify Islamic banks funding profiles.
In November 2012, Abu Dhabi Islamic Bank, one of the largest sharia lenders, issued $1bn-worth of Tier 1 capital certificates, making it the worlds first Basel III-compliant, Tier 1 sukuk issuance, attracting an order book of more than $15bn.
Conventional banks have also sought to issue debt instruments to boost Tier 1 capital, more out of prudence than necessity. Dubais Emirates NBD raised $1bn from a Tier-1 bond issue in May, and other banks are waiting in the wings. Saudi Arabias Sabb is understood to be looking to sell a riyal-denominated sukuk to boost its Tier 2 capital position.
Although the regions banks are, in general, well prepared for Basel III, they still need their national regulators to play a constructive role in explaining how debt instruments will be treated under Basel III terms.
Qatar is most advanced in this regard, publishing guidelines for implementation in late 2012. Yet Qatari banks still need firmer instruction on how debt instruments, such as hybrid bonds, will be treated under the new Basel standards. Much of the groundwork still needs to be done, particularly on the liquidity side.
UAE banks, for example, are being penalised for their high share of corporate and government deposits. In Basel IIIs interpretation, only retail deposits are regarded as being sufficiently sticky.
Many Gulf banks operate an asset-liability mismatch, as they are heavily deposit funded and tend to take short-term deposits versus making longer-term loans. Much of the deposit base in the region is corporate, which is penalised versus retail for the Basel III liquidity ratios, says Howladar. Local regulators are likely to use their national discretion to place more emphasis on the stickiness of these deposits, which have historically proven quite stable and are less confidence sensitive than market or interbank funding. The regulators will likely ensure the incoming regulations are tailored to the specificities of the region.
Banks may also need to issue regulatory capital in the near future to not only cover existing lending activity, but anticipated lending. This would enable them to grow their balance sheet in accordance with directives they receive from their central banks.
Some regional banks are going out and lending aggressively to SMEs [small and medium-sized enterprises], which is a particular focus of policymakers across the Mena region, says Alex Roussos, a Dubai-based partner at UK law firm Dentons, with experience of several capital market transactions. They are now anticipating they will have to increase their total capital ratios to be able to grow their balance sheets and be in a position to lend more.
Lower lending levels
An additional concern relating to the roll-out of Basel III is that the enforced boost to capital and liquidity will yield unintended consequences in the form of lower lending levels and higher transaction costs. The unspoken danger is that Basel IIIs insistence on tighter liquidity coverage ratios will ultimately crimp banks risk appetite and thereby contribute to weaker lending.
Any reduction in long-term bank credit induced by Basel III would constrain overall economic growth, so it is a clear concern for the regions policymakers.
The evidence that such preparations are contributing to lower lending activity is still sketchy. In Saudi Arabia, lending growth has been slowing since reaching a peak in May 2013 of 16.5 per cent, but this is not anywhere near crisis levels.
Instead, the impact may be felt on the pricing side. There is an impact on lending in the kingdom, but its indirect, says one senior Saudi-based banker. Mostly it is anticipatory, as Sama [Saudi Arabia Monetary Agency, the central bank] has done a good job of moving banks to Basel III. But some aspects are having an impact. The banks treasuries are keenly aware of the liquidity coverage ratios, especially when it comes to long-term obligations, 10-year loans and the like. That has impacted pricing more than anything else. People have decided the funding for that is going to be more expensive.
Project lending is more affected than other areas, says the Saudi banker, because these are long-term, illiquid and fully risk-weighted assets. The raised capital and liquidity ratios, and the bolstered exposure-funding matching needs, are making long-term lending relatively less attractive. Replicating the funding structures of most Mena region project finance deals of the pre-2009 period will prove a challenge in the post-Basel II climate.
According to S&P, several big-ticket infrastructure transactions in the Gulf have been arranged by what are effectively state-backed holding companies. The implementation of Basel III may well encourage these corporates to raise capital through a joint-venture project or structured financing, given lower availability of long-term financing from banks, it said in a research note published in October.
In the absence of a watering down of Basel III regulations, the solution to the lending gap in the project market may lie in local banks making a better effort of deploying the full range of the capital markets instruments at their disposal.
We are already seeing a lot of hype across the region over the possibilities of project bonds and sukuk, says Roussos. Some of that has yet to materialise, but there has been some good project finance debt instruments financed by the capital markets recently and we may start to see more of these come out of the region.
Despite some signs of slackening loan growth in key Gulf markets this year, the generally positive economic environment in the GCC may limit the negative impact of capital boosting measures on lending activity.
Capital Economics, a London-based consultancy, estimates that bank credit in the Gulf is currently expanding at an average of about 10 per cent a year, rising fastest in Qatar and Saudi Arabia at about 15 per cent. Even in the UAE, it notes, banks are starting to lend again following a period of deleveraging in the wake of Dubais crisis.
This is manifestly not a lending crisis. Moodys Investors Service, for example, expects the increase in net income at UAE banks will provide them with the internal capital-generation capacity necessary to support asset growth over the next 12-18 months, while maintaining their strong Tier 1 capital levels, which stood at about 16 per cent as of June 2013.
If financial institutions in the Mena region can finally realise their ambitions to widen their funding sources, taking in innovations like project bonds, they will have achieved an impressive double: meeting the Basel III requirements and engineering themselves into a stronger position to extend long-term loan facilities to the burgeoning pipeline of major projects.
The interim constraints on lending activity brought on by Basel III preparations may seem to many a bitter pill to swallow. The long-term prize, however establishing a more mature banking market that is much less dependent on the funding appetite of large foreign banks is well worth the discomfort.
In November 2012, Abu Dhabi Islamic Bank issued the worlds first Basel III-compliant, Tier 1 sukuk worth $1bn