Emphasis shifts to local banks in financial sector

04 February 2013

Local institutions and Islamic finance are taking on an ever greater role in Middle East finance

High oil prices and large government spending programmes have sustained GCC economic growth and helped improve profits, while provisioning levels have generally fallen. Progress has been made on further restructurings in Dubai.

That has been coupled with subdued credit growth, increasing regulations and a weakening global economic environment. Further debt restructurings in Dubai are under way and questions about the emirate’s ability to reduce, rather than just reshuffle, its debt pile are increasingly being asked.

Strong diversification

According to the latest forecast by the Washington-based IMF, non-oil growth in the GCC is set to be about 5.9 per cent in 2012 and 5.5 per cent in 2013. That is stronger than growth in the oil sector and more indicative of how the private sector is performing. It is, however, a downgrade of the IMF’s predictions from six months earlier, when it forecast non-oil growth of 6 per cent in 2013.

Huge government spending, especially on wages, will help drive some banking activity over the next year, but activity is still likely to be subdued compared to previous years, albeit at an improved pace over 2010-11.

One of the biggest trends of 2012 has been the development of the capital markets. In the first nine months of 2012, about $29bn of bond deals were arranged, compared with $27bn in the whole of 2011. This has partly been driven by firms finding it easier to raise new debt in the bond markets rather than from banks.

“Debt market activity has really picked up in 2012, at least in part driven by the reluctance of banks to extend credit, and partly because global investors have been looking for yield and Middle East bonds have offered it,” says a debt capital markets banker in Dubai.

One of the most important features of the market activity in 2012 is the move away from the domination of governments and state-owned companies in the banking sector and, albeit slowly, the private sector also. Lenders responsible for arranging regional deals say that private firms are increasingly mandating to raise money from the bond markets.

Last year, the beginning of the region’s political unrest and eurozone sovereign debt problems spooked markets and led many companies to put off tapping bond investors. Much of that issuance has taken place in 2012 as investors are now more accustomed to those worries and the Middle East’s core markets have continued to show strong growth.

Islamic growth

The maturation of the sukuk (Islamic bond) market has also helped. In the first nine months of 2012, $18bn of sukuk deals were completed by regional issuers, compared with less than $5.5bn in the whole of 2011, and a similar figure in 2010.

Islamic bonds have become increasingly popular as a tool for regional issuers to attract new investors and benefit from falling yields. At the beginning of 2012, the yield on GCC sukuk issues was 4.3 per cent, according to the HSBC/Nasdaq Dubai Sukuk Index. By late November, it had fallen to less than 3 per cent as investors rushed to buy new sukuk deals.

The greater liquidity in the Islamic banking sector is also evident in the loan markets. During the first nine months of 2012, $27bn was raised by Middle East borrowers in the loan market, of which $12bn was Islamic loans. In 2011, $36bn was raised, but only about $4bn of that was sharia-compliant. Islamic deals benefit from accessing a different liquidity pool in addition to conventional banks that can often also participate through their Islamic units.

The shift in emphasis from the loan market towards debt capital markets is clear. While market activity is picking up in the bond markets (the first quarter of 2012 was the most active in terms of the number of deals for the past six years) the loan market has slowed considerably.

There are also signs that the project bond market may finally start to come into existence over the next few years, giving project developers an alternative source of liquidity. Project finance has experienced a particularly slow period in 2012, with only about $8bn of deals completed in the first nine months, compared to $22bn in the whole of 2011. Several large deals that were expected to close in 2012 have slipped into 2013, but clearly the reluctance of banks to lend on new long-term financings is affecting activity.

In light of this, the trend towards more bond issuance will be a relief to bankers, who are finding that their ability to lend is being increasingly restrained. The biggest hindrance is regulation, which is becoming more restrictive in the wake of the financial crisis.

Upcoming international banking regulations, known as Basel Three, will place new limits on bank leverage and force lenders to keep more capital aside as a portion of their loan books. Although the new rules will not be enforced for regional banks as quickly as in developed markets, regulators in the Middle East are taking steps to get banks prepared for them.

Limiting regulation

In early 2012, the Central Bank of the UAE passed new rules that limited how much banks could lend to the government and also introduced new liquidity guidelines. Originally, banks were meant to comply with the government exposure rules by the end of September. That deadline has passed with no clarity as to how or when the new rules will be applied.

The central bank has remained cagey about such matters, but insists banks will have to follow the rules eventually. Several of the UAE’s biggest lenders, including Emirates NBD and National Bank of Abu Dhabi, are expected to be in breach of the rules because of their high levels of exposure to the governments of their emirates. Complying with the rules could force them into selling off large chunks of their loan books, which if poorly managed could cause the value of those loans to fall.

Even in Saudi Arabia, where banks have spent much of the past two years with excessive liquidity, the environment is starting to change. Loan pricing has been falling as pressure to book assets has been high, and banks have outbid each other to offer low-priced loans. That trend is now reaching a conclusion and although there is still ample liquidity, competition to lend is already showing some signs of relenting. “The pressure that we have been under from management to book assets has reduced a bit now, and hopefully that will start to be reflected in loan pricing soon,” says one structured finance banker at a local institution in Riyadh.

Broadly, though, the banking sector in the GCC is in a more positive position than a year ago. Ratings agency Moody’s has the banking sectors of Saudi Arabia, Qatar, Kuwait and Oman on a stable outlook based on improving profitability and a declining trend in problem loans. Only the UAE and Bahrain have a negative outlook, largely due to problem loans as a percentage of gross loans rising faster than profits. That outlook also masks an increasing disparity between the strong performance of Abu Dhabi banks and the relatively weaker showing from banks in Dubai, which are generally still struggling with their exposures to over-leveraged government entities and the real estate sector.

Outside the GCC, banks are doing less well. Moody’s either has the banking sectors of Egypt, Jordan and Lebanon on negative watch, or has already downgraded them this year. Political instability in those markets is hurting economic growth, discouraging investment and affecting asset quality. That trend is unlikely to be reversed any time soon.

As banks in these countries face weaker growth prospects, the opportunity for Gulf lenders to expand will increase. Qatar National Bank, the region’s biggest lender by assets, is planning to buy the stake in Egypt’s National Societe Generale Bank held by France’s Societe Generale. If the deal goes through it will be symbolic of the retrenching of many international banks in the Middle East to be replaced by stronger local banks, and also the increasing strength of GCC banks in comparison to lenders in the rest of the region.

The shift away from conventional finance to Islamic sources of liquidity also underscores that trend. With economic growth in the GCC expected to be strong in 2013, especially in comparison to the developed world, local banks will continue to grow and enhance their propositions. Moves during 2012 to strengthen their liquidity through long-term fundraising will continue, further helping to improve their reputation internationally and providing the funding for them to keep growing.

Oil reliance

However, a collapse in the oil price would lead to a sharp fall in government deposits in the banking system and state spending, cutting off banks from their main source of funding and loan growth.

That seems unlikely at the moment. During 2013, banks will continue to be reluctant to lend to anyone but top-tier firms, leading many borrowers to turn to bond markets instead. Profit growth for banks will continue to recover from the financial crisis and, barring any unforeseen events, provisioning for bad loans should remain on its downward path.

The next 12 months look like they will offer neither recovery nor crisis.

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