Purveying the retail stores at the Dubai International Financial Centre (DIFC), a banker comments that the closure of the De Beer’s diamond store, to be replaced with a Smokers’ Centre, is a sign of the changing fortunes of international banks in the region.

Banks are now much more willing to forego new business than do deals in an information vacuum

Head of an international bank in the region

In many cases, the Middle East has not turned out to be the glittering prize that international finance houses, lured to the region by the modern infrastructure of the DIFC, expected. Debt problems in Saudi Arabia, Kuwait and Dubai have led some institutions to question their commitments to the region.

The impact of the financial crisis has also had a deep impact on the volume of new deals generated out of Dubai, leading many bankers based in the emirate to spend more time elsewhere in the region than ever before. The question now facing international banks in the Middle East is: do they swallow the bad debts booked over the past five years and stick around waiting for growth to return, or should they cut their losses and leave?

Banks remaining loyal to Gulf market

Leaving would be a mistake. Although the past year has been tough for international banks, the Middle East offers a unique growth story, buoyed by the need to recycle petrodollars and the region’s strategic position between the East and West. Deserting a region that rewards loyalty will also make coming back harder.

Clearly though, international banks have been hard hit by the problems in the region, specifically in Dubai. The coordinating banks for the restructuring of Dubai World’s debt included four UK banks – HSBC, Royal Bank of Scotland, Lloyds TSB and Standard Chartered. They made up some of the largest creditors to the company and will have to make some substantial write-offs as a result of the restructuring.

Yet most have not rethought their commitment to the region. “A lot of the US investment banks have scaled down their presence in the region as a result of the slowdown, but not left entirely,” says one Dubai-based banker.

Several European banks, driven by pressures in their home markets, have also shrunk their teams in the Middle East.

Those that have been in the region longer have been more inclined to stay through the recent problems. “We have been here for a long time and expect to remain here for a long time to come,” says Christos Papadopoulos, regional chief executive at Standard Chartered Middle East. “So we will go through the perils of adversity, whether that is economic, political or other forces.”

Staying also puts banks in a good position with their existing customers. “Because you remain, your standing improves while everyone else abandons that space,” says Papadopoulos. “We felt some impacts of the crisis, but we were still here offering our balance sheet to clients throughout the crisis.”

Stephen Bottomley, head of strategy and planning at HSBC Middle East, agrees. “The financial crisis made people realise that they need their dedicated banks for the long term,” he says.

That has been the case in Dubai, where many of the banks that stood by the government during the restructuring process are now first in line for mandates on new transactions, such as bond issues.

“The impact [of the financial crisis] hit the region very suddenly and very hard,” says Bottomley. He says the bank took the decision to take deep provisions in 2009 to ensure it did not carry significant legacy issues with it when the market recovered. HSBC’s figures for the past 18 months show that profit has rebounded, although not yet to levels recorded in the first half of 2009. HSBC Middle East made $643m in the first half of 2009, followed by a loss of $189m in the second half. For the first six months of 2010, the bank recorded a profit of $393m.

Standard Chartered’s wholesale banking division for the Middle East and South Asia made $222m in the first half of 2009, followed by $146m in the second half, and $364m in the first half of 2010.

International banks top league tables

The fact that international banks can still make good money in the region is evidenced by the league tables for the first three quarters of the year. The top 10 list of underwriters for Middle East and North Africa region bond and loan deals is dominated by international banks. Nine of the 10 leading bond underwriters are international banks, with HSBC first. For book runners on loan deals, HSBC is again the top international bank, and only two regional banks feature in the ranking.

Results from other international banks that give details on their Middle East performance indicate that a corner has been turned since 2009, although some insiders say not all banks have been aggressive in writing off bad loans.

“There is still a big tail sitting in the UAE banking sector and not all of the international banks have taken all the write-offs they will need to,” says a senior figure at one international bank.

Some banks have not yet taken write-offs, but they have started shifting their focus. Whereas Dubai was once the regional hub of activity, banks are increasingly turning to other markets.

Chief among these are Saudi Arabia, Qatar, Kuwait and Abu Dhabi. Most international banks operate in Saudi Arabia as investment banks only, except for a handful that have controlling stakes in a local partner. Papadopoulos says Standard Chartered’s recently acquired licence for investment banking activities in the kingdom is “the first step to getting a bigger presence in Saudi Arabia.”

North Africa a key hub for banking firms

There is also growing interest in markets in North Africa. HSBC moved its retail banking hub for the region from Dubai to Egypt at the beginning of 2010 as it sought to position itself closer to the region’s largest population centre.

For retail banking, the move makes sense. The Middle East is split between countries with oil wealth and countries with large populations. Both are attractive for banks, but for different reasons. It is rare for countries to have both.

The financial crisis has also made banks give more serious attention to frontier markets such as Iraq, Syria and Libya. Here the risks are greater, but the potential of being an early entrant in a new market is attractive. So far, progress has been mixed. Six banks applied for a licence to start operating in Libya in 2010, but in the end only one licence was awarded, to Italy’s Unicredit. Other banks are still pursuing openings in Libya.

Standard Chartered is looking at establishing a presence in the Green Zone in Baghdad, and HSBC already has a licence to operate in Iraq, although threats against international banks make lenders nervous about what kind of presence and branding they can use.

Papadopoulos says the question banks face is not whether Iraq will be a major finance market for the region, but “when and how?” “A lot of our clients are already asking us to be there, particularly the oil majors,” he says.

The rationale for international banks’ continued presence in the region remains strong, despite the errors made in the past few years on corporate lending. The Middle East oil producers will be generating large amounts of money that need to be reinvested through sovereign wealth funds and economic diversification programmes.

“The value of this region for banks is in helping it to recycle its oil wealth, and we can help with that through our global connectivity,” says Bottomley. “The purely local players cannot access China for you. They cannot make introductions in Latin America, or help manage trade with Asia.”

Despite the challenges of competing with both international and local banks, there is still room for new entrants to the market. But the offering must be right.

“It’s easy for international banks to just put flags in a map,” says Bottomley. “It’s harder to get the size and scale necessary to secure profitability. It’s not too late, but new banks entering the market would need to have a clear view of what they bring and the value they create.”

Learning the unique risks of the region is also essential. A lot of the mistakes that international banks made in the past few years were down to the local practice of name lending, where borrowers are lent money based on the strength of their reputation, rather than their credit history, or what they want to use the money for.

Cautious approach from global banks

“Banks are now much more willing to forego new business than do deals in an information vacuum,” says the head of one international bank in the region. “They are also now modifying their underwriting standards from their experiences of the past few years, but not necessarily changing the way they do business.”

As international banks become more cautious, this will also help the financial markets of the Middle East to mature.

With a strong oil price and major infrastructure programmes being implemented around the region, international banks would be foolish to abandon the Middle East based on the troubles of the past few years, especially as growth rates in developed markets remain subdued.

At the same time though, the lessons of the credit boom must be remembered if international lenders are to avoid falling back into making the same mistakes the next time there is a major spike in oil prices.