The region's financial markets are successfully moving on from the stock market crashes of 2006, but the heavy losses continue to cast a shadow over the performance of the banking sector.

Despite the region's huge economic growth in 2007, MEED's survey of the region's biggest banks shows profits grew by an average of just 2 per cent over the year.

Bank managers across the region talk of 'core earnings growth' when discussing performance in 2007, avoiding any comparison with the profits from the huge stock market windfalls of 2006, which make 2007 look like a poor year.

Saudi Arabia, the region's second biggest market by assets, has been severely affected. Total profit for Saudi banks fell by 14.5 per cent in 2007, according to central bank data. It was in the kingdom that the stock market boom and bust was most sharply felt.

Broadly, revenues are now back where they were in 2005, when looking at consolidated figures for the six GCC nations, although some banks recorded strong growth in the first quarter of 2008.

The effect of the stock market boom on bank profits is leading some analysts to discount 2006 as an anomaly, the record figures merely distorting valuation models.

Disappointing performance

This year's results show that the UAE and Saudi Arabia, traditionally viewed as the twin engines of the GCC banking sector, are largely responsible for the disappointing performance of the region's banks, while other markets have posted strong growth. Kuwait's banking sector, for example, recorded profit growth of 23 per cent in 2007. The Kuwaiti stock market accounted for less of the banks' profit growth in 2005 and 2006, so they were less vulnerable to the subsequent crash.

The impact of investments in sub-prime-related assets also dragged down regional banks' profits in 2007. Although only four banks report any significant exposure to assets that declined in value, the losses were large compared with their profits.

Gulf International Bank (GIB) made nearly $1bn worth of provisions following its losses on investments in collateralised debt obligations and structured investment vehicles. This led the bank from making a $255m profit in 2006 to a $757m loss in 2007.

Arab Banking Corporation (ABC) and Gulf Investment Corporation (GIC) also took a hit from similar investments, although smaller in size and taking a lesser portion out of their profits.

The different accounting treatments applied by the three banks also played a part. GIB booked the whole loss at the end of 2007, while ABC made further provisions in the first quarter of 2008.

GIC is expected to reveal that its assets have decreased in value further when it reports half-year 2008 figures later this year.

Elsewhere, soaring oil prices are keeping liquidity high and driving more cash through the banking system. As infrastructure and residential projects open, developments attract more people, who in turn become potential customers for the banks.

"Core businesses are all growing well, and if you strip out the exceptional brokerage revenues, the growth trend is pretty positive," says Robert Thursfield, director at ratings agency Fitch Ratings.

In 2007, the UAE banking sector eclipsed that of Saudi Arabia as the largest in the region. The UAE sector now represents assets worth $336bn, while Saudi Arabia's has $293bn worth of assets.

This trend is echoed in the merger of Emirates Bank International and National Bank of Dubai to form Emirates NBD, making a UAE bank the biggest in the region by assets, overtaking Saudi Arabia's National Commercial Bank by $13.4bn.

Emirates NBD is also the biggest by loan book and deposits, although it is still dwarfed by several Saudi institutions in terms of annual profits.

Now that this bigger bank has been created, it should be able to take part in larger deals. Already, subsidiary NBD Investment Bank has become more active in investment banking.

"We want to become a regional champion in investment banking, and there is a tremendous ability now to do a lot more for our corporate clients and use the bigger capital base to underwrite more and bigger deals," says Rick Pudner, chief executive officer (CEO) of Emirates NBD.

Sector dominance

The creation of such a huge bank by assets also demonstrates the dominance of big banks across the region. The top 10 banks in the survey hold just under 50 per cent of the banking assets in the region (see chart page 36).

The challenge now for the banking sector is to deliver growth that is appropriate for such fast-growing economies. With the economic tail-wind behind them, it should not be too difficult to record some significant gains.

One key problem marring an otherwise favourable economic environment for the sector in 2008 is how the legacy of the sub-prime lending collapse - the tightening of the global credit markets - will impact on the region.

The slowdown in project finance activity in the first half of the year, driven by the rising cost of dollar funding, is not expected to have a material impact on bank revenues.

"Project finance deals do not have a big impact on bank revenue in the year they are booked," says one Riyadh-based project banker. "The only income that happens as deals are booked is from upfront fees. The actual asset-related income does not come until the projects are a few years into development, so I don't see the lack of project deals this year as having a big impact on banks' profits."

While banks are suffering from being unable to access dollar funding, a lot of the deals in the region are now denominated in local currencies. Anecdotally, bankers say this has resulted in regional banks playing a greater role in financing regional deals, and with access to cheap local currency deposit funding, this could bode well for their profits. However, the global credit crunch is expected to act as a break on bank profits.

"Wholesale funding is becoming much more of a challenge for the banking sector," says Deepak Tolani, bank analyst at UAE-based Al-Mal Capital. "As a result, banks are actively trying to pursue more high-margin retail business. That should compensate for some of the declining margins in the wholesale market."

Another knock-on effect of the credit crunch comes from falling US interest rates, which have declined sharply from 5.25 per cent for much of past year to just 2 per cent today. Coupled with inflation in the UAE estimated by the Abu Dhabi Chamber of Commerce at about 14 per cent, real interest rates are now negative, which means it is more economical for customers to hold debt than deposits. "This makes it difficult for banks to attract additional deposits, which, although short term, are a stable source of funding while the capital markets are expensive," says Tolani.

"We are spending an increasing amount of time with our treasury department working out what our real cost of funding is, because London interbank offered rates [Libor] are no longer an accurate reflection of the price we pay for deposits and capital market funding," says one Saudi banker.

The difficulty in adequately pricing the banks' own funding sources is cutting into margins. "Interest margins are under pressure," says Eirvin Knox, chief executive officer of Abu Dhabi Commercial Bank (ADCB).

He adds that the last dollar fundraising the bank did in early 2007 cost 27 basis points over Libor. "Today, I imagine it would cost us 150-200 basis points to do a similar deal, but for a smaller amount," he says.

This is leading banks to focus on growing their deposit funding base, although achieving this is expected to be difficult, and also further distances bank funding costs from Libor rates, which they use to price the money they lend.

Loan growth

In the UAE, growth in loans and advances increased from 26 per cent in 2006 to 29 per cent in 2007, while deposit growth fell from 24 per cent to 23 per cent. The picture is slightly different in Kuwait because of the increased monetary flexibility following the shift to pegging the dinar to a currency basket, but loan growth is still outpacing deposits.

MEED's analysis shows that loans are growing at 34.5 per cent for the region as a whole, while deposits are growing at only 22 per cent. Despite attempts to grow the deposit funding base, this mismatch between loan and deposit growth is expected to continue.

"The current negative real interest rates discourage saving and make it difficult to raise customer funding," says Mardig Haladjian, analyst at ratings agency Moody's Investors Service. "But demand for borrowing remains strong on the back of buoyant economic growth."

The performance of banks across the region, based on return on assets, has been declining as competition pushes up asset prices and decreases returns.

"What we are seeing is an erosion of profitability in terms of return on assets," says Raj Madha, senior research analyst at Egyptian investment bank EFG-Hermes. "But also banks have been moving to more efficient balance sheets, which means that return on equity has been improving as banks are making better use of leverage to increase returns."

Declining returns

This has been reflected in the much sharper decline in return on assets than return on equity, which fell by 11 per cent in 2007, with the decline driven by greater competition. Return on assets, however, fell by 26 per cent.

Inflation is also taking its toll on asset prices, which depresses the returns banks can earn.This could turn some banks off making acquisitions as they remain wary of overpaying for assets from which it is difficult to extract value. Michael Tomalin, CEO of National Bank of Abu Dhabi (NBAD), says this has put NBAD off making any purchases.

"The difficulty is that the cost of acquisitions is very high in this part of the world," he explains. "So our strategy at the moment is to build rather than buy, unless we see something transformative at the right price."

Banks in the region that have set up operations in developed markets including Switzerland and London, such as NBAD and Qatar Islamic Bank, will probably take a few years to repay their start-up costs. In the Gulf, bankers say a new office starts contributing to group profits after about six months.

As in every business in the Gulf, inflation is becoming a greater concern. "If you look across the banking sector, costs are probably growing by 40-50 per cent as a result of inflation, rising salaries and expansion," says Tomalin. "At the moment, most banks are able to hold their cost-income ratios because profits are growing so fast."

The increasing concentration of lending to the real estate sector is a continuing risk, and regulators across the region have begun to take steps to limit the effects should the real estate market collapse in the way the stock market has. In Qatar, for example, banks can no longer lend more than 65 per cent of a project's value.

Khalid Hamad, executive director of banking supervision at the Central Bank of Bahrain, has also opened a dialogue with regulators in the GCC about how they can establish regulatory principles to prevent a real estate collapse from hitting the banking sector and cascading through the economy of the region.

Tomalin says good opportunities remain in the real estate sector, but banks have to be more vigilant to identify them. As exposure to real estate grows, banks have become increasingly keen to enter other market segments to diversify.

"Banks in the region seem to be becoming more willing to take risks, by moving into areas such as banking for small and medium enterprises (SMEs), which they previously regarded as not that attractive," says Madha. "So while the rest of the world is becoming more risk averse, regional banks are becoming more dynamic to capture new markets."

UAE banks in particular are starting to move into this sector.

Despite the external challenge of the credit crunch, and the internal inflation challenge, the outlook is positive. Losses associated with sub-prime assets have been minimal and the credit crunch has been partially avoided by switching to local currency funding, where there is ample liquidity. Bankers are expecting dollars to return to the markets by the end of the year.

While inflation will continue to eat into the cost base, as will expansion costs, growth should outpace it.

By the end of 2008, the banking sector across the region should have posted earnings growth in the range of 15-20 per cent. But as competition intensifies and margins come under increasing pressure, it is questionable how long double-digit profit growth can be maintained beyond next year.