The stellar growth of the Qatari economy has been reflected in the health of the banking system, which was one of the region's top-performing sectors in 2007. Raj Madha, senior analyst at Egyptian investment bank EFG-Hermes, says not only is Qatar now the region's fastest growing banking market, but that it will continue to be so for years to come.

The three Qatari banks rated by EFG-Hermes - Qatar National Bank, Commercial Bank of Qatar and Qatar Islamic Bank - produced combined income growth of 38 per cent in 2007. Madha says this will slow to 28 per cent in 2008, but Qatar's banking sector will remain the best-performing in the Gulf.

MEED's analysis shows the overall growth in profits in the Qatari banking sector is more limited than this, at about 22 per cent, but asset growth continues to outstrip the rest of the region, reflecting the country's fast-growing economy. In terms of return on assets and return on equity, Qatar is also one of the best-performing markets in the region.

Increasing competition

As in all Gulf markets, Qatar's performance in recent years is attracting an increasing number of banks, adding to the competition and driving down profit margins. This is expected to begin to take a toll on the existing banking system.

Qatar's banks have been seeking to expand geographically to ease competitive pressure in their home markets. Doha Bank recently put aside $800m for acquisitions, and Commercial Bank of Qatar is hoping to repeat the success it has had in acquiring controlling stakes in banks in other markets and putting its own management in place. Qatar Islamic Bank is also successfully expanding its franchise through the launch of several offshoots, as well as the Islamic investment bank QInvest.

Kuwait has also performed well, and as Randa Azar Khoury, chief economist at National Bank of Kuwait (NBK), points out, banks in the country have some of the best profit ratios in the region.

The key difference between Kuwait and Qatar, in terms of outlook, is that in Qatar, domestic opportunities are expected to provide a further boost to the banking sector.

In Kuwait, growth is expected to mainly come from abroad, with NBK in particular paying close attention to opportunities to expand outside its home turf, where growth opportunities are more limited.

Growth market

Oman is also posting strong growth, although from a lower base. The country's small banking sector is dominated by three banks - Bank Muscat, National Bank of Oman and Oman Inter_national Bank - which hold about 70 per cent of the banking sector's assets. Bank Muscat alone accounts for 40 per cent of these assets.

The five biggest banks in the country have grown their profits by a combined figure of more than 30 per cent for two consecutive years. However, they are facing growing competition and their margins are being eroded. Average net interest margins fell to 3.9 per cent in 2007 from 4.4 per cent in 2006, although return on average assets and return on average equity remained stable at about 3 per cent and 20 per cent respectively. The sector as a whole has grown its assets by more than 30 per cent for two years running, and has yet to suffer the inflation that has reduced the return on assets in other GCC markets.

In Bahrain, ironically, the maturity of the banking market led to losses in 2007 and the first half of 2008. "It is because Bahrain is more developed, has merchant banks without a retail deposit income and has played more in global markets for structured products," says one Bahraini banker.

This has led to sub-prime losses. Virtually all the reported provisions made by GCC banks have come from Bahrain. As a result, Bahraini banks' profits have dropped by about 25 per cent year on year. This made it the worst-performing banking market in the region in 2007.

The biggest concern is now over Gulf International Bank (GIB) and Arab Banking Corporation (ABC), which reported huge losses. Bankers in the region are questioning what damage this has done to the banks' reputations, rather than whether there is a systemic fault in the Bahraini banking system.

"Given the size of the losses at GIB and ABC compared to the size of income generated from the investment portfolios, there will have to be some rethinking of the strategy they use when investing outside the markets they know best," says the Bahrain-based banker.

Dollar liquidity

Bahrain is also expected to be one of the markets hit hardest by the current problems in sourcing dollars. "The availability of foreign currency funding could constrain growth in 2008, because although Bahraini banks have comfortable levels of local currency liquidity, it is difficult to deploy this," says George Chrysaphinis, senior analyst at ratings agency Moody's Investors Service.

"The central bank-imposed constraints have limited retail lending growth since 2005, while it [the central bank] is now considering limits on real estate-related lending."

This has made it hard for banks in Bahrain to expand their retail operations. Retail banking in the kingdom is also generally less profitable than elsewhere in the region because of the smaller scale of the Bahrain economy, and its lower margins.

All these factors are expected to keep Bahrain's growth more muted than its neighbours. Opportunities for corporate lending remain, and mortgage lending offers a new and growing income stream, but the limitations placed on the sector by the central bank should limit growth. Despite this, a recent report by the local Securities & Investment Company predicts growth in the country's banking sector will be about 20 per cent a year for the next three years.

Saudi Arabia is the only other market where profit is declining, driven by the fall in stock market income since its peak in 2006. "The core business in Saudi banks is still growing, the drop-off in revenue is just related to stock market income, which most of the banks admitted was exceptional anyway," says Robert Thursfield, analyst at ratings agency Fitch Ratings.

"The banking sector in Saudi Arabia performed strongly in 2007," says Jean Marion, chief executive officer (CEO) of Banque Saudi Fransi. "If you strip out the high element of brokerage fees in previous years and focus on core business, that has been growing by about 20-25 per cent a year."

However, headline profits declined by 14.5 per cent in 2007. Double-digit growth is expected to return in 2008, before moderating in 2009. In the first quarter of 2008, performance began to improve, with the sector as a whole reporting a 2 per cent increase in profits.

Saudi Arabia's banks are also thought to be suffering the most from the difficulty in attracting and retaining talent. Although a regional problem, the resources challenge is hitting Saudi Arabia particularly hard, given the attractive lifestyles and competitive salaries available in rival markets such as Dubai.

The UAE, now the biggest market in the region, still has ample growth potential. "It is difficult for us to make the rationale to shareholders to expand outside the UAE when the potential returns for them here are still so high," says Peter Baltussen, CEO of Commercial Bank of Dubai.

Maintaining profits

Baltussen does, however, see inflation becoming a more systemic problem that will hit growth from 2009 onwards. "After 2009, what we expect to see is a lot of inflation issues accumulating and starting to hit the debt-servicing ability of some of our retail clients, and the profitability of our corporate clients," he says. "[In the] long term, if interest rates remain low, inflation will become a bigger issue."

Despite the regional disparities, the broad consensus is that growth will begin to taper off after 2009.

Mardig Haladjian, general manager of Moody's, is more pessimistic. "There will be a lot of pressure on maintaining profitability levels across the Gulf banking sector," he says.

This will once again raise the spectre of consolidation in the banking market. "I do believe that the region needs large banks, but mergers in the West are normally driven by shareholders to improve the efficiency of companies they have invested in," says Baltussen. "While the region is doing so well, there is little incentive to push for mergers."

One Saudi banker says he sees a greater degree of specialisation occurring, as smaller banks carve out their own niches in areas such as banking for family businesses, small businesses, and catering to female customers or those on low incomes. This should allow them to survive while the market slows.

The creation of Emirates NBD last year sparked a wave of speculation that consolidation was on the way across the region. One year later, little has occurred, but it may be getting closer.