This year has begun with a string of strong results from the banks of the Middle East. Despite the sharp drop in oil revenues which plunged the economies of the Gulf states into recession last year, the financial institutions of the region continued to thrive. But conditions are getting tougher as the borrowing demands from both the government and the private sector start to test capacity.

The ratings agencies have been warning for months of difficulties arising from a decline in business volumes, but the gloomiest predictions of the negative effects on 1998 profitability have been confounded. Much of this can be attributed to closer regulation and improved management since the severe downturn in the mid-1980s, from which some banks took years to recover. Yet, there are still good reasons to be cautious - oil prices remain subdued and many of the region's stock markets, to which some banks are exposed, are down sharply from 12 months ago.

'We have got to look at why the banks are making profits,' says Andrew Cunningham at Moody's Investors Service, the US ratings agency. 'If it's because they've been extending credit to clients who are not getting paid by the government, then there's cause for concern. We remain pessimistic. If banks are not provisioning up then they should be.'

The results reported so far suggest robust good health rather than an impending crisis. Despite a 10.6 per cent contraction in gross domestic product in 1998, Saudi Arabia's banks performed strongly. United Saudi Bank (USB), created from the 1997 merger of United Saudi Commercial Bank and Saudi Cairo Bank, boosted profits by 50 per cent to a SR 611 million ($163 million). Saudi British Bank produced an almost identical result - with profits rising 13 per cent to SR 612 million - on an asset base 30 per cent larger than USB's. Saudi Hollandi Bank made record profits of SR 252 million ($67 million).

All the other Saudi banks to have reported showed similar gains, with the exception of Arab National Bank (ANB). Profits at ANB, which is 40 per cent owned by Arab Bank of Jordan, slumped by nearly 39 per cent, as a new managing director strengthened provisions against non-performing loans.

This year is already shaping up as the year of the merger. With few gains to be made from further internal restructuring and rationalisation, Arab banks are joining the worldwide rush towards consolidation. By common consent, most markets are overbanked and need to be streamlined. The six GCC states have nearly 70 institutions between them. There are too many small banks and the growth potential of the larger ones is constrained by the size of the market. They also have to ready themselves for the international competition which is sure to come as the WTO regime obliges markets to open up.

The agreed merger of Saudi American Bank (Samba) and USB is perhaps the most dramatic development to date. The two banks could hardly be more different. Samba is a high-tech, upmarket bank steeped in the culture of the US' Citibank, which has a 30 per cent stake. USB has a much larger, less automated branch network serving less wealthy clients with a low propensity for savings. The link between the two is Prince Alwaleed Bin Talal, the USB chairman who has a 6 per cent stake in Citibank and appears to have initiated the merger process.

Bankers see obvious advantages for the two partners - Samba acquires a nationwide network of branches while USB stands to gain from the integration and upgrading of systems. With a market capitalisation of $5,800 million and assets of SR 77,227 million ($20,590 million), the new bank will rank second only to National Commercial Bank.

Similar moves are afoot in the UAE, where National Bank of Dubai (NBD) and Emirates Bank International (EBI) have begun merger talks, with a final accord expected by mid-year. A merger would create the largest bank in the UAE - with assets of over AED 40,000 million ($10,900 million) - and could trigger similar consolidation in Abu Dhabi and Sharjah.

The government of Dubai - with 80 per cent of EBI and 20 per cent of NBD - seems to be encouraging the consolidation process and can expect the warm support of the Central Bank of the UAE, an advocate of mergers for years. Again, there are strong contrasts between the two institutions. EBI, itself the product of previous mergers, owns a large retail network and has been developing its corporate and merchant banking services. NBD, the larger of the two, is a sleeping giant with a loan-to-assets ratio of only 24 per cent and a return on assets which trails EBI's by a wide margin.

The agreed merger of Gulf International Bank and London-based Saudi International Bank is another milestone. In this case the Saudi Arabian Monetary Agency (SAMA - central bank) appears to be the driving force; it owns 50 per cent of SIB and co-owns GIB equally with the other GCC states through Gulf Investment Corporation, which owns 100 per cent of GIB. The two banks are seen as a natural fit, with SIB's investment skills providing a good complement to GIB's commercial and corporate focus.

GIB has moved quickly to capitalise on SIB's Saudi connections and has a licence to open its first branch in the kingdom. Branches are planned in other GCC states. SIB's other shareholder - Riyad Bank, Bank of Tokyo- Mitsubishi, Banque Nationale de Paris, Deutsche Bank, National Commercial Bank, National Westminster Bank and Union Bank of Switzerland - are to be bought out but JP Morgan, with 20 per cent of the bank, will stay in, giving GIB a blue-chip US connection.

Slow to move

So far there is no sign of a cross-border merger in the Gulf. The GCC sanctioned the idea in principle at its annual summit of heads of state in 1997 but members have been slow to reform regulations to make it possible. However, if the six nation alliance is to develop a single market and function more effectively as an economic bloc, it can only be a matter of time before there are developments on this front.

Mergers are also changing the financial landscape in Lebanon, where more than 80 local and international banks are active at present. The biggest deal - just completed - is the merger of Byblos Bank and Banque Libanaise pour le Commerce to create the second biggest bank in asset terms after Banque du Liban & d'Outre Mer. The merger has more than purely local resonance as BLC has four branches in the UAE which will provide Byblos with a platform for regional development. In similar moves, Bank of Beirut absorbed Transorient Bank and Societe Generale Libano-Europeenne de Banque has acquired a 51 per cent stake in Fidus, the private brokerage which handles about 30 per cent of the activity on the Beirut bourse. Attention has now passed to Banque Audi - the loser in the bidding for BLC - which wants to expand its local network, most probably through an acquisition.

The project finance market, which has been a strong growth area over the past two years, is moving into a quieter phase. Some big industrial projects are being delayed and several of the financing deals that came to market in 1998 are close to completion. There is still a healthy appetite for the risk, especially from regional banks, but prices have risen sharply since last summer. The last project financing for Dubai Aluminium, for example, was

$370 million worth of loans secured last July at a bargain price of 25 basis points (bp) over Libor; six months later Qatar Vinyl Company struck a deal at 70 bp over Libor for the first two years of a 12-year, $475 million loan, rising to 150 bp.

In a deal to be closed this month, the Taweelah A-2 power and water project in Abu Dhabi will be paying 105 bp over Libor for the first two years of a $556 million loan. The Abu Dhabi-based Thuraya Satellite Telecommunications Company has secured a $600 million loan at 70 bp (MEED 5:2:99). Two financing deals are approaching closure in Egypt - a $670 million mixture of bonds, local currency and international loans for MobiNil's GSM system and a $250 million loan for the first independent power project at Sidi Krier.

Egypt and the Levant are less affected by low oil prices and it is in the Gulf states where the quality and character of bank lending will be under close scrutiny in the coming months. But it is not just oil prices that the ratings agencies will be watching. Some of the Kuwaiti banks are indirectly exposed to the local stock market, which was down by 68 per cent last year and Omani banks have similar exposure. Loan to deposit ratios are at or above 100 per cent in all the GCC states except for Bahrain.

The strong profits for 1998 are good news and operating revenues are rising, as might be expected at a time of tightening liquidity. However, the real test will come in the months ahead as the region wrestles with a second year of demanding economic conditions.