During 2013, the region’s banking sector staged a relatively broad-based comeback.

Liquidity positions of banks across the major markets of Saudi Arabia, the UAE and Qatar improved, allowing them to hungrily book new deals. The international bond and sukuk (Islamic bond) markets remained open throughout most of the year, allowing corporates and sovereigns an attractive alternative source of funding. Strong economic growth helped boost consumer confidence and, as a result, lifted retail bank profits.

After a dismal few years in the wake of the global financial crisis, the sovereign debt restructurings in Dubai, and a slower economic growth, the recovery has been widely welcomed. It has not been without its challenges though.

Growing competition

While the increased financing activity and lower cost of funding are helping banks to report rising profits, they also make the sector more competitive. With so much liquidity struggling to find a home, lending margins have been dropping in many countries.

“We have been doing a lot more for only a marginal increase in profitability,” says the UAE country head for one international bank. “The cost of funding has been falling more than margins and there have been more deals, so you can get a one-time boost out of that, but it is not the sort of trend that can be sustained into a second year.”

As Gulf banks emerge from the financial crisis and find a surer footing, their attentions are increasingly turning to expansion

One sure sign of health in the regional banking sector is that the portion of loans denominated in US dollars has grown. At $37.6bn by November, the value of dollar-denominated loans in the Middle East was already more than double the amount borrowed in dollars in 2012, and the highest since 2008. Over the past few years, many corporates borrowed in local currencies as domestic banks tended to be able to offer cheaper loans in their own currencies, even though borrowers generally prefer to borrow dollars.

All this suggests a much rosier picture for the corporate finance landscape than in previous years.

The increase in profits that banks have recorded throughout the first three quarters of 2013 has been reflected in the large gains in their share prices. The question is whether the gains justify expectations of continued growth.

The region’s main banking systems, those of the GCC countries, face numerous regulatory obstacles in the near future, which could limit their growth. Speaking at a conference in Dubai in late November, Christos Papadopoulos, Middle East and North Africa chief executive officer for the UK’s Standard Chartered, said the cost of compliance with a web of international and local banking regulations will increase. The introduction of Basel III (new international regulations designed to prevent a repeat of the financial crisis by requiring lenders to keep more capital aside to absorb potential losses) will make the “conventional model of funding infrastructure unsustainable”, he added.

Prudential measures

Across the GCC, there are also various efforts under way aimed at introducing other prudential measures to either cap how much can be charged in interest or how much can be borrowed. In the long term, these measures should help create a healthier banking system; in the short term, the introduction of these rules will either slow down lending growth or make it less profitable.

One of the main impacts of the introduction of Basel III is that lenders will be under increasing pressure to push long-term funding into the bond markets, rather than hold it on their own balance sheets through loans.

Most GCC governments are already taking steps to stimulate the bond markets, either through issuing sovereign-backed bonds that establish pricing benchmarks for other issuers, or by starting to put together a regulatory framework for the issuance of local currency bonds.

The moves have coincided with a period of increased market activity. A clear sign of the markets’ health has been the activity in the regional bond and loan markets. By the end of 2013, syndicated loan volumes are expected to have risen substantially on 2012, although they are still a long way off their 2007-08 peak.

According to data provider Dealogic, almost $50bn of syndicated loans had been completed by late November 2013. This is the largest volume of syndicated transactions since the start of the financial crisis in 2008. In the whole of 2012, there were only about $32bn of deals completed.

Activity in the bond and sukuk market has also been strong, despite the market coming to a temporary hiatus during the summer, following comments from US Federal Reserve chairman Ben Bernanke that the reserve could start to slow the pace of its quantitative easing programme. When these comments were first made in May 2013, they sparked a sell-off in global markets. Debt markets did not open again before the reserve made it clear in September that it would carry on repurchasing $85bn a month of assets until the recovery in the US looked stronger.

This helped spark a fresh wave of bond and sukuk sales by regional firms. Going into 2014, the appetite for raising money through the debt markets should remain, unless there are fresh signs that loose monetary policies in countries such as the US, the UK and Japan will start to be wound down.

Investment bankers in the region say the pipeline of potential transactions in the debt market is strong, and as long as the market remains conducive to more issuance, there are plenty of corporates planning to tap the markets.

“We have definitely seen interest in both bonds and sukuk pick up since September, and at the moment we expect to see that momentum continue into the new year,” says one capital markets banker based in Dubai.

So far, most of the capital markets activity has been focused on companies looking for a better place to raise funding from than banks. In 2014 and beyond, more infrastructure projects are expected to either try to refinance their existing bank debt or raise new debt through the capital markets.

The success of an $800m bond issue to refinance the debt on the Shuweihat 2 power project in Abu Dhabi, coupled with a sukuk issue to fund the development of the Sadara Chemical Company petrochemicals plant in Saudi Arabia, have shown that bond investors are willing to invest directly in Middle East infrastructure.

Funding shortfall

With Basel III making long-term financing particularly unattractive for banks, the possibility of shifting the onus for project financing away from bank balance sheets and into the capital markets could help solve the expected shortfall between demand for funding and supply.

“The project financing requirements in this region are enormous, but it will become increasingly difficult to just rely on bank loans to fund these investments,” says one project finance banker based in the region. “The process of finding other sources of capital such as the bond markets has started, but will only develop slowly.”

As Gulf banks emerge from the financial crisis and find a surer footing, their attentions are increasingly turning to expansion. Qatar National Bank (QNB) and the UAE’s Emirates NBD, two of the region’s largest banks, have already demonstrated their ambitions by buying up Egyptian lenders. Those acquisitions have given them a foothold in the region’s most populous country and also one of the most under-banked nations. Political instability has helped to reduce valuations and make it an opportune time to enter the country.

Other markets with growth potential but unstable political backdrops are also becoming compelling opportunities, particularly Iraq. At the same time, many regional banks are pursuing expansion strategies in the Far East, aiming to capitalise on other fast-growth markets with strong trade ties to the Middle East and large Muslim populations.

Elsewhere, political instability, weak economic growth and conflict are causing lenders to retreat from markets such as Syria, Lebanon and Jordan. US ratings agency Moody’s Investors Service has Lebanon’s banking sector on a negative outlook. It has also lowered the sovereign rating for Bahrain and Jordan, which will have knock-on effects for their banking sectors. The outlook for financial institutions in the UAE, Oman and Saudi Arabia is either stable or positive, according to the ratings agency.

In November, National Bank of Abu Dhabi (Nbad), another of the region’s largest banks, announced its own plans for an aggressive expansion through a swathe of countries in North Africa, the Middle East and Asia. It also outlined plans to create eight regional hubs in Abu Dhabi, Lagos, Mumbai, Singapore, Hong Kong, London, Paris and Washington to serve its global clients. In contrast to QNB and Emirates NBD, Nbad has said its expansion will focus on organic growth.

With ample opportunity for growth based on either infrastructure investment domestically or the foreign investments of rich governments, and improving liquidity conditions, GCC banks are in the best position they have been in for years. The flip side of this is that competition is increasing and margins are shrinking.

The challenges this environment presents could further fuel much-needed consolidation across the region’s banking sector, although that may not really start to occur until political stability returns.

US-Iran relations

Another big opportunity banks will be watching for is the impact of the rapprochement between the US and Iran. The potential easing of sanctions against Tehran would open up a huge new market that could have positive benefits for Dubai’s banks, with their historic trade ties to the Islamic Republic. When this might happen remains unclear.

During 2014, regional banks will focus on the continuing development of the capital markets and the hunt for assets to make use of their abundant liquidity, while also looking for opportunities to expand into new markets. After a disappointing few years, lenders are now back in growth mode.