Banks in the UAE have been strengthened by a good economic climate, diversification of their lending and strict capital adequacy rules applied by the central bank, Moody's Investors Service says in a survey.

However, the US ratings agency says the banks may face problems because of bad debts in Asia, a rapid growth in consumer lending and, most of all, the possibility that more foreign banks will be allowed into their market. This could create a need for bank mergers.

Moody's says that most banks are now well-capitalised and well-provisioned and have reacted to growing competition for good-quality corporate business by diversifying into retail and investment banking.

The agency believes that retail lending 'is growing too fast' and could cause asset quality problems if the economy slows down. Moody's adds that most UAE banks only do business with top companies in East Asia, but there could still be a knock-on effect on the UAE if there is a systemic failure in any Asian country.

The biggest competitive threat comes from an opening up of the market to foreign banks, whose numbers have been limited by the authorities for the last decade. 'The recent establishment of the Abu Dhabi Islamic Bank ...coupled with a possible lifting of the freeze on foreign bank branching, will change the dynamics in the market and increase the level of competition,' says Moody's. This may mean that some banks have to form alliances with others to survive. Moody's currently rates four UAE banks: National Bank of Abu Dhabi, Abu Dhabi Commercial Bank, Emirates Bank International and MashreqBank.