Middle East banks could once rely on a captive market to generate steady business. Most countries were served by a multitude of local institutions and there was room for all to profit. Such cosy conditions are a thing of the past, however. Barriers to global trading are falling fast and Middle East banks are finding their competitive skills put to the test.

International institutions are mounting a challenge for some of the core corporate business of the local commercial banks, putting them under pressure to live up to the most exacting international standards. Another incentive for change is the interest of global investors who are now looking at the region as an undiscovered emerging market. Middle East banks are also facing renewed competition at home as more customers are looking away from conventional banking towards the alternatives offered by the rapidly expanding Islamic sector.

Middle East banks cannot take double digit profit growth for granted any longer. As more results for 1994 are announced and figures for the first quarter of 1995 are published, there is clear evidence that conditions are becoming more demanding.

In the first few months of this year, banks have found themselves facing volatile capital markets. Bond markets are more attractive than they have been for the past 15 months and interest rates have ended their recent rise. ‘I don’t see interest rates moving up that strongly for the balance of the year,’ says Don Kahrs of the Cyprus-based ratings agency Capital Intelligence.

On the currency markets, there has been every opportunity for the foreign exchange dealers to rake in fees, as the dollar has plummeted against the Deutschemark and yen. But the dollar devaluation brings with it the prospect of more belt tightening at home. GCC currencies are all linked to the US currency and have found their purchasing power impaired. Oil earnings are also priced in dollars which will mute the real gains to be derived from the rise in nominal oil prices over recent weeks.

There are some notable exceptions to set against these inauspicious trends. Banks in the UAE reported a string of profit increases in 1994. Benefiting from more diversity than is typical of a GCC economy, banks in the seven emirates reported combined profits of $629 million last year, up 18 per cent on 1993, according to the Central Bank of the UAE. The central bank attributed the rise to a surge in credits, mainly because of growth in construction and trade activities. The central bank report says that the credit extended by 19 local banks and 28 foreign units rose by about $4,350 million between 1992-1994. Foreign assets held by local banks have also been growing, reaching $17,700 million in 1994, accounting for about 38 per cent of total assets.

In Bahrain, where the offshore banks have been losing some ground to aspiring centres like Dubai, many institutions are responding to the challenge of more competitive international capital markets with innovations of their own. A host of new vehicles aimed at foreign investors have been launched and are being marketed direct from Manama. Bahrain International Bank has set up a fund that will allow foreigners to invest in locally listed stocks for the first time. Bahrain Middle East Bank has launched two funds in recent months to invest in global equity markets and the Asia Pacific region, both aimed at attracting capital from abroad. And the Bahrain offices of Citibank are marketing currency warrants in the Gulf which are the first derivative structured product to be listed on the Manama bourse.

In other markets, the competition for local market share is proving the greater challenge. The merging of local institutions is a perennial issue in Kuwait and is actively encouraged by the central bank. The profit squeeze of 1994 may have brought the day of reckoning closer for some of the prime candidates. Most banks in the emirate reported reduced earnings last year – Kuwait Real Estate Bank profits were down 44 per cent and Burgan Bank earnings slipped 18 per cent. Commercial Bank of Kuwait reported a KD 5.7 million ($19 million) loss, and is considering a merger with Bank of Kuwait & the Middle East, whose own profits were halved.

Credibility

In Saudi Arabia, the picture emerging from the performance of the 12 commercial banks during the first quarter is mixed. The results show profits down for Saudi American Bank, the top performer in 1994 and largest of the joint-venture banks. In contrast, two of the smallest banks, Saudi Investment Bank and United Saudi Commercial Bank, have turned in strong performances in the first three months. Yet, nearly all the banks are delivering healthy returns. Bank Al-Jazira is the lonely exception. The smallest of the kingdom’s banks announced another year of losses in 1994, and revised its losses for the previous year to an exceptional SR 479 million ($128 million). This should finally draw a line under the bad debt problems of the 1980s which Bank Al-Jazira was the last Saudi bank to address. The bank now faces a struggle to re-establish itself as a credible institution.

Credibility is also an issue elsewhere in the Middle East. Beirut has aspirations to revive its fortunes as a financial centre for the region. A handful of foreign banks have opened or re-opened offices in the Lebanese capital, but Beirut will have to work hard to prove its appeal. The financial landscape has changed dramatically since the start of the civil war in 1975 and other Middle East centres now offer better facilities.

The challenge for Lebanon’s own banks is to build on their success in attracting deposits, which have almost doubled since 1991 to $8,000 million, and to transform themselves into more diversified institutions that can play a role in project and investment finance. To do this, Lebanese banks must address the question of their low capital base. This could mean bringing in new shareholders and moving beyond the tight family structures that dominate so many local banks.

Yet there is one challenge that few Middle East institutions can afford to ignore – the rise of Islamic banks. If the results from conventional commercial banks presented a mixed picture in 1994, Islamic institutions could not have reported a more uniform performance. Islamic banks across the Middle East saw strong profit growth last year. The Geneva-based Dar Al-Maal Al-Islami reported profits of $8.5 million in 1994, after $26.8 million losses a year earlier. Its Bahrain-based subsidiary Islamic Investment Company reported earnings that rose by a multiple of seven to $12 million; and another Manama-based subsidiary Faisal Islamic Bank improved profits by 46 per cent to $16 million. In Saudi Arabia, Al-Rajhi Banking & Investment Corporation was the most profitable institution in the kingdom in 1994; in Kuwait, Kuwait Finance House and The International Investor, both bucked the trend and reported a healthy improvement in returns.

‘The key issue is that Islamic banks are different players that are selling a niche product, a specialised product, to a specialised customer and the customers are rewarding them much more handsomely because there is less competition,’ says Adnan al-Bahar, chairman of The International Investor. Like any financial institution that offers a new product, higher margins can be charged, and unlike their conventional competitors, the Islamic banks do not face the same competition from the international market, he says.

‘It is already much more competitive than it was 10 or 15 years ago, and it will get more competitive. But it is still a growing market,’ al- Bahar says. However, as more players enter the market, competition will reduce margins, and the rates of growth that Islamic banks now enjoy will ease off. But Bahar believes that the competition is unlikely to be from conventional banks that are now offering Islamic products. ‘In the long- term dual players will not be there,’ he says. ‘Soon the dual players will see that it is side business.’

But for the time being, Islamic banks are enjoying the demand for their services and capitalising on their growing market share. For the conventional banks, it is yet another aspect of a more competitive environment that is making them all work harder for their money.