For a region typically characterised as being awash with cash from its oil wealth, the drying up of liquidity in the banking sector came as a surprise to many.

Yet nearly two years since the effects of the global financial crisis hit the region, following the collapse of the US’ Lehman Brothers, liquidity is still tight in the UAE. After being constrained for so long, liquidity is no longer just a banking issue and the lack of access to credit now threatens to hold back the economic recovery of the federation.

Slow bank lending growth in the UAE

Total lending rose by less than half a per cent in the first quarter of the year, after climbing 2.35 per cent in 2009. Asset growth in the banking sector slowed to around 0.9 per cent in the first quarter of 2010.

The UAE is not really a good market for deposits. Most people send their money outside the country

Shabbir Malik, EFG Hermes

The situation is in sharp contrast to the 2006-08 period when credit growth was booming. In mid-2008, easy access to loans allowed credit growth to get out of control, hitting up to 40 per cent.

The pace of credit expansion was exacerbated by foreign ‘hot money’ flooding into the system to speculate on a revaluation of the dirham that ultimately never occurred. Most banks lent this money out again, creating a disparity between their short-term funding and longer term assets.

The main reason we are not seeing any new bond issues from UAE banks is that pricing is just too exorbitant

Peter Baltussen, Commercial Bank of Dubai

When it became clear the revaluation would not occur, currency speculators pulled out all their money, causing a gap between loans and deposits in the UAE banking system that is still crippling loan growth nearly two years later.

Analysts say credit growth will remain low throughout 2010. US ratings agency Moody’s Investors Service is predicting overall loan growth for the UAE of around 4-7 per cent. That is split between relatively robust growth in Abu Dhabi, of around 6-13 per cent, and the stagnant credit environment of Dubai, where growth is predicted to be between 0-5 per cent.

Growth in loan books is expected to remain slow for two main reasons: continued risk aversion from banks as a result of the bad debts built up during the credit boom; and the lack of funding to be able to spark a significant return to lending.

As the financial crisis took hold in late 2008 and hot money deserted the country, the Central Bank of the UAE asked banks to start working towards a 100 per cent loan-to-deposit ratio. By January 2009, the ratio peaked at 110 per cent for the whole banking system, but retreated to 105 per cent at the end of the first quarter of 2010. This still amounts to a funding gap of about AED55bn ($15bn).

The picture varies from bank to bank, with some more over-leveraged than others. Abu Dhabi Commercial Bank, for example, had a loan-to-deposit ratio of 130 per cent at the end of the first quarter, while EmiratesNBD, the largest bank in the region, had a ratio of 111 per cent.

In order to correct the mismatch, banks have embarked on a battle to attract deposits from customers, raising the deposit rate as high as 600 basis points, according to one local chief executive. That compares with the Emirates interbank offered rate (Eibor), which peaked at 2.3 per cent in March, up from 1.88 per cent at the beginning of the year. By late June it was still about 2.3 per cent.

The danger of deposit rates escalating out of control is that it puts pressure on banks to lend at rates higher than their funding costs.“This puts them at risk of chasing lower rated corporates, which is worrying in this kind of economic environment,” says the head of the local bank. “It also damages the reputation of the UAE banks internationally.”

To help ease the situation, the Central Bank and the Finance Ministry have provided more than AED70bn of funding to the banks. Calls for more funding continue, with some in the banking community arguing that additional government deposits would give banks the impetus to start lending again, helping to boost the economic recovery of the UAE, which is still struggling under the weight of bad debts.

Difficult decisions for UAE banks and authorities

The authorities face a difficult strategic decision. Senior bankers in Abu Dhabi say the Central Bank is reluctant to put more funding into the system as it thinks banks need to address their asset quality problems before they start lending again. Low credit growth also helps cool inflation, which has dropped to 1 per cent in June 2010, from a peak of more than 12 per cent in 2008.

MEED understands that there are other voices in the government that favour more cash being put into the banks to help get the private sector moving again.

However, a compromise may be emerging. The government has started putting money into banks for distribution into specific projects. First Gulf Bank, for example, has received AED6bn from the Abu Dhabi government to fund housing loans for nationals.

Using the banks to allocate funding to some of the government’s priority projects can work well for things like housing schemes. It is less viable to give out deposits to several banks and hope they decide to fund government-sponsored development projects. As the experience of the past 18 months has shown, globally, banks tend just to hoard money to shore up their balance sheets.

Shrinking deposits in UAE banks

The problem that UAE banks now face is trying to build deposits. “The UAE is not really a good market for deposits. Most people are sending their money outside the country so banks either have to get deposits from the government sector or from outside,” says Shabbir Malik, banking analyst at Egypt-based investment bank EFG Hermes.

Deposits actually shrank in the first quarter of 2010, by about 1.6 per cent, although analysts put this down in part to the banks transferring Finance Ministry deposits into tier 2 capital. In 2009, deposits rose by about 6 per cent.

The liquidity situation is more nuanced than simply the loans-to-deposits ratio, says one UAE-based banking analyst. “There is ample short-term liquidity in the UAE, the problem is long-term funding, and without that you can’t fund long term assets,” he says. Moody’s Investors Service estimates that about 85 per cent of deposits in the UAE are short term in nature.

A more important measure than the crude loans-to-deposit ratio is that of loans-to-stable resources. On this classification ADCB looks much more liquid with a ratio of just 91 per cent. Even with this healthier ratio, most banks say they will continue to be cautious in booking new loans in 2010, only growing their loan books to match growth in deposits. That means growth will be muted.

The main casualty of low credit growth has been the private sector. By the end of April 2010, credit to the private sector fell from AED607bn at the end of 2009 to AED603bn. For the government sector, credit rose slightly to AED92.4bn from AED91.8bn over the same period.

In a bid to address the funding disparity, several banks have tried to raise long-term bond funding. NBAD raised $750m earlier this year and First Gulf Bank raised $500m in November 2009, following a $1bn issue by Abu Dhabi Commercial Bank in October. For now, however, that avenue seems closed to local banks as prices in the debt market make raising new funding unattractive.

“The main reason we are not seeing any new bond issues from UAE banks is that the pricing is just too exorbitant,” says Peter Baltussen, chief executive officer of Commercial Bank of Dubai.

Lessons learned

While growth slows it will give banks time to reflect on the excesses of the past few years and how they can be avoided in the future. That could lead to an end to the easy credit that fuelled the real estate and equities boom.

“The most important lesson from this crisis has been that cash flow should be the main lending criteria,” says Michael Tomalin, chief executive of National Bank of Abu Dhabi. “If that had been the case in the UAE then a lot of the problems that arose would have been avoided because speculative investors in property and shares would not have had the access to capital that they needed.”

In turn, that would have resulted in slower asset price inflation as demand would have been focused on end-users or longer term investors. The subsequent crash would then have been much less dramatic.

The latest Central Bank figures show that mid-way through the year conditions are still tight in the UAE banking system. Loans grew 3.3 per cent in June, compared with the same period in 2009. Deposit growth was even less, at just 2.4 per cent. If banks continue to try to match new loans to deposits that does not bode well for the sector.

As one local bank chief executive says, “Lending is now falling back to levels that were typical before 2005. We all benefited from the boom and now we have to get used to being back at more normal growth rates.”

For many businesses in the UAE that will not be an easy task and a long, painful period of adjustment is under way.