Optimism may at last be returning to the UAE banking system. “If we had been talking 18 months ago, I would be a lot less positive,” says the chief executive of a Dubai-based bank. The reason behind his change of heart is that all the problems inherent in the system back then have now been identified.

Unfortunately, fixing them may take much longer. The UAE banking sector faces multiple challenges, including dealing with a number of high-profile debt restructurings, deteriorating asset quality, lack of liquidity and lower economic growth. These factors mean that not only have the boom years come to an abrupt end, but a return to that pace of growth is unlikely for several years.

Credit conditions are still tough and there is a round of second-order problems that are yet to emerge

Michael Tomalin, National Bank of Abu Dhabi

Profits drop at most UAE banks

In 2009, the total profits generated by UAE’s local banks fell by about 24 per cent. Most of the largest banks have struggled to maintain their profit levels. Emirates NBD – the UAE’s biggest bank by assets – was hit by a 9 per cent fall in profits last year. Abu Dhabi Commercial Bank saw income drop 141 per cent, while profits at National Bank of Abu Dhabi were flat.

Dubai banks are still going backwards, mainly because of the deleveraging that is continuing there

Raj Madha, Rasmala

Of the UAE’s biggest banks, only First Gulf Bank and Commercial Bank of Dubai managed to increase their profits compared with 2008.

The main cause of the sector’s weaker performance was a slowdown in lending volumes and a rise in provisioning that ate into profits. Specific provisions rose by 5.5 per cent in the first quarter of 2010, and general provisions by 28 per cent.

The trend has continued into the middle of 2010. “Profits in the second quarter will continue to be weighed down by provisions,” says Shabbir Malik, banking analyst at Egypt-based investment bank EFG-Hermes. “There is some growth, but not all banks are growing equally, and those in stress are having a hard time growing their profits.”

Overall 2010 is shaping up to be another slow year for the UAE banking sector. “There will be no wholesale return to growth in 2010,” says Raj Madha, banking analyst at UAE-based investment bank Rasmala.

“Dubai banks are still going backwards, mainly because of the deleveraging that is continuing in businesses there. Abu Dhabi banks will see some growth, but it will mainly be coming from government spending.”

One of the key issues weighing down on profits in 2009 was exposure to two defaulting Saudi corporates, the Saad Group and AH al-Gosaibi & Brothers. The total local exposure to the two firms is thought to be about $3bn.

New debt concerns in the GCC

The Saad and Al-Gosaibi exposure in 2009 has been replaced by the Dubai World debt crisis in 2010.

The Dubai government-owned firm is in the process of restructuring about $24bn of debt. Although there is no direct loss on the principle loans made to the firm, banks face having to take a 12 to 15 per cent cut on the interest levels on the loans, according to the head of a Dubai bank.

Other issues could also emerge in 2010 to dampen performance. “The banking market is still difficult,” says Michael Tomalin, chief executive officer (CEO) of National Bank of Abu Dhabi. “Credit conditions are still tough and there is a round of second-order problems that are yet to emerge.”

These include the impact of banks’ risk aversion and the slow economy on businesses. Corporates that are already struggling from slower trade and late payments are still finding it tough to get support from banks on the terms they need to avoid restructuring.

The Emirates Interbank offered rate (Eibor), an indicator of liquidity in the banking system used to price loans, remains elevated to stressed levels.

The result of all this is that non-performing loan levels (NPLs) will continue to rise. US ratings agency Moody’s Investors Service estimates that problem loans in the UAE, a broader definition than the one banks use to account for NPLs, could more than double to about 9.5-12.5 per cent by the end of 2010.

Rise in provisioning at many UAE banks

Specific provisions, when banks put aside money for loans they know are in trouble, will rise as restructuring deals are signed. General provisions, when banks put cash aside for anticipated specific provisions, should also increase. The Central Bank of the UAE has already started hinting that it wants 1.25 per cent of total loans’ value set aside for general provisions in recognition of the stressed economy. Regulations on the issue are expected to follow later, although some banks have already started to take this level of provisions.

Central Bank data for the UAE banking system shows that in the first quarter of this year, specific provisions rose by 5.5 per cent from the end of 2009, after rising 40 per cent throughout the year.

General provisions have also continued to rise steeply in early 2010, climbing 28 per cent in the first quarter, after a 50 per cent increase in 2009. Cairo-based HC Securities & Investment estimates that provisions took about 49 per cent off the profits of the top eight UAE banks in 2009. In 2010, it is expected to be about 42 per cent.

“We took a lot of general provisions in 2009 and we continue to do so,” says Peter Baltussen, CEO of Commercial Bank of Dubai.

“We decided to use some of our profitability to build up a buffer against future problems, and I expect a lot of other banks are doing the same.”

Given the severity of the slowdown on the UAE economy, and Dubai in particular, many analysts had expected NPL levels to be higher than officially reported. US rating agency Fitch Ratings has warned that even though average NPLs to gross loan levels have risen to 3.9 per cent at the end of 2009, from 1.2 per cent in 2008, the real figure is masked by loan rescheduling and restructuring. That enables banks to avoid accounting for problem loans as non-performing.

The rating agency says the true size of NPLs could peak in the mid-teens in the next three to five years. If correct, NPLs will prove to be a drag on bank earnings for longer than expected.

Banks may have hoped to avoid loan issues arising because most have some underlying collateral. However, the error of that thinking has been brutally exposed. Loans secured with real-estate collateral, or investments in the equity markets are suffering because the value of the assets has dropped substantially. This could leave some corporates struggling for the bank support they need to survive the next 12-18 months. Those that have expanded outside of their core operations have generally put the most at risk.

“The traditional trading houses and family groups of the UAE have managed the crisis well,” says Baltussen. “The areas where there are problems is where people have gone outside of their core business and tried to get into areas such as real estate or equities, and often have been too late in the cycle.”

As a result of this, banks have spent most of 2009 and the first half of 2010 concentrating on selling more products to their best clients, while working with stressed clients to help them deleverage. For strong clients, banks are often demanding a greater share of their business, saying that if they provide them 60 per cent of their loans, they expect a similar portion of their foreign exchange transactions or deposits.

UAE economic growth

The outlook for 2010 and beyond is unclear. The oil price, a barometer for economic activity in the region, has remained higher than many were expecting at the start of the global economic slowdown in 2008. The UAE government, although mainly Abu Dhabi, is stepping into the gap left by the private sector with billions of dollars of infrastructure investments and contract awards to help stimulate the economy.

Despite their troubled loan portfolios, no banks in the country have faced problems serious enough to threaten their survival. One local bank head says even the Dubai World debt restructuring has ended with an offer much better than many were expecting.

Banks in the UAE also have strong capitalisation ratios, thanks largely to the governments’ efforts to put fresh capital into the banking system. The total capital adequacy ratio increased to 19.2 per cent at the end of 2009 as a result of more than AED70bn ($19bn) of capital from the Central Bank and the Finance Ministry. Richard Musty, UAE CEO of the UK’s Lloyds TSB, is optimistic.  “The last 18 months have been testing, but the UAE remains strong overall and we are definitely seeing the green shoots of recovery now,” he says.

The outlook is not all positive. Any significant recovery in profits will not occur until loan volumes pick up, which seems unlikely to be any time soon. Economic growth is expected to be driven by Abu Dhabi, while the rest of the UAE struggles to recover. This means banks focused on Dubai will have to battle to get new clients.

Low growth in the UAE

Provisioning will continue to hang over profits throughout 2010 and much of 2011. “The UAE is now a low growth market,” says Malik of EFG-Hermes.

Getting used to that after the years of double-digit growth will be tough, and with little political appetite for acquisitions, banks will struggle to achieve economies of scale.

As Baltussen says: “For the time being we will not see growth like we had in 2006-08. It will be much more moderate.”

For many, moderation would perhaps be preferable to the boom and bust of the past few years.