A more difficult operating environment in 2016 and the challenges of new regulations and technology will expose the UAE banking sector’s weaknesses in 2016, according to consultants from Netherlands-based KPMG.

Those that do not take a proactive approach to these challenges will struggle in an overbanked market.

“There’s no doubt the banking sector is changing rapidly,” says Luke Ellyard, partner in financial services at KPMG. ”Those banks that use the challenges to drive improvement rather than just complying with what is required and ticking the box are the ones that will succeed and have that strategic advantage.”

Difficult conditions

Operating conditions are becoming more difficult as low oil prices have a slowing effect on regional economic growth. Government spending cuts, tighter liquidity and a higher cost of funding will weigh on asset growth and margins.

“The UAE has been resilient, but the low oil price has filtered down to the wider economy, which has inevitably led to tightening liquidity,” says Ellyard. “Banks are now relying on expensive deposits, negatively affecting margins.”

High-rated UAE banks with international operations are working hard to attract liquidity from outside the region.

Banking profits rose 11 per cent overall in the country in 2015, as lenders were able to cut impaired loan loss provisioning by 9 per cent, according to KPMG. But slower growth and high rates of default by small- and medium-sized enterprises (SMEs) will push up levels of non-performing loans (NPLs) again, requiring higher provisioning.

“The 18 per cent capital adequacy ratios are well above the regulatory minimum of 12 per cent, and return on equity is 17 per cent, comparatively [higher than] industry norms globally,” says Ellyard. “The question we are asking is: Is this really sustainable in the future unless the banks take proactive measures?”

More layoffs

Banks have already laid off hundreds of employees in the UAE, as cost-to-income ratios rose to 34.8 per cent. This trend could continue as the lenders weather further headwinds in 2016.

“Cost-to-income ratios are going up, and every single bank in their 2016 strategy has said one of their top focuses is to manage this,” says Abbas Basrai, director of financial services at KPMG.

The biggest challenges for lenders are adapting to new regulations and keeping up with digital innovation. Future high performance will depend on how each bank responds.

The largest change will be the global roll-out of Basel III regulations. These aim to increase financial sector stability by mandating banks to improve the quality and level of capital, as well as restrict leverage. They are accompanied by other regulations on risk management, disclosure and liquidity management. The introduction of International Financial Reporting Standard 9 (IFRS9), which changes how loan losses are recognised, will also have a major impact. Banks will now have to count expected losses on their balance books.

Lending appetite

The higher requirements for capital and provisioning will affect banks’ appetite for lending, especially on long tenors.

“Where in the past we saw 20- or 25-year maturity on loans, that’s not going to be there anymore,” says Basrai. “There’s still certain government-related entities exposure where there might be some long-term project finance happening, but overall, because of these new regulations, the tenor mismatch has to be addressed.”

Lenders are also struggling to respond proactively to technological innovation, which involves both defending against cyber-attacks and rolling out new digital products and services.

The recent hacks targeting Qatar National Bank (QNB) and Sharjah’s Investbank highlight the reputational and operational losses financial institutions can suffer.

“It is a big issue within [QNB] and it has shaken it up significantly,” says Farhan Syed, a partner at KPMG. “You should not be in the position to get affected in this particular manner. The banks can take far more proactive steps to mitigate this risk, and our view is the banks are not really doing much about it.”

Need for digital

Lenders should have responses prepared in advance to protect their reputation. They desperately need the specific talent and structures to keep ahead of the competition digitally.

“Digital is the single most-talked-about issue on the board and in the C-suite [management],” says Syed. “If [all the employees in the C-suite of a bank] have different versions of what digital really means, how are they going to transform the bank?”

The most efficient method is to test an idea on a small scale and then scale up, to avoid long lead-times. Ideas include augmented reality, fingerprint security, big data and crowdfunding.

KPMG also recommends focusing on recruiting talent, and understanding customers, their needs and behaviour.