Shock therapy wakes Gulf banks up to reality

  • 05 Jan 2009
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Gulf banks have had limited exposure to Western toxic securities but funding costs have jumped since the global credit crash and profitability is set to fall sharply in 2009. But a bonfire of bank failures and a regional financial meltdown following the US and Europe is unlikely, thanks to high quality assets and strong capitalisation, reports Sid Verma.

A week after the Kuwait central bank hailed the strength of its financial system, it was forced to guarantee all local bank deposits after Gulf Bank revealed a whoping $1.4bn loss on derivative deals. The revelation by Kuwait’s second largest lender in mid-November shattered hopes the country’s banking system was immune to the global financial crisis.

It’s not just foreign exchange volatility that has imperilled banking stability. Bahraini financial institutions also announced writedowns in November. The country’s largest private equity firm lost $200m on its hedge fund exposures, while Arab Banking Corporation has shed around $200m on investments linked to Lehman Brothers and Washington Mutual. In Dubai, Abu Dhabi Commercial Bank and investment bank Shuaa Capital have also written down $174m in total due to fateful investments in US financial institutions last year.

But in the main, Middle Eastern banks have limited exposure to Western toxic assets and so have avoided painful writedowns. However, capital outflows, refinancing woes, falling stock prices and increased funding costs have radically altered the banking landscape since the mid-September collapse of Lehman Brothers. "Our funding costs have jumped," says KJ Jackson, head of financial institutions at Oman’s Bank Muscat. "Borrowing costs — and not just interbank lending — have increased across the board. For example, we have seen three year syndicated loan costs with global banks double in price since September so we need to get more liquidity support from the central bank now."

Despite the well capitalised base and asset quality of many of the region’s banks, the future growth and viability of a host of institutions are now in doubt. The global meltdown of the international financial system has attacked conservative cash-rich Arab banks and Western investment banks alike. "There was a perception that our banks were immune from the Western crisis and would have a relatively easy ride in 2009," says the head of fixed income operations at a GCC government-controlled investment fund. "However, events since the summer show how wrong this prediction was."

Nevertheless, Gulf banks are in a healthy state compared with leverage-laden eastern European counterparts which are further challenged by acute currency weakness. However, higher wholesale funding costs, dollar illiquidity and the shortage of retail deposits pose big financial risks for financial institutions from Wall Street to Dubai.

In addition, as oil prices plummet and the regional economy slows down sharply, the operating environment and prospects for profitability this year has deteriorated sharply.


States to the rescue

In the end, the Kuwaiti authorities were forced to rescue Gulf Bank and have lowered the discount rate to 4.25% and the repo rate to 2%. But despite the deposit guarantee scheme, market confidence has taken a big hit with savers rushing to withdraw funds. As a result, the government has provided Kd1.5bn to shore up liquidity in the banking sector while the central bank has increased the loan to deposit ratio from 80% to 85%, thereby in theory freeing up around $4.47bn in credit.

Other governments in the Gulf have also been forced to jumpstart credit activities. Saudi Arabia has cut bank reserve requirements, provided deposit guarantees and flushed billions of riyals into the banking system to stimulate lending. "We started to place higher prices on our dollar/euro and riyal positions but the government has injected a lot of liquidity in the market and this is helping a lot," says Mina Ezzat, senior international banker at National Commercial Bank in Riyadh.

In addition, government-backed investment funds have uncapped the liquidity hose. Funds in Oman and Qatar have taken stakes in publicly traded banks while the Kuwait Investment Authority has placed cash directly with banks to shore up capital bases.

Foreign capital outflows destabilised the UAE money markets last summer as investors wrongly speculated on the depegging of the dirham from the dollar. The UAE government, faced with sky-high three month interbank rates in October, guaranteed all bank deposits, including interbank lending and deposits of foreign commercial banks that have significant retail operations in the country. In addition, the central bank has provided hefty credit facilities while the government has already placed $19bn directly in bank deposits.

Authorities across the region then have been quick to provide liquidity and buttress market confidence by firmly entrenching its lender of last resort status, while mandating banks to raise customer deposits in return. "A lot of banks did not have assets that matched their liabilities and so they have aggressively moved to get deposits from customers and corporates," says one regional head of international banking and syndications at a large government-backed bank in Dubai.

In the UAE, for example, authorities are hoping to reduce the 140% loan-to-deposit ratio. Ala’a Al-Yousuf, chief economist at Bahrain’s Gulf Finance House in London, says credit expansion in 2009 is set to slow down sharply. "At a stage when the loan-to-deposit (excluding foreign liabilities) ratio across most GCC banks stands at around 100% and the magnitude of petrodollar monetisation in 2009 is unlikely to match that of 2008, this may raise concerns over the pace of monetary expansion going forward."

But, analysts caution that the causes of the regional liquidity squeeze differ significantly with G7 markets. The short term shortage in liquidity has been exacerbated in the UAE by the abrupt and uncharacteristic reversal of foreign inflows in October in response to retaining the dollar peg.

More crucially, the fear of counterparty risk and systemic deleveraging has savaged banking stability in developed markets. In addition, GCC banks have a strong domestic funding base. In Saudi Arabia, for example, stable current account deposits comprise 45% of total deposits in the system. By contrast, US and European banks have become far more reliant on the wholesale market to finance loans and investments.

Nevertheless, Gulf investment banks have been rocked by losses and, in particular, their equity portfolios have been mauled by plummeting stock prices. Saudi Arabia’s Tadawal, the region’s largest bourse, shed 60% of its year-on-year value by the end of December. In addition, the National Bank of Abu Dhabi has marked down its investment grade portfolio by $16m while Abu Dhabi Commercial Bank announced a provisional loss of $57m in the third quarter of 2008 as non-performing loans spiked.


Low leverage but asset values a problem

Crucially, Gulf investment banks have much less in-built leverage than their Western counterparts due to underdeveloped domestic capital markets. In addition, exposures to illiquid and complex financial products are "too small to present significant systemic risks," says Mark Young, a Gulf financial institutions analyst at Fitch in London.

The biggest near-term challenge is how banks will cope with asset quality deterioration and stubbornly high funding costs. Ezzat at National Commercial Bank says the real estate sector will show signs of distress with lower loan growth and in some cases, sharply falling prices after the recent boom years. This is exacerbated by the fact that large banks hold property investments at market value on their balance sheets, which could expose some investments as pro-cyclical investment gambles in a downturn.

An increasing number of Dubai-based banks since 2005 have also provided brokerage services and proprietary investment in both commercial and residential property.

Similarly, the exposure of Kuwaiti banks to real estate and construction is close to 50% of their loan book, the highest level in the Gulf. If asset prices tumble, credit quality and lending dynamics will be seriously impaired due to the recent trend of using property assets as collateral for secured lending. Nevertheless, Fitch’s Young says there is still demand for real estate and construction in the Gulf but the speculative nature of some investments and cooling regional growth creates some systemic risks and risk management will now be tested to its maximum.

In general, most analysts argue that profits garnered in the boom years will help regional institutions cope with the new high-cost environment and lower profitability in 2009. "The slowdown in credit growth and re-pricing of lending will help to balance the boom years and slower balance sheet growth is manageable," says Young.

In addition, regional banks have strong government ownership that will mitigate the effect of financial distress this year. Credit differentiation will be more marked this year, which could profoundly effect the funding costs and profitability of regional banks. "Given the host of problems involved in counterparty risk and people blindly following high rated banks, we are monitoring risk more carefully now," says one investment banker in Dubai. "We look at the institutional holding of the borrower, whether it has a sovereign guarantee in terms of its capital base and inter-bank deposits."


Sugar daddies

There is majority government ownership of several of the largest UAE banks, including Emirates NBD, National Bank of Abu Dhabi and Abu Dhabi Commercial Bank. However, smaller institutions with a large proportion of lending directed towards the consumer and real estate sectors, and with less rigorous risk management practices might be put under stress. In addition, quite a few mid-size banks, in Bahrain in particular, operate with similar customer bases and business models. A wave of banking consolidation could therefore be expected. However, regional governments are protectionist and will intervene to mitigate the political fallout of any bank merger borne out of failure. "The GCC governments are considered interventionist toward their banking systems and this will slow down the essential process of consolidation," says Emmanuel Volland, Standard & Poor’s Middle Eastern financial institutions analyst.

In addition, sovereign wealth funds in the region are increasingly being called up to provide direct liquidity to the banking system by simply placing funds in deposits, following Kuwait’s example.

However, although regional governments are expected to drive consolidation in an orderly fashion, there is a danger this could distort the market and sow the seeds of future systemic stress. "The high propensity to support banks has the potential to create moral hazard," fears Volland. "When you have a massive excess of liquidity there is the potential for creating bubbles followed by asset quality deterioration, just like we are witnessing in the real estate sector as a product of the boom years."

In the first half of 2008, the main challenges facing regional banks were risk management, the negative real interest rate environment and competition for government construction projects. But the global credit crunch has raised funding costs and challenged business models in the region. More fundamentally, the oil boom of recent years has powered an unsustainable boom in domestic credit expansion and slowing growth could help reduce those excesses.

  • 05 Jan 2009

All International Bonds

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