It's not all gloom for funding issues

There remains significant volatility in world markets, particularly in connection with securities linked to financial institutions. Markets are still trading nervously and both banks and investors remain very cautious about both risk and exposures. Much of the concern still surrounds sovereign debt issues and the resulting impact on banks holding troubled debt exposure, which would need to be written down if values fall further or, in the case of a default, written off.

The concern is, in turn, creating a further squeeze on the interbank markets, with banks refraining from taking on bank exposure through loan facilities or debt purchasing. To ease the problem in Europe, the European Central Bank is providing banks with substantial funding. Despite this level of support, the cost of insuring bank debt for European banks has risen to more than 200 basis points.

Long-term funding options remain almost non-existent for many banks and any facilities over six months have a very hefty risk premium attached. Banks are mainly depositing any excess cash and liquidity with central banks as bank counterparty risk exposure is deemed too high at the moment in most cases. The fall in risk appetite is raising interest in covered bonds in Europe in order to enhance protection.

The risk issues have had, and remain having, a large influence on emerging market banks. Bank lending remains tight and the international syndications market is still very weak in terms of activity. Term lending over one year is hard to obtain and those that can must pay a high price. The credit and bond markets in emerging economies are still very difficult and spreads remain wide.

And what about the position of, and implications for, GCC banks? The regional markets are certainly not immune to machinations and risk aversion in the European markets. Wholesale funding remains tight in the region and longer term funding possibilities are still restricted. Bond markets remain largely anaemic with only a trickle of issues. Market demand is still low and there will not be any quick recovery. Despite the funding difficulties, the best credit quality names have been able to access wholesale funding, including facilities over one year in tenor. In certain incidences, this has been possible through the support of governments or other guarantors. A bellwether issue may well be the possible launch by Dubai of a dollar-denominated 7-10 year Islamic bond as early as the third quarter of this year after well-received presentations to investors recently. This may prove to be a fillip for the market.

Although liquidity in the GCC system remains relatively tight, it does not present any significant problems for banks and banking sectors. Central banks have injected large amounts of liquidity in their respective systems. Funding for the corporate and personal sectors remain tight however as banks maintain their focus on keeping high levels of liquidity and limit growth for risk weighted assets. Moreover, the loans to deposits ratio is a key risk indicator and for any bank hoping to tap the wholesale banking markets, they need to display moderate levels of deposit leverage. In addition, regulators are increasingly requiring banks to maintain a minimum net stable funding ratio of 100 per cent going forward, increasing the emphasis on stable core customer deposits together with longer term loan facilities if available to support their loan book.

Despite concerns in some quarters, most of the banking sectors in the GCC are in reasonable positions and not facing any meltdown. For the UAE, profitability in the system improved noticeably in the first quarter of 2010, and up sharply from fourth quarter 2009, aided by lower-than-expected provision charges. UAE banks' capital positions are on the whole strong and liquidity is sufficient with deposits growing during the first quarter. The big question is the outlook for asset quality. Non-performing loans will rise this year but possibly not to the extent some are expecting; some have forecast a more than doubling of bad debt. In any case, banks have the earnings and capital to comfortably absorb the expected rise in bad loans. Loan demand is low and banks are not chasing asset growth, which is not surprising given the challenging economic and business conditions. As a result, banks do not have any pressing need to obtain wholesale funding.

Local and regional banks still have significant exposure, particularly to real estate and investment companies, which come due over the next two years. Some of the debtors remain under pressure so banks may have to take a more flexible stance and look to accommodate rollovers where prudent. The level of future profitability is also dependent upon the classification and provisioning of the restructured Dubai World debt.

Qatari banks also recorded better results in quarter one of 2010. The domestic banks have benefited from the good position of the economy in Qatar as well as support to the banking and corporate sectors from the government. Challenges still remain in the Kuwaiti and Bahrain banking systems. Saudi banks also recorded weaker results in the first quarter of 2010, due to lower net interest income.

The second half of 2010 will remain difficult for banks globally with liquidity remaining tight on the interbank market. This continues to present challenges for regional banks in regard to diversifying and building funding sources. However, in most cases, local banks' liquidity positions are supported by good customer deposit funding.

- The author is a US-based commentator on business issues. The views expressed are his own