Fee income to fund bank's revenue growth

While things may be bad for the UAE's banking sector in terms of escalating non-performing loans (NPLs) and the consequent provisioning levels, the country's banks are solid enough to absorb even a higher level of provisioning, should that happen, Peter Baltussen, CEO of Commercial Bank of Dubai, told Emirates Business.

His bank is in an enviable position, with its Q1 operating profits rising 20 per cent to record the highest ever levels amounting to Dh346 million compared with Dh289m in Q1 of 2009. Baltussen explains that CBD was so far largely unscathed by the downturn because of its conservative risk management while the bank did not try to sell products that it's clients didn't understand.

With a strong base of affluent family-owned businesses as its clients, the bank's fundamental strength lies in corporate lending, said Baltussen. Banks in the country would do well to focus on improving their funding profiles and using their balance sheet more wisely, he advises. Excerpts:

How has the global economic crisis impacted the growth strategies of UAE banks and what do you expect from the rest of the 2010?

A few years ago, we could hardly manage the extraordinary growth levels. Banks were continuously recruiting people to cope with that growth just like most other companies. Then what happened, as you know, was that significant liquidity got taken out of the market, which affected the banking system and consequently the economy. To that extent the UAE Central Bank has rightly put in place liquidity guidelines where a bank can go only as far as its stable deposit base in terms of offering loans.

Clearly, one can obtain medium-term wholesale funding from the international markets but that option is not open to all banks and it is presently expensive. So if you don't have sufficient customer deposits, your lending growth is limited. In the past 12 months deposits have gone up a little, mostly through an increase of Government deposits with the banks. Moreover, consumers like you and me are generally spending less and saving more, which is also pushing up deposits.

But that's a relatively slow process. Last year was more or less flat in terms of loan growth, but we have seen some increase in the first quarter of 2010, and I expect between five and 10 per cent growth in the loan book for 2010, which, although low compared to earlier growth rates, is an important signal in the right direction.

A differentiating factor for banks will be whether they are able to focus on managing the effects of the financial crisis – which I would say we have seen the bottom of – and at the same time preparing for the opportunities that the present economic situation has given, because there is no doubt in my mind that there are good opportunities out there.

With liquidity still in short supply and lenders and borrowers both erring on the side of caution, where will near-term growth come from?

I would say that revenue growth in 2010 will come to a certain extent from increased lending, but mainly from higher fee income. Banks will use their balance sheets much more carefully now, and will try to leverage the relationship with their clients and maximise their fee income.

If you are, say, a company, we will generally not be interested to just provide you with a credit facility – we would like to get into an overall relationship with you, which will span lending, trade, cash management, treasury products, and so on. That's where the fee income comes in. This will ultimately create stronger relationships between customers and their banks. This also means that, if a company was earlier banking with a large number of banks, it will reduce that number going forward, which leads to more meaningful relationships than before, for both parties.

Do you see that as a sign towards consolidation in the UAE banking sector?

Consolidation happened in the West due to a number of factors like economies of scale, revenue synergies and lagging returns. I can envisage that there are reasons for banks here to consider consolidation but clearly there is always a large political component to any merger or acquisition, and it may be difficult to overcome that.

Secondly, from a profitability standpoint, most UAE banks are still producing healthy returns. CBD, for one, has made 20 per cent return on equity in Q1 which, in comparison to a Western bank, appears very high. Moreover, if you look at the cost-to-income ratios of local banks, it averages around 35 per cent, which is very efficient as compared to Western banks with ratios at twice this level.

All the above mentioned financial ratios are, from a global perspective, still very solid. In other words, the drive for consolidation from that perspective is not triggered sufficiently yet, in my opinion. So while we might see one or two bank mergers, I don't see this as a widespread phenomenon.

How have non-performing loans (NPL) levels in the UAE gone up due to the crisis and have we seen the bulk of provisioning or is more yet to come?

Local banks' NPL levels rose from around 1.5 per cent in mid-2008 to more than 4.5 per cent in Q1 – which is a significant increase. I think we haven't seen the end of it and NPLs will continue to rise for the time being. I am very pleased to see that the government has intervened in the Dubai World debt resolution and things are going in the right direction. But that doesn't mean that all the underlying problems are solved and no doubt there will be other companies that will have to restructure their debt.

I estimate that NPLs and therefore provisions will remain high in 2010 and part of 2011. But while NPLs may rise for the next few quarters, you will not see the same steep increases as in the past four quarters.

However, I want to add here that banks in the UAE are strong and can absorb these provisioning levels. Take CBD as an example – in 2009, we made roughly Dh1.3 billion operating profit before provisions. Our credit portfolio is about Dh28bn – it means that without making a loss, we can take, if necessary, nearly five per cent of additional provisioning in a year because the bank is very profitable.

This means that banks can really take a significant hit before they start losing money. To be fair, we haven't seen many banks in the UAE making losses – maybe one or two, but the vast majority is still profitable and profitability levels are quite high too.

On top of that, the banks have all increased their equity and capital adequacy ratios are presently at around 20 per cent, nearly twice the levels in the West. Even if you exclude the Tier 2 Capital, which was provided by the Ministry of Finance to all UAE banks, still the capital adequacy ratios are around 15 per cent.

Do you expect to see, in the next 12 to 18 months, a reversal of some of the provisioning that has happened or is happening now?

That's a good question. In the case of some of the NPLs that are being provisioned, a lot of banks have good collateral, ranging from deposits to real estate and shares. Since most banks like to keep their coverage ratio – total provisions versus total NPLs – at around 100 per cent, they are provisioning over time for the entire classified loan although they know that in many cases they will be able to recover a good part of the loan through collateral.

But I think that banks would not be in a hurry to reverse the provisions. Eventually, many banks might see this as a revenue opportunity down the line. Right now, however, most banks are being conservative with their provisioning levels and reversals are limited.

How has CBD coped with the default levels?

We are focussing on medium and large-sized family-owned companies and affluent clients. If you look at our retail loan book where normally NPLs are higher than with companies, it's relatively small – just nine per cent of the total loan book. In general CBD's default levels are quite a bit lower than the market average.

We have a large number of family-owned companies as our clients, who have been with us for many years and have been growing with us over the years. We are, in many cases, one of their main banks or their main bank. We understand those clients very well. It isn't just lending that we do with them – we get most of their turnover through our accounts as well as their forex businesses, and their trade businesses.

So we're not trying to just be a lending bank for our clients but to provide an overall banking solution. Clearly, that's what all banks are trying to do – but you can't build it overnight. Because of our historic links with the family-owned companies, those businesses are generally very loyal to us.

What do you expect to see in terms of asset growth in 2010 and 2011?

I think this year we will grow our loan book and customer deposits – by around five per cent. Fortunately, we do have enough customer deposits to finance our loan book growth.

What key learnings can be derived from what has happened?

I think most banks in general hadn't given enough attention to sourcing the appropriate levels of matched funding and liquidity. If you remember the run on Northern Rock Bank in the UK, the main issue wasn't the quality of their loan portfolio, but there was a funding gap between their long-term mortgage portfolio and their short-term funding, which was partly through wholesale funding. When that dries up [wholesale funding], even if you have a great portfolio, it is difficult to keep a bank running.

I think a lot of banks now realise that matched funding, in particular through customer deposits, is crucial. If you look at the new Basel III guidelines that are being discussed, liquidity of banks is one of the key components there. And if the liquidity is not at par, the capital charge will be significant. Banks in the country are today reporting as per Basel II requirements, but we most probably will have to abide by the Basel III guidelines when approved by our Central bank.

The other key learning is to keep banking products relatively simple, and make sure that your clients understand what they are buying. What has happened is that a lot of very complex financial products were structured and sold to institutions and individuals who didn't really understand what they are buying. They trusted their banks, their financial advisors and the rating agencies. The third learning is related to the level of leverage. Worldwide, and in some cases also in our region, people had over-leveraged themselves, and the effects are there for us to see. These are for me the three main lessons from the global crisis.

The cost of borrowing for the customers remains high, and analysts believe that is one of the reasons for slow economic growth. Your thoughts…

Cost of borrowing has indeed increased because of the re-pricing of risk. Before mid-2008, risk was priced differently from what it is today, but clearly the economic downturn affected companies and individuals, which resulted in an increased risk profile. Moreover, if we do see that more customer deposits are flowing into the banking system and banks don't have to pay up for deposits, borrowing rates will come down.

Let me explain this more in detail – in the past, banks were able to pay rates similar to Eibor [Emirates Interbank Borrowing Rate] for their customer deposits. Today however, one month's Eibor is relatively low at around 1.8 per cent, but some banks are paying deposit rates that are twice as high or even more. As banks need these expensive customer deposits to be able to lend money, they can not decrease their lending rates until the customer deposit rates come down.

Liquidity per se is not so much of an issue – interbank liquidity is abundant. But to maintain the loan-to-deposit ratio, banks have to depend on customer deposits.

Now, with consumer savings rates going up, retail deposits are slowly growing. The other way deposits will go up is when companies start making more profits and pay dividends – that is happening but at a gradual pace. Therefore, it would be important to route additional government deposits into the banking system as this would stimulate lending and reduce the deposit and lending rates.

What would you say is the biggest challenge for UAE banks today?

I would say the biggest challenges for the banking sector today is a combination of mismatched funding, worsening asset quality and limited revenue growth. So, customer deposits not growing fast enough to spur lending and support the economy – that's the first challenge. Then there is the issue of the asset quality, but I believe that most banks know who their probable defaulters are. The key thing is that if, as a bank, you haven't been proactive in the last 18 months – interacting with your clients and understanding how you can help them with the challenges they might be facing – chances are it might evolve into a worse situation.

The third challenge is revenue growth. Banks might still make returns on equity of 15 to 20 per cent, but if banks do not grow their revenue sufficiently, profits will eventually decrease, which is not what shareholders expect. This is further reinforced by that fact that I, for one, foresee that interest margins will come down. As the risk profile of clients improves, the risk premium will ease and interest margins should fall as from 2011.

By how much?

It's difficult to say. Some clients might see it coming down with 50bp depending on the risk profiles of the specific companies. Individuals already are seeing lower lending rates – some banks have for example decreased their mortgage rates to around 6.5 per cent – but clearly this depends on the risk profile of the individual.

The bottom line is that banks will have to look at other sources of income and they will have to be smart about how they use their balance sheet.

PROFILE: Peter Baltussen CEO, Commercial Bank of Dubai

Baltussen joined Commercial Bank of Dubai in 2006 as CEO, after being a career banker with ABN Amro Bank for over 18 years in a number of senior managerial positions, the last one being Managing Director and CEO of Banque de Neuflize-Paris. Prior to that, Baltussen was the Managing Director and CEO of Saudi Hollandi Bank in Saudi Arabia. He holds a Master of Business Economics from Erasmus University – Rotterdam in the Netherlands.

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