International rating agency Moody’s Investors Service has affirmed a stable rating for UAE banks but said that mounting competition in the fragmented financial sector is likely to tighten margins.
Fragmentation, however, is not the only challenge facing banking institutions in the country. The emergence of a large number of financial boutiques at Dubai International Financial Centre are constraining market share growth and increasing the chances of banking disintermediation, the rating agency said in a report.
The operations of UAE banks are still largely domestically focused, with large exposures to corporate and wholesale operations.
Significant funding and lending concentration along with a relatively high level of related-party exposure remain a major rating constraint. Hiring and retaining qualified staff is proving increasingly expensive, amid rising living costs and high demand-to-supply levels of financial human resources, thus causing high turnover. A challenging domestic operating environment also exists, where a severe correction in the prices of oil or real estate or any kind of geopolitical instability could have an adverse effect on banks’ financial fundamentals. Notwithstanding these concerns, the rating agency expects the banks and their profitability will flourish in 2008, but at a slower pace than in 2007, given the progress achieved in their financial metrics, good management and much-improved risk management systems. “Rapid lending expansion is likely to tighten banks’ liquidity and elevate their credit risk profiles,” Peter Carvalho, Moody’s vice-president, wrote in the report.
SLOW BUT STEADY
Over the past couple of years, banks have been riding the crest of a wave, underpinned by a vibrant economy and strong growth in a benign environment. High oil prices, escalating government spending on infrastructure, coupled with high private sector involvement in real estate and the positive momentum in the country’s stock and capital markets have created an overwhelming appetite for credit. The cumulative effect of these factors has been a surge in the growth of the asset and loan base of UAE banks. In tandem, other financial metrics have improved considerably as asset quality, operational efficiencies and capitalisation have soared. This is reflected in solid investment-grade ratings, the report said.
However, these same factors have also posed challenges for the banks, as the surge on the stock markets in 2004-2005 was followed by a severe market correction in late 2005 and in the first quarter of 2006. Thereafter, there was an initial public offering (IPO) boom in 2006 that boosted brokerage and capital market fee and commission income, before dissipating in 2007.
Moody’s believes that UAE banks withstood these tests very well, demonstrating their resilience in segmented problem areas. “The rapid growth in loans has been the basis on which profitability has continued to increase, and it is the denominator on which improved asset quality is determined.”
In May 2007, Moody’s new methodologies for bank financial strength ratings (BFSRs) and joint default analysis (JDA) were rolled out, leading to changes in the BFSRs and the JDA-induced high-support environment in the UAE. It, in turn, prompted upgrades in the local currency deposit ratings of a few UAE banks. The agency hopes that strong financial fundamentals of UAE banks and their fragmented franchises will persist, even though the mega-merger between Emirates Bank International and National Bank of Dubai to create the dominant Emirates NBD will change the banking landscape.
The buoyant economy and confidence-boosting environment will continue to prevail, encouraging banks to embrace growth, albeit with oil and real estate price corrections and geo-political risks looming on the horizon as the unpredictable factors.
UAE bank deposit ratings are underpinned by systemic support, in what Moody’s defines as a high-support environment. Focus is on retail banking, infrastructure and mortgage finance and Islamic banking activities, which are posting exceptional growth. Overseas expansion offers opportunities for geographic and revenue diversification as competition in the local market intensifies. Further consolidation may lead to stronger and more diversified financial institutions, it said.
According to Moody’s, the UAE banks’ individual global local currency deposit ratings are based on the following: the banks’ respective BFSR which translates into a baseline credit assessment (BCA); Moody’s judgement that there is a very high probability that the UAE Government (rated Aaa2 local currency deposit ceiling) would support banks in periods of distress; and the importance of the rated banks to the financial system, which in turn is considered to be the backbone of the burgeoning UAE economy.
Moody’s views the UAE as a very high-support country. History has witnessed several occasions when local authorities have stepped in to assist banks in times of crisis, irrespective of the bank’s size or importance. Government support has often taken the shape of orchestrated mergers and capital injection. Another major factor underpinning the high likelihood of support is the strong involvement of local governments (or their related entities) in the banking sector, through majority or partial equity ownership.
“Our strong assumption that the UAE authorities would provide support to failing banks is reflected in the local banks’ deposit ratings, which are often higher than would be implied by their standalone BFSRs.”
The absence of stock-market-generated revenues that fuelled profits in 2004 and 2005 and was followed by IPO-related profits in 2006, have impacted the returns of banks to greater or lesser degrees. These have been substituted by a strong growth in the loan book of banks, which consequently elevates credit risk as the loans season and the present vibrant economic cycle stabilises.
Escalating real estate valuations, a rise in rentals and increased spending on infrastructure, in addition to imported inflation are combining to raise inflation to from 6.2 per cent in 2005 to 9.3 per cent in 2006. Moreover, discussion on revaluation is adding to increasing prices on imported merchandise.
Massive investment in real estate is the flavour of the year in the retail consumer segment. Economic growth in double digits, a surfeit of liquidity and opportunities to invest this money make for an expansionary syndrome, Moody’s said. Banks nevertheless have to exercise caution, lest this frenetic pace and competition compromise their credit evaluation standards and lead to delinquencies.
A further risk is overheating in the real estate market, which is booming, with the country going through the throes of a construction cycle that is presently only going up. The repercussions of the major countrywide and regional correction in the equity markets from late 2005 to 2006 have had only a slight impact on UAE banks. While the impact on the banks, vis-à-vis their exposure to the equity markets, was muted, according to Moody’s, a severe correction in the real estate market will have a much greater fallout, given the size of the market and the involvement of so many players. This is where banks will face an acid test of their risk management systems and due diligence exercised in the conduct of their business and screening of credit.
The surge in oil receipts witnessed over the past couple of years, underpinned by a booming local economy, has anchored the growing profitability of banks in the UAE.
Aggregated banking system net profits have more than trebled between 2003 and 2006, increasing from Dh6.4 billion in 2003 to Dh19.7bn in 2006. The asset quality of the banks has improved significantly over the past few years. The average non-performing loan ratio of rated banks decreased from 8.3 per cent in 2002 to 1.7 per cent in 2006, while their provisioning cover rose from 80 per cent to 106 per cent over the same period.
The underlying rationale for this improvement is attributed to the strong loan growth – at a compound annual growth rate exceeding 33 per cent over the past four years – as well as a lower default rate.