Middle East Economic Survey

VOL. XLIX

No 24

11-June-2007

GCC

Gulf Banks Face Challenges From A Position Of Strength

The following article is an abridged version of Standard & Poor’s Report Card Research published in April. It was written by Emmanuel Volland, Director – Financial Services Ratings.

Commentary/Key Trends

The financial performance of banks in the Gulf is being supported by very good operating environments that will likely prevail in the foreseeable future. Strong demand for loans and banking services, as well as new infrastructure projects and IPOs, continued to support the upsurge in profitability and asset growth among Gulf banks. The recent stock market correction in GCC countries had limited effects on the very strong financial performances of the majority of Gulf banks for the year. In the future, however, asset quality and ultimately profitability at some banks are likely to slightly weaken: most of the banks in the region will be challenged to give repeat performances of their results in 2007, as the previous year's earnings were partially driven by extremely high turnover on the stock exchanges in 2006. Conditions on the stock market, however, should not obscure a positive part of the picture: there are large unexploited opportunities that stand to hold aloft balance sheets of financial institutions in the Gulf in the medium-to-long term.

Standard & Poor’s Ratings Services took several positive rating actions in the first few months of 2007. Among them was the upgrade of The National Commercial Bank (NCB) to ‘A+’ – the only Middle East bank now at that level – reflecting not only its stellar financial performance, but also strengthened capitalization. In addition, we revised the outlooks to positive on ‘A’ rated Dubai-based Emirates Bank International (EBI) and National Bank of Dubai (NBD) following their announcement of merger plans. The medium-term trend for ratings on banks in the region will depend not only on their ability to sustain their strong financial profiles, but also on the economic and industry risks of their operating environments. In this respect, some structural weaknesses remain, including the high dependence of Gulf economies on oil revenues; limited business and geographic diversification, which some banks are starting to address; large concentration risks in lending portfolios and deposit bases; and an increasingly competitive environment.

Increased Risk Profile

The stock market correction that started in the first quarter of 2006 (last quarter of 2005 for the Abu Dhabi Securities Market and Dubai Financial Market) had apparently limited effects on most banks in the GCC countries. Indeed, most of the Gulf banks rated by Standard & Poor’s continued to display very strong asset quality indicators with nonperforming loans to total loans averaging 2.0% at 31 December 2006, compared with 3.0% at 31 December 2005. The wide use of salary assignment, as well as the stringent guarantees requested by some banks for margin lending, buffered the immediate effects of the correction. The correction, however, increased pressure on households’ disposable income and reduced their ability to withstand other systemic or specific shocks. As a result, the risk profile of the retail loan portfolios at most Gulf banks increased. Indeed, the resulting negative wealth effect weakened the ability of households to spend, save, and leverage themselves. We believe this trend could exacerbate asset quality problems in the case of other systemic shocks or deteriorating economic conditions. On a positive note, the economic outlook remains bright for Gulf countries.

The asset quality of some of the banks we rate deteriorated slightly but the isolation of the effects of the stock market correction remains challenging. The erosion in asset quality of these banks was limited in absolute terms, but triggered additional provisioning requirements that raised the average cost of risk, which could weigh somewhat on their profitability in the future. We nevertheless expect profitability to remain strong.

2006 Strong Results: Hard To Beat In 2007

The average ROA of commercial banks rated by Standard & Poor’s in the GCC countries reached 3.3% in 2006, compared with 3.2% in 2005 (see Chart 1). Cumulated net profit for the banks continued on its upward course of 2005, but at a jog rather than a run – growing about 24% in 2006, compared with more than 59% in 2005. Gulf banks ironically benefited from higher non-interest income due to increased trading volumes in the aftermath of the stock market correction (see Chart 2), which offset the effects of the decline in equity values. The contribution of non-interest income to total revenues was roughly the same as in 2005, when they were trading gains amid rising stock valuations.

These overall excellent results for 2006 will be challenging for Gulf banks to repeat for 2007, with the twin reduction of transaction volumes and values on equity markets in the region since the second quarter of 2006. Indeed, the losses incurred by some retail customers scared investors away from the market and sharply reduced potential realizable gains. In addition, revaluation reserves at rated Gulf banks reversed and showed a decline in 2006 (see Chart 3). On a positive note, the banks rated by Standard & Poor’s carry limited direct exposure to stock markets. In addition, they are likely to go after unexploited opportunities, in particular in mortgage lending, which should support their future financial performance.

Funding And Liquidity

Customer deposits at Gulf banks grew rapidly in 2006, as some retail investors deserted the stock markets and went back to bank deposits, which provide lower but more stable returns. Total deposits of rated banks grew 22.4% in 2006, compared with 20.4% in 2005. This pickup reinforced an already strong liquidity profile, as average customer deposits exceeded average total loans by 1.1x. This new deposits inflow was mainly placed in liquid instruments, strengthening liquidity. Indeed, aggregate liquid assets (approximated by cash and money market instruments) increased by more than one-third in 2006, compared with less than 18% in 2005.

Retail Lending To Grow

The booming consumer-lending business line has supported profitability and ratings at Gulf banks in the past few years. The wider access of banks to retail borrowers has been a success, particularly for banks that took the lead and anticipated the natural expansion of demand for retail financing. The demand is fueled by the redistribution of oil wealth to a population in the process of altering its social habits and eager to rapidly improve its living standards. The retail contribution to loan books averaged 35% in 2006, suggesting that huge room still exists for banks to further develop their activities in this high-yielding and low-risk segment. Standard & Poor’s expects retail lending to continue to drive growth in the future, but with increasing pressure on margins. Meanwhile, the expected growth of some segments, particularly mortgage lending (see Chart 4), will increase the need of the banks to further access long-term funding sources. Long-term debt issuance is therefore set to continue growing, allowing the banks to cope with the sustainable momentum of this business line, despite a noticeable slowdown in 2006 that is unlikely to last long.

Maintaining Strong Capitalization

Most of the rated Gulf banks took the opportunity, in a year of stellar performances, to maintain robust capitalization ratios, reducing dividend payouts, and raising capital at several banks in the second half of 2006. These capital-boosting measures were also encouraged by the forthcoming adoption of Basel II starting in 2007 for some banking systems in the Gulf. Despite rapid asset growth, the ratio of average adjusted total equity to assets was stable at end-2006, year on year, resulting in a comfortable position to ride on expected business volume growth. We still view capitalization ratios as positive rating factors for the vast majority of the banks we rate in the Gulf.

Geographic Diversification/Consolidation

Several banks have started to prospect other markets to diversify their earnings. North Africa, Egypt, Malaysia, and Indonesia were the main destinations for selective acquisitions or expansion during the past 12 months. Standard & Poor’s views this trend positively, as it could reduce the exposure of Gulf banks to their operating environment, thus reducing concentration risk. This trend will not be without risk, as targeted countries usually exhibit higher country risk. At the same time, merger talks are back on banks’ agendas. The recent announcement that EBI and NBD would merge could provide more incentives for others to join the league of larger, more diversified, and therefore stronger regional financial institutions.

Rated Entities To Increase Again In 2007

The number of bank ratings assigned by Standard & Poor’s in the region increased rapidly in 2006, partially due to the Gulf banks’ increased need to access international debt markets. Even though booming loan demand was to a certain extent offset by a sharp jump in deposits, Gulf banks still needed to enhance their funding mixes and reduce maturity mismatches. As a consequence, the Gulf banking sector witnessed an unprecedented increase in international debt issuance. This trend is set to continue in the future as banks keep on building up their balance sheets.

First ‘A+’ Rating In The Middle East

Saudi-based NCB was the first bank in the Middle East to be upgraded to ‘A+’. The rating action reflected the bank’s strengthened capitalization and stellar financial performance amid strong economic momentum in Saudi Arabia (A+/Stable/A-1). The ratings on banks in the Gulf are likely to continue on their positive trend of 2006 in light of strong growth prospects. In the first few months of 2007, Standard & Poor’s upgraded BankMuscat SAOG (BBB+/Stable/A-2), and revised its outlook to positive from stable for KFH (A-/Positive/A-2), Burgan Bank (BBB+/Positive/A-2) and Al Ahli Bank of Kuwait (BBB+/Positive/A-2). The access to higher rating categories, although not out of the question, continues to be constrained by the economic and industry risks of the banks’ operating environment. Gulf banks operate in undiversified economies that are still highly dependent on the oil sector. Although diversification has begun in some countries, its positive effects have not had a impact on banks. Moreover, some banks operate in increasingly competitive systems with relatively weak credit cultures.

Standard & Poor’s analyzes the credit standing of a financial institution in the context of the broad political, economic, regulatory, and legal environment in which they operate. This wide-ranging analysis of the environment is synthesized into a single “banking industry country risk assessment” or BICRA, which reflects the strengths and the weaknesses of a country’s banking system relative to those in other countries. BICRAs classify countries into 10 groups ranging from the strongest banking system (group 1) to the weakest (group 10) from a credit perspective. BICRA scores in Gulf countries range from 4 to 6, which is average by international standards, as reflected in table 1. Other countries with comparable BICRA scores include, among others, Greece and Malaysia (4), Mexico and South Africa (5), and Brazil and Poland (6).

Table 1

Gulf Region Sovereign Ratings And Banking Industry Country Risk Assessment (BICRAs)

Source: Standard & Poor’s.

Chart 1

Chart 2

Chart 3

Chart 4