State of the GCC banking system

IFR/PFI Middle East Report 2010
23 min read
EMEA

Banking systems in the Gulf Co-operation Council region have been forced to tackle the aftermath of the boom but what kind of position do they find themselves in now? David French finds out.

Financial markets across the globe have taken a battering in the past couple of years, with the Gulf region experiencing its fair share of difficulty. While the Western world was brought to its knees by sub-prime mortgages and collateralised debt obligations (CDOs), the GCC region has found its major issues coming from bursting real estate bubbles and over-extended balance sheets. And while it hasn’t seen the bank failures that have happened elsewhere, the GCC banking system has been severely tested and, thanks to much government support, has come through the eye of the storm.

So what kind of state does the region’s financial system find itself in? The first point to note is that the GCC banking system is not a single homogeneous block but a web of different structures and situations. Therefore, the strains being felt in one part of the region are not always replicated across the board. This makes the drawing of a definitive, general conclusion on the health of the region’s banking system an impossible – and erroneous – task. What can be done is to highlight which areas of the system are more likely to see further trouble; and what the triggers for that might be.

Dubai

One might think that with all the bad news that has, and continues to, come from Dubai, it would be the Dubai banks that have fared worst in recent times. They have certainly felt the full force of the financial crisis, with the large restructurings at Dubai World and Nakheel, as well as other government-related entities (GREs) also looking to reschedule obligations.

However, banks in the Emirate have not crumbled under the weight of this and, according to Fitch Ratings’ report: “UAE Banks’ Annual Review and Outlook”, Tier 1 capital ratios at the three biggest banks – Emirates NBD, Dubai Islamic Bank and Mashreqbank – continue to be at healthy levels.

They have benefited from support measures brought in by the authorities. While some has come from the Dubai government – it purchased Dh4bn (US$1.1bn) of securities from Emirates NBD in June 2009 to help boost its Tier 1 capital – the UAE Central Bank has been the source of most of the financial assistance. This has come both in the form of capital injections (deposits that were turned into Tier 2 capital) and liquidity support (an Dh50bn short-term liquidity facility that gave banks access to funding at the height of the global financial crisis). This has ensured that no institution has got into serious difficulty.

What has to be noted, though, is that much of the damage stemming from Dubai GREs has yet to work its way through the system. Provisioning at banks in the Emirate have mostly reflected bad loans made to individuals, such as loans defaulted on by expats leaving the country.

Therefore, while provisioning has taken chunks out of profits in the last few quarters: for example, Emirates NBD, in its second-quarter results this year, set aside Dh1.2bn for provisions, up from Dh555m in the first quarter, impairment charges for Dubai World, Nakheel and other GRE restructurings have not yet been factored in.

One analyst believes that, going forward, a number of Dubai banks will be forced to take “quite significant” impairment charges and things will get worse before they get better. With both the Dubai World and Nakheel restructurings moving towards an agreement with creditors, third-quarter results could see the first chunks of provisioning taken. But no one yet knows the full extent of the damage provisioning might do.

Kuwait and Bahrain

While the travails of Dubai have made all the headlines, it is banking systems elsewhere in the GCC that, arguably, have suffered a greater degree of dislocation. Institutions both in Kuwait and Bahrain have come closer than anywhere in the region to failing, with the Central Bank of Bahrain (CBB) placing two banks in administration and the Kuwaiti authorities helping to bail out another that got into difficulty. However, while both jurisdictions have had their problems, most of the factors at play are specific to one country and not the other.

The one similarity that both the Kuwaiti and Bahraini systems have is that banks, like elsewhere in the GCC, have been hit by the real estate downturn. While the bursting of the asset bubble has impacted on many banks’ balance sheets, institutions in both states have been affected more than most as many invested heavily in the sector.

According to the Moody’s analysis of the Bahrain banking sector, 33% of all loans made by retail banks in the Kingdom are linked to construction and real estate. Meanwhile, figures from the International Monetary Fund (IMF) put real estate and construction loans at 32% of total credit extended to the private sector by Kuwaiti shops. Only the UAE, which saw many institutions invest heavily in Dubai’s real estate boom, is near the same levels.

One factor that helps to explain the significant sums linked to the property sector is that both Kuwait and Bahrain have a high ratio of Islamic banks. Given the constraints placed upon the areas in which Sharia-compliant institutions can operate, real estate – with its tangible underlying asset – provided banks with a growth sector during the middle of the decade in which to invest their capital. As well as providing cash, many Islamic banks also had their own development arms; thereby increasing their exposure to the sector. So when the real estate bubble burst, this hurt them more than their conventional brethren.

What Islamic banks do have in their favour is that some of this exposure can be treated as collateral; thereby avoiding the need to make large write-downs. However, the risk that the sector’s problems pose to both conventional and Sharia-compliant banks is significant.

According to Moody’s, the authorities in Bahrain have been pro-actively monitoring the situation for the past several months, with the CBB “actively recommending asset sales and capital injections from shareholders in cases where their financial condition [from real estate exposure] is under particular pressure”. The agency also noted that many banks in the Kingdom wouldn’t see a recovery in their performance before a reciprocal upturn in the real estate market; a point that is also applicable to Kuwait.

Apart from real estate, the factors that are impacting most on the performance of the Kuwaiti and Bahraini banking sectors are unique to each state. And, even within the individual jurisdictions, there are variations.

For example, in Kuwait, personal loans used to invest in the stock market are a significant problem and make up a large chunk of the total non-performing loans (NPLs) at many banks. According to the IMF, in its report: “Kuwait: Financial System Stability Assessment – Update”, these loans represented 11% of the total credit extended by the banking sector at the end of September 2008.

While this figure wasn’t too much of a problem when the Kuwaiti Stock Exchange (KSE) was going up, once the market followed global stock markets in plummeting at the end of 2008 – the KSE closed the year down 35.4% from its mark on January 1 – this credit became a millstone around investors’ necks. By the end of 2009, the ratio of NPLs across the Kuwaiti banking sector stood at 9.7%; much of this relating to lending for shares.

On top of personal loans, Kuwaiti banks were also exposed to the bourse through money provided to investment companies. These firms, which blossomed during the middle part of the decade on the back of easy credit, now represent, arguably, the biggest threat to the financial stability of the Kuwaiti system.

There have already been a number of high-profile restructurings linked to the sector, such as Global Investment House, involving billions of dollars of debt. However, anecdotal evidence points towards a sector-wide problem, with few firms escaping the need to correct a mismatch between short-term funding backing long-term assets.

Many obligations have been renegotiated quietly as senior management – many of whom are considered prominent businessmen and belong to important families – are eager to avoid the shame of a failing business and banks are equally keen to prevent the need for massive write-downs. While provisioning has been a drag on bank profits since 2008, analysts indicate that little of this is related to investment companies. With 11.5% of total loans made by Kuwaiti banks going to investment companies as of the end of 2009, the potential ramifications for banks are all too clear.

As for Bahrain, the main problems in its banking system have emanated from its large offshore financial sector. Like Kuwait’s investment companies, many institutions were caught out by the freeze in international money markets after the collapse of Lehman Brothers. These banks, which were reliant on wholesale funding, had also grown in the boom times on the back of cheap short-term finance. However, once these markets were closed to them, they were unable to refinance these facilities and problems ensued.

This lack of available funding combined with another problem to cause further headaches; primarily for those that were set up as investment banks. The global slowdown and the collapse of the real estate boom led to revenues from structuring deals drying up very quickly. This meant that for many investment banks, their business plans became redundant and, with few other sources of income, their cashflows were severely impacted. This had a knock-on effect in their ability to meet the maturities of their short-term obligations.

The most obvious example of this problem has been Gulf Finance House (GFH), which in August completed its third restructuring of 2010. However, anecdotal evidence once more points towards wider problems, with other investment institutions quietly restructuring obligations.

Many banks that have publicly got into difficulty have said they are focused on changing their business models to cope with the new financial realities. Arab Banking Corporation, for example, said it would switch to become a deposit-taking bank to reduce its reliance on wholesale funding. However, Moody’s has warned that some investment banks might not survive. It calls the challenges that this section of the market faces “severe” and warns, in many cases, that firms “do not possess sufficient franchise depth to cope with the sharply lower private investment activity and depressed regional asset values”.

Should they fail, these offshore institutions are unlikely to receive any financial help from the authorities, as the number of banks and Bahrain’s limited resources would make a bailout package untenable. While this may be different for a retail bank regarded as highly important to the Bahraini economy, the way Awal Bank and the International Banking Corporation were put into administration illustrates what would happen to the rest.

Elsewhere in the GCC region – Oman, Qatar, Saudi Arabia and the rest of the UAE – the banking systems seem to be on much surer footing. This position can be generally attributed to either one of, or a combination of, two factors: a conservative banking culture and large financial support from the authorities. However, even within countries, some banks are in a better position than others and some are tackling specific issues.

UAE, Qatar. Oman and Saudi

For the UAE excluding Dubai, most banking activity is centred on Abu Dhabi and these institutions have benefited from significant state resources: Dh16bn was injected into the five biggest Abu Dhabi banks in February 2009 to shore them up against the after-effects of Lehman Brothers’ collapse. Combined with the liquidity facilities from the UAE Central Bank and Ministry of Finance, this helped ensure the system remained supported during the worst of the volatility.

Now, any problems that face UAE banks concern debt obligations; although some have bigger burdens than others. For example, in terms of exposure to Dubai World, National Bank of Abu Dhabi stating in its second-quarter results that it had no exposure to the conglomerate and Abu Dhabi Commercial Bank, in its respective Q2 numbers, said it had around Dh6.6bn. There are also exposures to real estate and personal loans, in much the same way as Dubai banks, that could cause the need for further impairment charges to be taken. However, exposures are generally less significant than in Dubai and are thought to be at levels that are manageable.

For the three remaining countries, their banking systems are looking quite stable. In Qatar, potential issues over real estate were removed when the government purchased banks’ real estate portfolios worth QR15bn (US$4.1bn) in May 2009. The Qatari authorities have been the most proactive in deploying state capital to nip any potential problems in the bud. In October 2008, the Qatar Investment Authority announced plans to take a 10%–20% stake in the country’s main banks – effectively a capital injection worth around US$5bn – while the government also purchased the stock portfolios of banks in March 2009.

In Oman, the conservative nature of the banking system and the country’s small economy has meant that few problems have emerged. Some Omani banks have exposure to one or more of Dubai World, Saad Group and the Algosaibi Group. However, these are relatively minor sums.

As for Saudi Arabia, while provisioning in the past few quarters has been notable, the system itself has had few shocks due to its conservative nature. While NPLs increased to around 3% in 2009, analysts insist there are few asset quality issues for Saudi banks to contend with and none of the problems with personal loans seen elsewhere.

The only real worry for Saudi banks has been in the corporate sector, with a few firms running into difficulty. By far the biggest, and most widely publicised, concern has been the multi-billion dollar restructurings at Saad Group and the Algosaibi Group. When their problems surfaced in the first half of 2009, it was thought they had the potential to cause major damage to Saudi banks; with all thought to be exposed to one or both. However, despite denials from the authorities, it is widely thought that a settlement worth SR9.7bn was reached with Saad Group over its obligations to local banks.

Even if Saudi banks have managed to agree a deal with Saad Group, the debts of the two conglomerates are one of the factors that will be seen as a threat to balance sheets going forward. A number of banks in each state are thought to have exposure to either one or both firms, with arguments over repayment of the sums expected to be protracted.

Provisioning against all this capital is still to be reflected in results. Some of this has already taken place; the UAE Central Bank, for example, instructed banks in the Emirates to make provisions worth 50% on their Saad/Algosaibi debt by the end of 2009. However, there will still be further pain ahead.

The problems at Dubai World aren’t the only ones that will be worrying banks, in regards to the Emirate. A number of other GREs are looking to tackle their debt burdens through restructuring; affecting many billions of dollars. Names such as Dubai International Capital and Limitless have already announced plans in regards to specific loan facilities, while advisers are said to be working with Dubai Holding and some of its subsidiaries about reorganising their businesses. Therefore, many can expect further Dubai GRE-related provisioning.

The real estate market is also set to remain in the doldrums for the foreseeable future; extending the possibility of further losses being incurred. Although each market is different, prices are not expected to recover in 2010 and the drop could extend as far as 2012. This will push up the ratio of NPLs and force banks into additional provisions.

There is also the unknown problem, which appears from nowhere to inflict damage on one or a number of banks. Gulf Bank was an example of this. It was forced into an emergency recapitalisation after a client defaulted on KD375m (US$1.4bn) of losses from currency derivatives trading in October 2008. Other episodes like this are not impossible to imagine and could do significant harm.

However, while all these problems could have an impact on individual banks’ balance sheets, do they have the potential to cause a significant shock to the region’s banking system? The answer, on the whole, is probably not. The events listed above have already been flagged and banks will have taken sufficient measures to counteract their potential effects.

Their progress is also being tracked by regulators, who are managing the impacts on the wider system. Even in regards to unknown shocks, the heightened risk environment should mean that possible eventualities have been tested by banks and regulators. Therefore, the possibility of an event that shakes a banking system – be it at a state or regional level – is unlikely.

Riding out the shocks

This means that attention should be focused on the ability of individual banks to ride out shocks. Yes, there are needs for regulatory reforms, which would help guard against future shocks; especially in Kuwait. However, this should be the focus for the medium-term. The more pressing need is to ensure banks are in a position to handle the immediate future and the current environment.

The need for governments to implement system-wide interventions – whether they are preventative, like in Qatar, or to tackle a specific threat, like in the UAE – should be behind us. Some question marks have been raised over whether banks in the UAE, in particular Dubai banks, could get more state assistance to help manage losses against loans.

Shuaa Capital, in its “UAE Banks Put To The Test” report, stated that while the banks it looked at had sufficient capital, some would need up to Dh15.8bn of capital injections to ensure they met the UAE Central Bank’s regulatory requirements in all scenarios; with the government a possible source for this capital. However, others have argued that the government is unlikely to want to intervene directly in the system again.

Despite this, there could be some government role in recapitalisations as many hold stakes in banks and these institutions could decide to tap shareholders for equity. We have already seen a number of Kuwaiti banks either announce plans for, or have already held, rights issues; on the back of stress tests ordered by the Central Bank of Kuwait.

There has also been talk of capital calls in Bahrain, where Ithmaar Bank and Gulf Finance House have already completed issues, and the UAE. Most of the rights issues so far have been aimed at rebuilding balance sheets and capital adequacy ratios and this is likely to be the case for the time being.

There could also be future issues to fund the expansion of businesses, although these are likely to be a long way off as most banks, with the exception of Saudi Arabia, are still adopting cautious lending practices and loan growth is either flat or negative. When loan growth starts to turn, banks will want to maintain the higher capital ratios, so a rights issue could be used to the way to achieve this.

So, while steering clear of sweeping generalisations, the one thing that can be said about the state of the GCC banking system is that it is in decent enough health to manage what is ahead. The system has had to deal with unprecedented turmoil but, despite a few hiccups, it has come out the other side intact. However, while the system is still in place, it is now up to individual banks to ensure they remain part of it, as any future problems will be isolated within a limited number of institutions.