For banks in the United Arab Emirates (UAE), 2006 looks like being something of an anti-climax, following the phenomenal boom of last year. Most banks reported record earnings in 2005, with profits often doubling or even trebling year-on-year. Some even carried that success through to the first quarter of 2006. But tumbling local stock markets finally put the breaks on the gravy train as the hot summer months approached. Most bankers and analysts think this year will be one of steady growth and consolidation, rather than spectacular gains.
The Dubai stock market lost more than half its value in the first six months of 2006, while shares in Abu Dhabi fell by a third. This hit fund management, brokerage and investment banking fees. Lending has also eased: in the initial public offering (IPO) frenzy of 2005, investors borrowed tens of billions of dollars, but there has not been a major share sale since March.
Lending ghosts
Perhaps most worrying, some analysts are warning that the lending spree of recent years may come back to haunt UAE banks. “I think risks are quite significant,” says Constantinos Pittallis, vice-president and senior bank analyst at Moody’s Investors Service. “The banks have been increasing their exposure to the equity and real estate markets in recent years.”
Proprietary trading carries obvious risks, but Mr Pittallis says indirect exposure – lending for stock market investment – is probably more of a factor. For some banks, it could account for up to 30% of their loan book, although measuring this is not an exact science in the Emirates. “It is very difficult to get a true picture. Reporting and disclosure is not that transparent,” says Mr Pittallis.
Central bank rules limit lending for equity investing, but not all investors tell their banks that they will use the money for this purpose. Some individuals use personal loans to invest in the stock market. In addition, says Mr Pittallis, companies may have channelled their working capital facilities in equity investments. In 2005, many cement and poultry companies were making more money from stock market trading than from operations, according to research from EFG-Hermes, an investment bank.
Sound fundamentals
It would be wrong to overstate these woes. Most UAE banks have strong balance sheets following years of profitability. And the economy remains extremely buoyant on the back of high oil prices, a rising population and strong government spending. Many bankers in the Emirates believe there are enough checks and balances in the domestic banking sector to mitigate risks.
“I don’t believe that the banking sector, as a whole, is under stress as a result of the significant change in share valuations,” says Michael Tomalin, CEO of National Bank of Abu Dhabi (NBAD), the country’s biggest bank by assets. “Real estate price levels have, so far, remained relatively steady, although I acknowledge some downward drift in some segments.”
Others share that view. “Banks operating in the UAE have, over the years, diversified their income sources, improved their asset quality and stacked up their provision allocations,” says Mohammed al Shroogi, head of Citigroup in the UAE. “This is particularly true following the series of IPOs in the market, which saw many banks providing finance for shares acquisition, and in the process growing their balance sheets.
“Besides, the UAE central bank is vigilant about such concerns, and the latest move to increase the frequency of disclosures among UAE-based banks is one way of pre-empting and mitigating these risks.”
Against this background, what is the next move for banks in the UAE? Many are adopting a two-tier approach: aggressively tapping the fast-growing retail market in Dubai and Abu Dhabi; and setting up separate, dedicated units to explore regional opportunities in investment banking.
Local players that are following this route include National Bank of Dubai (NBD), one of the big five domestic UAE banks. In July, it opened a subsidiary in the Dubai International Financial Centre (DIFC) to handle investment banking business, hiring Shahzad Shahbaz from Bank of America to head the new division.
Citigroup is adopting a similar strategy. For decades, it has been one of the leading international players in the domestic UAE market, and it wants to grow that local currency business as the economy expands. But it has created a separate unit, in the dollar-denominated DIFC, to target investment banking opportunities.
“Dirham-denominated business remains our bread and butter,” says Mr Shroogi. “The traditional perception that the UAE market is overcrowded does not take into consideration the rapid demographic changes in the UAE or the increased sophistication of clients who look for niche services.
“Today, we see that the UAE banking market is expanding, owing to the continued economic boom, which is fuelling demand for banking products, and the overall impressive rate of economic growth in the UAE.”
However, tapping into this market will not be easy. The economy may be growing rapidly, but the country is home to 47 local and international banks chasing a population of just 4.5 million.
In private banking – a high margin, high growth and therefore highly attractive sub-sector – competition is even more fierce. As well as the 47 institutions with full banking licences, dozens more have representative offices staffed by a handful of well-paid relationship managers selling offshore investment funds and advice to wealthy Emiratis and expatriates. These include niche players such as Coutts, the blue-blooded British private bank that is now part of Royal Bank of Scotland.
NBAD’s Mr Tomalin recognises this challenge. He says the sector will struggle to repeat the three-digit profit growth of last year: NBAD reported a 127% increase in 2005 net profit to Dh2.6bn ($708m), a growth rate broadly in line with its peers.
However, he remains optimistic. “During 2005, NBAD enjoyed exceptional profits from the stock market boom. NBAD is the nation’s largest stockbroker and domestic fund manager. In the second quarter of 2005, when the boom was at its height, NBAD earned exceptional profits with an annualised return on equity in excess of 60%. Clearly, these levels were unsustainable,” he says.
“Looking at 2006, the core business of the bank, retail and corporate banking in the UAE, and international banking and treasury will produce continued strong growth, although the froth of 2005 is unlikely to repeat,” says Mr Tomalin.
The bank’s 2006 first quarter results illustrated this. Net profit was $172m – up a healthy 26% from the same period in 2005, but modest compared with 2005’s gains on the previous year.
High growth sectors
NBAD has unveiled plans to launch three new units in 2006, which offer pointers to the high growth sub-sectors within the UAE. They are real estate, private banking and Islamic finance.
The growth of Islamic finance is one of the most noticeable trends in the country’s financial services industry. Conventional banks, such as NBAD, Emirates Bank and international players, such as Citigroup and HSBC, have all launched dedicated shariah-compliant units. Some have converted to Islamic institutions, such as Dubai-based mortgage lender Amlak Finance.
Pure-play Islamic banks, such as Dubai Islamic Bank (DIB), are not giving up market share easily though. DIB CEO Saad Abdul Razak said in June that the bank’s branch network in the UAE would reach 53 by the end of 2007, from 30 currently.
“DIB is in expansion mode. All our products and services are witnessing exponential growth. Our branch expansion programme will also comprise doubling the number of our ladies branches from the current four branches to eight by 2007. All the new branches will have state-of-the-art facilities,” says Mr Razak.
“In addition to the expansion in the channels through which our customers can transact, significant enhancements have been made in our product and service portfolio,” he says. These include products such as Al Islami Personal Finance, Al Islami Credit Card and Al Islami Auto Finance, in addition to a growing range of investment funds.
Investment banking
DIB is also competing in the investment banking arena. In particular, it is tapping into the growing demand for Islamic bonds (sukuk). In the capital-raising market, domestic banks face growing competition from international banks locating in the DIFC. This includes major international institutions, such as Morgan Stanley and Credit Suisse, but also regional players like Egypt’s EFG-Hermes.
In June, EFG CEO and co-chairman Hassan Heikel moved from the firm’s head office in Cairo to Dubai, signalling the group’s intentions in the region. It is targeting advisorymandates for transactions such as IPOs and mergers and acquisitions (M&As), as well as brokerage and fund management.
“The rationale behind the move is that the investment banking fee pot is huge in the Gulf,” says Mr Heikel. “EFG is expanding regionally. We have just received a fully fledged investment banking licence in Saudi Arabia, and we are also looking at Qatar and Kuwait. The business opportunity is huge for a firm like ours.”
He dismisses suggestions that the recent falls in Gulf stock markets, and consequent slowdown in IPO activity, will hurt the business.
“It may have a short-term impact on the business, but this will not affect the business model. There is plenty of liquidity in the region, particularly where oil prices are now. There is a lot of wealth. There is a new breed of CEOs and there is a new breed of rulers. The outlook for the region is very positive.”
According to Mr Heikel, EFG has a strong pipeline of potential IPOs from family firms in the Gulf, as well as privatisations. “We think we will see a number of IPOs by leading families in the region, but obviously this has been postponed until the equity markets come back to life,” he says. Although he says this may not happen in 2006, he is “bullish” about the prospects for 2007, based on strong macroeconomic fundamentals and increasingly attractive valuations.
In the meantime, his investment bankers are busy working on M&A deals. “UAE firms are looking to acquire assets in the region, and internationally,” he says. He points to activity in sectors like financial services, telecommunications, food production, retailing and building materials.
The trend is evident in financial services. DIB has unveiled plans to invest about $80m on establishing a branch network in Pakistan. State-owned Dubai Holding has acquired stakes in banks in Greece and Malaysia. State-owned DIFC has also been on the acquisition trail through its new investment arm: it owns more than 3% of Euronext, the European stock market operator.
Against this background, one of the greatest challenges facing all banks – but particularly investment banks – is hiring and retaining good staff. Pure-play investment banks (such as EFG-Hermes and Dubai-based Shuaa Capital), commercial banks (such as National Bank of Abu Dhabi and Mashreqbank), international players (such as HSBC and Standard Chartered), and a growing number of private equity firms (such as Dubai-based Abraaj Capital and state-owned Istithmar) are all driving up salaries for top investment banking talent.
“The critical element in this business is human capital,” says Mr Heikel. “We cannot compete on cash payment vis-à-vis international investment banks. But where we can compete is to offer ownership, to give them part of the business.” These kind of equity related compensation structures are becoming commonplace.
Back to earth
Clearly, UAE banks face challenges in the coming 18 months. For commercial banks, the lucrative lending opportunities from massively oversubscribed IPOs may have come to an end. Competition in the high street is becoming increasingly severe, which could put pressure on asset quality because they lend to customers who they may have rejected during less competitive eras. For investment banks, the correction in UAE markets has dented their advisory business – but all claim this has merely delayed transactions, not cancelled them.
Even though Moody’s Mr Pittallis has expressed concerns about asset quality in some banks, there is little prospect of wholesale ratings downgrades. “If there is any further decline in equity prices and an increase in non-performing loans, then we may see some pressure on financial strength ratings. But for the deposit ratings, we believe there is strong external support from shareholders or the government, so we don’t see any pressure on deposit ratings.”
