The onset of the global financial crisis in 2008 has forced a radical overhaul of banking regulation across the globe. While the United Arab Emirates banking sector has fared better than most, the events of the past few years have exposed inherent weaknesses in the way it had previously been regulated.
The weaknesses were particularly apparent in the retail banking sector. Given their high exposure to real estate – loan portfolios averaged 30% across the country – UAE banks saw a spike in non-performing loans (NPLs) after the bursting of the real estate bubble in late 2008, which led property prices to plummet by as much as 50%. Prior to 2008, many banks used capital inflows that were coming into the region for the anticipated Gulf Co-operation Council's (GCC's) currency revaluation to fund their asset growth, which averaged 35% across the sector.
Funding gap
The Gulf’s 20 largest banks, as ranked by asset size, added more than $46bn in new loans in 2008, bringing their total loans outstanding to $359.3bn, up from $312.8bn a year earlier. Furthermore, many of the banks lent the hot money out over the longer term and so when it departed from the region in September and October 2008, they found themselves with a funding gap, hence why loan and asset growth came to a near standstill.
“Our main concern since the onset of the financial crisis has been to treat the cause of the problem, which was that the funding for banks was reliant on international capital sources,” says Sultan bin Nasser Al-Suwaidi, governor of the UAE's central bank. “It has led us to believe that we have to ring-fence our banking system in terms of sources of funding by increasing local customer deposits and we have been successful on that front.”
The credit boom of 2008 led to notable excesses in retail banking, with banks extending loans to customers at a multiple of 60 to 80 times their monthly salary. With an estimated 3.7 million credit cards in the UAE racking up a combined bill of $3bn today, the country’s credit-card debt accounts for just under half of the Gulf’s total balance of $6.8bn, outpacing even Saudi Arabia, which has a bill that stands at $2.3bn.
Banks are more careful now about the way they deploy money and that’s because the liquidity isn’t as abundant as it used to be prior to 2008, and the opportunities aren’t as good as they used to be
In an effort to restore banks’ asset quality, in mid-2010 the UAE central bank introduced tightened regulatory standards by stipulating that all UAE banks will have to take legal measures against defaulting debtors within 90 days instead of 180 days. The new central bank rules on NPLs require banks to take provisions of 25% of the loan after 90 days and 50% within 180 days. The loan will then be fully written off as a bad loan after two years and this requires banks to take provisions of 100%. The rules also stipulate that lenders should build up general provisions equal to 1.5% of risk-weighted assets over a period of four years, up from the previous requirement of 1.25%. Consequently, provisions for NPLs rose 11% in the first eight months of 2011 to Dh49.2bn ($13.4bn) – the highest level since April 2010.
Lending tidy-up
The UAE central bank has also moved to clean up lending practices through the introduction of a new multiple of earnings law in February 2011 that stipulates a loan cap of 20 times a customer’s monthly income. The repayment period is set at 48 months, with repayment instalments not to exceed 50% of the borrower’s gross salary. Furthermore, the consensus among industry professionals is that banks are themselves becoming more cautious in assessing credit risk and choosing to place a greater emphasis on self-regulation.
“Banks are more careful now about the way they deploy money and that’s because the liquidity isn’t as abundant as it used to be prior to 2008, and the opportunities aren’t as good as they used to be,” says Mr Al-Suwaidi.
“We are noticing some serious discussions on risk management taking place at the board level,” says Nick Nadal, director at the Dubai-based Hawkamah Institute for Corporate Governance. “We have seen many more chief risk officer positions being created over the past few years. I think the financial crisis has brought corporate governance and banking regulations into focus in the UAE over the past couple of years. It has also put forward a lot of insolvency restructuring issues in the emirates, hence why the UAE's ministry of finance drafted a new insolvency law in December 2011 that is expected to become official in the first quarter of 2012.”
The proposed insolvency law – currently under consultation by government officials – aims to decriminalise the bankruptcy process. Some of the most significant changes include a desire to move the process away from being mostly court-driven. In light of this, an entirely new commission would be established by the UAE Council of Ministers to encourage private, out-of-court settlements between debtors and creditors and to assist businesses with financial restructuring. A streamlined bankruptcy process would also be made available for smaller businesses that run into severe financial problems.
Regulator power
“Banking and finance regulation is definitely moving in the right direction today but the issue is always implementation,” says Mr Nadal. “It is always a question of how much power a regulator has in ensuring that companies adhere to the law in both letter and spirit.”
Aside from crafting new pieces of regulation, the UAE’s financial regulators are also gearing up for compliance with the Basel III global banking standards, which will gradually be phased in from 2013 until full implementation in 2019.
In September 2010, global regulators agreed to introduce sweeping reforms to the rules governing financial institutions, including a requirement for banks to more than triple their Tier 1 capital ratios by 2019. With an average Tier 1 capital ratio of about 11%, UAE banks boast some of the highest capitalisation levels in the world – noticeably higher than the target ratio of 6% set by Basel III.
Although the country is awash with cash, the debt problems in Europe and the US have impacted the UAE banks and they are facing a liquidity problem
However, the Basel Committee’s package of reforms also stipulates an increase in the minimum requirement for common equity (the highest form of loss-absorbing capital) from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand periods of stress, bringing the total common equity requirement to 7%.
One of the key proposals of Basel III is for banks to hold sufficient cash-like instruments to withstand 30 days of severe fund outflows. Members of the banking community have voiced concerns that these demands to build bigger capital cushions could hamper trade financing and so jeopardise trade flows in the Gulf. Furthermore, given that GCC banks largely fund themselves through short-term customer deposits, it is somewhat inevitable that Basel III will reduce the appetite for project finance that relies on longer tenor loans.
“In total, yes it will subdue the appetite for project finance,” says Mr Al-Suwaidi. “In the past, banks were free to use their liability side and to fund unlimited projects. Under the new regulations, they will be limited to certain instruments and longer-term funds that are available on the liability side. We are going to address this issue through regulation.”
Many businesses are already struggling to access capital as GCC banks rein in their lending – the volume of GCC loan deals fell to $5.5bn in the second half of 2011 compared with $15.8bn in the first half of the year.
Heading home
In light of the debt problems in the West and in anticipation of the higher capital requirements under Basel III, there has been a noticeable withdrawal of both European and US banks from the inter-bank loan markets in the Gulf.
“With the deposit decline, a lot of liquidity left the banking system in the second part of 2011,” says Nicolas Charnay, an associate analyst at the Dubai office of international ratings agency Moody’s. “In Moody's view, this is partly driven by the retrenchment of international banks and international money leaving the region in the context of the deterioration of market conditions in Europe.”
Khalid Howladar, vice-president and senior credit officer at the Dubai office of Moody’s, says: “Usually the main driver of liquidity in this part of the world are oil revenues, which benefited from the oil price increase in the first half of 2011 in light of the Arab Spring [Brent crude was trading at $111.13 per barrel on 18 January 2012]. There is still a lot of oil cash coming into the country, but banks are showing a reluctance to lend because of the uncertain economic environment and instead are showing a preference for investing in government bonds.”
This is best illustrated by the fact that loans extended by the 51 local and foreign lenders operating in the UAE grew 4.2% during 2011, while banks’ investment into financial instruments such as government bonds increased by about 17%.
“These instruments are most probably high-quality GCC government bonds because they know these are highly liquid and that if there’s another inter-bank disruption or a crunch, they can generate the cash to deal with that,” says Mr Howladar. “So it’s not that the cash isn’t there per se – it’s just that they’re choosing not to lend it.”
Liquidity challenge
But while UAE banks can comfortably meet the capital requirements of Basel III, the liquidity rules are expected to pose more of a challenge. One key reason is that Gulf debt markets are not as deep or varied as developed markets, resulting in banks having a limited choice of liquid instruments that they can use locally. Mr Al-Suwaidi acknowledges the need for the UAE central bank to find new liquidity tools to ensure compliance. “We are compliant on the capital portion for Basel III and have no problems with that,” he says.
“But in terms of liquidity requirements, we still have to introduce some new instruments that banks can use to create liquidity and this is going to take time. This is not an issue for the banks – it is for us to discuss with the other authorities such as the ministry of finance – but, for example, we need to look at the issuance of government bonds and certificates of deposits [CDs].” In June 2011, the central bank launched a repurchase facility for Islamic CDs in an effort to provide a new liquidity tool for the banks.
Along with other regulators worldwide, Mr Al-Suwaidi has been maintaining the push for more stringent liquidity requirements. Under UAE central bank guidelines that came into effect on September 1, 2011, banks must submit monthly liquidity reports and periodic stress-tests to reduce “the frequency and severity of banks’ liquidity problems”, according to the regulator.
“Although the country is awash with cash, the debt problems in Europe and the US have impacted the UAE banks and they are facing a liquidity problem,” says Abdullah Mohammed Saleh, governor of the Dubai International Financial Centre – a financial free zone established in 2004 and governed by the Dubai Financial Services Authority. “I think it will be about six years before dollar liquidity properly returns to the region but the central bank will ensure that liquidity is provided. It has proven itself to be a very capable regulator and I have no doubt it will live up to its reputation.”
In the meantime, as dollar liquidity tightens and banks rein in their lending, it is only inevitable that this will lead to a rise in the cost of borrowing for both corporates and consumers.
Decline in borrowing
However, the slowdown in lending is not just symptomatic of banks’ reluctance to lend but also of a reduced appetite to borrow by customers. “I think the banks will have to accept reduced earnings and net incomes over the next two to three years,” says Mr Al-Suwaidi. “Lending has two parts – the appetite of borrowers and the appetite of banks to lend. And neither will be in full swing.”
Given these existing challenges in funding, borrowing and asset quality, the current growth outlook for the UAE banking sector is limited. The UAE’s banking sector has suffered a series of high-profile setbacks over the past few years. Aside from being over-leveraged to the real estate market, credit exposures to certain government-related entities – most notably the $25bn restructuring of the Dubai state-owned global holding company, Dubai World – have weighed down on their performance.
There remains a substantial number of renegotiated loans on the balance sheets of UAE banks and how these are dealt with will remain an important factor in the banking sector’s future success. “The key challenge is in getting banks to lend responsibly by running stress-tests on businesses,” says Mr Al-Suwaidi. “Repayment is very important so they need to study carefully the viability of the business. The reward needs to be commensurate to the risk.”
The UAE central bank has made significant headway in implementing much-needed regulation over the past few years. But it is important to recognise that it is starting from a low base in comparison with many of its global peers.
There are also concerns among the banking community that the new regulation brought in to date has not addressed the true source of the problem of over-leveraging. The cheap money of 2008 that led to the unprecedented expansion of credit in the UAE is certainly a thing of the past. The fact that global liquidity is now at a premium will force banks to exercise better risk management in the coming years but it also places greater pressure on the central bank in devising new liquidity tools.
Tightening liquidity will inevitably feed through into the broader economy and in this way, revival of bank credit growth will be a key determinant of the UAE’s economic recovery.
