Banks in the UAE have never had it so good. Profits more than doubled for many institutions in 2005, while the early signs suggest the first quarter of 2006 was also strong. Ratings agencies have upgraded a number of leading banks to the A category in recent months. But analysts warn that the era of triple-digit profit increases may soon be over, with future earnings growth likely to be solid rather than spectacular.
“Recurring profits should grow double digit, but not at the levels of last year,” says Anouar Hassoune, Middle East banks analyst at Standard & Poor’s in Paris. “In the long term we think the non-recurring part of profit will just shrink.”
The issue of non-recurring profits strikes at the heart of today’s UAE banking sector. The impressive gains of 2005 were driven, at least in part, by profits related to booming local stock markets. The Dubai Financial Market index more than doubled in 2005, while the sister bourse in Abu Dhabi was up more than 80% for the year. Turnover also increased sharply, while investor appetite for initial public offerings (IPOs) reached frenzied heights.
Revenue frenzy
For commercial banks, this opened a new torrent of revenue streams. Rising markets led to increased sales of mutual funds, with lucrative performance fees for generating exceptional returns (most fees were based on absolute returns, rather than outperforming a benchmark).
Many banks own brokerage subsidiaries, with fees rising sharply in line with turnover. Most important, though, were the extraordinary revenues from interest and arrangement fees on lending to investors buying IPO shares.
Michael Tomalin, CEO of market leader National Bank of Abu Dhabi (NBAD), stressed this fact when unveiling the bank’s 127% increase in net profit for 2005 to Dh2.6bn ($708m). “Buoyant local equity markets have helped our results this year,” said Mr Tomalin. Investment banking revenues more than tripled, contributing 43% of group earnings. It was a similar story for many of the UAE’s 21 locally owned banks.
Oversubscription pay-off
A cursory glance at the IPO numbers reveals why. UAE firms raised $1.9bn through IPOs in 2005, according to figures from Ernst & Young, up from just $500m the previous year. Established listed firms raised even more through rights issues. But that tells only half the story. The real money-spinner for banks was financing the massive oversubscriptions for these primary issues.
The IPO for Abu Dhabi’s Aabar Petroleum was the most extreme example, being 800 times oversubscribed. The firm wanted to raise just Dh485m in capital, but attracted Dh385bn in subscriptions – more than the UAE’s gross domestic product. Most of that money was borrowed.
“Banks are lending to individuals to finance IPO subscription and generating significant revenues from interest and fees,” says Dubai-based Philip Khoury, head of research at EFG-Hermes, an Egyptian investment bank. “The cost of subscribing is measured in a multiple of the allocation, not a percentage of the allocation, which brings huge gains to the banks.”
Crucially, though, Mr Khoury agrees with S&P’s Mr Hassoune that this party will soon be over. “I don’t think this is sustainable. That source of income would then fall into the non-recurring category.”
What will derail this gravy train? The UAE government is drafting reforms to the country’s securities law that should curtail such huge oversubscriptions.
That may come too late to impact first-quarter results. Abu Dhabi Commercial Bank, the first of the UAE’s ‘big five’ commercial banks to report earnings in 2006, said net profit surged 182% in the three months to March 31, to Dh623m. “Abu Dhabi Commercial Bank’s [ADCB] participation in the public offerings of many new companies accounted to 30% of the bank’s total revenues,” says chairman Saeed Al Hajeri. (Two major IPOs took place in the UAE during the period, including Du, the country’s second telecoms operator, that was 186 times oversubscribed attracting $109bn. The subscription set a world record, according to Bloomberg News.)
Officials from the central bank and the economy ministry met in early April to discuss changes. The root of the problem is that the economy ministry has to approve valuations of companies listing on the Dubai and Abu Dhabi bourses. Typically, they insist on artificially low valuations, partly to encourage UAE national retail investors to participate in the local stock market.
However, the artificially low issue price means share prices inevitably shoot up on their stock market debut: Aabar shares sold for a face value of Dh1, but traded at more than Dh4 on the first day of listing. A vicious circle has emerged. Investors see easy money to be made, so apply for as many shares as possible. But because of this, the IPOs are massively oversubscribed, so investors only get a tiny proportion of the shares they apply for. So they borrow heavily to apply for more shares. And so it goes on.
The central bank has capped IPO leverage at five times an investor’s cash stake, but in practice banking sources say many banks are offering leverage at ratios of up to 1:19. Authorities are looking to move towards a more conventional method of IPO pricing, with investment banks acting as bookrunners.
Income adjustment
Some senior bankers recognise that they cannot maintain the current level of profit growth indefinitely. “2006 is likely to be a tougher year,” said NBAD’s Mr Tomalin when announcing the full-year 2005 results. “Our return on equity and cost-income ratio are better than trend line and are likely to adjust from these levels in the medium term.” (The Banker spoke with Mr Tomalin in mid-April, but he declined to comment on the bank’s 2006 performance before it published first-quarter results).
Business related to stockmarkets has dominated the debate on the quality of banks’ earnings in the UAE. But it is only one element of their business. Bread and butter commercial banking remains the mainstay of their operations, and here they face both opportunities and challenges in 2006.
The over-arching theme is that the UAE remains an exceptionally high growth economy. This presents enormous opportunities for banks operating in the Emirates: both the 21 local banks and the 26 international banks, including HSBC, Standard Chartered and Citigroup. Figures released by the Abu Dhabi Chamber of Commerce in April show the UAE economy expanded by 29% in nominal terms in 2005, to Dh496bn. Much of this is related to high oil prices (the UAE is a member of the Organisation of the Petroleum Exporting Countries, pumping about 2.5 million barrels of crude a day), but the non-oil economy is also expanding.
“We believe the economy will add almost 50% over the next five years,” says Steve Brice, senior economist and regional head of research at Standard Chartered. “Compare that with the period after the oil boom in the 1980s when the economy contracted by a third. What has changed? We believe that structurally, things have changed. Governments are diversifying their economies away from oil and gas. Money has been spent more wisely and more money has been saved.
“We believe there will be a lot of development in Abu Dhabi going forward in the non-oil sector, particularly tourism. What has happened in Dubai will be replicated, with a different style and focus, in Abu Dhabi. The economies are more sustainable, although how much more sustainable will only be apparent over time.”
Demographic fillip
This gives rise to retail, commercial and project lending opportunities. The assets of many UAE banks increased sharply in 2005: NBAD remained the biggest bank by assets, rising 49% to Dh83.7bn. This rapid acceleration may not be sustainable, but with a fast growing economy and population, the ingredients exist for banks to lend more money (official population statistics are sketchy, but most observers believe the population is growing by about 7% a year, many of them expatriates attracted to the main cities of Dubai and Abu Dhabi).
However, this rapid growth also brings challenges. As always, excessive lending during boom times can come back to haunt banks when the economic cycle turns against them. In the UAE, analysts warn that the procedures for managing that risk are untested, particularly as increasing competition is forcing banks to lend to riskier clients, such as expatriate consumers and unproven companies.
“The competition will come on three levels – local, regional and international,” says S&P’s Mr Hassoune. “There are 21 local banks all chasing a limited pool of banking people and corporates. International players have a cyclical approach to the Gulf. They tend to leave when the political climate is worrying and return when there is growth. Today those fundamentals are very attractive.”
In Dubai they are chasing corporate business, while retail and project lending are tempting them in oil-rich Abu Dhabi.
“The retail credit portfolio is untested by a sharp economic downturn,” warns Mr Hassoune. “Some of this liquidity has reached into real estate and equity markets. So you have strong bubbling of financial assets and more leverage on the corporate side.”
Mr Brice shares concerns about the risk of falling asset quality, which he says is a global issue that could impact the UAE. “A lot of banks are now waking up to the Middle East; with the Dubai International Financial Centre more people are coming into this space. That will put pressure on margins. When you get increased competition, what do you try and do? One option is to offer new products as a bank. The other is to go down the credit curve and lend to weaker companies because the spreads on lending are higher.”
The lack of a credit bureau in Dubai exacerbates the potential credit risk. Dubai Department of Economic Development is working on building a national credit bureau, and has hired Dunn & Bradstreet to help run it. But the project has been in the development stages for more than a year, and while bankers had hoped it would launch in 2005, many now feel 2007 is more likely.
Unknown risks
“We think that from a retail and small business perspective, you don’t have full information on the clients that walk in the door,” says Mr Brice. “You don’t have their payment history and you don’t know their exposure to other organisations. It is quite possible that they are coming to you for credit to service other debt, which suggests there is an issue, but you have no way of knowing. For your own clients you can build up a payment history, but not knowledge of their exposure to other organisations.
“At the current stage of the economic cycle, maybe 95% or more of clients are meeting their payments. But you don’t know the ‘what if?’ scenario. What if the economy takes a downturn and they lose their job?”
These risks have to be viewed in context. The UAE economy has enjoyed five years of relatively high oil prices, and banks have benefited from this. Many have strengthened their balance sheets, earning ratings upgrades along the way. In April, Moody’s Investors Service upgraded the Financial Strength Rating of ADCB to D+, and affirmed its bank’s foreign currency deposit ratings at A1/Prime-1, the UAE country ceiling for foreign currency deposits.
Against this background, Abulaziz Al Ghurair, chairman of Dubai-based Mashreqbank, summed up the mood of cautious optimism among most senior UAE bankers. “I think the growth last year was phenomenal. It is not going to be repeated during this year. I don’t think we are going to grow our profit by 130%. It’s now back to normal growth, anything between 10% and 25%.”
