Banks in the United Arab Emirates are generating decent profits, but there are still significant underlying risks in the operating environment that all market participants need to address.

Judging by impressive recent financial results in the United Arab Emirates, it seems the worst is over. However, it would be a mistake to interpret the recent trend as a return to another benign period for UAE banks. Some fundamental fault-lines still remain.

UAE has transformed itself in the past 40 years. The World Economic Forum’s Global Competitiveness Report 2011/12 classifies UAE as an innovation-driven economy – the only country in the Organisation of Petroleum-Exporting Countries to enjoy that status. The not-so-good news: in 2011, ratings agency Standard & Poor’s downgraded UAE's "banking industry country risk assessment", citing "economic imbalances" and "credit risk in the economy". While the country has made significant progress in the past four decades, the agenda is far from finished. The challenge is the continuation of competitiveness-enhancing structural reforms to reduce the risk of asset bubbles and put economic development on a more stable footing.

UAE has made strides in reducing hydrocarbon dependency. From 2000 to 2007, non-hydrocarbon real gross domestic product (GDP) grew at more than twice the rate of hydrocarbon GDP. But judging by banks' lending, this recent growth was driven by a handful of sectors – real estate, services and trade. Today, bank lending to these sectors accounts for 42% of total lending. Real estate alone accounts for 21%.

Asset quality hit

Unsurprisingly, banks have seen asset quality deteriorate in these sectors. This situation is not going to change soon, and will involve a period of adjustment during which the banks should be prepared to take a hit. What can make this hit unpalatable are the institutional factors that make it difficult to recover losses.

Collateral mitigates risks – but only if it holds value, has a liquid market in which to trade it and has an institutional framework that ensures lenders' rights to enforce on it. The collateral held by UAE banks is disproportionately skewed towards real estate and local equities. Market capitalisation of UAE stock markets halved from 2005 to 2011, and market liquidity – measured by value of shares traded as a percentage of GDP – fell by almost 90% over the same period.

The real estate story is no different. The World Bank’s Ease of Doing Business survey ranks 183 countries. While the UAE’s overall rank of 33rd is impressive, it disappoints in three areas – enforcing contracts, protecting investors, and resolving insolvency. Ironically, the UAE ranks very high when it comes to dealing with construction permits and registering a property. This dichotomy – remarkable transactional efficiency in the midst of weak institutions – does not bode well for development of a sound banking sector.

Another economic activity that takes up a large share of banks' credit is 'personal loans for business purposes', which accounted for 18% of total bank credit in 2011. This is a vague and oxymoronic credit facility, partly cultural as business and personal interests are so entwined that it becomes difficult to draw a line. Some of this credit would be more appropriately known by another term: name lending – providing credit to family or other private businesses, primarily on the strength of the name of the proprietor. The amounts associated with name lending are high, and a few sour loans can significantly impact banks' performance.

Sharper focus

In evolved financial systems, banks gain confidence because of their ability to obtain publicly available information and understand the borrower's operations. However, in the UAE, and more generally in the Gulf countries, enforcement of contractual claims largely depends on long-term business relationships because of the paucity of public information. This is further compounded by a complex web of interrelated companies and cross-holdings.

The UAE's private sector is dominated by family-owned conglomerates. Though some of these are professionally managed, a closer look reveals that a number of them are engaged in everything – from construction to luxury goods. Over time these companies will have to develop a sharper business focus with a handful of competencies. Until then, these conglomerates pose risks to UAE banks.

In 2011, Aldar, an Abu Dhabi property developer, received a government bailout package worth about $10bn, a similar size to the bailout of Dubai developer Nakheel in 2009. The bailouts engineered by the UAE government have sent positive signals to investors and rating agencies and, if anything, have been good for the local banks. The problem is that they severely distort incentives and create a moral hazard, all the more so in an environment where business and financial transactions are based on personal relationships.

The government has the fiscal resources to bail out large or well-connected companies, but then the much-sought-after competitiveness will remain elusive. This moral hazard trickles down into other parts of the economy and impacts the relationship between lenders and borrowers in an undesirable way.

The UAE is in a uniquely advantageous position, with a budget surplus, a prime location as a regional hub, a flexible labour force and a government committed to improving competitiveness. What is needed now is a common, concerted, all-encompassing structural solution. Key participants of the country's financial sector – banks, regulators and government – need to work together to complete the unfinished agenda. The recipe for a solution may not be simple, but all the ingredients are at hand.

Amit Tyagi is vice-president of the risk management division at National Bank of Abu Dhabi. The views are those of the author, and not those of the bank.

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