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Middle EastSeptember 3 2018

Palestine presses on with banking sector development

Despite Palestine’s uncertain geopolitical environment and lack of a national currency, efforts continue to establish a mature banking market and increase financial inclusion. But an economic shock could derail any progress made, as Kit Gillet reports.
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Bank of Palestine

Ongoing tensions with Israel and a stagnating economy paint a bleak picture of Palestine’s economic situation, but its banking sector continues to mature and develop, raising hopes that it is ready to play a larger role in the economy.

According to the Palestine Monetary Authority (PMA), the country's banking sector has been growing steadily in recent years, with total assets up 11.6% in 2017 to reach $15.8bn, deposits up 13% to $12bn, and bank profits hitting $170.5m at the end of 2017, rising 15.2% year on year.

In total, over the past five years assets in the banking sector have risen by 41.6%. At the same time, credit to the private sector has grown rapidly, while banks have continued to expand their branch networks. There are now 342 bank branches in Palestine, serving a population of roughly 4.8 million people.

The regulatory environment has also been steadily improving, as the PMA establishes measures to create a modern banking system. “The Palestinian banking sector has developed significantly in the past two years in many aspects, especially in terms of risk,” says Salah Hidmi, general manager at Quds Bank, which saw total assets rise by 12.11% in 2017 to reach $1.08bn. Still, the uncertain geopolitical landscape and economic situation in Palestine means those involved in the banking sector are unable to plan too far ahead.

Challenging landscape

Palestine’s economy is facing considerable challenges. In February 2018, the International Monetary Fund (IMF) predicted economic growth in Palestine would continue to be slow in 2018, at about 2.3% of gross domestic product (GDP), saying: “The resilience of the Palestinian economy in the face of long-standing political and security constraints is now being tested.”

“The ongoing occupation, settlement expansion, dim political outlook, growing uncertainty and regional instability are key features of the current political scene,” says Azzam Shawwa, governor at the Ramallah-based PMA. “If not addressed properly, their repercussions will affect not only the banking sector, but also the overall Palestinian economy.”

In recent years, the IMF has been providing technical assistance to the PMA as it moves towards becoming an integrated central bank, focusing on strengthening its capacity to supervise and regulate banks, introduce government securities and prepare for the eventual introduction of a national currency.

According to Robert Tchaidze, the IMF's resident representative for the West Bank and Gaza, “work on the new central bank law is particularly important,” with the IMF advising the PMA on ways to ensure core principles of central bank independence and executive accountability. The PMA has also adopted a risk-based supervision framework, with the development of risk profiles for each bank.

A central bank vision

When the formal financial sector was established in Palestine in the mid-1990s, there was not a clear vision. “Basically the regulators allowed in every bank that wanted a licence, so we ended up with too many banks. A lot of them were weak, with limited capital,” says Ahmad Hajhasan, general manager of The National Bank (TNB), which was created in 2012 through a merger between Al Rafah Microfinance Bank and the Arab Palestinian Investment Bank, with the 2015 addition of Bank al Etihad’s operations in Palestine.

Mr Hajhasan adds: “Ten years ago, the regulators started to develop ... their vision into a central bank, and one part of that was wanting stronger banks, and fewer banks. Minimal capital was increased from between $20m and $35m, to $75m and maybe soon to $100m, while capital adequacy requirements were increased to 12%, Basel II was implemented and now they are in the final stages of implementing Basel III.”

Foreign banks from Jordan and Egypt played a key role in the early years of Palestine’s banking sector, bringing expertise, products, knowledge and technology. However, in recent years domestic banks have played a larger role. “The local banking industry has become stronger. If you look at the figures you’ll see that the market share of the local Palestinian banks has increased steadily in the past few years,” says Mr Hajhasan. “Instead of having the foreign banks controlling 90% of the market [as they did 15 years ago], currently the market share of Palestinian banks is exceeding 55%.”

Credit growth

Banks operating in Palestine have traditionally taken a conservative approach to lending. “This policy played a significant role in protecting banks from the problems experienced by other economic sectors during the first intifada [from 1987 to 1991] and the second [from 2000 to 2005],” says the PMA’s Mr Shawwa.

However, there has been a major shift in lending policies since 2008, he adds, helped by PMA initiatives to deepen the financial depth and enhance the role of the banking sector in the economy. “These efforts contributed to increasing the available financing opportunities and thus raising the ratio of loans to GDP to more than 55% at the end of 2017. This indicates that the Palestinian economy is increasingly relying on the banking sector,” says the Mr Shawwa.

According to the IMF, bank credit to the private sector has grown by an annual average of 20% since 2009, more than double the rate of nominal GDP growth. Small and medium-sized enterprises (SMEs) constitute more than 95% of all enterprises in Palestine and 55% of GDP, making them an important driver of growth. And while the World Bank’s 2013 Enterprise Survey found that less than 10% of SMEs in Palestine used banks to finance investments (compared with up to 28% in the Middle East and north Africa region and lower middle-income countries), significant progress is thought to have taken place in the years since the last survey was conducted.

“The SME [sector] is growing in Palestine,” says Hashim Shawa, chairman of Bank of Palestine (BOP), Palestine’s largest bank. BOP has so far lent more than $250m to SMEs, with its credit facilities to them increasing 8% in 2017. “The difficulty of operating with SMEs is not a major bottleneck, but [the requirement of] more government support and incentives to encourage lending to SMEs and [the need for] more support from international guarantee funds,” he adds.

Slowdown risks

BOP, which was founded in 1960, saw its assets grow by 18.53% to $4.88bn in 2017, with customer deposits reaching $3.8bn, up 19.9%, and profits before tax up by 7.3% to $73m. Meanwhile, its loan portfolio grew by 13.8% to $2.52bn at the end of 2017, with a non-performing loan (NPL) ratio of 2.66% and loan-to-deposit ratio of 66.83%.

However, a slowdown in the economy could have strong implications for banks’ loan books. According to a March 2018 IMF report, NPLs edged up in 2017, while the number of delinquent creditors increased sharply, particularly in Gaza and among SMEs. The capital adequacy ratio of banks also continued to decline, reaching 17.6% in December 2017.

There is also risk related to direct government and public sector employee borrowing. “These two factors together accounted for 36.9% of the total credit portfolio of the banking sector in 2017, compared with 39.5% in 2016, and 156.4% of banks' equity compared with 161.4%,” say the PMA’s Mr Shawwa. “Despite the decline, this level of exposure raises many concerns, which require constant monitoring and follow-ups by the PMA, especially if the fiscal situation of the government worsens.”

In 2017, authorities kept the overall deficit to an estimated 7.8% of GDP. However, gross public debt was estimated at 36.7% of GDP at end 2017, up 0.7% year on year, with the IMF predicting that gross public debt will reach 46.9% of GDP by 2023 under a business-as-usual scenario.

Unbanked population

Adults account for just over half (51.3%) of Palestine’s population of 4.8 million. However, the country's financial inclusion rate is low, at just 36.4% of the total adult population, equivalent to roughly 900,000 individuals, according to PMA figures. Mr Shawwa says that in addition to constraints caused by the geopolitical landscape, there is an overall lack of financial awareness, with 59% of adults having weak financial literacy.

“Financial inclusion has come to the forefront of the development policy and reform agenda in Palestine,” he says. The National Financial Inclusion Strategy, launched in 2017, is targeting a rise from 36.4% of the adult population having a bank account to at least 50% of adults by the end of 2025.

The situation in Gaza is also challenging for banks operating in Palestine, both in terms of the economic situation and also in supplying services to customers there.

“As the economies of the West Bank and Gaza have developed differently, today they are subject to different constraints, which, among other things, manifests itself in the fact that people in Gaza do not have the same access to banking services as [those] in the West Bank,” says the IMF’s Mr Tchaidze. “In the West Bank, there are 36 branches and 72 ATMs per 100,000 adults; yet in Gaza there are only 11 branches and 16 ATMs per 100,000 adults. This, together with the more complex situation, adds to the inability of the Palestinian banks to attract deposits in Gaza.”

Staff training in Gaza is also an issue, according to Quds Bank’s Mr Hidmi, “because we're not able to send trainers to the region or send our employees outside Gaza for training”. Instead, banks must rely on e-training.

Islamic finance

Islamic banking opportunities have grown in Palestine in recent years. In 2017, BOP bought a majority stake in Arab Islamic Bank (AIB), one of three Islamic banks operating in Palestine. The acquisition created a financial group with assets of almost $5bn, roughly 31% of total assets in the Palestinian banking sector.

“Today the market share for Islamic banking in Palestine is 11%, with the potential to grow to 25%, at a par with regional markets,” says Hani Nasser, a general manager at AIB. “So we see great room for growth for AIB. This year the board has increased the capital of the bank [to $100m] to achieve additional increases in physical branches and digital channels.” In 2017, AIB, which has 18 branches, had assets of $1.04bn (up 31% year on year), deposits of $791m and a net profit of $6.4m.

In April 2018, TNB announced it had become the largest stakeholder in Palestine Islamic Bank (which saw its assets grow by 25% to more than $1bn in 2017), after buying 45% of the financial institution in a transaction valued at $70m.

Palestinian banks have also started to expand their physical presence into areas of east Jerusalem, for the first time since 1967. “In the past decade, with the separation wall, it became very difficult for people to bank with the Palestinian banks – they have to go through checkpoints [and it took] a lot of time,” says TNB’s Mr Hajhasan. “We found a part of the 1967 West Bank – Israel and Palestine consider it as West Bank, but the wall took it inside Jerusalem.” TNB opened a branch there in April 2017, followed a few months later by BOP.

Currency concerns

Palestine does not have its own currency, meaning banks have to deal with three currencies: the Jordanian dinar, the US dollar and the Israeli shekel. “This has an effect on foreign exchange costs, having to juggle operations between three currencies with divergent interest rates on deposits and loans,” says BOP’s Mr Shawa.

According to Samir Abdullah, senior researcher at the Palestine Economic Policy Research Institute, the main challenge for banks resulting from the lack of a national currency comes from the Bank of Israel’s denial of free transfers of Israeli shekel to and from Israeli banks. “Palestinian banks can’t efficiently manage their cash and face a frequent lack or excess of shekel liquidity,” he says.

“Furthermore, Palestinian banks are frequently denied transport of currencies between branches and especially between the West Bank and Gaza, which results in liquidity crises and expensive borrowing. This also results in a distortion in the foreign exchange prices. As for the impact on the economy, the lack of a national economy deprives the PMA of seigniorage revenues and the use of monetary policy tools, such as interest rates, to boost economic growth.”

In the past, the Bank of Israel has placed restrictions on the flow of shekels from Palestinian banks to Israeli banks, according to Mr Abdullah. “This arbitrary action accumulated billions of redundant Israeli currency in these banks, which increased their costs and hit their operating return,” he says.

However, a March 2018 IMF report predicted that a new, higher limit on transferring shekel cash from the West Bank to Israel – in place since late 2017 – should help alleviate pressures in managing excess liquidity for banks operating in the West Bank. Maintaining effective Israeli-Palestinian banking relations will remain of paramount importance for Palestine’s banking sector.

Continuing resilience

Going forward, the main operating challenges for the Palestinian banking sector continue to be linked to the low economic growth and political unpredictably. “This is clearly reflected in the steady decline in the net profit-to-asset ratio, from 1.23% in 2013 to 1.04% in 2016, and in the net profit-to-equity ratio, from 10.5% to 8.8% for the same period,” says Mr Abdullah.   

However, despite the uncertainty, banks are optimistic about their ability to weather any potential storm. “Bank of Palestine has operated in worse economic and political conditions before,” says BOP’s Mr Shawa. “We have established a good degree of adaptability and resilience to stress.”

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Read more about:  Middle East , Palestine