Project Finance, Retail Lending Driving Gulf Banks’ Growth, Says Dresdner Kleinwort

Against a backdrop of high regional economic growth driven by energy prices, the growth of Gulf banks is being driven by retail lending and project finance, according to research by Dresdner Kleinwort. In a 30 August report, the banks says that, “firmly in the single A rating category, major Gulf banks provide sound fundamentals, superior capitalization, [and] favorable growth potential.” Gulf banks continue to trade significantly cheaper than their similarly rated Western counterparts, it says, largely as a result of the political risk of their operating environment – risks which are mitigated, it adds, by growth potential and benign fundamentals. Until recently foreign banks were rarely allowed to operate in the Gulf, and as a result the sector is dominated by local ones. But foreigners are playing an increasingly important role as the industry gradually opens to cross-border branches. Consolidation of the many smaller banks is inevitable and much-needed, says Dresdner, and will help local banks to participate in major project finance deals and exploit growth opportunities more effectively.

Growth Opportunities

Investment and banking growth opportunities in the Gulf are abundant, says Dresdner. Despite steady growth of assets and lending in the past five years, the current level of financial intermediation (as measured by bank credit/GDP ratios), indicate further room for growth. The scope and breadth of lending has some way to go before it catches up with Western banks, but the availability locally of an estimated $300-500bn for investment provides support for further corporate and retail lending. Islamic finance has become an important differentiation and market-entry tool for Gulf banks, encouraging customer loyalty and providing access to cheaper funding. The growth of both Islamic and retail banking has helped to increase banks’ core margins, while corporate and retail deposits continue to dominate the funding structure of Gulf banks. However, the importance of debt securities for bank funding has been growing steadily over the past two years, and in 2006 Gulf banks were among the most active borrowers on global debt capital markets, says Dresdner. It expects this trend to continue as local long-term debt remains scarce and banks increasingly need to lengthen the maturity of their liabilities.

Gulf Banks V Western Banks

(%)

2005

Asset

Growth

Net Interest

Margin

ROE

ROA

Cost/

Income

NPLs/Gross

Loans

Loans/

Deposits

Tier 1

CAR Ratio

Equity/

Assets

Gulf Banks (Top 16)

22.4

2.9

23.2

3.3

31.4

4.3

84

16.7

13.7

Western Banks*

-0.9

2.2

13.9

0.9

57.7

1.2

88

9.5

6.4

Source: Dresdner Kleinwort Debt Research.

* Western banks include over 100 US or European-based banks single A rated by Moody’s.

A Number Of Threats

Despite the abundance of opportunities, Gulf banks face a number of threats on top of geopolitical risk. Further upgrades to banks’ ratings are constrained by concerns over their exposure to local equity and real estate markets, says Dresdner. Gulf banks are exposed to local stock markets direct through holding securities, and also through loans which can be used for speculative investments. However, local regulators have paid close attention to smoothing the impact of stock market volatility, including putting limits on index and individual stock price movements, and pushing banks to reign in margin lending. In the real estate market, Dresdner believes that concerns over a ‘bubble’ are overplayed with the possible exception of Dubai. “Real estate was arguably undervalued for some time due to various political, economic and legal/ownership reasons,” it says. “Some correction in the residential real estate markets in certain countries can be expected, but we do not believe that a melt-down scenario is likely in the near to mid-term.” Finally, the bank says that while capitalization among Gulf banks is strong, recent generous dividend payouts in the region of 50-80% of net income may become a concern in the future.

Banking Sector Consolidation

The limited size of many local banks and economies outside Saudi Arabia and the increased competitive pressure expected after the introduction of a single currency are both key drivers towards the process of consolidation among GCC banks – a process which Dresdner views as both inevitable and positive. As investment flows begin to move more freely, local banks will need to strengthen their presence in the region. Currently they are doing this by expanding their branch network, but joining forces with regional heavyweights could be a more successful strategy. Foreign banks dominate project financing and are encroaching on other areas such as corporate banking. As they continue to expand in the region the pressure on local banks to join forces will only grow. Running counter to these forces is the fact that many smaller banks operate in niche markets and still see plentiful growth opportunities. Lack of human resources rather than lack of capital tend to constrain their growth, and many are still run as family businesses. Moreover, remaining regulatory protectionism and high current equity valuations of the banks also slow down the consolidation process, says Dresdner.

Regulation

Gulf regulators continue to emphasize credit risk aversion over fast growth, says Dresdner, a stance which most GCC banks are happy with. The implementation of Basel II dominates the agenda and local regulators are busy assessing the likely impact on local banks. Kuwait introduced the measures in January 2006, and other countries are expected to follow suit in 2007-09. Major changes are expected in the banks’ capital requirements which should improve stability. Another major priority is to reduce lending risks, on which regulators also take a conservative approach – on consumer loans restrictions include ceilings on loan terms; the frequency of restructuring; and loan payment ceilings. The aim is to strike a balance between fast lending growth and adequate risk levels. Like other growth markets, buoyant lending has led to higher levels of non-performing loans (over 4%, three times higher than Western Europe). Dresdner believes the situation could be worse than that figure suggests, but notes on the positive side that many banks have now written off NPLs which have been on their books for decades, resulting in a gradual decline in NPLs since the early 2000s.

GCC Monetary Union To Boost Economic Growth From 2010

The GCC formed a customs union in 2003, imposing a uniform 5% import tariff on most products imported from outside the union (with exceptions for alcohol and tobacco). In 2005, guidelines (along the lines of those employed by the EU), to facilitate the transition to monetary union and to promote economic stability were proposed – a fiscal deficit ceiling of 3% of GDP; a debt-to-GDP ratio of less than 60%; foreign reserves of at least four months of imports; and inflation below the average of the six members plus 1.5% percentage points. All states are expected to be admitted to the union whether or not they meet these criteria, and are expected to receive a boost from the elimination of transaction costs, increased intra-regional trade, and deeper financial integration. This, and the increase in local and foreign investment that it is expected to spur, should provide for a continuing profitable environment for the region’s banks.