Fitch Ratings-London: UAE banks' credit profiles face deterioration due to the economic effects of the coronavirus and the slump in oil prices, Fitch Ratings says. Coronavirus-related fallout threatens several sectors and events that are critical to the UAE economy, including tourism and hospitality, real estate and construction, retail and wholesale trade and transportation, along with the Dubai Expo 2020. This will be compounded by lower oil prices, particularly through reduced lending growth.
Asset quality is the factor that has the highest influence on UAE banks' Viability Ratings (VRs), which average 'bbb-'. Capital and liquidity buffers should protect VRs in the short term, but if operating conditions remain difficult for a prolonged period, downgrades are likely, especially for banks with weaker capital buffers. Smaller banks are generally more vulnerable as they have weaker franchises, thinner capital buffers, and lower revenue generation and diversification. If coronavirus challenges persist, a wave of mergers and acquisitions could follow, particularly among banks with weaker franchises.
Consequences of the coronavirus will weaken banks' asset quality due to deteriorating business conditions in retail and wholesale trade, and in the real estate and construction sectors, which represented 29% of total bank lending at YE 2019. Operating conditions in the real estate sector are already very difficult due to persistent oversupply, lower oil prices and weaker business confidence, putting pressure on property prices. Recent measures by the Central Bank of the UAE to increase maximum loan-to-value ratios and to allow real estate lending up to 30% of total loans may increase banks' asset quality vulnerability to falling real estate prices.
UAE banks' potential problem loans (Stage 2 and Stage 3 loans under IFRS 9) are already high, averaging 10%-20% of gross loans, and are likely to increase. The Stage 3 loans ratio for Fitch-rated UAE banks averaged 4.7% at end-first-half 2019 and we expect faster Stage 3 inflows due to deteriorating credit conditions.
The government support package allowing the postponement of principal and interest payments could provide some relief, but will delay the recognition of impaired loans and will understate the real level of problem loans. Lower cash-flow generation by corporates as a result of subdued economic conditions will lead to further loan restructuring. Banks with already low reserve coverage of problem loans are the most vulnerable to rising Stage 2 loans.
Pressures on banks' asset quality will increase if Dubai Expo 2020 is severely disrupted. The event was expected to provide an economic boost equivalent to 1.5% of GDP, according to Ernst and Young. Many banks are exposed to Dubai Expo 2020-related projects in infrastructure and the real estate and construction segments.
Deterioration in loan-quality metrics is likely to translate into higher loan impairment charges (LICs), denting banks' profitability. Continued subdued real estate prices will hamper banks' prospects of loan recoveries and push up LICs, as most loans are collateralised by real estate assets. Other collateral such as shares will also be significantly affected. Banks also face pressures on margins from the 125bps reduction in the central bank's one-week certificates of deposit interest rate, with interbank rates (EIBOR) reaching their lowest levels since mid-2016. We expect growth in banks' non-interest revenues to be limited given subdued business volumes.
The central bank's proposed AED50 billion liquidity injections at 0% will limit the effects of rising funding costs on banks and help maintain liquidity should the government and government-related entities (GREs) start withdrawing their deposits. Government and GRE deposits equate to 29% of total deposits at YE 2019. We do not expect government and GRE deposit withdrawals to be significant.
Total reserve coverage for Fitch-rated banks was adequate at 107% of Stage 3 loans at end-first-half 2019, while annual pre-impairment operating profits averaged 4.1% of total loans, providing banks with a good cushion against deteriorating credit conditions. The sector's common equity Tier 1 ratio was 14.6% at YE 2019, providing adequate loss-absorption buffers. A reduction in regulatory capital ratios in 2020 will be allowed by the central bank as part of the stimulus package to encourage lending.
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