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GCC banking risk, growth and deregulation

For instance, almost all the leading UAE banks have doubled their profits in the past two years. Saudi Arabian banks earned $4.5 billion in 2004, up an extraordinary 40 per cent above 2003. The leading banks in the Gulf — Samba and NCB in the kingdom, NBAD in the UAE, NBK and KFH in Kuwait — all exhibited returns on equity in excess of 25 per cent despite high Basel Tier One capital ratios, making them among the most profitable institutions in international banking.

The macroeconomics ballast behind the El Dorado in Gulf banking is the unique combination of $60 crude oil and extremely low interest rates.

Real interest rates in the Gulf are still negative, despite ten successive Federal Reserve rate hikes, regional central banks whose currencies are pegged to the dollar cannot hike interest rates higher than dollar rates, even though inflation and money supply growth is far higher in the GCC than in 2003. Negative real interest rates in the Gulf stimulated, in turn, an unprecedented boom in boom in bank credit, real estate and stock markets.

Oil prices might have ignited the current banking and asset bubble in the Gulf in 2003. However, it is sustained by negative real interest rates to the point where GCC central bank, haunted by the memory of the Souk Al Manakh collapse in Kuwait and the share meltdowns in the UAE and Oman in 1998, are now acting to curb excessive bank credit growth.

For instance, the IMF has applauded UAE Central Bank plan to squeeze liquidity in the banking system via CD issues. It would not surprise me to see GCC central banks raise reserve requirement to restrain asset bubbles in the capital market and runaway inflation that have made these economies at risk of overheating.

The Kuwait Central Bank, limited bank loans to 80 per cent of customer deposits, an inevitable deterrent to undisciplined asset growth. More significantly Kuwait's central bank has also limited bank IPO financing to a mere 15 per cent of assets. At the other end of the regulatory compliance spectrum, UAE banks have repeatedly violated central bank prohibitions against IPO financing leverage ratios. High oil prices have meant a quantum increase in infrastructure spending across the Gulf. Water, power, telecom, gas, and petrochemicals have all triggered a project finance bonanza.

Project Kuwait (international major participation in northern Kuwaiti oilfields), Dolphin Gas (the largest cross-border GCC project), Al Taweelah in Abu Dhabi and the Bahrain Financial Harbour have all created new finance opportunities for banks, including Islamic tranches, an invariable component of all mega deals now that the sukuk markets includes Islamic bank issuers in the Euromarkets.

Retail banking is both a growth engine for GCC banks as well as a potential systemic sword of Damocles. The UAE, with a bankable population of 1.5 million people, has 1 million credit cards in issuance and 47 banks scrambling for a retail pie that is over lent, leading to an inevitable squeeze in margins, market share, underwriting culture and asset quality whose impact is simply not captured in current loan loss provisions. A credit card borrowing spree in South Korea led to catastrophe in the banking system as bad debts decimated banking profits. NBAD, the largest bank in the UAE and the only local bank to generate a billion dirhams in profits, has only 15 per cent market share, proving exceptional market fragmentation. In contrast, the leading bank in Saudi Arabia (NCB) generated a billion USD in profits, the leading bank in Kuwait (NBK) had one third market share in its home market and double the market share of its next competition (Gulf Bank). Banking consolidation is in the best interest of the UAE economy and banking system, as economies of scale and WTO make it simply wasteful to have 22 separate management hierarchies, head offices, IT divisions, treasuries etc. An optimal efficient banking structure for the UAE would probably be four to six banks in Abu Dhabi and Dubai. Banking deregulation creates its won momentum in the competitive structure of the GCC financial services industry. For instance, the new Saudi capital markets law has attracted BNP Paribas, Deutsche Bank, HSBC and all the major “national champion" GCC banks (eg Emirates, Bank Muscat, NBK) to the kingdom. Kuwait has also allowed international banks into its domestic market, albeit with a single branch. DIFC, Qatar Financial Centre and the Bahrain Financial Harbour will also attract new banks and fund managers. As in the City or Wall Street, convergence in investment banking, lending, asset management and insurance is inevitable. The new Insurance law in Saudi Arabia, for instance, triggered joint ventures between local banks and international insurance companies, such as between Riyadh Bank and Royal Sun Alliance. As GCC economies deregulate and compete to attract foreign investment, they create new opportunities, business models and synergies in banking and capital markets. The Etihad Etisalat financing, prompted by Saudi telecom deregulation, resulted not just in one of the biggest Islamic syndication deals but also an IPO in which no less than 4 million Saudi citizens subscribed for shares. Similarly, the deregulation of real estate ownership in Dubai spawned the birth of new specialist banks.

The IPO pipeline in the Gulf since 2003 has resulted in new regional banks - Bubayan in Kuwait, Al Bilad in Saudi, Amlak in UAE, several Islamic banks in Bahrain and Qatar. However, there is also growing overcapacity in certain niches. Note that there are about as many stockbrokers in the UAE as listed companies, a phenomenon I have not seen anywhere else in world! Banks in the GCC have definitely profited from high oil prices and negative real interest rates. The best managed banks have raised capital in the Euromarkets via MTN issues on the eve of Basel II. Yet euphoria is a dangerous sentiment in banking. It is impossible to have perpetual outsize returns without outsize risk.

Risk management is an art that will be learnt the hard way in Gulf banking when the chickens come home to roost, as they always do.