Managing growth: Strategic development and careful regulation allow the sector to remain strong

Operating within the largest banking sector in the GCC, Abu Dhabi’s banks have thrived, and today the UAE capital is home to some of the most successful lenders in the country. In 2011 they demonstrated continued profitability despite the challenges presented by regional unrest and global economic turbulence. The possibility of exogenous shocks remains in 2012, while on the domestic front the sector is adjusting to new regulations, addressing some of the potential risks that the recent credit crunch exposed.

However, to date, Abu Dhabi’s lenders have shown an ability to adjust their strategies in response to the altered economic environment, and the result is a leaner, more efficient banking sector that is learning to diversify its sources of income and remain profitable in an increasingly competitive market.

HISTORY: The modern era of banking in Abu Dhabi began with the establishment of the UAE Currency Board in 1973, the primary task of which was to oversee the introduction of the UAE dirham. The new national currency replaced a system in which the Bahraini dinar and the Qatar/Dubai riyal were used for cash transactions. After its successful circulation, the board reverted to its oversight role, working with the International Monetary Fund (IMF) to produce the annual reports and bi-annual bulletins that tracked the progress of the nascent banking sector. By the end of the decade, the economy of Abu Dhabi was heating up on the back of an expanding hydrocarbons industry, and the emirate’s banking sector entered a new phase of development.

The promulgation of Union Law No.10 of 1980 converted the UAE Currency Board into the Central Bank of the UAE, granting it an array of powers, including the formulation of monetary, credit and banking policies. Since its inception, the central bank has overseen the emergence of a banking sector that has played an integral part in the economic development of the nation. In the little over three decades between January 1980 and January 2012, the activities of the central bank and the institutions it oversees have expanded exponentially: cash in circulation has grown from Dh2.1bn ($571.6m) to Dh42.6bn ($11.6bn), credit facilities extended to the nation’s private sector rose from Dh25.2bn ($6.9bn) to Dh816.5bn ($222.3bn), while monetary deposits increased from Dh5.2bn ($1.4bn) to Dh229.4bn ($62.4bn). The UAE’s banks, and Abu Dhabi’s in particular, have demonstrated their robustness in the face of the global economic crisis, while the central bank has moved swiftly to address the potential risks that the new economic environment has exposed. Throughout these political and economic vicissitudes, the banking sector has continued to grow in both depth and complexity to assume the regionally significant role it enjoys today.

MARKET STRUCTURE: Abu Dhabi’s banking sector sits within a wider UAE market of financial institutions operating across the seven emirates on a border-free basis. They compete for business in a competitive market where domestic giants rub shoulders with foreign institutions that have established a presence in the UAE. “It is a very crowded market. On the HerfindahlHirschman (HH) index of market concentration, the UAE is less than 0.2. And although we have a big four or five, there is no dominant player,” Arup Mukhopadhyay, executive vice-president and head of consumer banking at Abu Dhabi Commercial Bank (ADCB), told OBG. A 2012 report by Abu Dhabi Islamic Bank (ADIB) established that the UAE banking sector, with 51 banks and more than 840 branches for a population of 8m, is the most competitive in the GCC – a fact reflected in a net interest margin, or the spread between what banks pay on deposits and what they charge for credit, which is the lowest amongst the Gulf states. As of June 2012, 23 domestic banks operated 799 branches throughout the UAE, according to the central bank. They share the market with six GCC banks, which operate a branch each, and 22 foreign banks that maintain 82 branches. Additionally, as of December 2011, 110 foreign banks have established representative offices in the country, 42 of which are located in Abu Dhabi.

As one of the UAE’s two banking centres, Abu Dhabi is home to some of the sizeable domestic players that play a leading role in the development of the economy through their lending and investment activities (see analysis). National Bank of Abu Dhabi (NBAD) is the second-largest bank in the UAE, and runs the largest lending book of the Abu Dhabi-based institutions – valued at Dh164bn ($45bn) in March 2012. An Abu Dhabi government interest of over 70% has helped it to maintain its position at the centre of the emirate’s economy. The government also retains an interest of 64.8% in Abu Dhabi’s second-largest lender, ADCB. The largest privately owned bank in the emirate is First Gulf Bank (FGB), although the sizeable stake the ruling family holds enhances its ties to the state. Union National Bank (UNB) is the fourth-largest bank and the only one in the UAE market jointly owned by the governments of Abu Dhabi and Dubai. Abu Dhabi Islamic Bank, meanwhile, is the fifth-largest bank in the emirate, as well as its largest sharia-compliant lender (or, in Islamic terms, financer). Abu Dhabi’s top-five domestic banks offer sharia-compliant financing either through subsidiaries or dedicated Islamic windows.

REGULATION & REFORM: The responsibility of ensuring that expansion is carried out in a prudent and sustainable manner falls to the Central Bank of the UAE. Since the onset of the global economic crisis, the central bank has responded to the altered economic landscape in two discernible phases. In the first, it moved to secure the sector by setting up a Dh50bn ($13.6bn) short-term liquidity support facility that was followed by a similarly sized liquidity injection provided by the Ministry of Finance. During this period the government of Abu Dhabi provided a further Dh16bn ($4.4bn) injection to five Abu Dhabi-based banks, significantly strengthening their capital base. Having given the banks the opportunity to strengthen their balance sheets, the central bank has more recently commenced the second phase of its response, which aims to address the potential systemic risks that the economic crisis exposed.

Consequently, Abu Dhabi’s banks are adjusting to a number of key regulatory changes, the first of which came in late 2010 with the Regulations for Classification of Loans and Determining their Provisions, better known as the Provisioning Circular. The new regulation establishes a framework by which banks are to evaluate their loans and advances portfolio to better reflect their asset quality, as well as to introduce consistent, prudent credit risk management policies. The new loan definitions range from “normal”, “watch-list”, “sub-standard”, “doubtful” and “loss”, and their adoption across the sector has brought a heightened degree of clarity to portfolio management. An even more comprehensive regulatory change soon followed, in the form of the Regulations No.29/2011 Regarding Bank Loans & Other Services Offered to Individual Customers, published in February 2011 and implemented in May 2011. The regulations are applicable to individual consumer retail banking practices, and have the dual purpose of controlling lending activity and the level of fees that might be charged for it. A new lending cap of 20 times salary has replaced a previous fixed limit on expatriates of Dh250,000 ($68,050), and has been welcomed for the heightened flexibility it has brought to the market. The regulations also set out a standard formula for the calculation of interest on a loan, and establish that the combined monthly installations for all loans, including overdrafts and credit cards, must not exceed 50% of an individual’s gross salary. The caps on fees and commissions that the regulations have levelled represent the most significant challenge to the industry. The reduced revenue from fees and commissions during 2011 has led to a drop-off in non-interest income for all five of Abu Dhabi’s top banks (see analysis).

A third significant regulatory change was introduced by the central bank in April 2012; Notice No. 209 of 2012 is an amendment of a central bank circular from 1993 concerning the monitoring of large exposure limits. The revised regulation changes the nature of banks’ concentration of risk levels, removing a previous lending limit to any individual borrower of 7% of capital base and replacing it with a new matrix that encompasses government-related entities (GREs) and local governments, although not credit extended to the federal government. The move has been broadly welcomed as a prudent response to the potential concentration of risk within the sector. “It’s a straightforward concept. The central bank is trying to prevent excessive concentration of risk whilst acknowledging the general strength of GREs. GREs in Abu Dhabi are solid, but even with these comes a point where you get over-concentrated. The approach seeks to prevent excessive concentration to any counterparty, which is good, prudential regulation,” Colin Fraser, the executive vice-president and group head of wholesale banking at ADCB, told OBG.

BASEL II & III: In addition to the ongoing process of regulatory reform originating from within the UAE’s borders, Abu Dhabi-based banks are also engaging with the broad current of international reform the Basel process represents. The market’s reaction to the provisions of Basel II and III is partly bank-led and partly driven by the regulator, while its more recent actions concerning retail lending and risk concentration chime with the strategic priorities that the Basel process establishes. The more particular capital structures established by Basel do not pose a challenge to Abu Dhabi’s banks, with average Tier 1 capital ratio standing at 16.3% across the UAE in December 2011, well in excess of Basel’s 7% requirement. Moreover, the bulk of this Tier 1 might be described as “classical” capital – equity and retained earnings – with a relatively small component of innovative funding.

In November 2009 the central bank implemented the standardised approach to capital adequacy standards, which has now been adopted by all banks within the UAE. However, both the central bank and Abu Dhabi’s larger lenders are turning their attention to Basel III, and in particular the challenges associated with its more onerous liquidity requirements. In July 2012, the central bank issued circular No. 30/2012 to “ensure that liquidity risk are well managed at banks operating in the UAE and are in line with the Basel Committee for Banking Supervision recommendations and internal best practices”. Starting in January 2013 the central bank will require local banks to comply with four ratios (two of which are interim) until the Basel III Liquidity Coverage Ratio and the Net Stable Funding Ratio come into effect in January 2015 and January 2018, respectively.

PERFORMANCE: The central bank’s light yet prudent regulatory touch has been a contributing factor to the rapid expansion of the banking sector in recent years. In 2011 the total assets of banks operating in the UAE (net of provisions for bad and doubtful loans and interest in suspense) increased by 3.5% to reach Dh1.66trn ($452.4bn), making it the largest banking sector in the GCC according to central bank data – a position it has held since 2006. As the UAE banking sector continues to expand, it is the Abu Dhabi-based institutions that have been making the running over recent years. Less affected than Dubai by the global economic downturn, the emirate’s banks have succeeded in increasing their share of the national market. “This trend has been established for some time. Data from banks’ financial statements show that the assets of Abu Dhabi’s publicly listed banks are getting closer to accounting for half of the UAE banking system. In 2008 they accounted for around 34%,” Gıyas Gökkent, the group chief economist at NBAD, told OBG.

This expansion comes within the context of a gradual recovery from the effects of the global economic crisis. In 2009 the UAE banking sector’s net profit fell year-on-year (y-o-y) by 20.6%, principally as a result of increased allocations for loan loss provisions. Profit recovery began almost immediately: the net earnings of the 12 national banks that released their semi-annual results in the summer of 2010 showed an aggregate expansion of 2.2%, but elevated provisioning levels were a downward force on bottom-line growth. In 2012, the question of where Abu Dhabi’s banks lie in the nonperforming loan (NPL) cycle remains moot. Aggregate figures for the UAE sector show that NPL formation has slowed, growing by 4% in 2011, a trend that has been assisted by the de-recognition of exposures that have been successfully restructured. There is a growing sentiment within the Abu Dhabi banking community that the worst of the NPL challenge is behind the sector. “I think we are in the middle of the NPL cycle, barring another catastrophe. For us it peaked in the third quarter of 2011, and we don’t believe there will be anything other than sideways movement. We have reached a plateau in which we are not seeing new entrants into the non-performing category, just a deterioration of existing cases. We have worked with customers that have recovered, but it will take a while. I think we are probably two years from recovery,” Andrew Moir, global head of strategy and finance at ADIB, said.

Banks’ provisioning against bad debt, meanwhile, presents a muddied picture as a result of their need to meet a 1.5% collective provisions target set by the central bank with a deadline of 2014. While some of Abu Dhabi’s largest banks showed a decline in provisioning activity over 2011, the expansion of provisioning of up to 24% in other cases has been attributed to efforts to meet the new target on schedule.

Against this backdrop of loan-book cleansing, Abu Dhabi’s banks have maintained their profitability. An OBG analysis of the five largest lenders reveals that all posted a growth in net profit for 2011, at an average of 145%, although this figure is distorted by the 694.2% growth shown by ADCB as the result of a one-off asset sale. Net interest income for the four largest banks in the capital (excluding the sharia-compliant ADIB) averaged 7.5% for the year, with ADCB’s 27.3% leading the field. The “big five” also managed to build and expand their lending activity at an average rate of 6.66% over the year, with NBAD posting the biggest gain at 17%.

MARKET TRENDS: Despite the expansion in lending activity exhibited by Abu Dhabi’s five largest banks, they form part of a sector-wide trend of slow loan growth in the wake of the global economic crisis. The 30% y-o-y lending growth of 2008 gave way to a 2.4% increase in the extension of credit in 2009, and lending activity has remained muted since. The effects of the subdued growth have also been felt in the banks’ deposit maturity profiles. Research by Global Investment House shows that while 24% of UAE bank deposits had maturities of over one year in 2008, this had contracted to 7% by 2011. Beyond the obvious explanation of depositors being reluctant to lock in their capital for long periods at low interest rates, one of the factors adduced for this “fat tailing” of banks’ deposits is a move by lenders to shed higher-cost, longer-term deposits as a reaction to their low loans distribution. The slowdown in NPL growth seen in 2011 has thus come as welcome news to the UAE banking sector, interpreted by many as the first sign of a market rationalisation that will allow for sustainable loan growth.

FUTURE GROWTH: Even during the recent era of rising NPLs and loan book restructuring, Abu Dhabi’s banks fared better than their counterparts elsewhere in the UAE, showing an NPL ratio on Tier 1 capital of 6.8% in 2011 compared to the 10.6% average of banks based in Dubai, according to the International Monetary Fund’s (IMF) 2012 Article IV Consultation document. Banks operating from the capital also continue to benefit from government spending on the ambitious Abu Dhabi Economic Vision 2030, the blueprint for the emirate’s economic development, as well as the robust rate of deposit growth that the local sector has recently displayed. Nevertheless, while big-ticket corporate lending continues to underpin the sector’s expansion, the post-credit-crunch economic environment has encouraged banks to engage with as much of the economy as possible in a bid to secure income. As a result, small and medium-sized enterprise (SME) and retail lending are playing a more prominent part in the portfolios of Abu Dhabi’s banks. “While we believe that government projects are more secure than in the private sector, we cannot close our eyes to private enterprise. There is a shift in focus whereby SMEs have been made a part of the strategic equation for future progress in the UAE. All banks are focusing attention to this and if they are not, they are losing market share,” Mohammad Nasr Abdeen, CEO of UNB, told OBG.

In the retail segment, salary increases for federal government employees implemented in late 2011 are expected to play a part in what leading Middle East investment bank EFG-Hermes anticipates will be a 5% growth in lending in 2012. According to research conducted by Gulf Investment House, credit extended to the retail sector by Abu Dhabi’s five largest lenders varies from 17% of total lending (NBAD) to 41% (FGB). While the introduction of the new regulations concerning retail lending has impaired non-interest income originating from this segment, the prospect of a federal credit bureau with a legal mandate to collect and provide information from all of the UAE’s banks has the potential to considerably widen the retail lending space.

In the meantime, technology represents another means by which banks can bolster revenue streams whilst providing enhanced services. Larger lenders are introducing new technology platforms in areas such as transaction and trade banking. ADCB’s ProCash and ProTrade, for example, bring automation and reduced operating costs to clients using platforms comparable to those of the largest multinational lenders, and therefore represent a significant step forward by the local sector. Using such technology to build relationships with customers and diversify sources of interest and non-interest income will play an increasingly important part in Abu Dhabi’s competitive banking sector.

OUTLOOK: Fiscal prudence and hydrocarbons wealth combine in Abu Dhabi to make it one of the most robust economies in the region, and the recent performance of the emirate’s banks compared to those in the rest of the UAE reflects this. The government’s commitment to the sizeable infrastructural projects underpins the future growth of the sector. Still, the increasingly competitive nature of the domestic banking market will continue to drive the established trend of revenue diversification. An announcement in May 2012 that a new “twin peaks” regulatory model is to be introduced to the UAE promises to bring the biggest regulatory restructuring since the creation of the central bank. Under the current proposal, the central bank will continue to oversee the banking sector for a transition period of up to four years before handing over its conduct-of-business role to a new Financial Services Authority. The central bank will then retain its prudential role, taking a birds-eye view of financial oversight as well as formulating the country’s monetary policy. Plans to introduce a new banking law intended to replace the 1980 Banking Law were also announced in 2012.