Dubai's loan recipient profile shifting, though overall credit growth lower than expected

Banks are poised to face competitive conditions in the UAE’s lending market in 2014 and 2015, due to factors including new regulations, supply-demand dynamics and the sheer number of players looking to lend. The end result is likely to be muted credit growth and a contraction of net interest margins. Loan growth came in at 9.6% in the first 11 months of 2014, on course for the biggest annual increase since 2008, according to the Central Bank of the UAE (CBU), but was expected to soften in 2015.

Big Borrowers

As of the end of 2013, loans to companies comprised the largest market segment, worth some Dh455bn ($123.9bn), or 38.6% of the Dh1.18trn ($321.2bn) total, according to the UAE Banks Federation annual report for the period. Retail lending came in next, at 23.7%, followed by real estate (15.3%), government (12.3%) and services (10%). Non-performing loans have been on a downward trend since 2012 and stood at 7.1% at the end of the first quarter of 2014, while provisions for non-performing loans have been rising – from 85.1% in 2012 to 102.1% in the first three months of 2014.

Loan growth in the second quarter of 2014 was 2%, according to a sector survey by the Dubai-based investment bank SHUAA Capital. This comes at a time when banks have more cash to lend – the loans-to-deposits ratio dropped from 107% in the first quarter of 2010 to 93% at the end of 2013, according to government data – but also at a time when credit supply is so robust that those looking to borrow are demanding better terms.

The situation in the UAE is mirrored across the region. In GCC countries in the first nine months of 2014 the average interest rate spread over the London interbank offered rate (LIBOR) was 164.12 basis points, down from 211.49 in 2013, according to Thomson Reuters, and at the lowest level since 2008. For example, in June 2014 Bourse Dubai received a $500m loan from Dubai Islamic Bank at a premium of LIBOR +0.90%, according to Thompson Reuters.

Exacerbating the situation further is the fact that banks are increasingly well capitalised and therefore able to handle major loans on their own – as opposed to sharing risk with peers through a syndicated loan. This typically results in even lower rates, as customers can shop around for the best deal rather than dealing with a united front of lenders through a syndicated arrangement.

Government Borrowing

In 2013 banks increased their exposure to government and public enterprises by Dh15bn ($4bn), according to the IMF. This level of financing may be unlikely to continue in the future, however, thanks to regulations introduced in recent years to limit banks’ exposure to state agencies, in the hopes of avoiding concentration risks similar to those seen in 2009 and 2010.

The CBU is now forbidding banks to lend more than 25% of available capital to any one entity, further classifying government-related entities (GREs) as a single body under this rule. In effect, this means that banks cannot have more than one-quarter of their loan portfolios exposed to the government. However, there are two important exceptions. The first is for GREs that are profitable – rated at least “BBB-” or the equivalent by the three main global ratings agencies Standard & Poor’s, Moody’s and Fitch – and that can service their debts on their own. The CBU will allow banks to consider these GREs as separate entity, rather than grouping them in with the others. A bank can have 25% exposure to qualifying GREs, alongside its existing 25% exposure to the grouped remainder of the segment.

The second exception is that banks’ investments in the bonds and sukuk (Islamic bonds) of GREs will not count toward the cap if these specific debt instruments are rated “AA-” or higher. Prior to the introduction of these regulations, some banks were already over the limit and will therefore be required to slowly reduce their exposure until they are in compliance. The overall impact of these regulations should be less concentration risk for the banks and greater reliance on debt and equity for the GREs.

Retail Cosumers

While the banks are now mandated to reduce their exposure to GREs, consumers could end up off limits as well, thanks to existing regulations that prevent banks from lending to customers whose existing debt payments make up 50% or more of their monthly income.

With the introduction of the Al Etihad Credit Bureau and a law that requires banks to consult its database when making credit decisions, it is expected that by early 2015 many consumers will be deemed too indebted to qualify for new loans. “The credit bureau has just been introduced, and it is likely to show the banks that debt-burden ratios of consumers are much higher than they thought,” said Redmond Ramsdale, director of financial institutions ratings in the Dubai office of Fitch.

Lending to new retail consumers is often done through partnerships with large employers, via company payroll accounts, and is driven by growth in the expatriate workforce. In these relationships, companies pay employee wages through direct deposit arrangements with the bank, which in return guarantees that all employees get access to bank accounts, loans and other products, depending on their salary levels and once they are confirmed in their posts. This gives banks a degree of certainty about the job security and income level of their retail customers. “Company payroll accounts mean you can guarantee all employees will get a certain suite of products once they pass their probation period. Right now our average cross-sell is 1.75 products per customer, and we want to boost that to 2.25,” Adnan Chilwan, CEO of Dubai Islamic Bank, told OBG.

Commercial Lending

With the regulatory and legal environment leaving little room to scale up lending through government and existing retail customers, Dubai’s banks will likely be looking to new expatriate arrivals and the commercial sector to drive credit growth in 2015. In the corporate segment, the strong competition seen as banks headed into the first quarter of 2015 may fuel demand at the high end of the market, as companies seek to refinance at lower costs and lenders decide whether to compete for these lower-margin opportunities. Dubai’s special economic zones have historically been fertile territory for banks; however, increasing costs are slowing growth in new tenants, which is having a knock-on effect on banking business.

Banks have traditionally been reluctant to provide financing to small and medium-sized enterprises (SMEs) in emerging markets – in large part because of the abundance of lending opportunities amongst larger companies, which typically pose a lower degree of risk. However, given the impact of the new regulations, servicing the SME segment could become increasingly attractive. Indeed, greater exposure to SMEs could be a way to boost net-interest margins over a lender’s entire loan book, as they typically borrow at a higher rate. However, as Mohammed Masri, Arab Bank’s UAE country manager, told OBG, “Due to the cap on the number of foreign bank branches, targeting the SME segment remains challenging from a cost standpoint for many of the international banks operating in the UAE.”

Another obstacle to entering the segment is the current licensing structure. “Many foreign banks registered in the Dubai International Financial Centre would like to be able to provide greater support for local businesses,” Min Fang, the senior executive officer of the Agricultural Bank of China, told OBG. “However, current licensing laws often prevent international banks from providing services to firms based in free zones such as Jebel Ali and others throughout the emirate – though on the whole, Dubai’s trade finance regulations are quite flexible compared to those elsewhere in the region.”

Knock-On Effects

A possible external influence that could bring relief to the country’s banks is a rise in the benchmark lending rate in the US. As the dirham is pegged to the dollar, the UAE’s monetary policy effectively tracks US movements.

The current expectation is that the US Federal Reserve’s benchmark rate – the federal funds rate – is going to climb. While the Fed has not signalled its intention to raise rates, it is expected that after the tapering of its quantitative easing programme in late October 2014, the central bank will no longer be buying back bonds from the private sector for the purposes of stimulating the economy. This signals a greater confidence in economic growth and, therefore, a greater chance that interest rates could be raised. The strong employment report from January 2015 also points in this direction.

As of September 2014, the median forecast from Fed officials projected the rate at 1.375% by the end of 2015 – up from a forecast of 1.125% as of late June 2014. The impact in the UAE is significant: for every 50-basis-point increase in the US, UAE banks can expect, on average, a $50m increase in revenues.