New legislation should stabilise Dubai's banking sector

The banking sector in Dubai is part of the wider federal system covering the UAE, as banks from all seven emirates are authorised to operate across the country. The list of licensees is long, and banks are typically well capitalised and – in the current economic climate – keen for quality credit opportunities, creating a highly competitive environment.

In 2014 lenders continued the process of distancing themselves from the problems left over from the global financial crisis and credit issues centred in Dubai, with additional regulations introduced to avoid a repeat of those circumstances. The UAE’s banking sector has returned to profitability since the crisis, and now faces the challenge of continuing to grow profits despite price competition that is threatening to further squeeze margins.

Credit

Credit growth in 2014 and 2015 was initially expected to be moderate, but in the middle four months of 2014 the rate ranged from 8.7% to 7.1% on a year-on-year basis after provisioning (see analysis). Competition in the short term may be a challenge, but financial analysts following the sector still expect strong profits: a jump of 17% in net profits in 2014 and 19% in 2015, according to a Thomson Reuters compilation of analyst forecasts.

Long-term prospects are aligned to Dubai’s selection as the host city for Expo 2020. This will bring financing opportunities, as new event venues, infrastructure, hotels and other facilities across the hospitality sector will all be needed to support the event. Banks are expected to play a major role here, and the opportunity is an important one, alongside other investment flows. “The reliably stable inflow of international investment to Dubai is a major attraction for foreign banks, as international clients continue to enter the market, requiring a full spectrum of banking support services,” Mohsin Nathani, Standard Chartered Bank’s CEO for the UAE, told OBG.

On the surface, this looks like a repeat of recent history, in which major government corporations borrowed heavily to finance projects, and when some of them failed or were interrupted by the global financial crisis, the banks were left with loans in default. However, the relevant authorities – in both Dubai and at the federal level – have taken steps that they believe will help the emirate avoid a repeat of that pattern this time around.

Reducing Risk

New regulations in place across the financial services spectrum are designed to protect financial institutions from systemic risk, including caps on lending to government-related entities (GREs). As a result, banks are likely to be just one of several funding sources for the government-owned companies at the centre of the upcoming construction effort, instead of the dominant source as they would have been in the past (see analysis).

To that end, GREs are being encouraged and incentivised to seek funding from capital markets and elsewhere, in addition to borrowing from the country’s lenders. “The banks have been sorting out huge issues from the financial crisis,” said Redmond Ramsdale, director of financial institutions ratings in the Dubai office of Fitch Ratings. “They entered a growth phase in 2013 and now they are diversifying.”

Incorporating more sources for borrowing should help to lessen the pressure on the banks and prevent undue levels of systemic risk; however, it also means that lenders must seek new types of customers and areas of expertise in order to power their next cycle of growth – this in addition to pursuing operational efficiencies, additional fee-based revenue streams and opportunities in other countries with less mature banking sectors.

While these adjustments are already under way, the existing drivers of growth in the banking sector – which, along with GREs, include real estate and the expatriate population – will remain important considerations. From the end of 2012 to early June 2014, for example, the publicly traded stocks of Dubai banks jumped by some 168%, and real estate shares 207%, according to data from Bloomberg. An extension of the rally in bank stocks seen in the past two years could be powered by a continued distancing from the financial crisis, as well as success in cutting costs and improving operational efficiencies.

Key Lenders

The UAE’s banking sector comprises a variety of lenders, with the governments of Dubai and Abu Dhabi holding significant stakes in the country’s four largest banks by assets.

Emirates National Bank of Dubai (Emirates NBD) and the National Bank of Abu Dhabi are the two largest banks in the country, each with around Dh348bn ($94.7bn) in assets as of the end of the first half of 2014. The Investment Corporation of Dubai, the investment vehicle of the emirate’s government, owns a 55.6% share of Emirates NBD, while the National Bank of Abu Dhabi is 70% owned by the Abu Dhabi government through its Abu Dhabi Investment Council. The next two largest banks, First Gulf Bank and Abu Dhabi Commercial Bank, each held about Dh198bn (54bn) in assets.

The largest sharia-compliant lender and the fifth-largest bank by assets overall is Dubai Islamic Bank, with some Dh123bn ($33.5bn) in assets. There are also smaller lenders that are owned or majority-owned and controlled by emirates other than the two largest, Dubai and Abu Dhabi, such as the National Bank of Ras Al Khaimah (RAKBANK) and the National Bank of Fujairah. While these banks typically offer services across the whole of the country, they tend to be closely associated with government customers and the economic narratives in their home emirates. The largest lender without a government stake is Mashreq Bank, which has been majority owned by the Al Ghurair family since its founding.

Market Structure

Overall, there are 23 national banks operating 964 branches and 28 foreign banks with 169 branches in the country, according to the Central Bank of the UAE (CBU), the sector regulator. In addition to these 51 full-service lenders, the roster of specialists includes two investment banks, four wholesale banks, 25 finance companies, 120 representative offices, 23 investment companies, one investment-finance company, 12 monetary and financial brokers, and 128 currency-exchange companies. There were 366 licensees operating 1882 locations as of 2013, according to the CBU.

As the UAE does not issue separate licences for Islamic banking or distinguish between conventional and Islamic finance for the purposes of regulation, the regulator’s list of sector actors includes financial firms from both segments.

Competitive Environment

For universal banks the market is considered crowded and in need of consolidation – in order to both reduce the number of competitors and give the remaining players more room to grow and achieve better economies of scale. Indeed, Shayne Nelson, the CEO of Emirates NBD, told local media in August 2014 that mergers would help banks in the country to diversify their income streams, reduce costs and focus on improving their services.

In the meantime, growth is taking place via overseas acquisitions or expansions, typically in countries with less mature banking sectors. For example, in 2013 Emirates NBD completed a $500m acquisition of a majority stake in the Egyptian arm of BNP Paribas. For its part, Dubai Islamic Bank owns stakes in lenders in Pakistan, Sudan, Jordan and Bosnia-Herzegovina. In May 2014 the bank also reported that it was planning to open branches in Nairobi, Kenya and Indonesia. The CEO of Mashreq Bank, Abdul Aziz Abdulla Al Ghurair, said at a conference in September 2014 that the bank was looking to expand in Egypt and Turkey, but quashed market rumours by saying it was not considering purchasing the UAE operations of Standard Chartered Bank.

In addition to the domestic banking system, there is a regionally focused sector located in the Dubai International Financial Centre (DIFC) – a financial services free zone in the heart of the city that also houses insurers, investment houses, law firms, ratings agencies and other financial services providers. While banks that are located in the DIFC can service the region, they are not permitted to operate in the domestic market. They are not regulated by the CBU, but instead overseen by the Dubai Financial Services Authority (DFSA) – a regulator created specifically for the free zone.

The DIFC operates under laws separate from those of the rest of the country. Its legal and regulatory framework was designed specifically for companies operating in the centre, but with the assurance that in case of any doubts, English common law will be followed in the process of dispute resolution. The DIFC also maintains its own court system. However, DIFC firms are subject to federal anti-money laundering laws and regulations.

Crisis Recovery

The impacts of the global financial crisis were indirect and therefore delayed in Dubai. The emirate avoided defaults early in the process because banks were not buyers of the complex securities created in the US that triggered the crisis; however, as contagion spread, Dubai’s banks and borrowers were eventually affected in 2009-10.

GREs have since worked to sell off non-core assets to service debts, as well as restructure loans to delay “bullet payments” – lump-sum amounts due at the end of a loan, as an alternative to making regular payments over the life of the arrangement. The idea is that extending maturities will allow existing assets to appreciate and new revenue streams to emerge, making repayment easier.

Several such restructurings have been agreed upon and others are ongoing. In the meantime, default has been avoided, and for the banks in particular the outlook seems to be improving. The nonperforming loan ratio, which peaked at 8.4% in 2012, had fallen to 7.3% by the end of 2013 and to 7.1% as of the end of the first quarter of 2014, according to data compiled by the IMF.

For the banks, some of which qualify as GREs themselves, the process is slow but showing signs of progress. Emirates NBD, the largest single creditor to the largest single debtor, Dubai World, changed the conglomerate’s loan status from non-performing to performing in the fourth quarter of 2014, which was followed by a $14.6bn debt restructuring agreement in early 2015. As of June 2014, Emirates NBD’s total sovereign debt exposure was Dh98.6bn ($26.8bn), or about 40% of its total loans.

For state-owned property developer Nakheel, the effects of the crisis are also starting to dissipate. In August the company announced it had repaid all its debts in advance – a total of Dh5.54bn ($1.5bn) owed to 31 banks, for which final instalments were not due until March 2018. Of that total, Dh3.45bn ($939m) was owed to UAE banks, with Emirates NBD and Dubai Islamic Bank the two largest recipients.

Improvements on this front have been noted by the major global credit ratings agencies – for example, Moody’s raised its outlook on several major lenders from “negative” to “stable” in November 2013, and in May 2014 bumped Emirates NBD up to the same rating. According to Moody’s, the overall improvement in the UAE’s operating conditions as well as the recovery in real estate prices in Dubai were behind the change in status.

Improving Operations

In addition to diversifying their customer base and reducing exposure to GREs, banks have been looking to cut costs. Banks in the UAE have historically been more cautious than banking industries elsewhere with respect to advanced products and proprietary trading, seeking instead to achieve the highest possible net-interest margins and build their fee-based income, which is spared from the inherent risks of lending.

Income from fees has been increasing at a double-digit rate in recent years, according to sector research from Dubai-based SHUAA Capital. The contribution of fees to the total rose from 17% in the third quarter of 2011 to 20% in the fourth quarter of 2013. Fees have come from servicing trade, brokerage income and capital markets commissions, among other sources, according to SHUAA.

With this type of business model, a focus on gaining scale and shrinking costs is advisable. Emirates NBD’s Nelson said in an interview in September 2014 that the bank was focused on reaping large aggregate benefits from many small-scale savings opportunities, such as reviewing procurement procedures or negotiating its rental costs.

For 2013, banking sector assets climbed 13.1% on the year from Dh1.79trn ($487bn) to Dh2.03trn ($552.5bn), according to the IMF. Deposits rose from Dh1.17trn ($318bn) to Dh1.28trn ($348bn), a 9.5% advance, and capital adequacy ratios remain strong, at 18.3% overall, as of the end of the first quarter of 2014. This was an improvement from the 13% ratio seen in 2008, just before problems started. The figure has bounced between 18% and 21% since 2009, the IMF numbers show.

Conditions improved in 2014, with second-quarter results coming in ahead of projections, according to SHUAA. Net income was 9% above consensus expectations, thanks to a smaller-than-expected contraction in the net interest margin (the difference in interest rates between what banks pay for deposits on average and what they charge for loans). The increase in net income was also boosted by the targeted pursuit of operational efficiencies and raising fee-based income. Revenue in this category rose 18% in the second quarter of the year, compared to the same period in 2013. The average non-performing loan ratio was down to 5.5%, an improvement over the 6.2% seen in the first quarter of 2014.

“Our banking industry is strong – well capitalised, liquid and adopting global best practices. The governments and regulators are very supportive of the industry’s orderly growth,” Mark T Robinson, CEO of Commercial Bank International, told OBG.

Strong Deposits

A constant in the past several years has been growth in deposits, already an area of strength for UAE banks. The banking system enjoys a strong local deposit base thanks to ample domestic liquidity, which in turn lessens banks’ reliance on international wholesale lending markets – typically associated with a higher cost of funds.

Deposits grew by 13% in 2013, compared to 10% for loans, according to SHUAA. Private customers have driven deposit growth, as government deposits have been falling. “We are expecting noticeably weaker deposit growth in 2015 and 2016 due to a drop in government and public sector deposits,” Standard & Poor’s credit analyst, Timucin Engin, told local media in early 2015. media in early 2015.

By late 2014, concerns were growing that banks’ profits would be muted because the degree of competition for customers was leading to lower net interest margins. Both Emirates NBD and First Gulf Bank lowered full-year lending targets in early 2014 as a result. SHUAA’s sector research noted that net interest margins are a theme that bears watching in the short term, in addition to the overall pace of credit growth. Other main focus points for banks were lowering the cost of funding from current and savings accounts and ensuring that their existing loans do not deteriorate into default.

Real Estate Connection

The improved outlook has, in part, come thanks to a rebound in real estate prices, with the fortunes of banks set to remain intertwined with real estate performance for the foreseeable future. This is a positive for now, albeit with the caveat that another real estate bubble, such as the one that burst in 2009, is a real concern.

Prices in the sector surged during the first quarter of 2014 – house prices increased by 27.7%, according to the global real estate consultancy Knight-Frank, while Jones Lang LaSalle measured the increase at 22.1%, which it said was among the fastest rates worldwide. “The rapid pace of price increases, if continued, could trigger an intensification of destabilising speculative demand, and thus warrants close monitoring,” an IMF country assessment published in July 2014 said.

Cooling off the market is an important objective for the authorities, and the changes that have been implemented underscore that aim. In October 2013, for example, the government of Dubai raised the real estate registration fee from 2% to 4%, in an effort to reduce incentives for speculative buying. At the federal level, CBU regulations introduced in 2013 limit the extent to which real estate can be financed. First-time foreign buyers cannot finance more than 75% of a property worth up to Dh5m ($1.4m), or 80% for Emiratis. The threshold is lowered to 65% and 70%, respectively, if the sale price exceeds Dh5m ($1.4m). For secondary properties, the cap is set at 60% and 65%. For off-plan properties, which are those bought in advance of construction, all mortgages are capped at 50% of the sale value. In addition, monthly repayments cannot exceed 50% of a borrower’s monthly income, and the size of the total loan cannot exceed seven years of annual income at the foreign buyer’s current salary rate, or eight years in the case of an Emirati.

While these measures are expected to help protect consumers and the banking system from taking on too much exposure to real estate, they may have a more limited impact on the real estate market, as most purchases – at least 75% – are paid for in cash. That leaves Dubai’s banks with some degree of indirect exposure to the real estate market, as loans to property developers are a core part of their business and the sector remains a major contributor to the overall economic outlook.

According to the IMF, there is scope to increase the transaction fee beyond 4%, citing similar instances in markets where this tool was effective, such as Hong Kong and Singapore. Some of Dubai’s key government-owned property developers have supported this goal by introducing their own rules to curb the flipping of assets. For instance, Emaar Properties has independently banned the resale of incomplete properties unless 40% of their value has been paid (see Real Estate chapter).

Regulatory Changes

There are several other recent legal and regulatory developments that are relevant for the banking sector, starting with a change in the leadership of the central bank. In late September 2014 Mubarak Rashid Al Mansouri, the CEO of the federal Emirates Investment Authority, and a previous member of the CBU’s board, was appointed to a four-year term as governor of the CBU, succeeding Sultan Nasser Al Suweidi, who had held the post since 1991. Suweidi will be remembered as an advocate for developing a local bond market, for helping the country weather the financial crisis and for his role in tightening regulations, including the mortgage caps that are now considered important stability mechanisms for the banking system.

Monetary policy is not a focus of the governor’s role at the CBU, as the dirham is pegged to the dollar and interest rates therefore track the American currency. Rather, the position is most important in terms of regulatory policy and economic leadership. The CBU features a dual-leadership structure, in which the governor oversees day-to-day operations and represents the central bank at international events, while the chairman heads board meetings and has ultimate authority over policy. Khalifa Mohammed Al Kindi has been serving a four-year tenure as the chairman since November 2012.

Follow The Money

Recent regulatory developments include a stronger anti-money laundering law at the federal level, featuring longer prison terms and fines for people and companies that break the law. According to the regional law firm Al Tamimi & Company, this update to the anti-money laundering regime also expands the scope of the law – while the crime of money laundering previously covered the proceeds of drugs, bribery or fraud, it now extends to any felony or misdemeanour crime.

“Local financial institutions are working in close collaboration with the UAE central bank to pave the way for a better understanding of the stringent international regulations being imposed upon Western banks,” said Sultan bin Kharsham, the managing director of Wall Street Exchange Centre.

The launch of operations by the Al Etihad Credit Bureau in 2014 is expected to provide lenders with additional information to evaluate credit risks of customers effectively. This is the first attempt to provide such a service with the full backing of the federal government, which passed a law in 2009 mandating the establishment of a federal-level credit bureau, though previous attempts had taken place at the emirate level. The Ministry of Finance established Al Etihad in 2012, with information gathering beginning in earnest in 2014. The expectation is that by early 2015 its database will have enough information to be a useful tool for banks.

Direct Debit

In October 2013 the CBU introduced a direct debit system, which is expected to boost consumption levels, according to a study by the global ratings agency Moody’s that was published in February 2013. The ability to move money in real time through such a system may be relevant for what has become an ongoing debate over the appropriate penalties for bounced cheques in the emirate. Bouncing a cheque is a criminal offence in the UAE, and this is an important part of the banking market, as cheques are a common method for renters to pay landlords and for car payments.

With greater transparency in the UAE’s credit markets, thanks in part to the credit bureau and the rise of electronic transfer methods worldwide, it may be sensible to downgrade cheque bouncing from a criminal to a civil offence, according to the CEO of the Dubai Chamber of Commerce, Hamad Buamim. However, that process may take some time, as banks and customers adopt and adapt to new alternatives. Mashreq Bank’s Al Ghurair, who is also the chairman of the UAE Banks Federation, said in September 2014 that at this point cheques remain the primary tool for the country’s trade system.

The transition to e-payments has been slow and has had a negative effect on online commerce, though this is beginning to change. “The cashless payments sector in the MENA region continues to grow, which means that there are many opportunities to grow our business in both the consumer and corporate payment space,” Usman Arif, vice-president and country manager of the UAE for American Express Middle East, told OBG. “Dubai’s electronic payments market is growing; however, its continued growth is dependent not only on consumer appetite for electronic payments and online sales, but also on the evolution of online payment infrastructure in the region. The more sophisticated this infrastructure becomes, the easier it will be for consumers to make purchases as diverse as travel tickets and household white goods online. This infrastructure will take time to evolve, and this will help fuel the further growth in cashless payments,” he added.

Outlook

Real estate and large-scale public sector developers were at the core of Dubai’s growth story in the 2000s and central to its crash. As the emirate looks ahead, these factors are once again at the heart of the narrative. Hosting Expo 2020 means more large real estate projects and has the potential for a repeat of Dubai’s recent boom-bust experience. “The strengthening real estate cycle, particularly in the Dubai residential market, could attract increased and potentially destabilising speculative demand, creating the risk of unsustainable price dynamics and an eventual, potentially disruptive correction,” the IMF’s July assessment said. “An acceleration of the Dubai megaprojects, currently planned to be flexible and in line with projected demand, could exacerbate this risk.”

However, the new regulations in place offer a remedy that could signal sustainable growth to come, despite the possibility of some price adjustments in the short term. “New legislation introduced, including the credit bureau, mortgage regulations and loan concentration for GREs, will all obviously be beneficial for the growth of Dubai in the long term, despite the short-term pressures that this may exert on new business,” Nathani told OBG. Furthermore, the option of tightening these rules and regulations at a later date provides governments and regulators with the tools to respond to market conditions as needed.