Steady hand: Banks have faced nearly five years of economic and political challenges with aplomb

The political transformation of Egypt that began in early 2011 has presented the banking sector with fresh challenges at a time when it was gaining ground on those already pushed forth by the global economic crisis. Nevertheless, financial results for 2011 reveal that the nation’s lenders put in a robust performance that year, and entered 2012 well positioned to take advantage of new opportunities.

The reform of the sector, meanwhile, continues apace. Led by the Central Bank of Egypt (CBE), the process of regulatory restructuring has been credited for playing a large part in safeguarding both the sector and the wider economy during an historic and challenging period. In 2012 political uncertainty remains and difficult economic conditions prevail, yet the sector is largely optimistic that a successful political transition will allow it to return to the levels of growth it enjoyed before the crisis.

EARLY DAYS: Egypt’s modern banking sector has undergone a series of transitions since the 1950s that largely mirror the seismic shifts that have taken place in the nation’s political arena. The era of Nasserite socialism that followed the Egyptian Revolution of 1952 saw the sector reduced to four state-owned commercial banks and a few other specialised financial institutions. During the 1970s state-orchestrated centralism gave way to a revived private sector under President Gamal Abdel Nasser’s successor, Anwar Sadat, and the government-owned monoliths were joined in the market by a large number of joint-venture banks and branches of foreign banks. The 1990s saw this private sector renaissance grow even deeper, largely as a result of a series of decisions done by the central bank to ease restrictions on loan growth, loan-to-deposit ratios, public sector transactions with private banks and foreign ownership of local banks.

However, while deregulation and liberalisation brought a welcome degree of competition, it also brought instability and – by the turn of the century – an unsustainable number of non-performing loans (NPLs). Concerns regarding the sector’s stability compelled the CBE to embark on a process of reform; the changes mark a “deep cleaning” of the sector that has continued to the present day.

REFORM: The CBE’s efforts to overhaul the system, led by its Banking Reform Unit, began in 2004 with a raft of structural changes that married tighter regulation with enhanced governance. Increased minimum capital requirements, higher capital adequacy ratios, and measures focused on improving asset quality and creating a more conservative provisioning regime were at the centre of the process.

The CBE also turned its attention to the inefficient state banks, recruiting local and foreign consultants to oversee the introduction of new systems and even additional whole departments in key areas such as risk management. Moreover, some 90% of NPLs, a particular problem within the state-owned institutions, had been settled by 2010. Since 2009 the CBE has been overseeing a second phase of reform, intended to further increase the competitiveness and risk management ability of the sector.

SECOND PHASE: The country’s specialised state-owned institutions, such as the Egypt Arab Land Bank and the Industrial Development and Workers Bank of Egypt, are a particular focus of this phase, which includes a drive to improve risk management, financial intermediation, human resources and IT infrastructure across all state-owned lenders.

The implementation of Basel II standards across the sector also forms part of this phase of reform. From July 2009 until June 2010 the CBE published a number of discussion papers regarding the introduction of the Basel accords, as well as carrying out a series of quantitative impact assessments regarding their potential consequences. From July 2011 the CBE moved on to the fine-tuning of proposed supervisory regulations related to Basel II, and announced that upon their issuance there would be a short “parallel run” with existing regulations. As of mid-2012, the CBE was preparing for the application of this trial phase, as well as completing a new data warehousing framework, which will be implemented to support the supervisory regime. While full implementation of the Basel II standards is scheduled for the close of 2012, the CBE has begun to approach local banks regarding issues arising from Basel III – particularly in relation to the liquidity standards that this version of the accords will usher in. As yet, however, no guidelines have been issued on the subject.

MARKET STRUCTURE: The most visible result of the CBE’s reform efforts is a reduction in the number of banks from the 61 of 2004 to the 39 of 2012, according to the CBE’s most recent data. Between them, they operate 3502 branches distributed across the country, with the greater part of infrastructure concentrated within the urban areas of Cairo and Alexandria. Those banks that continue to expand their branch networks, however, are attempting to access new geographical areas. “Geographically-speaking, the majority of banking is done in Cairo, with branch expansion focused on the new satellite cities such as Sixth of October,” Mohamed Naguib, the president of Société Arab International Bank, told OBG.

Despite a process of consolidation, recent years have seen a slight increase in the availability of branches and ATMs, as branch networks have expanded. In 2004, there was one branch per 24,900 people, but by March 2012 there was one per 22,400 people.

The private segment is composed of 26 private sector banks and a further seven joint venture operators (created by the state banks in partnership with private lenders). The largest of these by assets is the Commercial International Bank, with total assets of LE85.5bn ($14.3bn) as of December 2011 and a loans market share of 8.83%. Its industry peers include National Société Générale (with 7.37% of loans market share at the close of 2011), HSBC Egypt (4.02%) and Crédit Agricole Egypt (2.43%).

Despite the government’s long-term policy of divesting itself of some of its largest assets, a large public sector banking segment remains in place. Of the five public sector banks, three of them (National Bank of Egypt, Banque Misr and Banque du Caire) control an estimated 40% of the sector’s total assets. A privatisation programme of government-owned banks came to an end in 2009 when an attempt to sell off Banque du Caire was called off, with the government announcing that it could not obtain a fair value for the institution. Unfavourable economic conditions as a result of the global economic crisis resulted in the postponement of a second attempt to sell the bank, originally scheduled for 2011, and therefore the Ministry of Finance has decided to create what it describes as “national champions” of the remaining government-owned lenders. This it intends to accomplish through the application of the reform programme that is currently being overseen by the CBE.

REGULATION: As well as its reform activities, the CBE is charged with supervising one of the most vibrant banking sectors in the MENA region. It also regulates the monetary system (see Economy chapter) and deals with the daily settlements and clearings of its licensed banks. It does so according to the Central Bank, the Banking Sector and Money Law No. 88 of 2003 and its numerous amendments.

Recent years have compelled it to act swiftly to safeguard the sector against external and internal challenges. In the wake of the global economic crisis it moved quickly to reassure investors by announcing the creation of a guarantee on all bank deposits and dropping interest rates six times in 2009 as part of an expansionary monetary policy.

PROTECTING THE LOCAL MARKET: In 2011 it acted decisively in the face of domestic unrest, closing the banks for more than a week as a security measure. Mindful of a possible run on the banks, it moved LE5bn ($836.85m) into the financial system before depositors were given access to their savings again, as well as imposing daily withdrawal limits of LE50,000 ($8370) and $10,000. As a further precaution, it imposed a five-day execution period for outbound transfers and closely monitored the frequency and volume of foreign exchange transactions.

As a result of these measures, the interruption to business within the banking sector was not as great as many had feared. “During the revolution everyone suspected there would be chaos involved in the reopening of the banks but everything went surprisingly smoothly due to the careful handling of the situation by the central bank, and the well capitalised position of the banks,” Bruno Gamba, the chairman and managing director of AlexBank, told OBG.

Perhaps the most significant regulatory change the CBE has made since its initial response to the political uprising of 2011 was the reduction in March 2012 of the local currency reserve from 14% to 12%, and then in May 2012 to 10%. Lowering the amount of funds which banks must hold in reserve was an attempt to “provide permanent liquidity into the banking system and help to ease credit conditions in the market”, according to the CBE’s press release at the time. Credit conditions had deteriorated over the second half of 2011 and early 2012 as a result of Egypt’s inability to raise funds on the bond markets, which compelled the Ministry of Finance to turn to the domestic sector to meet its increasingly onerous fiscal obligations. Rising yields on government paper caused concern, as did fears that the private sector was being starved of liquidity as a result of the banks’ widespread take-up of it. These were both motivating factors for the ratio change (see analysis).

In the fourth quarter of 2011 the CBE’s Monetary Policy Committee (MPC) raised the interbank and discount rates after two years of maintaining them at a constant level. The overnight deposit rate was raised by a percentage point to 9.25%, while the overnight lending rate and the seven-day repo rate rose by half a percentage point to 10.25% and 9.75%, respectively. Explaining its decision, the MPC cited inflation risk – the result of local supply bottlenecks and distortions in the country’s distribution channels – as well as other "fiscal and banking sector challenges facing the Euro Area and possible spillovers to other regions along with weaker than anticipated growth rates in a number of advanced economies”.

SOLID PERFORMANCE: Egyptian banks have displayed a high level of robustness over the past year, despite the challenging political and economic environment that prevailed during this period. They have been aided in this by an aggregate loan-to-deposit ratio of around 49.4% and the fact that most of them do not rely on external funding or interbank lending from international banks. The moves by the CBE to safeguard against transfers of capital out of the country have also played a part in maintaining the stability of Egypt’s banking sector.

The anticipated decline of deposits and rise in NPLs that industry observers feared in the wake of the political unrest did not materialise. According to the CBE, the aggregate capital adequacy ratio, which stood at 16.3% in December 2010, remained strong at 15.6% at the close of 2011. Indeed, non-government deposits rose from LE836.6bn ($140bn) to LE868.9bn ($145.2bn), while the ratio of NPLs to total loans declined over the same period, from 13.6% to 10.9%, and provisioning for impaired assets rose only marginally, from LE92.5bn ($15.48bn) to LE94.6bn ($15.8bn). Although the number of depositors trading in their Egyptian pounds for US dollars increased, the mass dollarisation that was expected as a consequence of the instability did not come about.

CHALLENGING TIMES: Though these anticipated crises did not materialise, Egyptian banks faced major challenges during 2011. Their take-up of government debt through the local treasury market helped the government tackle a growing budget deficit in the absence of foreign investors, but left the banks overly exposed to the sovereign in the eyes of credit ratings agencies. Therefore, after downgrading the sovereign credit rating to B1 in 2011 over concern regarding Egypt’s ability to meet its funding obligations, similar downgrades for five Egyptian banks with considerable exposure to government debt followed (see analysis).

Moreover, profitability has been negatively affected by the increased cost of provisioning. Crédit Agricole Egypt saw net profit fall 26% over the first nine months of 2011 to LE239m ($40m). Egypt’s largest private lender, Commercial International Bank, showed a decrease in net profit from LE2.02bn ($338m) in 2010 to LE1.61bn ($269m) for the financial year 2011, a decline of around 20%. Net interest income, however, held firm, rising from LE2.26bn ($378m) in 2010 to LE2.69bn ($450m) in 2011 – a trend which extended across the sector.

Egyptian banks also show a high degree of liquidity compared to global standards: lending expanded by 2% year-on-year to September 2011 while deposits grew by 6% according to CBE data, bringing the loan-to-deposit ratio down to 54%.

According to Aftab Ahmed, the CitiBank country officer and managing director for Egypt, “The banking sector is highly liquid and capitalised. One has to understand that 70% of the economy is fuelled by domestic consumption.

The resilience of the sector over the past year underpins the air of optimism which surrounds it in 2012. “At a macro-economic level the country is in shambles, however, at the micro level many Egyptian companies are doing OK. The nation’s potential remains thanks to its demographics – the large population who will all need to eat, grow crops, buy medicine and work,” Jean-Philippe Coulier, the managing director of National Société Générale Bank, told OBG.

LENDING: A slowdown in lending in 2011 was a widely anticipated result of political uncertainty. A lack of demand from the corporate sector and banks’ reliance on treasury bills issued by the CBE on behalf of the Ministry of Finance are frequently adduced as the primary reasons for the anaemic growth of credit.

However, the question of lending practices was a salient one within the industry before the recent period of political instability. A conservative regulatory environment, in which banks were required to hold 20% of their funds in liquid assets and 14% with the CBE, has traditionally been regarded as a hindrance to loan growth, although by 2012 the 14% reserve requirement had been reduced to 10%. Another possible inhibitor is the institutional memory of the mass NPLs of the 1980s and 1990s that left lenders with a bias for blue-chip firms and government debt.

However, banks have taken a greater interest in new areas of the economy as they seek lending opportunities, such as those with small businesses, which have shown strength despite the difficult environment. “Since 2010, and even earlier in some cases, banks have been focusing on small and medium-sized enterprises (SMEs). Many have dedicated departments to re-gear their efforts into this sector, believing in its potential profitability,” Sameh Badry, the deputy-chief financial officer of the financial division at National Société Générale Bank, told OBG.

SME LOANS: The CBE has played its part in this drive to engage with Egypt’s SMEs, which it defines as businesses with a turnover of less than LE10m ($1.7m) per year. In 2010 it introduced regulations that allowed for an exemption to the local currency reserve requirement (which then stood at 14%) equal to the amount that a bank was exposed to SMEs.

A shortage of credit information pertaining to the SME market, once a barrier to credit growth in this area, has been greatly alleviated with the establishment of I-Score – Egypt’s first credit bureau. The bureau first came to the market with a soft launch in 2007. I-Score’s shareholder base is made up of 25 locally licensed banks, and as of December 2011 it holds over 95% of the credit data of individuals and SMEs from the nation’s commercial lenders. With its first phase of development over, I-Score is looking to reach beyond banks in terms of credit information.

“We want to create more awareness for credit in Egypt outside of the financial sector. With the help of the state, we are intending to encourage legislation that allows telecom companies to work with us without breaching their privacy laws of revealing customer information, but crafting that legislation and garnering support from telecom companies has been challenging,” Mohamed Ahmed Kafafi, the chairman of I-Score, told OBG.

Despite the development of credit information coverage, however, some in the industry feel that many Egyptian SMEs are beyond the risk envelopes of major institutions. “The SME segment doesn’t meet many financing requirements for lending, which often pushes it to the underground economy for additional funds,” Mohamed Abbas Fayed, the vice-chairman of Banque Misr, told OBG.

MORTGAGES: Another potential area for credit expansion that remains problematic is mortgage financing. Not a traditional concept within the financial system, the framework for mortgages was established as recently as 2001 with the promulgation of the Real Estate Finance Law No. 148. The government took a proactive role in the promotion of the concept by creating a mortgage refinancing company and implementing foreclosure rules, and the first mortgage finance company (MFC) opened its doors in 2004. By 2011, licences to over 10 MFCs had been granted, and nearly 20 banks had developed mortgage instruments based on the new regulation.

However, estimates of the ratio of mortgages to GDP in Egypt range from 0.5% to 1%, an insignificant figure in comparison to an average of 12% that is observed in developing countries. A low average income and the lack of affordable housing are the main inhibitors in this segment, in addition to problems arising from an overly complicated and sometimes opaque system of ownership. “One of the biggest bottlenecks to growth in mortgages has been the lack of proper documentation in the real estate business. There are no property titles in Egypt, they do not exist. Government authorities need to quickly introduce property titles to the market,” Francois Edouard Drion, the managing director and senior country officer of Crédit Agricole Egypt, told OBG.

The formalisation of the housing market is seen as essential to the long-term prospects of the mortgage lending sector. A step in this direction was taken in 2010, when the government attempted to introduce a new real estate tax law intended to replace a system which had stood since 1954. The new tax law simplified assessments and established a flat tax rate, although under its provisions close to 90% of the nation’s housing stock would face no tax liability.

Political opposition to the law delayed its implementation until January 2012. It has since been delayed again until January 2013 to “accommodate social and economic needs of the Egyptian people”, according to a government source quoted in the local press. Moreover, although the foreclosure law has been successfully tested in the court system, doubt remains as to whether mortgages can be realised efficiently. A new bankruptcy law and a collateral registry of moveable assets are both seen as desirable additions.

A NEW DIRECTION: Finally, Egypt’s present process of political transformation has raised questions about another area of potential expansion for Egypt’s banking sector. The Muslim Brotherhood’s Freedom and Justice Party, which won the single biggest bloc of seats in the parliamentary elections held at the close of 2011, revealed its intention in 2012 to overhaul the banking law with a goal of boosting the market share of Islamic banks to 35% from the current 5%. Draft amendments had been presented to the parliament before its dissolution in June 2012, and the Muslim Brotherhood’s calls for reform had been joined by the Salafist Al Nour party and the Ministry of Finance.

Egypt’s early adoption of Islamic finance during the 1980s ended in a scandal over insolvent sharia-compliant money management firms, but by 2012 some 14 banks in the country held Islamic licences. Operators include wholly Islamic lenders such as Faisal Islamic Bank Egypt and several lenders which operate Islamic windows, such as National Bank of Egypt and Ahli United Bank. In 2012, AlexBank, one of the nation’s largest commercial lenders, announced its intention to launch an Islamic financial services unit within a year. With roughly 200 branches between them, Egypt’s Islamic banks represent a small but growing component of the banking industry, claiming about LE120bn ($20bn) of the wider sector’s total assets of LE1.3trn ($217.6bn).

The government publicly announced its consideration to raise about $2bn in a sukuk (Islamic bond) issuance. Proponents of Islamic finance believe that a sovereign issue, and the pricing benchmarks it would establish, would encourage sukuk sales by private firms. The momentum generated by the Islamic banking segment is likely to lead to advances in the short to medium term. “Islamic products should be embraced and not feared. They have been highly successful in other banks portfolios,” Edward Marks, the managing director at Barclays Bank Egypt, told OBG.

OUTLOOK: Uncertainties regarding the political transition remain, but the conservative regulatory culture of recent years has ensured that the banking sector is in good shape to deal with internal and external shocks. In the longer term, the macroeconomic fundamentals which underpinned the prospects of the industry remain in place: a large, young population which grew at 3.1% over 2010; a compound annual growth rate for GDP of 5.31% between 2005 and 2011, according to estimates from the IMF; an under-leveraged market, with a loans-to-deposit ratio of some 54%, total bank debt around 36.2% of GDP and corporate loans at 24.2% of GDP as of June 2011, according to CBE data; a diverse economy; manageable external debt; and a programme of robust sector reforms that began in 2004 and continue today. Banks have cleaned up their balance sheets and begun to thrive in a liberalised yet scrutinised market, which enabled double-digit annual profit growth in the years prior to the global financial crisis, as well as granting them the means to survive it. Most in the industry expect it to successfully weather this storm as well.