Cautious optimism is the word of the day in the Saudi banking sector as the gains of mid-decade failed to recur in the wake of a bearish first quarter 2006 at the Riyadh-based Tadawul (stock exchange). The remarkable fall in brokerage and asset management fees, which had seen record profitability over the previous three years, proved a serious concern for the industry. A Fitch Ratings report based on an analysis of ten major commercial banks in Saudi Arabia suggests that on average the banks recorded a year on year decline in profit, the first in recent years. New regulatory curbs on lending, and the global credit crunch resulting from the US subprime crisis fallout, also had negative impacts on the sector.

Competition from new entrants to the industry proved another challenge for Saudi banks. According to Zawya Dow Jones, there are now six foreign banking institutions in the kingdom and this number is expected to rise. Saudi banks have duly raised capital to help fend off the burgeoning threat as the region prepares for a wave of mergers and acquisitions. Global Investment House has suggested that the “banking sector in the country is on the threshold of a new era, where foreign banks are likely to give a tough time to local banks.” Capital has been raised by a handful of banks to date, including Samba Financial Group, which has upped its capital 50% from $1.6 billion to $2.4 billion. Al Rajhi Bank will increase its capital from $3.6 billion to $4 billion, Arab National bank has gone up 43% to $1.7 billion, and Saudi Investment Bank has added $200 million to its $1 billion cash base. Riyadh Bank and others are expected to follow suit as well.

The capital boosts also help facilitate Basel II, which was implemented in January. The new rules should help stakeholders better understand risks taken by banks, said one expert. Basel II compliance is expected to have a moderately negative affect on year-end capital ratios for Saudi banks.

Effects of oil and inflation

Despite the poor performance in asset management fees and the challenges of raising capital, banks in Saudi Arabia did show consistent improvement in their core revenues. Loan volumes grew quickly due to record high oil prices and effervescent economic conditions. Bank assets grew by 25% in 2007, however, inflationary pressures on wages and rising loan provisions cut operating profitability.

Slow growth in consumer lending, due to new regulatory constraints, was also an issue. It is suggested that the new constraints were aimed at slowing the practice of borrowing money to invest in the overheated Saudi stock market. The slowdown was, however, offset by accelerated growth in private sector corporate credit. High regional liquidity pushed up consumer deposits and funding asset growth. In a further boon to the industry, 43% of these deposits are non-interest bearing, which has proven to be an excellent source of low cost funding for Saudi banks. Fitch Ratings believes that “the asset quality is sound.” But write-offs and retail loan provisions are climbing in an early indication of segment deterioration.

On the upside, US subprime woes and structured credit risk pose little risk to the industry. Saudi banks have modest exposure to CDOs and SIVs, according to regional bankers. Write-downs from the incident are mostly taken care off and have had little impact on profitability. However, residual fall-out has prompted some delay in new debt issues as spreads widen due the global credit crunch. Furthermore, large maturity gaps and concentrations in funding remain.

Net profit of top 10 Saudi banks ($ million)

Top ten banks by total assets

The Saudi banking sector had total assets estimated at $290 billion in 2007 after a 16% year-on-year drop in total net income. The majority of this vast sum is shared between the top ten local, commercial banks by total assets. Largest among them is the National Commercial Bank (Al-Ahli) with $55.6 billion in total assets. The bank saw its profits drop from $1.67 billion in 2006 to $1.60 billion in 2007, although this was still stronger than its 2005 profits recorded at $1.32 billion. Established in 1953, National Commercial Bank is the oldest bank in Saudi Arabia.

Second on the list of total asset value is Samba Financial Group with $41 billion. The group saw its 2007 profits down to $1.28 billion after earning $1.38 billion in 2006. Samba, formerly known as Saudi American Bank, has a strong presence in Pakistan as well. It was established in 1980 when Citibank’s branches in Riyadh and Jeddah were taken over by Saudi investors in a partial nationalization scheme that required banks in the country to be 60% owned by Saudi nationals.

Al Rajhi Bank, despite its third place rank with $33 billion in assets, was the most profitable bank in the line-up for 2007. Although it lost ground from 2006, the bank was still able to turn a whopping $1.72 billion in profit for the year. This is ostensibly due to its prominent position in Islamic banking, which has recently experienced massive growth.

The only bank on our list of top ten to actually record a year-on-year rise in profit is Riyad Bank, which saw profits climb from $776 million in 2006 to $803 million in 2007. The bank sports total assets of $32 billion and is entirely Islamic, another nod to the success of the sharia-compliant finance industry in an otherwise sluggish year. The non-interest bearing nature of Islamic finance provides an excellent source of cheap funding for banks.

Middle of the list at number five is Banque Saudi Fransi with total assets of $22 billion. Net profits fell from $802 million in 2006 to $723 million in 2007. The bank was established in 1977 and is affiliated with Calyon of France. Next up is SABB (formerly known as the Saudi British Bank), which counts $26 billion among its total assets. This affiliate of HSBC was established in 1978 and saw profits drop from $811 million in 2006 to $695 million in 2007.

Number seven on the list with $25 billion in assets is the Arab National Bank, founded in 1979, with profits declining from $668 million in 2006 to $656 million in 2007. It should be noted, however, that both of these figures are significantly better than the bank’s 2005 net profit of $487 million.

Next is Saudi Hollandi Bank with $13 billion in total assets. This bank came in last on our list in terms of profits with its 2007 earnings of $117 million, well behind its 2006 take of $254 million. According to Fitch Ratings, the drop in profits was “due to higher impairment charges taken on its corporate book.”

Saudi Investment Bank has $12 billion in assets. The bank’s net profits fell by more than half, from $535 million in 2006 to $219 million in 2007. The first quarter of 2008 has shown no respite from this trend with a further 16% year-on-year drop in profits.

The final bank on our top ten is Bank Al-Jazira, holding some $5.7 billion in assets. This bank had a poor showing this year as well with profits falling from $526 million in 2006 to $215 million in 2007. Apparently, it was highly dependent on brokerage during the recent boom and this factor lead to the bank’s large drop in profit for 2007.

Total assets held by top 10 Saudi banks ($ billion)

Country Forecast

Forecast According to Zawya Dow Jones, “growth opportunities abound in the region for players who are willing and ready to meet the challenges.” This comes as no surprise considering Saudi Arabia’s real GDP growth is expected to climb from 4% in 2007 to 5% in 2008. Record high global oil prices and private sector investment should encourage private sector corporate lending. This will likely make up for slow consumer lending growth. Furthermore, strong asset growth should drive-up profitability, despite the continuing global credit crunch. Looming risks include growth in credit card holders, real estate lending and consumer NPLs. Increased competition from foreign banks in Saudi is also on the horizon. High liquidity will continue to fuel large customer deposit bases, which means there will be no shortage of funding for the banking industry. In conclusion, the Saudi banking sector suffered a bullish year in 2007 as a result of the 2006 stock market tumble. And although the sector faces noteworthy issues in 2008, high liquidity and the

E What are the top three most challenging issues the banking sector faces today? And what is your bank doing to address them?

Human capital. That’s the most important challenge in banking today. Not only on the management side of the activities, but at all levels below that. You just cannot find enough qualified people to hire. This is going to have an impact in the future on the newly formed giant bank. For example, there is a new, very large bank coming to Saudi Arabia, and the challenge for them is not to collect money and capital to run the bank, it’s finding the right people to run the bank. To hire people with a long history of banking experience is very expensive, and with a specialized bank there is an even greater need for the right people; it’s a major challenge, especially within Islamic banking, to find somebody who is “well-trained”, highly qualified, someone with the knowledge to handle Islamic banking — both simple transactions and more sophisticated transactions. It’s very difficult to find people of the right caliber. Islamic banking requires a lot of sophisticated people in all departments — legal, sharia, management… all of that needs qualified people.

We have confronted the problem on two fronts: training and retaining. To train, we have established a management associate model where we go to top-notch schools all over the world, and recruit only A students. When I talk about A students I mean 3.6-4.0 GPAs, nothing lower. We put them on an intensive program for 2 years until they’re trained, and then we polish and further educate them according to whatever market we feel they best fit into.

The second front is retaining. We have been watching the market very carefully, and we’ve even engaged an international company to study the market for us so that we can see where we stand compared to the rest of the market. Basically, we want to always be in the 50th-to-75th percentile of the market, and we try to maintain and move within that. We do this with action, every Khaliji knows that. For example, if I feel that there is a 20% push upward in the housing element, I will act on that. I will act on that because we have to remain flexible and be prepared to make moves; in the UAE market there is a lot of competition taking place so retaining is a very important issue. Because we are in 102 countries we tend to tap from different markets in the region. We are approaching a fantastic period all over the world. If you look around the bank we have at least 20 to 25 different nationalities, not necessarily just Arabs from the UAE, but Latin Americans, Indians, Pakistanis, Malaysians, and others. Even within the Gulf we have Bahrainis, Kuwaitis, Saudis… We have managed to achieve quite a good mix. That’s one way that we’ve been able to overcome this challenge.

E In your opinion, especially with Emiratization, is the development of human resources the responsibility of the private sector, of banks like you, or of the public sector?

Actually, both. What you see today is a private sector that does the hiring and training, and a public sector that re-hires. That’s always the case, except for a few, very rare cases where people start in the public sector and then move to the private sector. The majority, though, start in the private sector and move to the public especially with the Emiratization trend. There is an issue with Emiratization for each institution. I think we are meeting the issue. We have very strong human resources programs in the UAE. We train Emirati candidates for four months academically and on the job, and then there’s a series of tests that they have to pass. On successful completion of the program, they land full-time positions at the bank. This has been a very successful program here, evident in the hundreds of full-time hires we’ve achieved through the program.

E When Emirates Bank and NBD merged everyone said that this is a new era in banking. Do you think that the synergies are there in the market to say that “yes, there will me more Mergers and Acquisitions (M&A)”?

I think there definitely will be. The Basel II capital adequacy stipulations will really force people into mergers, but what I would like to see here is a more active role for central banks to orient and educate banks about the merits of merging and creating larger entities, versus forcing them to merge because that’s not their job. It should become clearer for local banks that joining hands makes sense in order to survive in the future and to be able to create the activity and growth that they truly aspire to achieve. Having said that, we’ve found that when there is a huge project, the majority of local participants are able to participate thanks to strong capital adequacy monitoring by the UAE central bank and other central banks in the region. In some markets we are even competing head-to-head with larger, stronger banks that have more capital.

Competition is good for our bank; it brings better quality, better customer services, and better customer satisfaction. We welcome competition. We are unique in the sense that we consistently bring value-added products into the region and more often that not we do complement local banks activities rather than compete with them. If we cannot continue to add significant value as a global bank, then we should not really be here. We have to bring expertise, new and innovative products that benefit institutional clients as well as individual customers. That’s what differentiates us from other banks.

E What are the pros and cons of financial sector liberalization? How will banks be affected by liberalization? How do you plan to utilize this liberalization?

We are entering into a new era of economic liberalization at all levels including in the financial sector, and I think the biggest challenge that would persist is the lack of transparency. Today you don’t have immediate access to figures that come directly from the banks. A lot of activities take place and these activities cannot necessarily be translated into a number or disclosed properly. On a macro level, you have chronic issues with accounting for inflation levels and fairly assessing the currency system… these all cause problems in terms of putting raw numbers into strategy models, hence creating an information gap and major distortions. We work very hard and pay a lot of money to find estimations of these numbers. It’s very difficult to find information that can actually help you.

On the other hand, the opening up of the financial sector and other sectors will create huge financing opportunities especially in infrastructure and real estate projects. There is a phenomenal need for financing, and banks have to really work together to handle significant transactions.

For us, there is much opportunity for M&A services and advisory activities here in Dubai and out of Dubai. On the consumer side, liberalization means that we will be able to compete on equal footage with any local bank, so we expect more products and services to be rolled out through an expanded footage.

E What role does corporate governance play in this environment?

Again, this needs an education process. The regulators have to find a way to educate financial institutions on the crucial role of corporate governance and its ensuing benefit. For example the UAE Central Bank and the DIFC are putting a lot of emphasis on corporate governance and they are finding ways through meetings and round tables and discussions to enrich this subject. More of that, I think, will have banks buy into the need to put in place strong corporate governance mechanisms while they go about making money.

Issues such as corporate governance and capital adequacy should not be addressed at the senior executive level only, but should go to the board of directors of the institution who should fully understand the grave implications of a lax attitude. This can be done informally through roundtable discussions or even over casual meetings, not to say more formal gatherings. Bottom line, the subject should be brought to the table as a top priority and a matter of survival. Every bank should start thinking: “I cannot survive in this funny sea, unless I join efforts with another or more banks, or unless I cease my operations. Unless I am very big like a crude carrier, I will certainly sink.” Preparing for the next stage has to be mapped, really mapped, and I think this is exactly what the UAE Central Bank is doing.

E Do you have plans to expand in the region? If so, to which countries, and why?

The Middle East market as a whole is among our top five globally significant markets when it comes to growth potential. We certainly see opportunities across all banking sectors, especially in investment banking and consumer markets.

We now have presence across 10 Arab countries including all of North Africa, Egypt, Jordan and Lebanon. In the Gulf region, we’ve had a presence for the past five decades. In the last two years, we established full-fledged branches in Kuwait and Qatar, while the DIFC is now housing our regional businesses, including Investment Banking, Equities Distribution, and Equity Research covering the MENA region. In fact, we have recently shifted our global Co-Head of Investment Banking, Alberto Verme, to the DIFC, in recognition of this fact. Saudi Arabia is on our expansion list; meanwhile we continue to provide our full suite of global services to top institutional clients in the region include Saudi clients.

E Do you feel that banking regulations in the UAE are growing as fast as the banking industry?

Regulators here tend to be selective and prudent when it comes to issuing new licenses. We certainly do not see a wave of, say, 20 or 30 banks coming to the market every year. Rather, in the past two years we’ve seen only two or three banks joining the banking community and they are mainly Islamic banks. Another new bank is now operating out of the DIFC and regulated by the DIFC’s regulatory body.

E What is your perspective on GCC countries de-pegging their currencies from the US dollar? What is your take on inflation in the region, especially in the UAE, and what are the best policy measures to deal with inflation whether on a macro level or on a micro level, because at the end of the day it will be affecting your customers. What are the policy measures at hand to deal with the inflation problem?

I think they have tried one, and I don’t think it fully worked. They went for a salary increase of 70% to every single government employee. It helped but not enough to match inflation. To the contrary, such an action would eventually contribute to even higher levels of inflation by itself. The only solution is to do something about the currency. That’s a costly solution for the UAE and for other Gulf countries, nevertheless a solution. De-peg and revalue. This could cost money, most likely in the GCC countries whose currencies and a big chunk of their imports and major export, oil, are denominated in dollars. With a sliding dollar and an ever increasing oil price, this is going to be very, very costly.

Another complicating factor is that the ultimate buyer of dollars in this region are central banks who have seen a huge demand for local currencies in anticipation of revaluation. If they contribute indirectly to a weak dollar, they would reduce the value of their own holdings. It’s definitely a dilemma, so central banks, at least here in the UAE, are staying on the message that they will not revalue, full stop.

Meanwhile, an active subsidy system has to be put in place to combat inflationary pressures and to see this phase away. This is of course a sub-optimal solution, but can be part of the ongoing social welfare system, especially with ever increasing oil revenues. If we take the position that the dollar is at bottom levels, then revaluing at this time may not be in the best of the UAE’s interests.

E Let’s talk corporate social responsibility. In what way is Citi Bank giving back to the community? What is the CSR role that is played?

I think this is a good question. We are extremely committed to the community and we do give back in different forms. Ours is a universal CSR model, which aims at empowering all the communities which host us across the world, including those in the region. The best way to do that is to engage in activities where we can contribute more than just checks, but rather expertise and volunteer time.

Financial Education is an extension of what we do every day in more than 100 countries. We provide scholarship funds to deserving university students whose only barrier to achieving good education is financial. This we do across top universities in the region, including AUB and LAU, whereby we take it upon ourselves to provide full or partial scholarships to business and finance students. Meanwhile, a strong system of transparency is put in place to ensure that there is no conflict of interest or any touch of favoritism — as a bank, we do not recommend that so and so student receives one of our scholarships… this violates our compliance rules which are very, very stringent. However, Citi scholars are welcome to train with us in summer time, and once they graduate, we seriously consider them for full time positions with us.

Another CSR avenue is micro-finance. Here, again, we not only provide grants to micro-finance institutions — which in turn disperse them to deserving micro-entrepreneurs — but we do provide banking expertise to help orient micro-finance clients in rural and urban areas in the region about the best ways to access banking resources for improving their businesses. An excellent program that we execute here in Dubai is a women entrepreneurship workshop with the University of Dubai, which educates young women entrepreneurs about building robust feasibility studies for their upcoming businesses. We take an active role in evaluating and improving these studies to stand out when evaluated by banks’ credit officers.

The UAE’s banking sector has recently been crowned the largest market in the GCC by total assets, valued at $336 billion. The IMF believes the “financial system remains sound,” even though external borrowing by financial institutions and big corporations has tripled from 2004 through the end of 2006, reaching $80 billion. The IMF holds back from sounding any alarms, as the UAE’s large net creditor position suggests  there is no reason to worry.

The bursting economy of the UAE is mainly due to population influx, considerable infrastructure projects, and increased oil prices. Mihir Marfatia, author of a Global Investment House (GIH) report published in March 2008 believes, “High oil price revenues are a major benefactor to [the banking sector which is] benefiting from a booming economy.” The increased demand for sharia-compliant banking services is also positively influencing the banking sector.

The US subprime mortgage calamity is a hot topic throughout the global financial sector — yet the majority of banks in the UAE have been unaffected, as according to Fitch Ratings, the “UAE banking system seems to be less exposed to the turmoil than the Bahraini sector, where a number of banks have reported significant losses.” Fortunately, the UAE economy has vanquished most external negativity, allowing its economy to rocket further. Marfatia added that: “These boom times are creating strong investment-led growth, a rapidly expanding population and a recovery in fee income.”

In May 2008 Fitch Ratings released a report United Arab Emirates Banks: Annual Review and Outlook, analyzing the overall performance of the UAE banking sector. Fitch Ratings states that as the banking sector is “benefiting from a benign operating environment and a strong demand for credit, operating profits for most banks grew in double digits.”

Further, GIH brings to light the factors aiding efflorescence of the banking sector: “The considerable project pipeline in the UAE is also providing ample finance opportunities for the Emirates’ leading institutions. In addition, a favorable demographic profile is accelerating urbanization and infrastructure investment, providing impetus for corporate and consumer lending portfolio growth.”

While the banking sector flourishes, there are some factors to be wary of. Fitch Ratings rightfully highlighted that UAE macro-economic indicators suggest “the banking system is highly exposed to risks associated with rapid credit growth, excessive property price increases (and to a lesser extent stock market exposure), and high inflation.” Overall the banking sector is exceptionally robust, but the IMF notes that it faces challenges ahead.

Total UAE bank assets ($ billions)

Key performance measures

Bank performance

At present, Fitch Ratings states that the UAE banking sector “continues to benefit from the buoyant economic environment it mainly operates within.” The banking sector’s net income greatly increased by a healthy 26% year-on-year growth, reaching record highs of $6.53 billion in 2007. Overall, the performance of banks in the UAE “have been very encouraging, with all banks (with the exception of ADCB) experiencing double-digit annual growth in operating income during the year.” The Index of Economic Freedom 2008 reckons that six major banks in UAE account for 70% of total assets. According to Fitch, the net interest of banks operating in the UAE swelled by an average of 26%, and “[for] almost all banks, it remained the main source of income.”

The UAE tops its fellow GCC members, possessing the highest penetration level in the banking sector in terms of assets, loans, and deposits. Abu Dhabi-based investment bank The National Investor (TNI) trusts that such soaring levels of banking penetration “is reflective of the relatively developed nature of banking infrastructure in the UAE.” Between 2003 and 2007, assets to GDP of banks witnessed a sturdy increase from 118% to 180.2% respectively. Banks’ deposits to GDP also saw a substantial increase, from 76.4% in 2004 to a whopping 105.6% in 2007, “and credit penetration, i.e. loans to GDP ratio increased from 75.2% in 2004 to 105.3% in 2007,” reports TNI. Currently, UAE deposit penetration ranks highest among all other GCC nations.

Fitch firmly believes that “banks with domestic retail franchises continue to benefit from increasing demand for consumer credit, where wider margins can be charged.” For example, the National Bank of Ras Al-Khaimah (RAK) bears considerably higher net interest margins than other banks in the UAE.

The banking sector is dominated by the recent birth of Emirates NBD (ENBD), a merged entity of the UAE’s two leading banks — Emirates Bank International (EBI) and the National Bank of Dubai (NBD) — in 2007. In terms of asset size, the merger recently surpassed Saudi-based National Commercial Bank, becoming the largest banking entity in MENA region. (It is imperative to note that the merger is still in its final phases, as EBI is still independently operating in some aspects. Regarding total assets, with $39.5 billion EBI ranks second in the UAE. The last phase of the merger includes de-listing EBI and NBD from the Dubai Financial Market.)

As a necessary trend to follow, bank mergers assist the government’s diversification plan involving colossal infrastructure projects. TNI firmly states that, “size is the key with respect to project execution and scalability.” TNI views the merger as highly beneficial “by way of cost and revenue synergies as well as help the merged entity to fund such large ticket projects at competitive pricing.” Due to an increase in demand growth and corporate and retail loans, Q1 profits in 2008 weighed in at $324.5 million, up 37% from the same period last year. ENBD rules in the UAE with total assets measured at $69.2 billion, and according to TNI are “expected to grow at a CAGR of 21.8% during [2007-2011].” The enormous ENBD amalgam makes competition slightly difficult for other UAE banks.

Coming in third place, the National Bank of Abu Dhabi (NBAD)’s total assets for 2007 rang in at $37.9 billion. Better known as the ‘bank of the Abu Dhabi Government’, TNI notes that NBAD capitalizes from both government and public sector companies. First quarter profits for 2008 rose 45% from the Q1 of 2007, reaching $238.3 million. TNI reports that NBAD should expect a CAGR growth of 20.5% in fee income for 2007-2011. “The thrust towards consumer lending has benefited the bank during the last three years… the consumer loan has increased by 19% to AED14.3 billion [$3.9 billion] in 2007” asserts TNI. At present, NBAD is making efforts to diversify its non-interest income by increasing fee related business. TNI ensures that the bank “is well positioned to benefit from the current economic boom in Abu Dhabi.”

National vs. foreign banks (asset size)

National domination

With a population of 4.5 million and 49 banks, the UAE is rather ‘overbanked’. Currently, of these banks, 22 alone are national banks while the remaining 27 are foreign banks. And let’s not forget the 65 representative offices of other foreign banks throughout the UAE, as well as two specialized banks. Emirates Bank Group highlights that the UAE has “one of the highest ratios of bank branches / presence population.” Although there are more foreign banks than local ones, the latter largely surpasses the former in overall performance. The market share of domestic banks increased from 78.7% in 2003, and by September 2007 had reached 82%.

While national banks are outperforming foreign banks, especially in terms of credit growth, “one might feel that the [domestic banks] must be having a tough time in sustaining the current position in the UAE market,” according to the March 2008 Global Investment House report. More bad news for foreign banks is they are restricted from operating more than eight branches, whilst national banks are not subject to any such regulations.

Though outnumbered, domestic banks have an unbeatable edge over foreign banks. Seeing as there is no homogeneous taxation policy for banks throughout the UAE, national banks are exempt from any tax operations within the UAE. Foreign banks are not as lucky and are subject to a 20% tax on all profits.  The IMF suggests extending liberalization policies to non-GCC foreign banks, thus permitting them to benefit from the thriving economy, as currently GCC banks have the advantage, especially regarding credit growth.

An April 2008 report Exciting Times Ahead by TNI states that internal banks are able to dominate the sector “as they have access to the UAE government surplus funds”.

Although the UAE has been under pressure from the WTO to liberate the banking sector to allow foreign competition, TNI doubts any such action will occur in the near future. But, TNI observes, “local banks are scaling up their operations and are expanding their footprint locally and regionally to combat the increased competition.”

Even more good news for national banks: TNI identified that UAE national banks account for approximately 75% of the banking sector’s total assets. With the perks of government on their side, domestic banks will continue to reign over the banking kingdom.

United Arab Emirates bank ratings at May 2008

Current United Arab Emirates bank government ownership

Inflation on the rise

The banking sector’s most noted challenge to growth is undoubtedly the continuous rise of inflation. The UAE economy was smacked with a 19-year peak of 9.3% inflation rate in 2006, and soared further in 2007 to 10.9%. According to Zawya Dow Jones, inflation velocity is expected to surge to possibly reach a dangerous height of 12% in 2008. Investment bank Merrill Lynch cautioned that such a staggering increase is unavoidable “unless the dirham is re-valued or de-pegged from the US dollar.” The UAE government is bravely attempting a target of 5% inflation for 2008, but in reality this goal is acutely unattainable.

The UAE’s endeavors to fight inflation involve tightening monetary policies and cutting interest rates. Given that all GCC currencies have been pegged to the US dollar since 2003, shielding options are rather restricted as central banks of the region are required to emulate the US Federal Reserve’s policy.

In line with Federal Reserve reductions, Central Bank of the UAE (CBUAE) cut its discount rate in 2007 and “is expected to continue to move in step with US dollar rates, given that the UAE dirham/dollar currency peg still holds,” according to Fitch Ratings. What’s worse is that “high inflation has put the peg under pressure, and Fitch expects that any potential revaluation of the currency would be coordinated with other GCC states, as preparation for a GCC currency is still ongoing,” albeit, Fitch subtly notes, “the official target date of 2010 looks unlikely.”

At a time when, according to OBG, the “US economy’s fundamentals are precisely the opposite of the Gulf’s,” the dwindling muscle of the dollar has jeopardized the ambition of a GCC monetary union by 2010. OBG notes that “the varying effects of the weak dollar and the high price of oil have strained solidarity among the [GCC] members.”

Mohsen Khan, IMF Director of the Middle East and Central Asia believes, “At the moment, since inflation is not driven by dollar depreciation, focusing on de-pegging or revaluation is not the solution.” Contrarily, other financial experts consider that by making imports more expensive, the dollar peg plays a key role in driving inflation rates in the UAE as well as throughout the GCC as a whole. The paramount downside to revaluation, explained Khan, is that Gulf states risk suffering approximately a $400 billion loss in their holdings value, “if they were to revalue by [only] 20%.” Without a doubt, CBUAE needs to create an anti-inflation strategy in order to tackle the banking sector’s primary dilemma. 

Transparency concerning the veridical level of inflation in the Emirates is rather limited. In February of this year, the government of the UAE revealed it intended to kneel to long-term pressure imposed by the IMF and agreeing hereafter to publish a monthly consumer price index (CPI) rating. “However,” the Oxford Business Group (OBG) notes, “there is some debate as to whether the CPI basket currently used will give an accurate reflection of the true picture for UAE residents. Economists say up to 50% of local inflation is directly attributable to increases in rents, whereas the basket allocates only 36%.”

Country forecast

Basel II

As of January 2008, banks operating throughout the UAE were required to implement Basel II, a standardized regulatory accord to credit risk. The CBUAE has worked alongside UAE and other GCC banks in order to efficiently utilize the principles “giving due consideration to points of national discretion under Basel II.”  Fitch Ratings believes that the 2008 implementation of Basel II “has had a moderately negative impact on most banks’ capital ratios given the charge for operational and market risk.” Under the auspices of Basel II, the large UAE banks “are aiming to maintain capital ratios… at 12%-15%,” considered sufficient by Fitch. In the big picture, Basel II should aid transparency regulations as well as management of credit risk.

Forecast

Mainly thanks to mammoth infrastructure projects, real estate investments, expanded bank investments, high oil prices, monetary liquidity, and consumer spending, the UAE banking sector has seen vigorous growth. TNI trusts that the “contribution of UAE’s banking assets to the aggregate GCC banking assets as at end 2007 stood at 40.5%.” Fitch reports that UAE banks will continue to enlarge their branch networks in order to “remain competitive and attract retail customers.” With Emiratization efforts being made, talented UAE nationals are being urged to join the banking sector. Many banks are providing programs aimed at informing new graduates of the new developments, issues, and services of the banking sector. With such opportunities, the banking sector is only sure to flourish from here on out.

TNI expects collective assets of UAE banks (specifically ENBD, NBAD, Abu Dhabi Commercial Bank, Mashreq Bank, RAK, First Gulf Bank, and Union National Bank) to increase at a compound annual growth rate of 20.1% in the coming four years. Profitability is predicted to persist “in 2008 at broadly the same levels as in 2007,” given the UAE’s propitious operating environment.

Although tackling inflation is a challenge for UAE banks, their performance is rather stellar. Sallie Krawcheck, CEO and Chairman for Citi Global Wealth Management believes that the “best is yet to come in the Middle East… and the UAE is making quite a significant impact on the global economy.” The future of the UAE banking sector looks exceptionally positive, and trends of profitability are expected to remain sound.

E What are the top three most challenging issues CBD faces today? How can they be solved?

Without hesitation, I think that the number one issue is hiring and retaining quality employees. The business has been growing at such a fast pace; CBD as an example has been doubling its business in the last 18 months. New banks have been established, and UAE nationals in particular are in high demand. There is a responsibility for all banks to recruit, train and retain them, but it’s not easy as there are so many good opportunities for young people entering the field.

Another important challenge is inflation. I believe that inflation, more and more is becoming a critical issue, and it’s become more difficult to control imported inflation. The UAE does not have an independent monetary policy as it is following the US in relation to the dollar-peg. Fighting the double-digit inflation in the UAE with a 2% interest rate is very difficult. Inflation affects peoples’ daily budgets and it means that debt-service ratios are no longer representing the appropriate level at which people can actually bear debt and repayment of debt.

When people came here a few years ago, there were good opportunities to save, in particular for foreigners; today it’s getting more and more difficult for people to actually make ends meet. For companies, the cost of doing business has increased significantly, and imported inflation is partly responsible.

E Human Resources are a continuing issue for regional banks. How does CBD ensure to acquire and retain highly qualified staff and management? What internal training programs does CBD have? Do you have programs supporting Emiratization?

Let’s start on the level of management and leadership. About 18 months ago we deliberately started a very innovative leadership development program where we complete 360-degree reviews of our managers. We supply direct reports to give input to the managers — how they felt about the climate, how they felt they were supported in their career development, in their jobs, in their personal growth. Based on this, we’ve organized workshops where the top 75 managers of the bank are trained in applying different styles of leadership depending on the environments and the situations they are faced with. We emphasize that there are different leadership styles which can be applied in different situations and, as a good leader you need to be able to use those styles when they are required. The changing leadership culture has a major impact on the people working in the different departments.

Second, training and development of people is a very important element of our Emiratization drive. We have extensive training programs set out for both internal training as well as external training. We have an entire floor of our building completely dedicated to training, not only training of our own people, but also external young Emiratis. We train them just to make sure that they are prepared for professional life in society. It is partly a social responsibility, and partly our own teams that are being trained.

Emiratization is an important issue for us. We have one of the highest Emiratization rates of all banks. We gave special attention to ensure that when young UAE nationals come to our bank we prepare them though induction programs for each level, ranging from those with a high school diploma to university graduates.

Another element is the right incentives. We are one of the few banks that have introduced long-term incentive plans for the top layer of our bank. We have KPIs — Key Performance Indicators — objectives that actually cascade down to the lowest level in the organization. It’s relatively easy to do that at the top level, but at the lower levels it’s complex to measure; it’s complex for people to understand what the KPIs are and how they are measured objectively. We went through the process and I think it made people feel more engaged with what the organization is all about. This serves to provide very clear alignment and much more transparency in terms of why some people receive a higher bonus, or a higher salary increase than others.

When Emirates Bank & National Bank of Dubai merged everybody said it was the start of the mergers and acquisitions (M&A) phase in UAE, and that it was in preparation for the liberalization of the market and the penetration of the big banks like HSBC or City Bank, which were expected to become much more aggressive once the market liberalized, but then nothing happened…

I tend to disagree with what everybody said. Typically, in the West, mergers are driven by a desire for higher returns or more efficiency.  Here, if you look at the efficiency ratio or cost to income ratio of banks, we’re talking typically between 30-35%. If you look at Europe, banks are typically between 60-65%, so banks here are already quite efficient.  Then, if you look at the returns, a return equity of 20-25%, which is higher than the returns in the West, is not unusual here. So, it’s not yet the time for shareholders to look at mergers from that perspective.

However, I do believe that Emirates and NBD have set a very important example in the region, as we now need larger banks. One of the reasons is that our projects are becoming larger and larger, and the region should be able to depend on its own banks to a large extent.

If I look at the years to come, I do believe that in the next two to three years we will see a fair amount of consolidation. The Basel II requirements, the corporate government requirements, will require higher degrees of professionalism and for smaller banks it’s difficult and costly to achieve that on their own.

E Lebanon is a small country where banks have much smaller assets, and obviously less profitability. They are able to expand and to penetrate new markets whether it’s in North Africa, or Sudan, or other parts of the region. But we haven’t seen this yet with huge banks in Emirates for example. How can one explain this?

We must look at this from both sides. Let’s start with the GCC side: the returns here are still so high, and the market is growing at such a rapid speed, there is a lot of business for everybody. So the incentives to look outward are not as strong as they are in Lebanon. The Lebanese market is a very peculiar market. It’s a relatively small market and you have a lot of very good banks with well-trained people. Realizing that their market is relatively restricted, Lebanese banks have been innovative in going out into markets that show higher-risk profiles, but because of the depth of the management that many Lebanese banks have, they are able to mitigate those and do profitable business.

Eventually, I believe we will see cross-border mergers and acquisitions in the region, but typically the case is that first we’ll see consolidation within the country, and after a strong entity is established we’ll see cross-border mergers.

E In an increasingly competitive environment, M&A strategically benefit most banks. Is CBD planning to merge with any banks in the UAE?

I think every CEO of a relatively large bank, as part of his agenda, must look at inorganic growth, in other words, acquiring. CBD, because of its shareholder structure, is very keen about keeping destiny in its own hands. We would like to be on the acquiring side.

For us, it’s important to see that what we acquire will fit our strategy. If we execute an M&A transaction, we should then be able to export the specific knowledge and the specific strength that we have into any entity that we acquire. It’s not about just expanding, we have a very distinct strategy that is about family-owned business — both middle-sized and large-sized — it’s about wealth management. We service, through wealth management, the owners of these family businesses and the management of these family businesses.

E What are the pros and cons of financial sector liberalization? How will CBD be affected by liberalization? How does CBD plan to utilize this liberalization?

Liberalization is a good thing. It will bring all of us to a higher level, and it forces us to provide better quality service to our clients. When we have international banks coming in it just means we have to work a little bit harder to ensure that we provide service that is comparable or better in terms of quality. I think liberalization will bring better personnel, more professionalism, better client service, and more competition. I do believe, however, that there are distinct client sectors that national banks will focus on, and distinct client sectors that local banks will focus on.

E What does CBD believe are the best policy options to fight the increasing inflation rates at present?

Apart from the monetary policy mentioned before, I would say that the short supply, high demand, and liquidity have increased inflation. Now, what do we do as a bank? In terms of judging credit risk and looking at the capabilities of people to repay, we are very clear about not wanting to bring people into financial difficulties. Our consumer lending is relatively conservative and that’s not only to protect the bank, but also to protect our clientele.

Regarding our corporate clients, it’s about making them aware of what’s happening around them; making them aware of what’s happening to their suppliers, their buyers, and the market as a whole. It’s really about understanding the business, being a good business partner, and advising the business owner. We feel that this is an added value to the relationship, which is why we often become the main bank for many of our clients.

E How is CBD giving back to the community? What are the CSR initiatives you are supporting & why?

We are a bank that has been here for nearly four decades. We are really an integral part of society. We have a strong desire to achieve and maintain a high Emiratization ratio, not just to meet the numbers, but to make sure that we prepare UAE nationals for careers within our bank as well as outside. Even if people leave us, hopefully they will have had a good experience and they will come back to us as clients at the end of the day.

It’s about making sure that we give back to society through that. We don’t advertise this, but we have been a very significant contributor to the Dubai Cares Program; we’ve contributed 20 million dirham [$5.45 million]. Moreover, we have for many, many years contributed to a large number of organizations which help disabled, orphans and underprivileged. It’s not just about giving money, it’s about really participating. I am very proud to say that our staff actively participates in blood donation programs in a stand against poverty. It creates engagement — it makes people feel more connected to their bank. 

E What are the keys to strengthening the institutional framework of the banking sector in the UAE? To what extent are Basel II and WTO implemented throughout the regulatory framework of CBD?

More than ever, the need for a fast implementation of Basel II has been proven by what has happened in the US subprime crisis. Basel II is not only about compliance with the rules, it’s about improving risk-management capabilities, improving risk-management awareness within the banking sector, which is very important. Many of the central banks in the region are quite proactive and I think that banks have been given the proper timeline to adjust to it.

E What role does corporate governance play in CBD?

We are very keen to follow corporate governance guidelines. We have very clear internal controls in place, which ultimately ensure that the financials that we publish as a company are indeed transparent and are projecting reality. I think the transparency aspect is particularly important in the corporate governance guidelines because we have many shareholders and we don’t want to privilege the larger shareholders over the smaller shareholders. CBD has always been one of the first to come out with the quota results; we’ve actually won awards for that. We have a committee within the bank that has been implementing corporate governance according to the standards and regulations that have been issued.

E Does CBD have plans to expand regionally and/or internationally? If so, to which countries, and why?

Every CEO, particularly of the most significant banks, has been looking at expansion inorganically as well as organically. I think the priority for us would lay first within UAE because a lot of opportunity remains in UAE, and the returns are still significantly higher here than other parts of the region. We also scan the market internationally, but at this moment there is nothing specific that we are looking at. Whenever you have an expansion strategy you must be ready in terms of depth of management, and if you buy a stake in a bank you must make sure that it fits into your strategic framework.

E What is CBD’s perspective on GCC countries de-pegging their currencies from the US dollar? How will valuation against a basket of currencies affect CBD?

In all fairness, de-pegging is not really the discussion, the way I see it. The discussion is much more about monetary policy. I can understand that if you have a lot of your assets invested in dollars you don’t want them to devalue from one day to another, so I appreciate why certain governments have expressed their reluctance. However, to have an independent monetary policy in a country that’s going through a strong growth phase is important. You cannot follow the same monetary policy of a country that is sliding into recession or already is in recession, that being the US. For me, de-pegging is a little less important on the agenda than monetary policy.

The GCC has enjoyed vigorous growth in the banking sector, with the exception of Saudi Arabia that suffered the aftershocks of the 2006 downturn in its stock market. These profits have been driven by record high oil prices across the region, better regulation practices (e.g. Basel II), financial diversification, and nationalization.

Basel II acts as an internationally standardized regulatory accord to manage credit risk, improve transparency, and strengthen the overall stability of financial systems. The GCC’s recent implementation of Basel II will alter how banks lend money, and to which countries they lend it to. With this standard on their backs, banks will have to invest abundantly to upgrade their IT systems and consultancy fees in order to comply with the new regiments. Basel II compliance will also encourage banks to liberalize their policies, be more transparent with their balance sheets and to manage their risks more effectively.

Floating on crude

With crude oil pushing $130 per barrel, the Gulf is awash with liquidity. Such an overflow of liquidity means customers have more money to place in banks, thus driving their desire for better services. The soaring liquidity has bred inflation. Inflation rates across the GCC are high, with Qatar hitting a record of 14.81% in March of 2007. Finishing in second place is the UAE, with inflation rates expected to reach up to 12% in 2008. Oman ranked third with inflation rocketing to 11.5% in 2007, but it is expected to come down this year. Inflation in Kuwait also soared from 4.4% in 2007 and is anticipated to climb to 6.6% in 2008. Saudi Arabia falls right behind Kuwait, with probable inflation of 6% this year, up from 4% last year. With the lowest rate across the GCC, Bahrain’s inflation is expected to rise to a mere 4.5% this year, up from 3% in 2007.

The high liquidity and resulting inflation plaguing the GCC has lead to renewed talk about severing ties with the ailing American greenback. While Kuwait removed its dollar peg in May 2007, it remains the only Gulf country to have done so. The move came as a surprise as most analysts had expected a more unified approach to the issue, especially with the idea of a joint GCC currency still being floated. It appears that the de-pegging has had two effects on the Kuwaiti economy. First, it has helped to curb inflation somewhat, although rising real estate prices have done much to cancel the effect. Second, the move has cut into Kuwait’s oil profits by $2.9 billion in 2007, according to a study by Aljoman Centre for Economic Consultancy. Apparently, the loss resulted from reduced oil income calculated in dollars. This development may make it even more difficult for the rest of the GCC countries to de-peg their currencies before the anticipated joint currency in 2010.

GCC top 10 banks in assets

Index of economic freedom 2008

Banking penetration GCC

Diversification necessary

Other issues in the GCC banking sector include the need for diversification. Most of the Gulf countries practice heavy-handed protectionism. For example, the UAE levies 20% tax on profits for foreign owned banks, but local banks pay nothing. This has understandably limited foreign direct investment and limited the market. Other countries, like Oman, have opened their doors to foreign financial institutions, driving up standards and pushing the economy forward. Furthermore, nationalization has been and will continue to be an issue. Countries like Saudi Arabia are working hard to qualify and employ their indigenous human resources in the banking sector. Perhaps moves like this will not only benefit the sector, but ultimately help to solve social woes as well.

Having avoided the rest of the world’s economic downturn and the resulting credit crunch, and by slowing tackling their own homegrown challenges, the GCC’s banking industry is poised to continue make strong profits on the back of record high oil prices. The region’s financiers are certainly smiling… all the way to the bank.