The UAE banking industry has come a long way since the country’s foundation in 1971. Banks operated in the states that became the United Arab Emirates even earlier. The British Bank of the Middle East (which later became part of HSBC Group), the Eastern Bank (which later merged with Standard Chartered) and the Ottoman Bank (which joined Grindlays Bank) were among the lenders that operated in the emirates prior to unification.

The National Bank of Dubai was the first local lender to be set up in 1963, followed by the National Bank of Abu Dhabi in 1968. The banking sector expanded rapidly in the 70s as oil prices soared. The lending troubles of UAE banks also started in the 70s and extended into the 80s and 90s. In 1977, Ajman Arab Bank fell into trouble and was rescued and renamed First Gulf Bank, now a leading Abu Dhabi-based lender. In the 80s, the slide in oil prices drove a number of banks to near bankruptcy, which prompted the Central Bank of the United Arab Emirates to intervene and rescue the lenders, leading to increased government ownership in the sector. In the 90s, the scandal of the Bank of Credit and Commerce International and its affiliate, the Bank of Credit and Commerce Emirates tainted the UAE.

BCCI, which was set up with capital from the UAE, was closed down in 1991 at the behest of the Bank of England and others amid accusation of money laundering, bribery, and fraud among others. Set up in 1972 in Pakistan, the bank grew to become one of the largest international private banks. By 1991, the Abu Dhabi government owned 77% of BCCI, although most of its operations were outside the United Arab Emirates. Besides the BCCI fiasco, in the 90s the UAE government had to intervene to rescue a number of banks that merged to improve their financial standings. They include Abu Dhabi Commercial Bank, the outcome of a merger of Khalij Commercial Bank, Emirates Commercial Bank and Federal Commercial Bank. The Central Bank of the UAE also came to the rescue of Mashreqbank and Dubai Islamic Bank, which faced financial difficulties in the 90s.

“In the UAE, the regulatory environment is not as strong as in Saudi Arabia or Bahrain,” Robert Thursfield, a Dubai-based analyst at Fitch Ratings told Executive. “Management teams are not as strong as in Saudi Arabia.”

In this decade, however, the UAE banking industry is making headlines for news other than scandals and bankruptcies. The Emirati banking sector is now only second to Saudi Arabia in size of assets. In a non-rescue-related move, the Dubai government this year decided to merge the two largest lenders in the emirate, forming the biggest bank by assets among the six GCC states and the Middle East as a whole. Dubai-based Emirates Bank International and the National Bank of Dubai became Emirates Bank NBD, with assets exceeding $45 billion at the end of 2006. Previously, the National Bank of Abu Dhabi, with assets of $27.5 billion at the end of 2006, was the largest lender among the seven emirates. The new bank officially listed its shares on the Dubai Financial Market in October.

“UAE banks have been some of the more competitive ones because of their high number, including many foreign banks, and the ensuing competitive pressures,” according to Alexander Von Pock, a Dubai-based manager at US consultancy firm A. T. Kearney.

This merger announcement has fuelled speculation of further consolidation within the UAE banking industry, as all eyes are now set to watch the Abu Dhabi government make a similar move when it merges its two largest lenders, the National Bank of Abu Dhabi and Abu Dhabi Commercial Bank. However, the two banks have said that  this event may take years to occur. Currently there are 26 foreign banks operating in the UAE, 22 local ones, and two investment banks.

Industry analysts have argued that the Dubai bank merger was facilitated by the government’s controlling stakes. Otherwise, mergers in the United Arab Emirates may prove difficult. Each of the seven emirates has its own national bank and its own rules for the banking industry. Besides, private banks are usually largely owned by big families, such as Mashreqbank, which is majority held by the al-Ghurair family. Abd al-Aziz al-Ghurair and his family rank No. 86 on Forbes’ list of billionaires, with a net wealth of about $8 billion.

“The trend is for further mergers as nearly 50 banks service 4.5 million people, which makes it an overbanked market,’’ Dubai-based Raj Madha, senior financial research analyst at Egyptian investment bank EFG-Hermes, told Executive. “The problem is that most banks have significant controlling shareholders, and this makes it problematic for mergers to occur.”

Analysts say the Emirates Bank NBD merger also could lead to consolidation among banks in the Gulf Cooperation Council. Already lenders in the GCC are beginning to acquire stakes in other Gulf banks. Commercial Bank of Qatar has received the initial approval to buy a 40% stake in the UAE’s United Arab Bank, a move seen as a further sign of consolidation in the GCC banking industry. But not all analysts agree that mergers will begin to roll out in the near future. Continued profitability, regulatory hurdles and high liquidity in the Gulf continue to act as disincentives to mergers and acquisitions, according to A. T. Kearney’s Von Pock.

“Some players are trying to get acquisitions to become regional players, but there are still obstacles and regulatory hurdles to mergers and acquisition activities in many countries in the region.”

Record profits

Profits at UAE banks have been rising steadily over the past three years, having climbed from $1.8 billion in 2003 to $5.4 billion in 2006.

“In line with the other GCC countries, the UAE banking sector continues to benefit from a buoyant operating environment, principally driven by high oil prices resulting in increased government infrastructure spending and general growth in both retail and corporate lending,” Ken Matheson, Dubai-based CEO of HSBC Bank Middle East Ltd, told Executive. “The UAE’s economic outlook continues to be favorable with an increasingly diversified economy. The banking sector remains competitive and closely regulated.”

Profits in 2004 and 2005 were aided by a bullish stock market, a large number of initial public offerings (IPOs), and sale of shares on the UAE stock exchanges. The benchmark Dubai Financial Market General Index soared in 2005, only to lose more than 40% of its value in 2006 as the number of IPOs declined and investors viewed stocks as expensive. Likewise, the Abu Dhabi Stock Market Index shed more than 40% of its value in 2006. The stock market slump and IPO slowdown in 2006, which hit all GCC countries, cut the UAE banks’ non-interest commissions and fees.

The fall in non-interest income didn’t drag bank earnings to the bottom as lenders hastened to boost income from core banking activities. Also, the Central Bank intervened, limiting the amount of money that banks lent to investors in IPOs. These actions helped maintain profitability at UAE banks, earning praise from the International Monetary Fund.

“The financial system is sound and has not been affected by the correction of the UAE stock markets in 2005-06. Directors noted the strength and resiliency of the UAE financial system, as evidenced by the high capitalization and profitability of financial institutions,” the fund said in October in a statement following consultations with UAE officials. “They encouraged the authorities to further strengthen prudential regulations and bank supervision, especially in the context of the current rapid credit growth and buoyant real estate market.”

This year, banks have reported a 26% increase in profit to $3.2 billion as of June, compared to $ 2.5 billion in June last year, according to latest Central Bank figures.

Going forward, banks in the UAE banking industry are expected to remain profitable as long as lending practices don’t change. “Outlook for the region remains positive while oil prices remain as they are. Barring regional political issues and instability, Fitch expects banks to continue to report good numbers,” Robert Thursfield maintains.

Standard & Poor’s also sees the future of the UAE banks in a favorable light.

“We expect the banking sector in the UAE to continue to enjoy healthy profitability, asset quality and capitalization,” said Mohammed Damak, a Paris-based financial analyst at Standard & Poor’s. “Profitability should be further supported by increasing loan volumes, even though margins are under climbing pressure.”

The UAE banking industry’s transformation from disarray in the 80s and 90s to profitability in this decade partly stems from better regulation by the Central Bank and better management among lenders.

“Banks are much better run and regulated now compared with the 90s,” said EFG-Hermes’ Madha. “In the 90s systems were weaker and management was not as strong.” The high rating given to banks by agencies such as Fitch also relies on the strength of the UAE economy, which has been buoyed the last three years by soaring oil prices. The United Arab Emirates, 90% of whose oil is produced in Abu Dhabi, is among the top five oil-producers in the Organization of Petroleum Exporting Countries, the supplier of close to 40% of the world’s crude.

“All bank ratings are high because they are driven by support from the UAE, mainly Abu Dhabi,” said Thursfield. “On standalone basis, banks would not be as highly rated.”

Profitability of UAE banks has been spurred by the growth in the emirates’ population due to the influx of expatriates, and robust economic growth exceeding 8% over the last three years, according to the IMF.

Foreign and Islamic competition

Local banks are operating in a tight market. They face competition from foreign banks, which have always outnumbered them. Foreign banks have been offering their services in the United Arab Emirates prior to the formation of the federation, but their role in the UAE has been curtailed. Unlike local banks, they are limited to having eight branches only and require local ownership.

However, it won’t be long until foreign banks in the emirates start to operate on par with local banks as the federation inches closer to signing free trade agreements with the US and the European Union. Although talks with the US and the 27-nation bloc have been delayed, banks are getting ready for real competition.

“The market must be aware of the US free trade agreement, which looks at issues of putting foreign banks on a level footing with national ones,” said Madha. “Local banks are preparing for competition as we can see from the big rise in costs — evidence that banks are looking at broadening product appeal and building a more defensive franchise as competition picks up.”

Conventional local banks face another challenge: They must vie for market share with the rising number of Islamic banks, lenders that are shari’a-compliant, meaning that they do not use of interest, as it is considered usury, and prohibit investment in alcohol, gambling and prostitution.

Already this year two new Islamic banks have been set up. Dubai Holding, the holding company of the government of Dubai, created Noor Islamic Bank and the government of Abu Dhabi announced the establishment of Hilal (Crescent) Bank.

“Islamic banks will take away market share from conventional banks,” Madha asserted. “They are growing more quickly than conventional banks, now that they are capable of giving customers more or less the same level of prices and products as conventional banks. We expect Islamic banks to be more competitive than they used to be.”

Over the past two years many conventional lenders, such as Dubai-based Mashreqbank and Abu Dhabi Commercial Bank, set up Islamic banking units or services in a bid to face off Islamic lenders.

A number of conventional banks have also converted to become Islamic lenders. National Bank of Sharjah converted to Sharjah Islamic Bank and Middle East Bank renamed itself Emirates Islamic Bank.

Feeling the pinch in the UAE market, lenders have also set their eyes on buying stakes or acquiring banks abroad. There has been a foray of acquisitions in Egypt, where the nascent banking market has been opened up to foreign investors. Abu Dhabi Islamic Bank, a shari’a-compliant lender, bought Egypt’s National Bank for Development and Abu Dhabi-based Union National Bank purchased Egypt’s Alexandria Commercial and Maritime Bank to benefit from the Egyptian market’s low banking rates. Abu Dhabi-based First Gulf Bank also recently announced that, together with the Libyan Fund for Social and Economic Development run by Saif al-Islam Gaddafi, it will set up a commercial lender in the North African country.

Except for allowing some Gulf banks to open branches in the UAE, the Central Bank hasn’t issued any new licenses for foreign banks since the 80s, when it strove to limit their number that in 1977 had swelled to a record  of 34. Foreign banks have been flocking to set up base in the Dubai International Financial Center, where they can have 100% ownership and don’t need a license to operate from the Central Bank. Goldman Sachs, Morgan Stanley, and Commerzbank are some of the international lenders that are taking advantage of the free environment in the DIFC and enlarging or even moving their staff to the new financial community.

“The establishment of the DIFC has been a breakthrough in the UAE,” said HSBC’s Matheson. “International investment banks, in particular, have had their entry to the region made immensely easier by the establishment of such a center, and this will have a significant impact on the UAE financial industry and beyond. However, they cannot all exist offering all things to all men. Instead, we will see a specialization within the new players, whether into Islamic finance, equity capital markets, funds or other specialist areas.”

Real estate and oil price correction exposure

Banks in the UAE are also susceptible to exposure to the real estate sector, as real estate prices are forecast to cool down by 2009, according to the Egyptian investment bank EFG-Hermes.

Standard & Poor’s has also warned about such a fall in real estate prices. “A real estate crash would be far more severe compared with the recent stock market correction,” Damak told Executive. “Real estate loans are much bigger in volume compared with what has been invested in the stock market. Direct and indirect exposures to the property sector are larger, and a real estate crash could affect the real economy, and ultimately translate into material hikes in banks’ delinquency rates, a factor that is not captured by the banks’ current non-performing loans ratios.”

Such warnings have been echoed by the International Monetary Fund. “The growth of private sector credit remains high and banks’ exposure to the real estate sector has increased recently. Reforms are underway to strengthen the prudential and regulatory oversight of the banking system,” the fund said in its October statement. “Directors welcomed the authorities’ intention to establish a federal credit bureau to help improve the reporting and monitoring of credit data.”

“uae banks have been some of the more competitive ones because of their high number”

The establishment of a credit bureau is seen as an essential component safeguarding the UAE banking sector from future lending shocks similar to those the occurred in the previous decades. Rating agencies and consultancy companies have been quick to point out the benefits of such a bureau. “Information is key and a credit bureau can provide such information that mitigates credit risk,” said Von Pock of A. T. Kearney.

Besides a real estate sector shock, UAE banks can be affected by their historic reliance on oil-generated wealth, which has fluctuated along the years and left the industry vulnerable to crashes, as was the case in the 80s. But this is unlikely to occur in the short-term, given that oil prices have shot up to new records, with the oil price hovering around $90 a barrel in New York.

“It would need a significant drop in oil prices to impact the banking sector,” said Raj Madha. “Abu Dhabi has a huge amount of financial resources that they have built up over recent years and could be used to subsidize projects in the medium term.”

Analysts also point out that the UAE government, along with other governments in the GCC, is currently basing their state budget on low oil-per-barrel calculations to cushion any possible shock from a fall in prices.

Thus, Van Pock is sure that “no major oil price correction is expected, and so there will be excess liquidity in the region for some time.”

Twenty years ago, I first landed in Dubai when I was sent on assignment by Agence France Presse to cover the “tanker war” which was raging out in the middle of the Gulf. In short, the Iranians were bent on punishing all of the Arab Gulf states for supporting their arch enemy Iraq. As a result, all ships that entered though the Straits of Hormuz were at risk of being attacked by Iranian speed boats using small arms fire and rocket propelled grenades The Iranian objective was to disrupt the flow of oil and other maritime activity in the region.

To counter this threat, the US navy, along with its coalition partners, amassed a naval flotilla of warships to protect Kuwaiti registered oil tankers as they transited the Gulf to pick up and deliver the worlds’ most precious cargo. Unfortunately for most of the ships, the only ones that were guaranteed protection were those Kuwaiti tankers whose flag had temporarily been swapped for an American flag. All other ships in the Gulf remained fair game. Everyday I boarded my helicopter with a CNN news crew and flew out over the waters to photograph burning cargo ships and oil tankers. My month-long stay lasted for almost two years.

That was then

That first night I flew into Dubai I remember looking out of the plane’s window and seeing this futuristic building on the edge of the water all lit up in the night sky. I was met at the airport by my colleague, who I was replacing. On our way out of the airport I asked about the building I had seen. He suddenly turned to me and said, “Guess what my friend, that’s the brand new Hyatt Regency hotel and apartment complex and, as of today, your new home!”

I must say I felt quite privileged to live in one of the newest and most expensive pieces of real estate in Dubai at the time. Before that I was living in a one bedroom apartment in the center of Cairo with my only view being the wall of the building next door. Now, suddenly I found myself in a very spacious two bedroom flat on the 22nd floor with a view to the sea on one side and the city of Dubai on the other. From my windows I could see no other building; I was too high up. Apart from the Hyatt, the only other noticeable building at that time was Dubai’s World Trade Center, just off Sheikh Zayed Road. It stuck out like a thumb in the desert.

On my daily helicopter flights out over the Gulf I would always look down and marvel at the wide open empty spaces. Since there was very little in the way of real estate development, the only distinguishing characteristic about Dubai was the creek winding its way from the sea into the desert with the souqs of Bur Dubai and Deira on either side. Other than that, the only other landmarks were the Hyatt and the World Trade Center. Even our helicopter pilots would use these two buildings as reference points when communicating with the Dubai tower.

They also served as landmarks for motorists driving around Dubai. Wherever you were in the emirate you could always see at least one of the two structures. Today, you would hardly know they are there.

so much has changed in 20 years that i feel i’m in a completely different country

This is now

I returned to Dubai with my family last year. The first thing I did after leaving the airport was search the skyline for these two reference points. I looked in vain. So much as changed in 20 years that sometimes I feel I’m in a completely different country.

Twenty years ago Sheikh Zayed Road was four lanes (two lanes in either direction) connecting Dubai with the capital Abu Dhabi. Once you got on to the road and passed the World Trade Center you were in the middle of the desert until you reached the capital. A friend of mine used to work at Gulf News, one of the Emirates’ first newspapers, and one of the first businesses to relocate out on Sheikh Zayed Road. Across the road there was the Metropolitan Hotel that was particularly famous among Americans because it had a baseball diamond and hosted tournaments for American expatriate baseball teams in the Gulf. Occasionally, I would meet them in the hotel bar, the Red Lion, and I was amazed each time I went out there how far away the place was from anything else. Driving back into town late at night was always a bit risky because there were hardly any other cars on the road and the trucks felt they owned the tarmac.

Recently, I had an appointment at Gulf News. I had heard about the changes along Sheikh Zayed Road but it wasn’t until I drove back out there that the extent of Dubai’s real estate construction boom sunk in. To start with, when coming from Sharjah, you don’t notice crossing the Dubai creek bridge anymore because everything has become so big and wide and crowded that all your attention is focused on the road in front of you and the cars darting in and out all around you. On Sheikh Zayed Road, the four lanes have now expanded into ten, sometimes fourteen, lanes with fly-overs, bridges and underpasses along the entire stretch. On either side of the freeway there are new shopping malls, compounds and skyscrapers, including world’s tallest building and largest shopping complex, both still under construction. Gulf News is still in the same location except that they have moved into a bigger building next door and the Metropolitan with the baseball diamond has had a facelift. Both have been long overshadowed by everything else sprouting out of the desert landscape.

Dubai is expanding at such an alarming rate that before long the sight of open desert will become a rarity. In the past, one had to travel over long stretches of sand in order to reach civilization. In the future, we will have to do the reverse; drive through an endless concrete jungle before we can reach the sand.

Once upon a time there was a concept arrived at called the Free Economic Zone (FEZ). In order to bring in foreign investors, along with their capital and know-how, a government would set up a special area with legislation and tax breaks that would encourage the growth of new industry. In the aftermath of the economic nationalization policies followed from the 1960s on in most of the MENA area, such zones were seen as politically expedient: too small to worry those concerned about national economic sovereignty, and effective enough to bring in some of the benefits that foreign direct investment (FDI) can offer. However, the raison d’etre of FEZs across the region is beginning to change, and with it could come a series of foreseen consequences that at present worry few. Once again, the UAE case seems the most pertinent.

FEZs can go by a number of names, such as Free Trade Zones (FTZs), Free Zones (FZs), Special Economic Zones (SEZs), Qualified Industrial Zones (QIZs) and Special Industrial Zones (SIZs). FEZs are not, however “tax-free areas” or areas where the rules of a nation are entirely absent. There are quite a few inexperienced investors who haven’t cottoned on to that fact yet. Such zones, or enclaves, are established with different conditions to the external environment in which they are placed to encourage economic activity. FEZs also do not mean that the state has in some way surrendered sovereignty. Their creation entails the formation of a special environment under which alternative rules apply that still are under the control of the ruling political authority. Bigger companies understand this fact. As one senior foreign executive told me, “If the business idea can only work inside of a free zone, forget it. It ain’t working.”

At present, the Middle East has some 63 functioning FEZs according to the World Bank, with Saudi Arabia being the exception. It, however, offers a range of inducements to investors that make its Industrial Zones (IZs), especially in the Royal Commission of Jubail and Yanbu, function in a similar manner. The largest number of FEZs in the Middle East is in the UAE, with the Jebel Ali Free Zone Area (JAFZA) now considered a worldwide benchmark for this form of operation. The most common forms of FEZs are those concerning logistics or industry, or a combination thereof, although a new form that deals with service industries, especially in the financial area, is becoming more and more the case, finance hubs being the flavor of the month nowadays. However, the use of FEZs in the UAE is beginning to exhibit differences from classical economist thinking.

At the vanguard

Technically, FEZs in the UAE are not allowed to export goods and services into the local economy unless such exports are done in conformance with federal law. While this is reasonably well-enforced in terms of goods, the use of services in the broader UAE economy has proven almost impossible to regulate, and the legal restrictions have rarely been enforced. Laws pertaining to foreign labor mean that while workers are employed by a specific company in the FEZ, the free zone authority itself is the official sponsor of the employee.

The UAE has been at the vanguard of the free zone landscape in the MENA region, yet some worry that the lines between the regular economy and the free zone are beginning to become blurred. The country managed to attract 60% of the $26 billion of FDI for the region in 2006, and more importantly has managed to concentrate it into industries such as IT, tourism and construction instead of the hydrocarbon sector.

The heightened readiness of the UAE to receive FDI and utilize it in different ways is very much a tale of how a Gulf state can break out of the restrictions that the economic enclaves oil and gas investment have tended to produce. Linking the concept of economic growth and employment with FDI is never as straightforward as it first appears. Generally, such attempts point out the improvements in technology, efficiency and productivity that come following the arrival of FDI. Another concept is that an economy receiving FDI benefits from the “contagion” effect, as the practices and technology from overseas become adopted by local businesses. Such a contagion effect is also called a “spillover”. This generally occurs in situations where the education and technological gap between the two parties is relatively low, facilitating ease of replication.

Another form of spillover can occur when local companies must better use their own resources and technology in a more efficient manner, or bring in such things to be able to maintain a competitive edge with the foreign entrant. In such a case, the local firm either has the ability or the resources to replicate or purchase externally the tools and methodology of a foreign entrant. This also requires a low gap between education standards, and sufficient capitalization to be able to bring in inputs necessary to remain competitive.

Equally, the foreign firm may require services and inputs not available on the market, thus inspiring local businesses to begin supplying them. In other words, the arrival of foreign firms means that it is looking for inputs from local firms in order to supply its operations. Electronics manufacturing is a good example of this process, as a central producer outsources for parts from smaller local firms.

Another kind of spillover effect

A different form of spillover can occur when the local employees hired by the foreign firm leave and join other local companies or start their own, and thus bring with them the techniques learned previously. In most of the above examples of spillover, we are seeing how the UAE has been successful at inspiring its creation. Of course, these are not the only ways that the entrance of foreign firms, and hence FDI, into a market can improve its growth and employment patterns, and economists will likely argue for many more years to come over the effects of the now highly sought FDI.

However, the UAE seems to have become overly enthusiastic in the use of FEZs. The answer for this is simple: lack of consensus. While all of the emirates are pursuing their own free zones, and thus can create the rules pertaining to them for their local environment, attempting to come to federal agreement on changing company law at present appears an impossibility. So, in the absence of agreement, each emirate has gone its separate ways. While they are drawing in foreign investors, the big question is “What happened to the rest of the economy?”

ither the rules of the regular economy begin to replicate those of the fezs, or the reverse will happen

While the creation of FEZs has brought in business, the disadvantage those in the mainstream economy may be operating under might begin to become more apparent in years to come. Either the rules of the regular economy begin to replicate those of the FEZs, or the reverse will happen. Either way, through their multiplication in the UAE context such a result seems to be a long-term consideration. The golden age of the FEZ may be but a temporary affair. And once again we are left with the question: If a business needs an FEZ to work, is it really such a good idea?