GCC banks up against fresh challenges

It was more about fiscal consolidation than being adventurous in 2017 for the banking sector in the Gulf Cooperation Council (GCC), which has felt the ripples of continued low oil prices most. Though banks warded off liquidity concerns by keeping capital buffers intact and adopting more stringent lending criteria, the loan growth continues to be subdued.

The recent policy rate hikes by the GCC central banks in response to 25 basis points’ increase in interest rates by the US Federal Reserve will further impact borrowing costs. The New Year has rung in for Gulf banks with fresh challenges with the implementation of International Financial Reporting Standards 9 (IFRS 9) and the Value Added Tax (VAT).

As banks face pressure of low profitability and tighter liquidity, mergers and acquisitions (M&A) are the way forward for many of them, especially in Bahrain and Oman, to create larger entities to stay afloat. Besides financial challenges, robotics, artificial intelligence and financial technology, popularly known as Fintech, have forced banks to embrace digital transformation. This has meant greater exposure to cyber threats and increased focus on creating a sound IT infrastructure to safeguard consumers’ interest.

“We are increasingly seeing banks looking to create efficiencies and find innovative ways to stay relevant to customers. There’s a gradual shift from banks looking to win the ‘battle of the balance sheet’ toward the ‘battle of the customer’,” says Omar Mahmood, Head (financial services), KPMG in the Middle East and South Asia.

Stable outlook

According to Fitch Ratings, even though low oil prices, weakened sovereign ability and rationalized government spending have affected GCC banks’ financial metrics, two-thirds of them will maintain a stable outlook this year too. As oil prices have stabilized in the $50-60 bracket, the government bank loans have gone down. In fact, the governments have injected fresh liquidity through international debt issuances to ease the funding squeeze on banks.

In the UAE, government deposits in banks rose in October, last year, to $13.6 billion from $5.4 billion the previous month. In Bahrain, total deposits during the year grew over five percent to $52.8 billion. In Saudi Arabia, liquidity pressures have eased owing to record bond issuance of $17.5 billion in 2016. Kuwaiti banks tapped the debt markets to raise tier 1 and tier 2 Basel-III compliant funds exceeding $1 billion. Besides, banks have re-priced their loan books and are well-placed to benefit from further interest rate ups due to high levels of non-remunerated deposits. “We expect capital levels to be largely unchanged in 2018 due to lower loan growth. Ratios are above international peers but buffers are only adequate given high concentration (single borrower and sector) and therefore event risk,” says Redmond Ramsdale, an analyst with Fitch Ratings.

In its latest report, Moody’s Investors Services’ forecast is the strongest for banks in UAE, Saudi Arabia, Kuwait — which account for 75 percent of GCC banking assets — while those in Oman and Bahrain weakest due to fiscal deficits.

Moody’s sees the GDP growth to rise to nearly two percent in 2018, up from 0 percent in 2017, and pins hopes on large-scale projects such as Dubai’s Expo 2020 and the Saudi National Transformation Program to spur capital spending and credit growth.

Moody’s note that the banks’ capital levels will remain well above the Basel-III minimum regulatory requirements and the problem loan coverage across the region high at 95 percent. High loan-loss reserves provide banks the capacity to absorb losses.

“The strong financial fundamentals in the Gulf banking systems make the industry more resilient to lower profitability and weaker loan quality issues,” says Olivier Panis, vice-president, Moody’s.

Low loan growth

The Moody’s report says problem loans for the region’s banks will edge higher in 2018, following sluggish economic activity in 2017. Profitability will also decline slightly as low credit growth impacts interest income, fees and commissions.

U Capital’s banking outlook report says the GCC banking sector, which clocked in a 6.4 percent year on year credit growth in 2016, will continue to pursue a cautious stance on loan book growth as focus remains on preserving asset quality. A KPMG study reveals the credit quality of many banks deteriorated with overall impairment charges increasing by approximately 25 percent from 2015.

In the UAE, decelerating GDP growth coupled with rising impairments and non-performing loans have pressured banks. Net impairment charges on loans and advances increased 28 percent to $3.7 billion in 2016. Higher impairments along with the increased cost of funds lowered profits by 5.8 percent year on year, leading to a drop in returns on both assets and equity.

Fitch expects the upward revision of lending rates across the GCC to adversely impact loan growth. “The interest rate increase will naturally translate into higher borrowing costs and affect the rate-sensitive sectors such as automobiles and real estate,” says Emilio Pera, Head (Financial Services), KPMG Lower Gulf.

Credit growth remains an area of concern. Analysts believe central banks and ministries of finance need to cooperate on exchanging information on projected government cash flows to forecast how much liquidity the banking system needs. Central banks should review and expand their instruments to inject or withdraw cash from the banking system to ensure credit growth.

New regulations; paradigm shift

IFRS 9 will impact the way credit losses are recognized in the profit and loss statement of banks. Impairments that were earlier based on incurred losses will be now based on future expectations, namely expected losses.

“New reporting regulation calls for change in the way risks are assessed and priced. It would impact the cost of provisions and ultimately profitability of banks, cost and availability of funds for customers,” says Abdul Aziz Al Ghurair, chairman of the UAE Banks Federation (UBF).

While it’s a paradigm shift for banks worldwide, S&P Global Ratings says GCC banks will adapt to the new standard easily with a minimal impact, thanks to their conservative approach to provisioning. Banks are working closely with their auditors and creating systems to make sure they can plug data gaps to model forward-looking losses. The Central Bank of Bahrain is preparing to introduce ‘FAS 30’ regulations the Islamic equivalent of IFSR 9 — to govern corporate governance and sharia external auditing.

Besides, implementation of Basel III and the liquidity capital ratio rules will have an impact on overall liquidity. New regulations are going to make the cost of doing business more expensive, impacting the credit growth further, stress analysts.

In addition to this, GCC banks have made hectic preparations for VAT, the new tax regime, and readied their customers by advising them about taxable services. Saudi Arabia and the UAE banks are proceeding with its implementation on schedule.

“Banks will have to absorb most of the VAT charged on them by their vendors and suppliers because VAT on majority of their output is exempt, so they cannot recover input VAT they pay to their vendors for various goods and services procured by them,” says Mayank Sawhney, Director, MaxGrowth Consulting.

Tech intervention

The increasing popularity of Fintech companies has forced banks to quickly adopt new technologies and launch new products and services. Some of them are even collaborating with Fintech firms to bring about financial stability in the market. Emirates NBD, Emirates Islamic Bank and First Gulf Bank launched Fintech-related competitions to develop financial solutions; several banks have underwritten substantial capital in the FINTECH startup Liwwa’s platform as institutional investors.

Robotics and Artificial Intelligence (AI) are driving the automation of core banking processes. For instance, Mashreq Bank has been using robotics and AI technology for over a year now. By introducing 20 robots for 35 different business processes, the bank claims to have made savings of nearly 60 percent in some areas. Several banks too are following the suit. GCC banks have also turned their focus on securing important data. The UAE Banks Federation (UBF) has launched its first Information Sharing and Analysis Centre to repel cyber attacks. The 48-member banks body says the centre would analyze online threats in real time and act promptly.

“The Centre will equip banks with the tools and intelligence to better identify, protect, detect and respond to cyber attacks and reduce sensitive data exposure,” says Ghurair.

Saudi Arabia has set up the National Authority for Cyber Security to “protect vital interests and sensitive infrastructure” following a number of attempts to hack government websites. It will also improve protection of networks, information technology systems and data, including that of banks.

Mergers & Acquisitions

The landmark merger between National Bank of Abu Dhabi and First Gulf Bank, resulting in the creation of the GCC’s second biggest bank, has laid the ground for further Mergers and Acquisitions (M&A). Kuwait Finance House and Ahli United Bank of Bahrain are reportedly in talks for the first cross-border merger. At least five M&A deals — three in the Islamic banking space and two in conventional — are in various stages of discussion.

Small Islamic banks realize that through M&A they will acquire the financial strength to compete effectively in a dynamic market. Currently, combined assets of the region’s top four conventional banks are $621 billion whereas all Islamic banks’ assets stand at $563 billion.

“Most GCC countries have become overbanked. Mergers are now natural to create larger entities that are financially more robust and efficient,” says Anthony Hobeika, CEO, MENA Research Partners.

Bank analysts believe more banks are likely to merge in the coming future for better liquidity management and enhanced profitability. However, the ownership structure of banks in the region is a stumbling block in this direction and authorities need to further strengthen their legal, supervisory and licensing frameworks for smooth M&A execution.

The GCC banking sector has shown tremendous resilience in the face of fast-changing emerging macroeconomics, evolving consumer behaviour and altering regulations. Banks have accepted the fact that the era of high growth is behind them and they have to live with the “new normal”. If analysts are to be believed, the banking landscape will continue to change at operational and strategic levels.