Arab Banking Begins to Bounce Back

Institutional Investor, April 2014

Better times appear to be returning to the Arab banking sector after a period which, while not as destructive as in the US and Europe, was nonetheless damaging.

While the six states of the GCC are not the whole of the Arab banking industry, they are the engine room, and it is heartening to note that after two years of declining profitability through the financial crisis, profits have been expanding since 2011 and look set to increase. An analysis by the Kuwaiti group Markaz finds that Gulf banking profitability grew 17.21% in 2011, 10.35% in 2012 and 9.86% in 2013; it expects a similar rate of growth in 2014.

“The GCC banking sector has weathered the global financial crisis rather well, but paid a big cost in terms of huge provisions,” says Raghu Mandagolathur, head of research at Markaz in Kuwait City.  Loan loss provisions in the region increased quite dramatically between 2007, when they stood at about US$2 billion for the sector as a whole, to over US$10 billion by 2009. They are climbing again in absolute terms, and Markaz says provisions grew 5.5% in 2013, but provisions as a percentage of total loans have fallen as banks have accelerated lending again.

Credit growth had averaged 30% a year in the five years prior to the crisis, which is arguably a sharper rate than is healthy. Today looks a little more sustainable: GCC banks recorded 12.5% growth in lending in 2013, alongside a 12.3% increase in deposits, suggesting that the lending increase is at least underpinned by a solid deposit book.

Naturally, each country is different: Markaz points to a range of outlooks from positive in Saudi Arabia (loan portfolios well diversified, low real estate exposure) to troubling in the UAE (significant concentration risk in exposure to real estate, large private groups and government-related entities; higher non-performing loan levels) and rebuilding in Kuwait (shattered by exposure to investment companies and households who had borrowed to engage in margin trading).

Each market has its own distinct stories.

In Saudi Arabia, for example, Al Rajhi demonstrates one of the better places to be, as well as the resilience of Islamic finance. Al Rajhi is not just an Islamic bank but perhaps the one with the strictest definition of Shariah compliance, yet that hasn’t stopped it growing (net profit of SAR7.438 billion (US$1.96 billion) in 2013 on SAR279 billion of assets, the biggest Islamic bank in the world), nor from being innovative. In particular, its Al Rajhi Capital business is pioneering, which is an increasingly useful attribute as Saudi capital markets gradually open up to the outside world.

“We believe that the Saudi Arabian capital market is going through an interesting phase, which has further strengthened its fundamentals and made it more attractive to local and foreign investors,” says Gaurav Shah, CEO of Al Rajhi Capital in Riyadh. He says these developments have helped all three of its business lines: brokerage, with a good pick-up in volumes thanks to increasing risk appetite and strong government expenditure boosting the domestic economy; asset management, with continued interest in sukuk from both retail and institutional investors, and a return of interest in the Saudi equity market; and investment banking. “We believe there will be a healthy pipeline of IPOs in the local market.” Sukuk issues have quadrupled in the last three years to about US$15 billion in 2013, he adds: expanding sukuk capabilities is a priority at Al Rajhi, as is the development of real estate funds.

Sooner or later, Saudi will liberalize sufficiently for it to be a major portfolio investment destination. “Any serious local or regional investor cannot ignore the Kingdom, the most diverse and broad stock market in the region,” says Shah. “It represents almost all the major economic sectors, unlike its regional peers.” The top 10 companies in the broad market index in Saudi constitute about 40% of total market capitalisation, whereas in Dubai, Qatar and Abu Dhabi, the figure is more like three quarters. Saudi, he adds, “with its favourable demographics, has a strong consumption-led domestic economy, an expanding social sector supported by the government’s expansionary fiscal policies, and an established export-oriented petrochemical sector benefitting from feedstock advantage.”

The story is less bright in Kuwait, a market in which banks have had to work hard to recover from a difficult economic environment. A key example here is Gulf Bank, which unquestionably would have gone under in 2008 without state support, having incurred KD359.5 million (US$1.28 billion) of losses that financial year, mainly because of derivative losses. It survived through a 100% emergency rights issue to raise KD375 million, for which the Kuwait Investment Authority sovereign wealth fund offered to take up whatever existing shareholders did not (it ended up with 16% of the bank), then hired ex-Citibanker Michel Accad to be the new chief executive. He spent three years getting back to basics: isolating the bad bank from the good bank and exiting bad loans (Gulf Bank’s NPL ratio in 2009 was 30%), building a far stronger balance sheet, focusing on core competencies in retail and commercial banking, and better service. By late 2013 NPLs were down to 7.3%, liquidity had been improved, and the bank had returned to profitability; Accad, his work done, is stepping down.

Qatar receives many of the region’s headlines these days, and increasingly hosts some of its more powerful institutions. Markaz – Kuwaiti, so hardly biased towards Qatar – ranks Qatar National Bank as top in the region in terms of loans, deposits, assets and revenue based on 2013 performance (Al Rajhi is second in loans and revenue, and Emirates NBD second in deposits and assets, Markaz says). QNB’s own numbers show remarkable growth: the five-year compound annual growth rates for deposits, assets, loans and advances, operating income and profit up to December 2013 were 26%, 24%, 25%, 24% and 21% respectively.

QNB, perhaps more than any regional peer, demonstrates the increasingly international presence a Middle Eastern institution can develop. It has branches or offices in 26 countries or territories, and while some are modest, there are powerful businesses from Indonesia (QNB Kesawan) to Jordan (34.5% of Housing Bank of Trade & Finance), Iraq (50.8% of Bank Mansour) to Libya (49% of Bank of Commerce & Development).

And at home, Qatar boasts one of the most resounding growth stories in the region, bullish and dynamic, epitomised by the FIFA World Cup bid and all the related infrastructure the peninsula state must now build.

The UAE provides an example of a bank preparing a bold new regional direction: National Bank of Abu Dhabi. To see an NBAD investor day today is to observe a streamlined and worldly institution that would not look out of place on Wall Street, and indeed, the bank has brought in a western CEO (Australian veteran of Standard Chartered and ANZ Alex Thursby) clearly with an international vision in mind.  It has a mission statement to be recognised as the world’s best Arab bank, talks conceptually about a West-East corridor peopled with megacities from Lagos to Tokyo, and articulates a carefully planned five-year build-out of its international strategy.

Outside the Gulf, a whole other order of difficulty exists in Egypt, where banks must attempt to thrive despite total instability in government, policy and society. Egypt is, on the face of it, a great opportunity: a large 87.8 million population with a median age of 24, according to Commercial International Bank in Cairo, yet underleveraged, with total bank lending facilities equivalent to only 32.7% of GDP (to put that in context, Markaz says in the Gulf states, the banking sector was equivalent to 94% of nominal GDP in 2013). Corporate loans represent 25.1% of GDP and household debt just 7.6%. Set against that is the obvious political turmoil, high unemployment, and the challenges presented by falling reserves in a country that relies on imports in many sectors.

From the bank perspective, banking reform has been underway since 2005 in Egypt, well before revolution, but CIB calls it “robust”. Both loans and deposits have grown steadily even through the volatility, CIB says, although the number of banking licences has fallen from 62 in 2003-4 to 40 by September 2013. CIB itself illustrates that a business can continue to grow in bad times: total assets grew 20.91% between 2012 and 2013 to EGP 113.6 billion (US$16.3 billion), and although net loans were only flat, customer deposits grew 23%, revenues 31% and net profit after tax 35%.

Egypt provides an opportunity for acquisitive foreign houses with a long-term view. QNB bought NSGB Egypt in 2013. QInvest came close to buying EFG Hermes before regulatory or political hurdles brought that deal down. And Abu Dhabi Islamic Bank has 75 branches in Egypt through its ownership of National Development Bank Egypt.

What has perhaps been missing from the region has been a pure-play regional Islamic bank, separate from a commercial parent, and not based on brokerage. This is a niche that Qatar’s QInvest, partially owned by state-backed Qatar Islamic Bank but basically private sector, is trying to exploit.

“The way the market is segmented, you have the international banks which have, for the last few years, been pulling people out of the region; their approach is to focus on the headline three or four transactions in the year, and that works well for them,” says Michael Katounas, deputy CEO and head of investment banking at QInvest in Doha. “Then you have the commercial banks that have the capital but lack the expertise to deliver investment banking. Then there are quite a lot of advisory firms, and some very nice shops led by talented individuals, but often they don’t have the capital. For us, it’s about putting it all together that makes it work: the international best-in-class mentality, the capital, the local access, and then the Islamic side.”

Maybe we’ll see more of this, and more cross-border activity. “Significant government and quasi-government ownership have reduced the scope for cross-border activity amongst GCC banks,” says Raghu at Markaz, but if a decent group of private sector institutions were to evolve, that might begin to change things.

Perhaps the financial crisis brought some good. “Markets in the past have gone through excesses, whereas we are now seeing a more rational approach towards investing,” says Shah at Al Rajhi. “After going through volatile cycles, we believe more market participants have become knowledgeable, rational, focused, and have realistic expectations about the markets.” If banks mirror that shift, there is the potential for growth without fear of retreat.