The banking paradox

The idea that banks are lending less to the private sector is not supported by statistics

In this section I look at the UAE banking system and come to some startling conclusions. It seems that banks are grabbing market share in a market with deteriorating margins and increased risks.

Last week I took a look at Union National Bank’s Q2 financial results. The focus was to look beyond the headline numbers and try to understand the underlying fundamentals and what the core trend might be. This led to the idea of core revenue and expenses, ie interest income from direct lending and debt securities and interest expense of deposits and debt securities. UNB also provides Islamic financing so I added those in as well. This tells us what is happening at the basic banking level and then I look at any out-of-the-ordinary movements in other parts of the business.

Mashreq recently reported Q2 results and announced an increase in profit of 3.4 per cent over Q2 2016. But looking at basic banking, core revenue rose 9.97 per cent whilst core expenses rose 19 per cent. This is not a good sign since if it continues, sooner or later, net core income will become negative. Operating expenses are flat at about 1 per cent so had little impact on changes to net profit.

However, non-core income from investments, fees and commissions and other income dropped Dh61 million and Dh47m, respectively. This was mostly offset by a reduction in impairments of Dh132m. The impairment drop is large relative to 2016 but the total amount is in line with 2015, which means it does not raise a red flag. Without further analysis the only real flag here is the 13.6 per cent drop in fee and commission income, income which is considered high quality.

Overall not a bad result with some caveats and performance indicators to keep an eye on. At this point I have looked at two banks and, although there are certain issues one needs to keep an eye on, it seems that the bank numbers are not consistent with anecdotal feedback from businesses that they are finding it harder to borrow since the oil price dropped in mid 2014.

A quick look at the UAE Central Bank’s statistical bulletin shows that domestic credit grew 14.55 per cent from the end of 2014 to the end of 2016 so the idea that banks are lending less to the private sector is not supported by this statistic.

To get a further understanding one would have to look at a number of bank financials. I will continue to use Mashreq, but keep in mind I use them as an example to shed light on the sector as a whole and for no other reason.

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Mashreq has some nice graphs in its 2016 report to help us figure things out. The first is loans and advances, which from 2012 to 2014 grew 40 per cent but from 2014 to 2016 grew only 5.2 per cent. In other words Mashreq kept lending but slowed down the pace of growth, an extremely prudent move. This points to one explanation for the idea that banks are lending less: perhaps the banks are not lending less, they are just stricter about their lending and they are growing loans at a pace commensurate with the current economic environment. In fact, the stricter lending is probably doing businesses a favour by making them more aware of the risks and stopping them from over leveraging.

Return on equity (ROE) grows steadily for Mashreq from 10.29 per cent in 2012, peaking at 15.59 per cent in 2014 before steadily falling to 10.55 per cent in 2016. At first this is a little bit of a puzzler if we combine the information that the bank has increased lending and the feedback that interest rates are the same or higher. One explanation could be a decrease in leverage, but for Mashreq this is not the case. Another could be that operating expenses are up but as measured by the cost/income ration this also is not the case for the bank. The answer comes from the return on assets (ROA), which mirrors the ROE’s rise and fall. This is understandable given the oil price drop, but it leads to a strategic contradiction.

If ROA’s are dropping and perceived risk has increased then why would a bank increase its lending? More generally, why would a company seek greater market share when its product/service is yielding lower margins and the market as a whole is becoming more challenging.

It is worthwhile to reiterate that I am using Mashreq’s results as an example for the market as a whole. So if the market as a whole is increasing profits whilst ROA is decreasing, and they are doing this by grabbing market share then the whole market is going to end up with bigger balance sheets of riskier assets but lower ROEs. As the competition heats up those ROEs will go even lower. I will remind you that there are 23 operating banks and leave it at that.

So what can the banks do? Merging will, at best, cut some costs. The concept of synergy is one peddled by consultants and advisors but it does not exist in reality. So a merged bank will simply have a bigger asset base, which increases the problem and it does not decrease it.

So what else can a bank do? There are three possibilities. Banks can shrink their domestic balance sheets by moving assets abroad. Banks can shrink their balance sheets by reducing their capital, which would force shedding of assets to maintain the necessary capital ratios. Or the banks can take more risk. Or any combination of the three.

An important point: I would argue that mergers will harm the banking sector as banks who manage their liquidity well are forced to merge with peers who were more adventurous. I want to be clear, this is about liquidity, not credit quality. A bank with poor credit quality but good liquidity is fine. A bank with an advances/deposits ratio, a measure of liquidity, of 115 per cent is not so fine. Mergers are not the solution, they are a race to the bottom.

The likelihood of banks reducing capital is next to zero. That means that our banks need to start to export lending.