Room with a view to a rebound

Last year was a bad year for the region's banks, with enormous provisions made for non-performing loans sinking their profits. But there is some cause for optimism that, despite chances of more provisions to be made, the worst is over.

From the window of his office on the 21st floor, Alaa Eraiqat can see some of the projects his bank funds. "We are financing that," says the chief executive of Abu Dhabi Commercial Bank (ADCB), pointing proudly to a building site below.

He sounds upbeat for someone who has just had to report one of the largest ever quarterly losses from a local lender. The emirate's second-largest bank lost Dh1.2 billion (US$326.7 million) in the fourth quarter of last year, after setting aside Dh2.1bn for bad loans in that period. About half of that relates to the Saudi Arabian conglomerates the Saad Group and Ahmad Hamad Al Gosaibi and Brothers.

ADCB's competitor, National Bank of Abu Dhabi (NBAD), also saw its fourth-quarter net profit fall by 13 per cent to Dh429m, and full-year earnings come in flat. Mashreqbank, also heavily exposed to the Saudi conglomerates, lost Dh120m in the fourth quarter after taking Dh2.1bn in provisions for the full year. Banks had hoped that the final quarter of last year would see them emerge from the worst of the financial crisis, but the latest earnings season has highlighted the extent of the banking sector's bad loan woes.

Sultan al Suwaidi, the Governor of the Central Bank, said last week that 4.4 per cent, or about Dh44bn, of the country's loans were non-performing, by far exceeding analysts' expectations. Worse still, Mr al Suwaidi said non-performing loans were likely to increase another 50 per cent to 6.5 per cent, or Dh65bn, this year. "I don't think we are going to see growth on the balance sheet this year," says Michael Tomalin, the chief executive of NBAD. "In that sense it will be more challenging to run a bank."

Reinhold Leichtfuss, a partner at Boston Consulting Group, simply calls last year "the year of provisions". While revenues of GCC banks only grew by an average of 6 per cent, provisions rose to extremes. UAE banks increased provisions by 225 per cent in the first nine months of the year. Some analysts say further shocks to the banking system could be on the way. Saud Masud, an analyst at UBS, expects non-performing loans to rise to 15 per cent, in line with the experience of Singapore after the property bubble.

Non-performing loans in Hong Kong and Taiwan, where banks were also heavily exposed to property, were higher still. But despite such fears, the performance of the country's banks in the past year compares favourably with many international rivals. "More provisions will have to be taken and we can expect lower growth, but they still compare positive to quite a few international banks," says Mr Leichtfuss.

The great question mark over the sector remains Dubai World and how its planned $22bn debt restructuring will add to banking sector strains. So far, none of the banks has provisioned for that effect, which could ultimately force some of them to roll over or extend their lending, or in the worst case accept a default. ADCB alone has lent about Dh9bn to the debt-ridden conglomerate. But as long as the Dubai Government-owned group services its loans and operational costs, banks cannot set aside money.

"The restructuring is in progress and it will lead to a satisfactory solution," Rick Pudner, the chief executive of Emirates NBD, said last week. "That is when banks agree they got a do-able deal to take the debt financing forward." More importantly, the fallout from Dubai World has led investors to shy away from lending to the UAE. And those who do lend are asking for more interest, leaving banks with little room to manoeuvre.

"I worry that banks will continue to be more strict in their lending policy," says Henry Azzam, the regional chief executive of Deutsche Bank. "Nobody wants to see more skeletons come out of the closet." Institutional investors demanding higher premiums have already led some banks, for example ADCB, to flatly rule out new bond issues this year. Others, such as Emirates NBD, the country's largest lender, delayed planned bond sales.

"People are once again moving their money away from risky assets," says Mr Azzam. "That is raising the costs of borrowing for indebted countries and emerging markets." Emirates NBD, for example, has Dh7.2bn in repayments coming up this year. Although it says it is comfortable repaying its loans, the bank openly admits it would like to return to the market sooner rather than later. "We would like to get back into the market, but without an explicit government guarantee, tapping the market is very difficult," says Mr Pudner.

While UAE banks have solid capital buffers, only some comply with Basel standards of "voluntarily" setting aside 1.25 per cent of their risk-weighted assets for performing loans. NBAD is one of the banks that has started doing so. The Central Bank has also asked lenders for their views on making those provisions compulsory but no decision has yet been made. "If 2010 proves to be a year of recovery, then clearly these provisions are excessive," Mr Tomalin says. "If they are just at the right level then they will be used, and if they are not enough then we have built a good cushion."

Most importantly, banks must adapt to changed circumstances. With international lending sources becoming more expensive and deposits only growing slowly, banks need to look for alternative sources of income. "Banks will not be able to grow their balance sheets at a high speed," says Mr Tomalin. He expects deposits to grow by about 10 per cent this year. This compares with growth rates of about 35 per cent in the boom years until 2008.

NBAD plans to focus more on fee-generating business such as asset management, private banking, custody and advisory in the debt and capital markets. The bank also expects to increase its workforce by some 500 people. Across town, Mr Eraiqat remains hopeful that the worst is behind the bank. After two tough years - ADCB had the heaviest exposure to US derivatives among UAE banks and a hefty Dh2.2bn exposure to the Saudi conglomerates - the bank is looking for a fresh start.

"2010 will have its own challenges," Mr Eraiqat says. "We will continue to be vigilant like everyone else. But the resilience of our core operations makes us accept volatile movements in NPLs [non-performing loans] and provisions."