Retail and commercial banks in the UAE

The United Arab Emirates is home to some of the region's most successful banks, but are there too many of them? Robin Wigglesworth examines where the opportunities lie for retail and commercial banks in the UAE, and whether consolidation is the panacea for an overbanked market


If anyone thought that the volatile stock market would put a damper on the record profits of banks in 2005, they were sorely mistaken. Though much of the profits of UAE banks can be attributed to the booming markets, their underlying performance seems to be stronger than many analysts fear, with many banks reporting excellent first quarter results in 2006.

According to a recent report by EFG-Hermes, an Egyptian investment bank, the massive oversubscription of two IPOs that closed in March "severely distorted" the first quarter balance sheets of UAE banks. However, the only bank that posted negative earnings growth compared to the same period in 2005 was National Bank of Dubai (NBD), and this was only because of the one-off sale of its investment securities in early 2005.

This is heartening for the UAE, which has often been accused of being bloated with banking institutions, with 21 locally-incorporated banks and 26 foreign banks servicing an estimated population of 4.3 million.

There are historical reasons for the current overbanked situation. For a long period, the UAE was not a single banking market, but rather a conjunction of many micro-markets. Each Emirate was keen on keeping a bank in its own jurisdiction, fearing that the larger institutions would not be keen on having branches in the peripheral areas that were economically weaker than the financial powerhouses Abu Dhabi and Dubai.

"THERE IS CERTAINLY A STRONG CASE TO BE MADE IN FAVOUR OF SOME MERGERS IN DUBAI AND ABU DHABI, THE TWO LARGEST SUB-MARKETS."

With a few scattered exceptions have been very few institutions that have focused on a pan-UAE reach, and concurrently, there has been a willingness by local governments to maintain a bank in each Emirate.

Furthermore, after the Lebanese civil war, Bahrain and Dubai both competed to become the regional banking centre, and opened up to many foreign banks. The largest foreign banks, such as HSBC and Standard Chartered, now even compete with the top five local banks.

The influx has now stopped, as the Central Bank of the UAE has correctly deemed that 47 banks serving such a small population is not sustainable. However, according to Anouar Hassoune, an analyst for Standard & Poor's, competition has remained very strong, because overall, the UAE is" a market that provides banks with tremendous opportunities in private banking, asset management and investment banking, not only because of Abu Dhabi's oil wealth, but also because of the Dubai experience".

Atif Bajwa, head of the retail banking group at Mashreqbank, admits that the UAE is "a small market", and given the number of banks involved in retail, a call for consolidation would be "justified". The population centres are few, and according to Atif, they are "well-branched and have a very high density of ATMs".

There is certainly a strong case to be made in favour of some mergers in Dubai and Abu Dhabi, the two largest sub-markets. In Dubai, the government directly and indirectly controls NBD, Emirates International Bank and Dubai Bank, just in the conventional space. In Abu Dhabi, the government and Abu Dhabi Investment Authority (ADIA) control both NBAD and Abu Dhabi Commercial Bank (ADCB).

Anouar says Standard & Poor's expects to see more consolidation of banks, particularly for those that it makes "no economic sense to have them as separate entities". It is certainly true that regional competition will increase and shareholders will eventually realise that size does matter. With a larger pool of assets and capital, banks would be able to finance larger projects, have a wider branch network, and establish new initiatives such as private banking or Islamic finance subsidiaries.

NBAD has recently noticed the cost of such ventures. Whilst it is the largest bank in the UAE, it is, as Michael Tomalin, CEO of NBAD admits, "relatively small" in global terms. "It costs a tremendous amount to set up all these ventures and subsidiaries," says Michael, "whether private banking, Islamic banking or even having an office in London or New York. All this has very high fixed costs, and you need a very strong base at home in order for the economies of scale to work for these new ventures."

And the bottom line is that mergers cut operating costs, and enable banks to compete on pricing to attract more customers.

The case for consolidation is seemingly rock solid, and has been so for some time, but there has been no true M&As since the 80s, when ADCB and Emirates Bank were formed from a merger of several banks. Michael has felt "quite strongly for some time that consolidation should come", but says it is"not very high on the agenda right now". Why?

The key driver for consolidation is a desire to increase the return on capital, and mergers generally shave costs and have revenue uplift possibilities. However, as long as profits remain as high as they have been recently, there is little pressure on the banks to cut costs by operating on a larger scale. "Return on capital is good right now, and is likely to stay that way for some time," says Atif.

As of today, even small banks such as Sharjah Islamic Bank and RAKBank are performing well, having found their niche market. Atif says competition from the "smaller, nimbler" banks has become "quite intense" over the past few years, and RAKBank, for example, has pursued an aggressive marketing campaign aimed at the middle income mass market, and come up with a series of interesting products, according to Atif.

Sharjah Islamic Bank (SIB) is another case in point. National Bank of Sharjah was said to be doomed either to be subsumed by a larger entity, or continue trooping on, with little possibility for growth or expansion. However, it identified a previously niche market, Islamic banking, teamed up with Kuwait Finance House (KFH), giving up 20% of the shareholding in return for a management contract with KFH, and converted completely into an Islamic bank. A good example of what effect the conversion has had is to look at the share price. Before the conversion, National Bank of Sharjah traded at AED 3, but SIB is now traded at around AED 13.

"YOU COULD END UP WITH A CROSS-BORDER CONSOLIDATION OF A UAE BANK, ENTERING A REGIONAL NETWORK."

It is by most measurements an outstanding success story, and one that is likely to be emulated by other banks. Dubai Bank, for example, has already announced that it will be converting to become completely Shari'ah compliant.

However, consolidation among UAE banks could happen as a result of two scenarios. Firstly, intense competition might force the hands of banks unwilling to be subsumed at this time. The UAE market cannot continue to grow indefinitely, and to expand their market share, banks will have to compete more aggressively on pricing than they do now. As in all markets, this will weaken the small institutions and strengthen the larger ones, and a small bank might be forced to seek a merger.

Secondly, consolidation might happen if banks realise how costly organic growth can be. The current boom and expansion of banks across the Gulf means that competition for human resources is fierce, and shareholders might be willing to trade some control for scale.

Morgan Stanley has more experience with mergers and acquisitions than most, and is likely to be at the thick of things should consolidation happen. Dr. Georges Makhoul, regional head of Morgan Stanley's Middle East and North Africa office, strongly believes consolidation among UAE banks will eventually happen, not because of a need for higher capitalisation, but "because the competition for places to invest is going to get harder and harder".

However, he stresses the need for thinking out of the box, rather than a simple consolidation of, for example, the Dubai government's shareholding in UAE banks. "You could end up with a cross-border consolidation of a UAE bank, entering a regional network".

Another possibility might be a Saudi bank entering the UAE market by buying RAKBank or other small to mid-size institution. They could then, thanks to abundant Saudi capital, grow organically across the UAE. Georges is "certain" that Saudi banks are interested in buying other GCC banks, and says that whilst the time is not right yet, "the structure is there, and they will do it". Anouar says it is "merely a question of speaking to each other", and with the continuous flow of financial conferences and official government meetings, it might be only a question of time.

Opportunities

So far, the primary focus of UAE banks has been on serving the affluent segment and the upper middle class, in particular the large civil service. However, there are still abundant opportunities in this and other customer segments. Whilst locals have been well-served, the large affluent expatriate population is, according to Anouar, still "underserved" by domestic banks.

Despite intense competition, there is still a huge pool of potential clients for private bankers, but local UAE banks have been slower in focusing on this segment than the large foreign banks, a fact that Michael is very aware of. "The percentage of the business with local banks is relatively small, and the overwhelming majority of it is with the international banks. This is something we would like to change." Private banking services at local banks tend to be priority deposit and loan service with a relationship manager, whilst the asset management and wealth advisory business has often been left with the international banks due to the lack of skill sets at local banks.

Atif feels that financing for small and medium sized enterprises (SMEs) and commercial banking has also been neglected by UAE banks, but maintains that this is now changing, and the market will soon see a series of initiatives and products from leading UAE banks.

The rush of banks such as NBAD, First Gulf Bank, Union Bank of Abu Dhabi and Mashreqbank to establish Islamic finance company subsidiaries after the Central Bank approved new regulation, and the success of Emirates Islamic Bank and SIB, indicates the strong potential of Islamic banking. However, whilst the potential of Islamic finance in the UAE is undeniable, the Islamic finance companies are limited to what they can do in the retail space.

"THE MORTGAGE MARKET, AND INDEED THE WIDER RETAIL CREDIT AREA, IS ALSO DEPENDENT ON THE ESTABLISHMENT OF AN EFFICIENT CREDIT AGENCY."

It is the mass retail market that has been ignored the most. According to Anouar, there are very few banks across the GCC that concentrate on the mass market, and "none in the UAE". Banks have understandably focused on the high earners, but astute banks should diversify their deposit base to include this mass segment. A large UAE bank should have the right tools to manage the risk on a portfolio basis, and consolidation would again allow a bank further to neutralise any risk involved with the mass market segment.

Mortgages are a staple banking product in almost any other market, but not among UAE banks. However, that trend is changing, with a flurry of banks entering the mortgage market, ready to take advantage of the opening of the property market and the vast amount of homes ready to hit the UAE market.

Anouar says that mortgages are the "next big thing" for banks, but adds one large caveat: The legal framework for property ownership in the UAE is inadequate. "It is not supportive of banks that want to foreclose on loans and seize collateral. Atif agrees, pointing out that whilst the mortgage market is "relatively new and immature", the implementation of a comprehensive legal and regulatory framework would be "a great boon" for the industry.

The range of mortgage products is still incomplete, and repossession, the basic concept underpinning mortgages, is still untested in the UAE. In many ways, this is due to the particular cultural characteristics of the Middle East. One of the most basic principles of Islam is that you cannot evict a family out of their home, so repossession by a bank is an anathema, not only to Islamic banks, but to the entire culture of the country.

Therefore, the mortgage practices of the west will probably not be directly copied in the Middle East, but as Anouar points out, Islam itself might offer the solution through the concept of Ijarah, where the bank owns the underlying asset itself and leases it to the customer. If the customer defaults, it becomes a question of how to settle losses and assets between the parties. It will need work, but the banks are on it, and don't put it past them to come up with a product that serves both the banks' need for collateral and the customers' need for a home.

The mortgage market, and indeed the wider retail credit area, is also dependent on the establishment of an efficient credit agency. According to Anouar, an agency is "necessary" for the further development of the mortgage market, but says it is difficult to establish if it is not managed by the Central Bank. Atif also calls for the active involvement of the Central Bank, which he says should "push the establishment of a central credit bureau to develop a robust and sound retail credit environment".

However, due to the federal structure of the country, the Central Bank of the UAE is weaker relative to other GCC regulators, so UAE banks now have to do it themselves. Government involvement is vital, as credit agencies are useful when everyone is part of them, but each individual bank has very low incentives to take part.