Funding pressures ratchet up for Gulf banks

A withdrawal of government deposits is leading Gulf banks to tap the bond markets to ensure they have enough funding. Published in The Gulf, 1 June 2015

Gulf banks are issuing bonds and sukuk at more than twice the rate of last year, according to data from the Dubai-based Gulf Bond & sukuk Association. Across all six GCC states, financial institutions have been going to the market to raise more capital, with at least $5.6 billion raised in the first quarter of this year, compared to $2.5 billion for the same period last year.

Most of the money raised so far this year has been via conventional bonds, such as the $750 million bond by Abu Dhabi Commercial Bank (ADCB)issued in March. The largest issue so far, however, has been the $1 billion Islamic bond (sukuk) by Dubai Islamic Bank in January.

There is a simple reason for this surge in debt market activity, and that is low oil prices. While energy prices have recovered somewhat this year, they are still far below the levels of last June. These relatively low prices have had a series of interconnected effects, including slower economic growth in the GCC, lower government revenues and more cautious public spending programmes.

All that is also chipping away at overall confidence levels, among individuals and companies alike. Bankers in the region report that many of their clients are now more cautious and they are not just talking about state institutions and oil-related companies. “I think the sharp drop in oil prices and the volatility that arose from this development impacted most businesses in the region,” says one banking executive.

Lower confidence can be clearly seen in the willingness of locals to borrow money. In Saudi Arabia, credit growth is now at its lowest level in almost four years, according to the local Jadwa Investment. In the UAE, the Central Bank says that overall credit conditions softened in the first quarter of this year compared to previous quarters.

But while it might be slowing, demand for credit is still growing. Coupled with the reduced activity in the wider economy, that is leading to some funding pressures for banks, including higher borrowing costs. In a report published in May, Saudi bank Samba Financial Group pointed out that the six-month interbank lending rate among UAE banks has ticked up by around 40 basis points since the start of the year.

Perhaps the greatest issue that banks need to grapple with in this environment is that of government funding. The region’s banking system relies to a large extent on government and government-related entities putting money on deposit. With state oil revenues in decline, the ability of these customers to maintain high levels of deposits is starting to change.

According to Moody’s Investors Service, across the GCC some 25 per cent of bank deposits come from governments and other public sector bodies. Bahrain is least exposed, with a rate of 14 per cent, but the UAE, Oman and Qatar all have levels above 30 per cent.

“For the last few years high oil revenues have been feeding into the banking system, either directly by government balances or from a lot of public sector companies who are cash rich,” says Khalid Howladar, a senior credit officer at Moody’s. “Governments and public sector deposits have been a source of cheap liquidity.”

Emirates NBD estimates that government deposits in the domestic banking system of the three biggest economies in the GCC have declined sharply in the final quarter of last year and the early months of this year. It says that in Qatar, government deposits declined by 53 per cent between October 2014 and February 2015. The declines in Saudi Arabia and the UAE were more modest over that period, at 14 per cent and 11 per cent respectively, but still significant.

The problem is not confined to those three markets. Banks in other Gulf markets such as Oman are also likely to have to take some corrective action if the trend of falling government deposits continues. The IMF pointed out in its latest review of the Omani economy, published in early May, that “a sudden sharp withdrawal of government deposits would induce liquidity pressures in banks.”

It is this trend that is leading Gulf banks to issue all those bonds and sukuk, as they attempt to shore up their financial position.

“In Qatar and Abu Dhabi in particular we have seen funding pressures and the banks there are looking at raising more term funding,” says Howladar. “We think over the course of the year, particularly in the third and fourth [quarters], we’ll see a lot more bond and sukuk issuance out of those banks.”

The conditions and the risks in each country vary. According to Jason Tuvey of London-based Capital Economics, credit growth has risen rapidly in Qatar in recent years, which creates its own problems.

“Worryingly, banks [in Qatar] are increasingly reliant on borrowing from abroad in order to finance new lending,” he says. “Admittedly, much of this lending has been directed towards investment projects and is therefore less likely to sour than, say, consumer loans. But there is a real risk that, in the medium-term, Qatar is left with significant overcapacity and investment projects fail to realise their expected returns. Local companies could then struggle to repay their loans, which could cause credit conditions to tighten.”

In the UAE, meanwhile, although part of the huge debt pile accumulated by government-related entities (GREs) have been dealt with over recent years, there are still a lot of outstanding loans that GREs have to repay in the coming years. According to Samba, local banks in the UAE had $26 billion in provisioning for bad loans as of February this year, compared to $31 billion in November last year. With oil prices low and economic activity more muted, there is a higher chance that some of those debts could turn sour. Samba says that it expects the combination of deteriorating asset quality, falling oil prices and rising credit defaults to mean that bank profits in the emirates will face a squeeze this year.

The pressures on the region’s banks can also be seen in the way that some credit rating agencies have been adjusting their views. This year, for example, Standard & Poor’s has changed the outlook on a number of banks, including Bahrain-based Gulf International Bank and the UAE’s Mashreqbank and ADCB, from positive to stable. It also cut the outlook on four Saudi banks - Al Rajhi Bank, National Commercial Bank, Riyad Bank and Samba - from stable to negative.

The number of banks that have seen an improvement in their ratings is far fewer, although Moody’s did upgrade Qatar International Islamic Banks long-term and short-term issuer rating in May, from A3 to A2 with a stable outlook.

None of the issues outlined above should cause too many difficulties for the Gulf’s banking system in the short term. Despite the funding pressures, the region’s banks are in good shape on the whole and have strong capital adequacy ratios. The level of non-performing loans has been declining in recent years as the debts of some GREs have been restructured and, in other cases, repaid.

However, what is unknowable is just how long oil prices will stay low and, in turn, how great the funding pressures will get. Most observers are predicting that oil prices will end this year slightly higher than they began and will edge up again next year. That will help government budgets, but the price is unlikely to rise by enough for many of the Gulf’s governments to avoid running large budget deficits.

The question then is how governments choose to pay for their deficits. They could continue to use their existing savings, such as their bank deposits; draw down some of the investments held by their sovereign wealth funds; or issue bonds and sukuk of their own. A combination of all these is likely, which means that, if the situation persists, or oil prices start to fall again, then the funding gap for banks is likely to continue.

“If this were to be a much more protracted decline, which we’re not really expecting - we’re expecting a $10 recovery in oil prices next year - then this would potentially lead to more funding loss,” says Howladar.

In its most recent review of the region’s economies, published in May, the IMF said that the risks for the region’s banks are likely to increase as time goes by. “The impact of lower oil prices on oil exporters’ banking systems is likely to be muted in the near term, but downside risks are likely to increase over time,” it said. “Second-round effects of lower oil prices on economic activity could weaken asset quality, liquidity, and profitability, but the speed of adjustment is likely to vary across countries.”

However, there is a silver lining of sorts to the current market conditions, says Howladar, in that the concerns of possible overheating in some parts of the Gulf economies have now eased somewhat.

“The low oil has been a quite timely reminder for the Gulf countries, where we started to see some exuberance returning,” he says. “We were starting to see a bit of a return to real estate prices of the peak. This low oil had drawn a bit of a pause to the credit growth that we saw resuming. Particularly in the UAE you’ve seen prices come off in a more measured way.”