The cash-rich banks of the Persian Gulf region are quietly rising to the challenges of modernization and financial globalization, even though on the surface it looks like little has changed. The Gulf banks rated by Standard & Poor's have remained financially healthy despite focusing almost solely on their domestic markets. Their ratings fall in a tight range in the low investment-grade categories. Profitability is good (average return on assets of 1.5% to 2.0% over the past decade), backed by high margins, cheap deposits and labor, and zero income tax. For the 30 largest banks in the Gulf, capitalization and asset quality compare favorably to other emerging markets.
But underneath the appearance of status quo are signs of a collective awareness of the need to speed the pace of regional and, to a lesser extent, national consolidation. In each country, the largest financial institutions are facing natural limits in new banking opportunities, and cross-border interest is stirring: National Bank of Kuwait is eyeing the Qatari retail-banking market, and Saudi Arabia-based National Commercial Bank was recently granted an onshore banking license in Bahrain.
This impetus is helped by the fact that Gulf banks have been working hard to put their houses in order, prodded by proactive regulators and governments (the latter tend to be owners -- and important clients). Leading Gulf banks are investing heavily in information technology to upgrade distribution channels and to streamline risk monitoring. Data-mining and -warehousing, credit-scoring, electronic records of defaults and recoveries, and value-at-risk measurement are increasingly common among top-tier players.
NOT EXACTLY UNIFIED.
Regulators in the Gulf have insisted on implementating International Accounting Standards (IAS) for several years. Moreover, regional consolidation could help Gulf banks overcome the limitations of their small size (less than 15 have equity bases of more than 1 billion euros), which prevents them from competing for big-ticket financing projects dominated by larger foreign banks.
But obstacles remain. The Gulf countries hardly constitute a single integrated economic and financial zone. The authorities in the region have all embarked on economic and capital market reforms but with varying degrees of speed and different starting points. So, significant differences exist. Although the idea of a regional customs union, and even a single currency, has emerged, the current separation will prevail at least in the medium term.
Plus, the shareholding structures of Gulf banks are often dominated by two groups of owners: governments or government agencies, and influential ruling or merchant families. These ties, along with legal ceilings on foreign ownership (40% in Saudi Arabia, and 49% in Kuwait), have largely shielded regional banks from foreign competition.
They have also bred clannish secrecy and perpetuated poor underwriting standards and lending practices, such as name lending and high single-name concentrations. In the past three years, a $350 million fraud involving UAE's Solo Industries, the $300 million restructuring of Qatar-based Ahmed Mannai Corp., and significant losses from the collapse of Oman-based Ali Redha group have underscored the risk of such practices.
It remains to be seen whether medium-term regional consolidation will help Gulf banks address more pressing issues, such as expanding their activities beyond plain-vanilla credit products and services, and reducing their reliance on interest income. For example, while deposits are cheap, the simple nature of most bank lending and the concentration of investments in government securities leave Gulf bank's earnings vulnerable to falling interest rates.
In some respects, the strong government presence serves as a counterbalance, smoothing output volatility and distributing guaranteed income via government employment. The percentage of civil servants among the employed population is very high in the Gulf. More than 90% of Kuwaitis are civil servants. In Qatar, about one-half of outstanding loans are to the public sector. It's no surprise that banks are mainly exposed, directly or indirectly, to governmental credit risk.
This tendency can be seen even in the booming consumer-lending segment, where outstanding loans have doubled over the last five years in Saudi Arabia. Consumer lending usually carries limited risks for the banks as the borrowers have low-risk profiles because the bulk of consumer credits are made to citizens employed by the public sector. In all Gulf countries, the prospects for growth in consumer lending are good, given young populations and strong consumption patterns.
Another area where Gulf banks have been able to exploit their expertise is Islamic banking (services that are compliant with sharia law) for individuals and corporates. Islamic banking activities in the Gulf have been increasing about 10% annually in volume over the past decade, and the pace is accelerating. And, to their credit, some banks are developing aggressive programs to widen their product range. This is reflected in increasing cross-selling ratios, as banks seek to offer more fee-rich products to reduce their reliance on interest margins.
Banks' ability to expand into new businesses and diversify income will also depend on the evolution of the local economies. The slow pace of economic diversification hasn't yet given birth to a solid and large nonoil private sector, and dependence on oil and gas revenues remains a fact of life. In the longer-term, the potential greater exposure to the private sector could lessen the safety provided by the strong government presence but would help banks by providing greater credit diversification, enhanced business opportunities, and widened product ranges.
By Emmanuel Volland in London and Anouar Hassoune in Paris, S&P emerging-market banks analysts