AMMAN, 25 October 2004 — Those Arab banks who published their results for the first nine months of the year have reported higher profits compared to a year ago levels. For example, the National Commercial Bank of Saudi Arabia, the largest bank in the region, saw its profits rise by 10 percent, profits for Bank of Bahrain and Kuwait were up by 10 percent, Riyad Bank by 6 percent, Arab Bank of Jordan by 25.8 percent, Dubai National Bank by 46 percent, Oman Arab Bank by 51 percent and Samba Financial Group by 83 percent. This followed good performance in 2003 where the consolidated profits of the top 100 Arab banks rose by 15.4 percent and the overall return on equity increased to 14 percent from 13 percent in 2002. This year appears to be another good year for banks in the region, solidifying the gains made in 2003 and boosting the banks’ asset quality, income statements and balance sheets. Banks are taking advantage of the good times to strengthen their capital base in order to support increasing activities.
The overall economic conditions in which banks are operating have been quite supportive. Most Gulf countries will be growing at double digit growth rates this year, while the non-oil Arab countries could see growth rates in the range of 4 percent to 8 percent. Low interest rates and high oil prices are generating excess liquidity conditions. Long delayed private and public projects are moving forward, creating healthy demand for funding.
The asset quality of banks in the region has improved considerably in the past 18 months. A favorable economic environment has kept loan losses at cyclically low levels. The rise in real estate and share prices and better cash flow conditions for borrowers boosted prices of collateral that banks hold and reduced percentage of non-performing loans to total loans. Because banks were able to build up reserves when the economy has been doing so well, most of them are now well positioned to weather a downturn if and when it occurs. Corporate lending has risen in the past few months as private sector activities picked up momentum creating healthy demand for funding.
However, the star performer has been consumer lending. This is a relatively new business, because until about a decade ago, Arab banks focused almost exclusively on corporate lending. This time around, almost all the banks in the region have discovered the virtues of lending to individuals and competition in this field has become intense.
Consumer lending is perceived to be less risky than corporate lending because activities and performance of projects associated with the later tend to be highly cyclical. Banks can mitigate their credit risks when lending to consumers by using salary assignment schemes. It is still very difficult to secure a personal loan without agreeing upfront that repayments will be automatically deducted from one’s salary.
This is why delinquency ratios for consumer loans tend to be very low, estimated in the region at less than 3 percent. Retail banking is proving to be quite profitable as well, given the wide margins that banks charge on consumer loans relative to the their funding costs.
Despite the encouragement of central banks, mergers and acquisitions in the region have been minimal. Not a single deal has been struck in 2003, but few have been concluded this year. Bahrain-based Ahli United Bank (AUB) acquired 40 percent of Al-Ahli Bank of Qatar and National Bank of Kuwait took 20 percent interest in Grindlays Qatar Bank with management control. Rising competition in the months and years ahead may eventually convince the smaller banks to seek the advantages of consolidation.
Will profitability of Arab banks suffer now that interest rates have started going up in the international and domestic markets? Broadly speaking, banks make money in two ways. They are paid for taking on the risk of movements in interest rates and the risk that borrowers fail to repay loans. On the average, more than 70 percent of banks’ income in the region originates from the spreads they make on loans and deposits, compared to less than 55 percent for most commercial banks in the US and Europe. Arab banks also earn fees for providing various banking, brokerage and treasury services to their clients.
Interest rates on the US dollar have risen by 0.75 percent in the past three months and they are likely to continue edging higher in the months ahead. The Central Banks in the region raised domestic interest rates to match those on the dollar. Fortunately, interest rates are going up at a time when the regional economy is growing. This is supposed to help banks, because rising personal income, higher corporate profits and robust stock markets will boost deposit-taking and increase lending and fee income. Moreover, rising rates should help banks generate more income from current accounts, particularly those that earn no interest, because banks can now invest this money in higher-yielding corporate and government bonds. In a rising interest rate environment, Islamic banks and those who have a high percentage of non-interest bearing current account deposits would benefit most.
The improving economic conditions have created “a feel good” factor among consumers in the region. Given that more than 60 percent of the population in the region is below the age of 24, the demand for individual loans will keep on rising. Western style consumer habits are becoming more prevalent, encouraging Arab banks to increase exposure to this previously under lent sector. Demography also suggests that there will continue to be a steady stream of new customers fueling demand for retail lending.
Consumer lending will get a major boost if credit bureaus are established in various countries of the region to help banks extend personal loans based more on the credit history of the borrower and less on salary assignment schemes. Kuwait is the only country in the region that has a functioning credit bureau owned by all the Kuwaiti banks. Saudi Arabia, UAE and Bahrain are in the process of establishing such bureaus. For example, when the Hong Kong debt crisis was at its worst four years ago, some individuals were going bankrupt with debt equivalent to 120 months’ income. At that time Hong Kong did not have a credit bureau. On the other hand in the US, where there are credit bureaus, banks refuse to lend more to a borrower if that person already accumulated debt equivalent to 22 months’ income.
Arab banks have managed the low interest rate environment of the past four years quite effectively and any pressure on margins now is likely to be offset by growing loan demand. Cost cutting is also likely to become a more common means of boosting profitability. Overall, Arab banks are in a very good shape this year and 2005 is likely to see solid growth rates for the sector.
(Henry T. Azzam is chief executive officer at Jordinvest.)