The state-owned conglomerate, which is grappling with $26 billion in debt, is in the final stages of preparing a debt restructuring plan to put to its 97 creditors.
Analysts have voiced concerns that domestic lending would dry up if banks are forced to take big losses on Dubai World-related debt.
The IMF estimated banks across the region would have to raise $10 billion in funds if they were forced to absorb a 50 percent loss, or "haircut", on their Dubai World loans.
The UAE banking sector, already crippled by large-scale defaults in Saudi Arabia and the Dubai property bubble, is struggling to reach pre-financial crisis profit levels.
Dubai-based banks in 2009 posted a 31 percent overall decline in net income, a report from Global Investment House showed. Mashreq and Dubai Islamic Bank were worst hit, largely because of a spike in bad loans provisions.
"Banks will take a cautious approach in credit expansion until they see their non-performing loans peaking," said HC Brokerage banking analyst Janany Vamadeva.
"Liquidity, too, would be a factor in play with stretched loan-to-deposit ratios and the current gridlock in the international debt markets post the DW announcement," he said.
Banking stocks have recouped some losses in the past 10 days, as concerns eased on the potential outcome of the Dubai World restructuring. Recent reports have said that Dubai World will propose its creditors to repay the debt over seven years.
Credit conditions in the Gulf have already tightened since the onset of the financial crisis at the end of 2008, when a regional property boom ended and economic growth slowed.
A rise in corporate and personal defaults combined with expatriates leaving the country leaving debts unpaid have all contributed to a spike in provisions.
The Dubai World debt restructuring is the biggest to hit the region and has worried international investors about Dubai's position as the region's prime financial hub. Banks in Dubai have strong government ties and hold up to $15 billion in exposure to Dubai World.
"Either you take the impact straight away or you spread over the next seven to 10 years, but in the latter case there will be an impact on the level of profitability and the banks could become less competitive in terms of pricing," said a banking expert who requested not to be named.
The long-term solution "still amounts to a fairly negative scenario because it is not clear how the banks will account for it," the person said.
Investment bankers argued domestic banks would be better to bite the bullet now and, if needed, could call on government support to remain well-capitalized. Such a course of action will provide better visibility over earnings and allow the banks to focus on improving risk management and growth, bankers said.
One possibility is that creditors, unhappy with any kind of debt proposal, would declare Dubai World bankrupt and attempt to reclaim what assets are left through court proceedings.
"They would not gain anything by forcing the entity into bankruptcy and as such they would benefit by coming to an agreement that would help them recover the dues with minimal losses," Vamadeva said.
