Key Features of UAE Banking Industry

Discuss about the Impact of Global Financial Crisis on UAE’s Banking Sector.

UAE’s banking industry is quite fragmented in nature. At present, the industry consists of 23 domestic and 28 foreign banks. The banks integrated in Dubai and Abu Dhabi enjoy the lion share in total domestic assets. The key features of UAE banking industry include concentration in deposits and loans, high proportion of exposure to the related party, availability of limited data transparency, and intense competition in the industry. The performance of UAE banking industry is aligned to the performance of real estate and construction sector (Zarrouk, El Ghak & Abu Al Haija, 2017). The banks though strong connection with local government but the concerned sector has limited diversification and show concentration in relation to geographies, customers and products.

During global financial crisis, like other GCC countries UAE affected significantly through financial and trade channels. The common symptom of increased risk was seen in high growth of credit, boom in property market and large inflow of capital. The funding of banks significantly disrupted during this time. Countries like UAE experienced a reversal of speculative inflow of capital. This in turn constrained liquidity condition affecting confidence of investors (Ashraf, Rizwan & L’Huillier, 2016). The problem further aggravated with collapse of Lehman Brother in September 2008. With this, the financial imbalance had become more evident in United Arab Emirates (UAE).

The banking sector of UAE is relatively less exposed to Europe. The foreign liabilities of UAE banks are only 19 percent of total liabilities. Having a relatively small size of European subsidiary, the effect of financial crisis was projected to be moderate (imf.org, 2012). However, the crisis transmitted to UAE financial sector through various channel leading to a decline in equity return, increase in Non-Performing Loan and crisis in financial crisis.

The global financial crisis that had begun in July 2007 was primarily caused by a sudden credit crunch in US financial market. During this time, any US investors lost their confidence in the subprime mortgage value causing a liquidity crisis in the economy. The origin of the crisis was found in deregulation initiated in financial market. This allowed banks to involve in hedging fund in terms of trading with derivatives (Rey, 2015).  The recession occurred in 2001 hardly hit US banks welcoming new derivatives. To counter the crisis, the Federal Reserve lowered the fund rate to 1.75 percent. The fund rate again lowered to 1.24 percent in 2002. This in turn lowered adjustable mortgage rate. The mortgage payment were lower as the interest rates were subject to yields from short term Treasury bills. The return on the treasury bills in turn depends on the federal fund rate. The low mortgage payment lowered banks’ income. The low fund rate was a good news for those who previously were unable to afford traditional mortgage payment. The favorable payment condition doubled the subprime mortgage, which rose to 20 percent from 2001 to 2006 (Feldkircher, 2014). The industry had grown so rapidly that by 2007, it turned to a $1.3 trillion industry. This lead to a real estate asset bubble in 2005. The mortgage demand boosted the demand for housing. With availability of cheaper loans, people started buying homes as an attractive means of investment and expected to sell these houses at a higher price. In 2004, the federal interest rate was started raising. The interest rate was hit to 5.25 percent by June 2006. As a result, many homeowners found the repayment unaffordable. After reaching peak in October 2005, the house price started falling. In July 2007, the price went down by 4 percent (Baylis, Smith & Owens, 2017). The low house price means that mortgage holders were unable to repay the loans by selling the low priced houses. This combined with high interest rate worsen the situation. This was the time when housing bubble burst leading to a banking crisis. The banking crisis created an economy wide financial crisis named as Great Recession of 2008.

Effects of Global Financial Crisis on UAE Banking Sector

United Arab Emirates is now considered as one of the fastest growing emerging economies. In the last few decades, the nation has accounted a significant growth rate. The growth potential of UAE has attracted many investors to invest in UAE market. The financial crisis occurred in 2008 raised great concerns for UAE economy. The crisis had brought the economy to a path of future uncertainty. The biggest impact of the crisis was on the oil sector. The sector being one of the crucial sector of the economies had hit badly (Ahmed, 2015). The second sector that called for an emergency was the banking sector. After declaration of bankruptcy by Lehman Brothers, the Banking sector fell into big trouble.

The banking sector in UAE was not resistant to financial crisis of 2008. There was no income tax in Dubai and government accounted only USD 10 billion of the nation’s debt. UAE tried to counter the growth slow down by increasing liquidity in banking sector. The central bank of UAE and Abu Dhabi provided Dubai additional USD 10 billion as loans. The bank deposit has declined to USD 252 billion in the second quarter of 2009 as compared to USD 285 billion in the first quarter (emirates247.com, 2018).

The bank shares in UAE had slammed by a historical fall in oil prices. The loan to deposit ratio fell to 108 percent in 2008. During this time, the coverage ratio also fell significantly. The banking sector of UAE was relied on wholesale global funding market. The global funding market was frozen after failure of Lehman’s Brother and this hurt the confidence of international interbank market. Following the crisis hit, many depositors run out from Gulf Banks. The Saad/Al Gosaibi bank loan scandal of $24 billion hurt confidence of banks. The bailout of US’s Treasury, AIG, RBS and Lloyds all contributed to an increase in risk premium for borrowers (Singh et al., 2017). This made borrowers nervous and unsettled in the financial market.

The lost confidence of banking sector had a direct impact on employees. Banks in order to reduce their employee expenses laid off many workers.  HSBC for example had served termination notice to many junior and middle management employees. During 2009, HSBC had experienced a 35 percent decline in H1 pre-tax profit to the $643 million as compared to the pre-tax profit in 2008 (arabianbusiness.com, 2018). The charges for loan impairment had increased sharply to $391 million from earlier $41 million following deterioration of credit quality due to weak economic condition.

Impact on Credit Demand and Supply

The integration of UAE with global financial market makes the nation extremely vulnerable to financial crisis in 2008. The banking sector of UAE is highly capitalized. The blue chip investment has made UAE an important participant in international capital market. The UAE banking sector is not only well capitalized but also the sector is highly profitable with support of banks’ asset base. During 2017, the profit of banks rose sharply. In 2008, the capital adequacy ratio was 13.3 percent exceeding the minimum limit of 10 percent (Rosman, Wahab & Zainol, 2014).  During 2008 financial crisis, the growth and profitability of UAE banking sector was severely interrupted. The global financial crisis of 2008 reduced the availability of wholesale funding. This hampered the flow of fund in to the banking sector. Extreme pressure on portfolio investment, shuttered real estate market, withdrawal of loan agreement from real estate projects all affected the performance of banking sector.

The economy had plenty of credit flow in the first half of 2008. However, the financial condition became tightened in the second half of 2008. There were three key factors that contribute to a sudden drop in the financial performance of UAE following global financial crisis. After financial crisis, it became difficult and costly to access to global capital market. This had an adverse impact on long term funding of banks and financial institution. This in turn constrained bank’s ability to lend and thereby raised economy’s reliance on the local bank markets. The other channel through which UAE banks were exposed to crisis was the foreign exchange market. In the phase of crisis huge amount of speculative funds were withdrawn from UAE market (Caporale, Lodh & Nandy, 2017). This affected deposit of banks leading to a dollar shortage. The third factor was that during this time the growth of loan far exceeds the growth of deposit.

In an economy, bank plays an important role. It is responsible for supply credit to meet the credit demand of individual and different businesses. Different banks in UAE similar provide credit to people and business. After global financial crisis in 2008, both demand and supply of credit were severely hurt and thus lead to contraction of banking activities.

The global financial crisis hit adversely hit different sectors of the economy. The economy had experienced a slowdown in the real GDP growth rate. Oil and gas sector is one of the dominant sector of the economy. With the aftermath of global financial crisis, the sector contracted significantly. The economy was hurt by the low oil price impacting financial health and the state of consumption and investment (Mohamed, 2016). The average oil production dropped to 2.2 mb/d. This is one of the crucial factor for a slow growth in real GDP and hence significantly influences the credit demand.

Contraction of Oil and Gas Sector

Figure 1: Real GDP growth in UAE

(Source: Kren, Edwards & Van Hove, 2015).

Another sector that contributed to a decline in credit demand was the construction and real estate market. In between 2002 and 2008, the property price in Dubai had quadrupled. The housing price rose by more than 116% in the third quarter of 2008. After global credit crisis, more than half of the construction projecting worth AED 1.1 trillion were either cancelled or kept on hold. This reduces the credit demand in housing sector. The central bank of UAE was forced to follow monetary policy of US which caused the inflation rate to reach at a recorded high level of 12.9% (Jreisat et al., 2017).

Not only credit demand but also credit supply was interrupted in the phase of crisis. The banks’ ability of long term funding reduced significantly following the difficulties to access to global market. Because of high inflation rate household had increased their credit demand. The higher growth of loans over deposits raised the loans to deposit ratio. Another factor that caused an interruption in credit supply was the decision of foreign banks to pull out their money from the economy. Immediately after the crisis, the two largest house financing companies in UAE, Amlak and Tamweel stopped to provide new loans (arabianbusiness.com, 2018).

Figure 2: Comparison of assets and liabilities of UAE banks

(Source: Dalwai, Basiruddin & Abdul Rasid, 2015)

Figure 3: Effect of financial crisis on banks

(Source: Waemustafa & Sukri, 2015)

The global financial crisis thus adversely affected both the supply and demand for banking services.

UAE has a dynamic business environment. The banking system of UAE is the backbone of the economy and hence is responsible for providing various product and services to the business sector. The banks offer merchant banking, treasury product and corporate banking to the corporate market. The product and services of banks are designed with priority given on needs of the client (worldfinance.com, 2018). Financial solution to the corporate finance, project finance, investment banking, corporate banking, trade and commodity finance all cover under broader category of banking product and service.

The cost incurred by the banking organizations are mainly classified in four groups- Distribution cost, IT costs, building cost and Operating costs. The distribution cost of banks refers to cost of channeling banks credit to various fields. The IT costs typically include cost of advanced technology, implementation and digitalization and other IT related cost. Building costs are type of fixed cost. The operating expense is the most variable part of banks’ cost. It includes payroll, benefit to employees, travel and transportation allowances, administrative and general expenses (Ashfaq, 2016). During financial crisis, banks faced with a lower income from non-performing loans and loan defaults. In order to reduce operating expenses bank laid off workers.

Fall in Real GDP Growth

The banking industry generally possess characteristics of an oligopoly market, a market which is dominated by a few large players. Being one of the important trading hubs of middle east, UAE has become a center of attraction for many investors and entrepreneurs across the globe. The banking sectors in UAE is one of the fastest growing and highly competitive sectors. The UAE however is an overbanked nation (Hesse & Poghosyan, 2016). At present, 51 banks are operating in UAE stimulating stiff competition and creating significant pressure on banks’ interest margin. The four major players in terms of asset and deposit shares are Emirates NBD banks, National Bank of Abu Dhabi, First Gulf Bank and ADCB.

After a period of rapid growth till 2008, the Abu Dhabi Commercial Bank had faced with spectacular setback at the phase of global financial crisis. However, the bank had quickly overcome the shock because of the outstanding performance of leadership team. The leadership team focused on improving core competencies and maintained transparency in its operation. The strategies kept the bank at a less disadvantageous position as compared to its competitors. The National Bank of Abu Dhabi was least affected from the crisis hit. While most of the banks has undergone dramatic turmoil due to credit crunch NBAD stood at a comparatively better position. The strategy of NBAD focused on areas such as promotion of leadership, development of people, service to the customers, constant improvement in the provided services and adaption of corporate social responsibility.

So far as the financial sector of UAE is concerned there exists close interconnection between banks and the government or the major financial institutions. The close interlinkage ensures that banks are very unlikely to fail in UAE.  The banking system of UAE resembles the characteristics of most emerging economies. The strength of the financial system is also considered as its weakness as well. The close connection with government provides depositors and business partners assurance of a steady return (Tlemsani & Al Suwaidi, 2016). This is strength of the banking system. However, the limited scope of disclosure has made it difficult to assess the quality of assets. This lead to potential moral hazard problem in UAE banking industry.

The central bank of UAE assured the world market that it would extend its support to overcome huge debt accounted to foreign banks in Dubai. The central bank announced for a special liquidity scheme for the overseas bank to provide the World companies operating in Dubai a comfort fearing of loan repayment. A $4 bn bond was paid as a part of central government’s rescue package.

In the phase of crisis ADIB, ADCB and DIB were the three banks that were worst off during global financial crisis. The UAE banks were adversely effected by the loan default of Sa’ad and Al-gosaibi (Trad et al., 2017). This lead the UAE banks to take provisions from corporate sector. The fall in property prices had a major impact on loan exposure of the banks that highly dependent on real estate sector.

Banks in UAE were lacked sufficient cash to meet their debt obligation. The Abu Dhabi government supported Dubai with an additional loan worth USD 10 billion. The government for boosting confidence of banking sector had undertaken the following measures.

• The central bank established additional liquidity facility of USD 21 billion
• The monetary authorities reduced the interest rate to 1.5 percent from prevailing rate of 2.5 percent in order to support borrowing (khaleejtimes.com, 2018).
• The Federal government took expansionary fiscal policy to offset the decline in aggregate demand
• The government followed a zero based budgeting in the budget cycle of 2011-2013.

The banks in UAE had received complete support from federal government and central bank in times of global financial crisis. The central bank had introduced extra liquidity facility. Based on the debt restructuring and exposure, some banks might require additional capital injection from the government. The federal government had a reserve of $5.5 billion to provide capital support to banks.

In the awake of crisis in financial sector of US, central bank of UAE asked all the banks to provide declaration regarding exposure to Lehman during this time. However, the measure did not involve any further exposure of these banks (Tlemsani, I., & Al Suwaidi, H. (2016). The exposures were in the form of trade derivatives involving Lehman as a counter party, bank bonds or structured investment.

The UAE bank had faced a probable threat from default of the Dubai world and related institution. The central banks of UAE asked banks for not taking provisions over Dubai World. According to CBUAE, banks were obliged to take fifty percent provisioning for the non-performing loans given to Sa;ad and Al-Qosaaibi. The rate is 100% while taking against TIBC and Awal bank.

The central bank issued circulation in relation to retail banking putting some restriction on the lending quantity. The regulation particularly focused on the retail exposure, pointed to specific case of FGB. The lending policy was revised to serve three primary objectives. The retail loans are generally highly yielding. It would limit loan expansion indicating a smaller interest income for incremental business (Miniaoui, Sayani & Chaibi, 2015). In reference to the modified borrowing terms, the loans with new defined limit would not be topped up in case such loans are already matured or paid off. The in turn implies that the retail loans might experience a decline. The third aspect was bank would lose a fraction of fee income from the retail sector.

The banking sector of UAE is not completely safe from financial crisis impact. The concerns remain because of following factors

• In the financial industry, there remain high penetration. The deposit to GDP ratio and loan to GDP ratio remain high and above 100%.
• The penetration of retail credit in UAE is amid maximum of 28% as recorded in September 2010.
• Banks remain highly exposed to real estate sector

Therefore, measure need to be taken to completely overcome the crisis and protect the banking sector from future shocks.

The first aspect that UAE government should focus on is to improve productive or service efficiency of banks.  United Arab Emirates holds second position within the Gulf region in terms of density of branch. The UAE is an overbanked region. The presence of different banks intensify competition among each players reducing margin and lending opportunities.

In economics, productive efficiency indicates a situation where the economy cannot produce additional unit of any good without sacrificing output of some other good. In other words, productive efficiency ensures the best possible combination of output given the resources. The absence of productive efficiency implies resources are not utilized properly. Like any other industry, the banking industry should focus on achieving productive efficiencies (Ganouati & Essid, 2017).  Studies however found existence of substantial cost inefficiencies in the UAE banking industry. The improvement in product efficiency of banks involves process improvement, increasing revenue gains, improving level of service and redesign of organization.

The Banks in UAE now are facing challenge of weak quality of assets. Most banks have accounted high concentration of non-performing loans and inefficient provision. This is a big problem for UAE banking sector and focus should be given to reduce concentration of non-performing assets. The presence of non-performing assets delays bank’s recovery from financial crisis. The performance of banking sector is dependent on the oil price and macroeconomic condition (Banerjee & Rafiuddin, 2015). This is why the declined growth of oil and gas sector affect the lending activities of bank. The banks should reduce its reliance on oil sector to improve productivity performance and sustain any future crisis. The banks are connected with the local government. The intervention of government often reduces efficiency of banks. Hence, intervention should be restricted up to a certain limit.       

The financial and economic development of a nation depend on the efficiency of banking sector. The financial and economic growth can be achieved only through better and efficient utilization of resources in the industry. The allocative efficiency indicates that resources should be allocated in such a way that social welfare is maximized. It refers to efficient distribution of the produced goods or services. In the context of banking, the banks should be proficient in identifying appropriate opportunity based products.

The banks in UAE should focus on channeling credit to the productive investment. The banks in the region have shown dependence on real estate and construction sectors. Too much flow of credit to the property market led to internal credit crunch in the economy. Such credit flow should be restricted and firms need distribute funds across among different sectors. In the late middle of 2008, the loan growth in UAE exceeded depository growth. Therefore, restriction should be placed on credit flow (Aghimien et al., 2016). In UAE, concentration of non-performing assets hampers allocative efficiency. Such assets have possibility of loan default and therefore, reduces efficiency of funds. Therefore, central bank of UAE should focus on channeling banks’ credit to productive sources.

The Corporate Social Responsibility is one form of self-regulation incorporated in any business model. The objective of CSR is to embrace the responsibility of a company’s action. The goal is to have a positive influence of performance of the company with focus on consumers, employees, environment, stakeholders, communities and all other aspects in public sphere (Schwartz, 2017). For banking industry, successful implementation of CSR stimulates growth of banking sector. This enhances customers’ confidence of banking service. The various dimension of CSR include responsibility on society, environment, employees and customers. The social responsibility of corporations includes corporate’s responsibility to return some proportion of wealth for community development. The environmental responsibility is less relevant for banking as there is no direct use of natural resources (Nobanee & Ellili, 2016). In addition to own benefit, the company should look after well-being of the employees and customer.

A successful CSR framework provides strength to the company to overcome social and environmental challenges. CSR provides a way out for new business creation. This by raising bank’s confidence help to attract new investors in the country and thus bring growth opportunities. The banks in UAE should maintain is commitments towards corporate governance and workplace commitment. The National Bank of Abu Dhabi has already shown significant progress in the front of CSR. The bank has shifted from a non-strategic corporate social responsibility to a strategic one (khaleejtimes.com, 2018).  The successful implementation of CSR has made the banks sustainable during financial crisis of 2008. The other banks in the region should follow the same strategy to overcome future crisis.

In addition to above mentioned measures, some medium and long-term measures should be taken to escape UAE’s banking sector from the recessionary impact of crisis.  Enhancing communication is one way to improve effectiveness of policy. The clear communication includes clear statement of policy action, objectives of the policy undertaken and clear indication of rules and regulation. This will speed up the recovery by providing investors clear understanding regarding the financial policy. The UAE banking sector need continuous vigilance. In order to regain consumer’s confidence, the bank needs to maintain a clear balance sheet. This will then support the intended credit growth. This will be accomplished by implementation of a clear supervisory and regulatory framework. The central bank should be forward looking about the recapitalization need of banks.

Conclusion

The report analyzes performance of UAE banking sector during global financial crisis. The evidences suggest that the banking industry severely affected due to the crisis attack. The crisis caused a decline in real GDP growth rate by hurting major sectors of the economy. Bank’s cost in terms of non-performing loans or default loan increases. In order to reduce cost, bank laid off employees leading to unemployment problem. This in turn reduced consumption spending affecting the aggregate demand. The central bank came at the rescue of domestic banks. The CBUAE established separate liquidity facility, took expansionary policies to overcome the crisis. However, the banking system of UAE has yet not fully recovered from hit of the crisis. Some of the recommended strategy to strengthen the banking system include enhancement of productive and allocative efficiency and implementation of CSR.

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