UAE Banking Sector Outlook 2014: An Uptick In Lending And Economic Activity Signal Continued Profitable Growth

Primary Credit Analyst: Timucin Engin, Dubai (971) 4-372-7150; timucin.engin@standardandpoors.com Secondary Contacts: Emmanuel F Volland, Paris (33) 1-4420-6696; emmanuel.volland@standardandpoors.com Goeksenin Karagoez, FRM, Paris (33) 1-4420-6724; goeksenin.karagoez@standardandpoors.com Trevor Cullinan, Dubai (971) 4372-7113; trevor.cullinan@standardandpoors.com Nadim Amatouri, Dubai +971 (0)4 372 7157; nadim.amatouri@standardandpoors.com

Table Of Contents
We Expect Our Ratings To Remain Stable Credit Growth Is Gaining Momentum Asset Quality Is Set To Improve Profitability Will Likely Stay Robust The Fed's Potential Policy Changes Will Not Hurt UAE Banks Related Criteria And Research

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UAE Banking Sector Outlook 2014: An Uptick In Lending And Economic Activity Signal Continued Profitable Growth
Banks in the United Arab Emirates (UAE) have good prospects this year because of healthy economic growth and an upbeat corporate sector, Standard & Poor's Ratings Services believes. What's more, real estate prices have been inching upward since late 2012, particularly in Dubai, and banks' credit losses are gradually decreasing. Over the past six months, we've also seen signs that credit growth is picking up. We expect these trends to provide banks with another year of strong financial performance, and they support our stable rating outlooks in the sector. We believe the key risk factor to watch over the next 24 months will be developments relating to certain large restructured transactions. Potential nonpayment of these debts could increase some banks' provisioning requirements, thereby reducing their profitability. Also, while the supply of credit continues to increase, it remains to be seen whether banks will manage to avoid the pitfalls that led to the costly boom and bust cycle in 2002-2008. Overview Our rating outlooks for banks in the United Arab Emirates (UAE) are stable, in view of improving economic and business conditions in the country. With credit growth increasing, the four UAE banks we rate are set to deliver solid returns in 2014, in our view. We think asset quality will continue to improve, although the cost of risk is unlikely to reduce further. Banks' robust funding levels and good-quality capital should help them withstand potential adverse market developments, such as tighter liquidity and higher funding costs.

UAE banks' funding profiles have improved substantially over the past four years. Lending slowed to a trickle following the slump in local real estate and stock markets in 2008, and this led to a noticeable improvement in the banking system's loans-to-deposits ratio. Also, the U.S. Federal Reserve Bank (the Fed) has confirmed that it will only reduce bond purchases gradually, to $75 billion per month starting from January this year, from $85 billion. Consequently, we think financial market conditions will remain favorable. Still, there could be bouts of market volatility as the Fed changes its monetary policy. This could reduce the liquidity available to banks and make it more expensive. We believe, however, that UAE banks should generally remain strong because they still have only marginal net external assets.

We Expect Our Ratings To Remain Stable

Most UAE banks' nonperforming loan (NPL) ratios have been stabilizing over the past 12 months, after a significant deterioration in asset quality over the past few years. The banks continue to generate strong preprovision earnings and increase their coverage of reported NPLs, and the incidence of new NPLs has slowed substantially. Although we

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UAE Banking Sector Outlook 2014: An Uptick In Lending And Economic Activity Signal Continued Profitable Growth

generally expect this trend to continue over the next two years, we don't believe it has the potential to trigger positive rating actions at the current rating levels. As such, our outlooks in the sector remain stable (see table 1).
Table 1

Rated UAE Banks

Issuer Credit Ratings National Bank of Abu Dhabi AA-/Stable/A-1+

Abu Dhabi Commercial Bank A/Stable/A-1 Mashreqbank Sharjah Islamic Bank BBB+/Stable/A-2 BBB+/Stable/A-2

Over the past four years, UAE banks have reined in their lending activity as they focused on cleaning up their balance sheets, restructuring large exposures, and improving their funding and liquidity profiles. We now see clear indications that credit growth is increasing, particularly in Dubai, a trend that we expect will gradually accelerate in 2014. Although this could lead to higher revenues, we are mindful of the risk to asset quality if banks adopt more aggressive lending practices.

Credit Growth Is Gaining Momentum

After four years of modest credit growth, we expect the pace of bank lending to quicken in 2014, with support from healthy economic activity. We expect real GDP growth in the UAE to average about 3.7% annually over 2014 (see table 2). This is owing to continued strength in the non-oil sectors and our expectation that oil prices will remain at about $100 per barrel. Key sectors, such as tourism and corporate services, are performing strongly, particularly in Dubai, and we've seen a strong rebound in real estate prices over the past 18 months.
Table 2

UAE Key Macroeconomic Factors

(Bil. US$) Nominal GDP Per capita GDP ($) Real GDP growth (%) Current account balance (% of GDP) Net external debt (% of GDP) 2009 255 33,013 (4.8) 0.7 2010 287 34,049 1.7 1.7 2011 349 39,058 3.9 13.8 2012 384 41,692 4.4 16.5 2013f 410 43,133 3.6 13.2 2014f 437 44,666 3.7 9.7

(127.7) (120.5) (101.6) (115.1) (122.3) (125.9)

Net general government debt (% of GDP) (135.5) (123.0) (103.8) (113.6) (117.4) (120.3) f--Forecast. Source: Standard & Poor's.

Banks in the UAE had stopped lending almost completely in 2008-2012 as they shifted their focus to cleaning up their balance sheets and improving their funding profiles. The compound average nominal growth in credit to residents was a meagre 2.3% annually, well below the 13.2% average nominal yearly GDP growth rate during that period. This translated into a steep drop in the ratio of domestic credit to the private sector and nonfinancial public-sector enterprises to GDP to 68.5% by 2012 from its peak of 92.3% in 2009 (see chart 1).

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UAE Banking Sector Outlook 2014: An Uptick In Lending And Economic Activity Signal Continued Profitable Growth

Chart 1

Last year, there were visible signs of a revival in UAE banks' loan portfolios. According to central bank data, in the first nine months of 2013, gross system loans increased by 7.5% and the amount of personal loans had risen by 9.3%. The banks we rate in the region showed gross loan growth of 9% over the same period. We expect the nominal growth of credit to remain at about 10%-12% in 2014 and 2015. The positive overall trend in employment and the retail sectors should continue to foster banks' retail loan books. We also expect vigorous demand for corporate credit in view of potential new projects in Dubai ahead of its hosting of the World Expo trade convention in 2020.

Asset Quality Is Set To Improve

The reported NPL ratios of the four UAE banks we rate have been improving since 2011, which we think will continue. As of Sept. 30, 2013, the aggregate NPL figure stood at $4.3 billion (excluding restructured exposures), about $450 million lower than at year-end 2012 (see chart 2). The main reasons for the rapid deterioration in asset quality in 2008-2010 were a drop in real estate prices in the UAE and the worsening financial position of certain government-related entities (GREs) in Dubai with large bank debt.

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UAE Banking Sector Outlook 2014: An Uptick In Lending And Economic Activity Signal Continued Profitable Growth

Chart 2

But there's been an upswing in the property markets since 2012. Real estate information provider REIDIN.com states that, as of November 2013, residential real estate prices in Dubai had risen by 22.4% compared with the previous year, and in Abu Dhabi the increase was 19.7%. In addition, the financial profiles of GREs in Dubai have improved over the past two years, through stronger cash flow from operations, asset sales, or debt rescheduling. Consequently, the banks we rate have reported progressively lower amounts of new NPLs over the past few quarters. The proportion of NPLs to gross loans has fallen in turn, and we expect this trend to continue as loan growth outpaces new NPLs. The banks' ratios of credit losses to average gross loans have also been declining since their peak in 2009, in line with the slower formation of net new NPLs: The ratio was 0.7% on average in the first nine months of 2013, down from 1.1% at year-end 2012 (see chart 3). We do not, however, expect further significant declines because we expect the rated banks to keep strengthening their loss provisions and coverage levels, as they did in the first three quarters of last year.

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UAE Banking Sector Outlook 2014: An Uptick In Lending And Economic Activity Signal Continued Profitable Growth

Chart 3

Despite the improvements in banks' reported asset-quality metrics, we note a fair amount of restructured or renegotiated exposures that could jeopardize some banks' future performance. This is because potential nonpayment of these exposures could lead to additional provisioning requirements that put pressure on earnings. This is another factor that will motivate banks to maintain conservative provisioning policies, in our view.

Profitability Will Likely Stay Robust

We expect the banks we rate in the UAE to post strong net income growth this year as revenues increase on the back of new lending. This is despite our expectation that the decline in credit losses will be less pronounced than in 2009-2012. During that period, credit growth had slowed considerably; therefore, falling credit losses were the key contributor to the recovery of profitability. The combined net income of the four rated banks was about $2.1 billion in the first nine months of 2013, about 17% higher than the $1.8 billion reported for the same period in 2012 (see table 3).

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UAE Banking Sector Outlook 2014: An Uptick In Lending And Economic Activity Signal Continued Profitable Growth

Table 3

Rated UAE Banks--Contributors To Return On Assets

--Year ended Dec. 31-(%) Net interest income to average earning assets Average earning assets to average assets = Net interest income to average assets (1) + Fee income to average assets (2) + Other noninterest income to average assets (3) = Operating revenues to average assets (1 + 2+ 3) - Operating cost to average assets - Credit losses to average assets - Other items to average assets = Return on average assets Equity leverage (avg. common equity to avg. total assets) 2007 2.58 73.34 1.89 0.84 0.70 3.44 1.25 0.36 (0.43) 2.27 9.30 2008 2.70 76.07 2.05 0.81 0.53 3.40 1.35 0.72 (0.26) 1.60 9.73 2009 2.71 82.07 2.22 0.77 0.58 3.58 1.24 1.64 (0.08) 0.78 9.73 2010 2.82 84.23 2.38 0.70 0.49 3.56 1.26 1.28 0.02 1.00 9.70 2011 2.90 83.02 2.41 0.62 0.43 3.47 1.33 0.97 (0.31) 1.47 9.43 2012 Q3 2013 2.91 81.96 2.39 0.65 0.43 3.47 1.28 0.70 (0.02) 1.51 9.10 2.88 84.55 2.44 0.55 0.71 3.70 1.28 0.60 (0.05) 1.87 9.07

The Fed's Potential Policy Changes Will Not Hurt UAE Banks
If the Fed decides to gradually end its bond-buying program, this could dampen investors' appetite for debt in emerging markets. However, we don't expect this to cause a major shock for the UAE banking system because banks have solid funding profiles. Systemwide funding improved substantially after 2008 as banks reduced debt and deposits grew faster than lending. As a consequence, the ratio of net resident loans to net customer deposits declined to about 94% by Aug. 30, 2013, from 111% at year-end 2008. At the same time, banks' already limited dependence on external funds became even lower. For example, at year-end 2008, the banking system's ratio of net external liabilities to its total asset base was about 5.5%; as of Aug. 30, 2013, this position had reversed, improving to a ratio of total assets to net external liabilities of 1.3% (see chart 4).

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UAE Banking Sector Outlook 2014: An Uptick In Lending And Economic Activity Signal Continued Profitable Growth

Chart 4

We also believe UAE banks are generally well placed to handle the effect of potentially higher global interest rates if the Fed changes its monetary policy. The proportion of capital market exposures on UAE banks' balance sheets has been traditionally lower than those of their Western peers, and most of the exposures are fixed-income securities with maximum terms of five years. Therefore, mark-to-market losses following potential rate hikes would be manageable, in our view. All in all, banks have ample loss-absorption capacity because their capital bases contain very high levels of Tier I capital. This, combined with gradually improving profitability, should keep them on a path of stable growth in 2014.

Related Criteria And Research

Related Criteria
Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011 Bank Capital Methodology And Assumptions, Dec. 6, 2010 Understanding Standard & Poor's Rating Definitions, June 3, 2009

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Related Research
Banking Industry Country Risk Assessment: United Arab Emirates, Jan. 21, 2014 Credit FAQ: How The UAE's Lending Caps Affect Domestic Banks, Government Entities, And The Capital Markets, Jan. 13, 2014 Credit FAQ: How The United Arab Emirates' Caps On Mortgage Loans Will Affect Banks And Property Developers, Nov. 18, 2013 Gulf Islamic Banks Continue To Grow Faster Than Their Conventional Peers, But Profitability Rates Are Converging, Oct. 1, 2013 A Growing Economy And Strong Capitalization Keep Gulf Banks On A Path To Recovery, March 20, 2013 Low Interest Rates Should Keep Gulf Banks' Debt Issuance Levels Strong In 2013, March 4, 2013 Exit European Banks, Enter Gulf Banks As Major Acquirers In The Region's Emerging Markets, Feb. 1, 2013
Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com

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