Thanks in large part to the dirham’s peg with the dollar, the record low interest rates at the US Federal Reserve have meant that Abu Dhabi’s banks have operated in a highly liquid market. This scenario has been further strengthened by the plentiful supply of deposits flooding into the UAE from countries such as Syria, Egypt and Tunisia. However, a drop in government deposits, tighter liquidity, higher interest rates, and domestic and global economic slowdowns could constitute serious challenges. The liquidity issue is likely to be a hot topic in the industry for some time.
On the regulatory front, the past year has seen significant developments, as the Central Bank of the UAE (CBU) begins the process of introducing Basel’s liquidity frameworks. On the business environment side, meanwhile, tightening liquidity is set to present fresh challenges for Abu Dhabi’s lenders.
Banks across the GCC enjoy sizeable capital buffers compared to their international counterparts. The issue of liquidity, however, presents more challenges to regulators. Basel’s focus has been on ensuring banks have enough easy-to-sell assets to last them through an economic downturn. The Basel Committee for Banking Supervision started with a 30-day scenario of adverse conditions, for which it formulated the liquidity coverage ratio (LCR), and in October 2014 it published its protocol aimed at protecting banks from a year-long economic downturn, the net stable funding ratio (NSFR). The CBU has taken a consultative approach with regards to the LCR and NSFR, which will affect Abu Dhabi’s lending institutions.
Ensuring that the liquidity position of the UAE’s banks conforms to the Basel Committee’s recommendations has been a central concern of the CBU for some time. Its approach has been informed by qualitative and quantitative criteria. On the qualitative side, the CBU has called on banks to implement a liquidity risk-management framework, each instance of which will take account of the importance of the institution to the UAE economic landscape, the size of its assets, the scope of its operations and its exposure to international markets. The framework requires banks to abide by liquidity-related directives, including ensuring that board members are familiar with liquidity risk and how it is managed; that management designs and implements strategies according to the risk tolerance of the bank; that regular internal stress tests are staged; and that contingency funding plans to combat liquidity shortfalls in emergency situations are prepared.
Implementing Basel III
The most significant milestone which the CBU passed in 2015 came in the form of the eligible liquid assets ratio (ELAR), made effective on July 1, 2015 as the first step of what will be a gradual transition to the full implementation of Basel III’s liquidity standards. The ELAR establishes a liquid assets ratio which banks are required to meet, consisting of physical cash in the bank, account balances at the CBU, central bank certificates of deposit, UAE federal government bonds and sukuk (Islamic bonds), reserve requirements, UAE local government bonds and foreign sovereign debt instruments.
The ELAR represents the first step of a journey to a more comprehensive liquidity framework, and as of January 2016 a set of “approved” banks are set to begin transitioning to the LCR. Taken from Basel III requirements, the standard is designed to protect banks from an envisaged 30-day stress scenario by ensuring that they have sufficient high-quality liquid assets to match the anticipated net cash outflows over such a period. The CBU has elected to follow the Basel-defined schedule of achieving 70% coverage of the standard in January 2016, and rising 10% each year to achieve 100% coverage by January 2019.
Looking further ahead, the CBU is preparing to transition banks to the NSFR – the Basel measure concerned with longer-term liquidity stability. This structural ratio addresses the key uses of funds and the various funding sources used by banks, with a focus on both the term of funding and its long-term stability. The CBU intends to follow Basel III’s NSFR standard from January 1, 2018.
The CBU’s focus on liquidity comes at a challenging time for Abu Dhabi’s banks. Low oil prices over the past year have resulted in a slowdown in deposit growth across the UAE banking sector, as the government has begun to draw down reserves in order to maintain spending. While in 2014 deposit growth outstripped lending growth as usual, in 2015 a new dynamic emerged whereby deposit accumulation has lagged the extension of credit.
The new UAE liquidity scenario is clear from the CBU’s data: between December 2013 and December 2014 aggregate deposits in the UAE banking sector grew from Dh1.28trn ($348.4bn) to Dh1.42trn ($386.5bn), a gain of around 11%. Domestic credit increased from around Dh1.2trn ($326.6bn) to Dh1.28trn ($348.4bn) over the same period – a rise of around 6.7%, and characteristic of the normative rate of credit growth in relation to deposits.
However, as the effects of a persistently low oil price became apparent on banks’ balance sheets a new pattern emerged: between December 2014 and December 2015, aggregate deposits in the UAE banking sector grew by a modest rate of around 3.5%, from Dh1.42trn ($386.5bn) to Dh1.47trn ($400.1bn). Domestic credit extended by UAE lenders, meanwhile, expanded by a relatively robust 7.8%, from Dh1.28trn ($348.4bn) to Dh1.38trn ($375.6bn). An OBG analysis of Abu Dhabi’s five largest banks shows by September 2015, the aggregate customer deposits had decreased by 1%, while loans and advances had grown by 10%. The divergent trajectories of deposits and lending, if sustained, promise to establish liquidity as the headline issue for the sector in 2016.
The prospect of subdued oil prices over the medium term means that the new regulations governing liquidity are likely to gain less attention over the coming year than the liquidity challenge presented by low deposit growth. While the new liquidity framework may present short-term difficulties to some lenders, the CBU has given itself sufficient leeway in its implementation plans to ensure a smooth transition to it. The move to the LCR from January 1, 2016, for example, will only be undertaken by “approved” banks, according to the CBU.
The principal question facing Abu Dhabi’s banks in 2016, then, is how will low deposit growth, or even contraction, affect liquidity – and therefore their prospects for business development. An important consideration in this respect is the comfortable capital situation of the sector, demonstrated by a capital adequacy ratio (CAR) of 18.3% in September 2015. Abu Dhabi’s largest banks are in an even stronger position than the average, with CARs for the big five ranging from 16.50% to 19.68% as of the third quarter of 2015, and all of them enjoying Tier-1 ratios in excess of 15.5%. Abu Dhabi’s banks are well positioned for whatever market conditions prevail over the coming months; the issue is one of business development.
Rising funding costs due to tightening market liquidity are likely to place further pressure on margins over 2016, continuing a trend that has already been sustained for some years: First Gulf Bank, Abu Dhabi’s third-largest bank by assets at the end of 2015, reports that its net interest margin has declined from 3.8% in 2011 to 3.4% in the first half of 2015, and that downward pressure is expected to continue.
However, while constricted liquidity is likely to result in increased funding costs, lower margins and more pricing competition between lenders, from a financial stability perspective the sector remains well positioned for what is essentially a natural movement of the liquidity cycle.
“I think that on the liquidity issue what we will see is a tightening, rather than a crunch, which is a reversal of the oversupply,” Monica Malik, chief economist at Abu Dhabi Commercial Bank, told OBG. In the liquidity landscape, one era gives way to another. Abu Dhabi’s banks, it seems, are well prepared to weather it.
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