Featuring both onshore and offshore markets, Dubai’s banking sector has become an integral part of the global financial services universe. Facilities range from conventional financial intermediation in a competitive domestic landscape to advanced specialist services housed in the Dubai International Financial Centre (DIFC), the emirate’s financial services free zone. Dubai has also positioned itself as a global centre for Islamic banking, a young and fast-developing market segment.
With oil prices ticking up in the latter half of 2017 and first half of 2018, the outlook for Dubai’s financial services providers is improving in tandem. While the fall in global oil prices beginning in late 2014 brought challenges, lenders have been able to manage, and the sector has maintained profitability and healthy prudential ratios throughout. As benchmark oil prices moderate somewhat in the second half of 2018 and going into 2019, they remain higher or on par with the 2015-17 period, and Dubai’s banks are poised to benefit, as are others across the region. “Oil will remain the key credit driver for the region over the next decade at least,” according to economic research from Dubai’s Acreditus, a credit ratings and finance advisory firm.
The long-term future is also likely to feature the increased adoption of new financial technology (fintech), ongoing drives for enhanced efficiencies, and regulatory reforms to further protect banks and their customers from excessive exposure to risk. According to a November 2018 sector report from global credit ratings agency Moody’s, as a result of the government’s willingness to embrace digitalisation, as well as the country’s high mobile phone penetration rate and “young, tech-savvy population”, UAE financial institutions will likely benefit from an environment conducive to digital innovation.
The emirate’s onshore financial system exists under the umbrella of the UAE, as all banks in the country are licensed at the federal level. Some lenders, such as Dubai’s Emirates NBD, have maintained a consistent nationwide presence, while others largely focus on their respective emirates, such as the Bank of Sharjah and Ajman Bank. Moreover, retail operations tend to be more – though not exclusively – focused on their home emirates. Emirates NBD operates 95 branches in Dubai compared to 25 in Abu Dhabi.
Dubai’s offshore sector, housed within the DIFC, is independent of the federal system. The government of Dubai founded the DIFC, along with the Dubai Financial Services Authority (DFSA) as its regulator, in 2002, with operations commencing two years later. The DFSA has recently introduced regulatory frameworks for loan and equity crowdfunding platforms, Eric Salomons, director and head of markets at the regulatory authority, told OBG.
In the mid 2000s, with oil prices reaching peak levels, the emirate’s financial services sector began attracting foreign capital and liquidity from across the region; however, the global financial crisis of 2007-08 was an abrupt change. Even though banks in Dubai and across the GCC region had minimal exposure to the US securitised mortgages at the heart of the recession, foreign portfolio investors withdrew from emerging market securities to cover losses at home. Dubai markets felt the indirect impacts of the crisis, and while no local lenders failed, asset quality deteriorated.
Moreover, government-related entities (GREs) – companies with more than 50% state ownership that are often tasked with driving economic development through investment – had to scale back ambition and loans were restructured. A number of financial institutions, including Emirates NDB and Dubai Islamic Bank, are classified as GREs.
Structure & Oversight
In the UAE domestic market banks reported Dh2.84trn ($773bn) in assets at the end of the third quarter of 2018, making the UAE’s banking sector the largest in the GCC region, according to the Central Bank of the UAE (CBU). There were 49 banks operating in the country’s domestic market – 22 of which were local and 27 foreign. Domestic banks accounted for 87.2% of system-wide assets as of end-September 2018, indicting an increase of 8.7% year-on-year (y-oy). Of 22 Emirati banks, six are headquartered in Dubai: Commercial Bank of Dubai, Emirates NBD, Mashreq Bank, Dubai Islamic Bank, Emirates Islamic (the Islamic unit of Emirates NBD) and Noor Bank.
Islamic banks account for about 20.4% of overall assets and activity as of the third quarter of 2018. Such facilities offer sharia-compliant alternatives to conventional finance that do not violate the religion’s ban on charging or paying interest. Islamic banking instead uses profit-sharing, fees and other structures to provide consumers with a similar product. The amount of sharia-compliant assets in the system is likely higher than the above figure, as many conventional banks offer such products as well through separate Islamic windows. While standard financial institutions are expected not to commingle funds, for reporting purposes, they do not separate these assets from their totals.
The CBU handles the licensing and regulation of the domestic banking system, including for both national and foreign lenders. The central bank was created by the Union Law of 1980, which is also the main piece of legislation governing the financial sector. In the DIFC’s offshore banking sector, a bespoke legal environment featuring fit-for-purpose laws, courts and arbitration systems was established, largely based on English common law.
The need for consolidation has remained a persistent structural feature in the market over the years, but the regulator has declined to use policy as an instrument. The situation is made more complicated by the fact that some banking institutions have been established to meet the needs of specific emirates, and controlling ownership stakes are in many cases retained by the emirates or their ruling families.
Previous high profile mergers and acquisitions have included the merging of the National Bank of Abu Dhabi and First Gulf Bank to create First Abu Dhabi Bank in 2016, as well as the combining of National Bank of Dubai and Emirates Bank International to form Emirates NBD in 2007. Market chatter on further consolidation is focused more on lenders in Abu Dhabi than in Dubai, however, as leadership there has been focused on streamlining its holdings.
Since early 2018 Emirates NBD has been negotiating the terms of a proposed deal to buy Turkey’s DenizBank from its current Russian parent, Sberbank, which acquired the company in 2012. The deal was valued at TL14.6bn in May 2018 – equivalent to around $3.34bn at the time – but was payable in dollars at closing. As of early 2019 the current market value of the deal in dollar terms had declined by 17% to $2.77bn. The lira’s drop makes the purchase less expensive for Emirates NBD if the deal goes ahead as initially structured; however, concerns about credit quality at Turkish banks has also raised the possibility of loan defaults by DenizBank customers.
Foreign lenders have established a strong presence in both the onshore market and in the DIFC. Dubai has become a centre for services aimed at high- and ultra-high-net-worth clients, as private wealth in the MENA region is expected to reach $12bn by 2021, according to US multinational management firm Boston Consulting Group.
While much of this activity is taking place in the DIFC, onshore foreign banks accounted for 13.1% of overall assets at the end of the third quarter of 2018, according to the CBU. That figure is down from 13.4% at end-2017, indicating that domestic banks grew at a faster rate in the first three-quarters of the year.
International institutions accounted for 81 branches and 5588 employees, or 15.8% of the onshore banking workforce. While branch numbers remained similar, dropping by one branch since end-2017, worker totals fell by 24% in the first half of 2018, from 7311, as lenders focused on digitalisation and alternative methods to reach customers.
Profitability was on the rise in Dubai in the second quarter of 2018, with lenders reporting increased operating income, at a rate of 2.25%. Net interest margins expanded as well, to 2.61% from a rate of 2.55% in the first quarter. Figures in 2017 showed profitability was 6.6% higher for the country’s top-10 banks, with asset quality improving as the country moved on from legacy debt issuances to small and medium-sized enterprises (SMEs) – an outgrowth of the collapse in global oil prices at the end of 2014.
At the close of the third quarter of 2018, sector assets had grown by 7.4% y-o-y, from Dh2.64trn ($718.6bn) in the third quarter of 2017 to Dh2.84trn ($773bn). Asset growth in the third quarter itself was 3.2%, compared with 0.4% quarter-on-quarter.
Banks remained liquid throughout 2018, with the loan-to-deposit ratio falling in September 2018 to a four-year low of 94.8%, down from 96.7% in March and 99.8% in August 2017. Aggregate bank deposits in the UAE rose nearly 6%, from Dh1.63bn ($443.7m) in 2017 to Dh1.73bn ($470.9m) at the end of quarter three 2018. This was on top of a 4.1% growth over 2017, according to data from the CBU.
Funding has rarely been a challenge for Dubai and the UAE, with the total increasing each year since 2015 despite the bear market for crude oil, the region’s chief generator of export income. National government deposits dropped by 16.5% in 2015, for example, yet deposits in that year still rose, and in 2016 deposits from GREs decreased by 11.8%, yet deposit growth remained intact.
While the Emirates Interbank Offered Rate increased in March 2018, this reflects less on tightening liquidity and instead the expectation of a rise in benchmark lending rates in the US. The UAE dirham is pegged to the US dollar, causing the CBU to mimic the movements of the US Federal Reserve.
As of the third quarter of 2018 national banks held 88.3% of total deposits, an increase on 87.2% in the same quarter in 2017. Over that same period, domestic lenders recorded growth of 9.7% y-o-y in overall deposits, whereas foreign lenders saw a 1.4% y-o-y reduction. Within specific market segments there was significant diversity. In the third quarter of 2018, national banks received 99.5% of all government deposits, 93.5% of deposits from GREs, 85.3% of deposits from the private sector, 83.9% of non-bank financial institutions deposits and 83.3% of non-resident deposits.
There is no formal deposit insurance available to account holders in the UAE, although a temporary measure to protect deposits was used during the global financial crisis of 2007-08. In May 2009 the Federal National Council approved a draft law guaranteeing federal deposits, although it was never fully ratified. New legislation introduced in October 2018 is expected to increase the CBU’s ability to monitor its licensees and protect consumers. Law No. 14 of 2018 on the Central Bank and Organisation of Financial Institutions and Activities gives the CBU enhanced powers to control banks, including the discretion to order individual institutions to adjust key financial ratios, cap single party exposures, force consolidation, and curb lending and/or demand additional provisioning. The law could possibly lead to a deposit guarantee scheme in the future.
Domestic bank credit expanded at a rate of 1.4% in 2017, down from 5.2% in 2016 and 8% in 2015. The pace picked up in 2018, however, with credit growing by 3.7% y-o-y to Dh1.64trn ($446.4bn) as of the third quarter of 2018. Among the strongest growth sectors for commercial lending were construction and real estate, and mining and quarrying, indicating a likely increase in real estate connected to the preparation for Dubai’s hosting of Expo 2020.
The subject of asset quality has not been without challenges, however. Beginning in mid-2018 Dubaibased Abraaj Group, a private equity firm active across the MENA region, was forced to partially liquidate its assets after being accused of funds mismanagement. A number of Dubai financial institutions that loaned to the group are waiting to learn how much of Abraaj’s $1bn debt they will be able to recover, including Mashreq Bank, Noor Bank and Commercial Bank of Dubai.
However, for the commercial lending segment of the market as a whole, the expectations are for positive growth with minimal concerns about asset quality. “Banks are well capitalised and relatively profitable,” Khalid Howladar, managing director of Acreditus, told OBG. “For corporations with good collateral, the door is open for business.”
Access to financial services still remains a challenge for SMEs, as defaults in the past have led to caution from lenders. According to figures from the Abu Dhabi-based Khalifa Fund for Enterprise Development, between half and 70% of UAE-based SMEs have had applications for bank loans rejected, and many do not apply in the first place. SMEs account for around 60% of the UAE’s GDP, however, they make up a much smaller proportion of bank lending, at 4% of outstanding bank credit, according to the Khalifa Fund.
While business incubation programmes led by Dubai’s government have helped, indirect aid to such businesses could come from the value-added tax implemented in the UAE in January 2018. In the process of registering and paying the 5% levy, businesses will gain tax credits, as well as complete a documentation process that will add greater transparency to SMEs and their balance sheets. This could then be provided to lending officers to give a more detailed understanding of their creditworthiness.
Banks in Dubai have historically sought to service government and corporate sectors as a first choice. Expanding retail lending means maintaining a network of branches and loan officers at a time when banks are working to boost efficiency and lower overhead costs by using fintech.
As with SMEs, however, increased transparency is expected to help. The Al Etihad Credit Bureau, which began operating in 2014, means that consumers can no longer patronise multiple lenders without the latter knowing the full extent of their debts, leading to fewer retail defaults. Consumer awareness of their own credit scores may also help improve financial literacy. Emirates NBD’s digital bank, Liv., allows customers to check their credit scores online, as well as their debt burdens and advise on how to maintain a positive credit rating.
UAE banks have historically been well capitalised. In 2015 the CBU issued the Liquidity Notice, a list of qualitative and quantitative requirements to align bank practices to Basel III standards. The regulations divide capital into two tiers: Tier-1 capital includes shareholder equity and retained earnings; while Tier-2 features debt securities held by the bank, which are considered riskier because of the higher risk of default.
In March 2017 new CBU regulations mandated a minimum Tier-1 ratio of 12% and a capital adequacy ratio (CAR) of 15.5%. According to the CBU, the banking system finished 2017 with Tier-1 capital of 17.4% and a system-wide CAR of 18.9%, both significantly greater than Basel III mandates of 8% for Tier-1 capital and 12% for the CAR. Foreign banks had the highest CAR average at 21%, with Islamic banks registering lowest at 16.6%.
The CBU has not traditionally acted as a potential lender of last resort in the cases of a system-wide financial crisis or for individual banks facing solvency issues. Instead, these matters fall under the jurisdiction of individual emirates, which control the financial institutions based in their territories.
However, in its 2017 bond prospectus, First Abu Dhabi Bank said it believes that a major crisis at the federal level could be different. “In the event of a run on the currency or a major banking crisis, it is likely that the UAE federal government would ultimately stand as de facto defender of the currency and the lender of last resort,” according to the document. Credit ratings for UAE lenders are also typically based on an assumption of federal support were it ever to be needed. Moody’s, for example, cited it as a factor underpinning its stable outlook for the sector as of November 2018.
Dubai Islamic Bank, founded in 1975, was seen as the first sharia-compliant lender of its kind, marking the beginning of the broader Islamic finance segment. Islamic banks are subject to the same regulatory oversight as their conventional counterparts, with elements of sharia compliance determined by the boards of the religious scholars employed at each company.
Also versed in finance, sharia councils are charged with issuing fatwas (rulings on Islamic law), certifying that a specific banking product or report complies with the principles of Islamic finance.
However, the degree of oversight may be set to increase, as the CBU is taking several steps in this area. In 2017 it established the Higher Sharia Authority (HSA), its own sharia board, similar to those the lenders maintain. The HSA met for the first time in February of 2018 and is expected to issue fatwas on the legitimacy of products, services and governance. HSA rulings will not have authority to replace or overrule the sharia boards that Islamic financial institutions.
A total of 12 countries with prominent Islamic finance segments have also established national sharia boards, including Malaysia and Pakistan. Establishing a national board can take pressure off of the system, as the number of qualified scholars is limited. While countries are working to establish a new generation of young scholars, a number of sector stakeholders have suggested standardisation in the segment. The process would see Islamic banks agreeing to a general set of previously tested methods and structures, meaning sharia scholars would be needed in fewer instances. The process of sharia certification also poses an added cost, limiting Islamic banks’ competitiveness in relation to standard financial institutions.
For Dubai’s financial services sector, this could mean lower costs associated with issuing sukuk (Islamic bonds), reducing corporate reliance on bank lending as a source of capital. “If you can use a template to issue sukuk, and it costs you much less in the process, then you’ve taken a market friction off the table,” Howladar told OBG.
The CBU also disclosed in its 2017 annual report that it intended to study the Islamic finance segment, focusing on the topics of liquidity, profit sharing accounts, sharia governance and potential regulatory reforms to maintain resilience and risk management. “The study will seek to provide implementation solutions for the central bank and wider domestic authorities in line with the UAE vision to become a leading international hub for the industry,” according to the report.
The central bank’s broader regulatory agenda will address standards on capital, major acquisitions, significant ownership transfers and new developments in financial technologies.
While 2018 began with expectations that oil prices might remain depressed, the appreciation of crude benchmark prices in the first half of the year brightened outlooks in Dubai and wider UAE markets. At Emirates NBD, Dubai Islamic Bank, First Abu Dhabi Bank and Abu Dhabi Commercial Bank – the four largest banks in the country – margins expanded and provisioning fell in the second quarter of 2018, driving quarterly profits 21% higher than in the same period of 2017. Problematic loans are expected to remain below 5.5% of the total in 2019, as the stability of large corporate borrowers offsets weaker asset quality of smaller customers, according to a November 2018 outlook from Moody’s.
Another external factor boosting sector prospects is interest rates, with the US Federal Reserve boosting benchmark lending rates by 0.25% to a range of 2-2.25% in September 2018, and then once again in December to a range of 2.25-2.5%, with the final hike representing the fourth such move in 2018.
Market analysts are currently expecting another two rate hikes in 2019, rather than the three projected in September 2018. With the UAE dirham pegged to the US dollar, the central bank’s monetary policy will most likely follow suit, providing a lending environment in which net interest margins can expand. In August 2018 Moody’s forecast that profitability would likely remain stable into 2019.