Fitch: UAE govt liquidity moves positive for banks; medium-term challenges mount

Fitch says it is unlikely to change the banks' Long-term Issuer Default Ratings as these are driven by expected support from the UAE authorities, although Individual ratings could come under pressure if the banks' ability to fund themselves deteriorates, leading to declining growth, profitability and the erosion of capital.

"The risks of a UAE bank suffering a capital markets-driven liquidity crisis are limited as none of the banks are reliant on these markets. Their funding bases are predominantly based on retail and corporate deposits, with the balance as inter-bank borrowings and some limited debt capital market issuance,"

says Robert Thursfield, Director in Fitch's Banks team.

"However, UAE banks face mounting challenges in the form of slower economic activity, a property market correction and negative valuation adjustments from continuing volatility in regional stock markets."

Fitch says the series of measures taken by the Central Bank of the UAE (CBUAE) and UAE Ministry of Finance (MOF) are likely to strengthen confidence in the bank sector. These include the establishment of a AED50bn liquidity facility by CBUAE to assist local bank funding - although to date drawings from this facility remain limited - a guarantee from the UAE federal government on all customer deposits and inter-bank placements at UAE banks for three years and a further AED70bn of funds to be deposited into the UAE banking system by MOF. A first tranche of AED25bn of the MOF's AED70bn will be placed as deposits will all banks (based upon their market share of lending) in the coming days. In addition, new funds may be attracted from other Gulf Cooperation Council (GCC) states, most of whom have not to date guaranteed their country's deposits. However, the above measures have not yet had a mitigating impact on UAE inter-bank lending rates, with benchmark 3-month Eibor at 4.7% on 21 October 2008, compared to about 2% on 30 June 2008, although the rate was above 5% in October 2007. UAE non-bank financial institutions which are dependent on local interbank funding are likely to feel even more pressure on their liquidity.

The longer-term challenge faced by the banks is to develop other funding/capital sources so they can continue financing a significant pipeline of infrastructure projects. Loan to deposit ratio trends in the system have been deteriorating (loans and advances/total bank deposits for the UAE banking system was 107% at end-June 2008 (end-2007: 100%)) and if these projects are not able to be financed internationally, then this trend will continue adding pressure to loan to deposit ratios as well as balance sheet liquidity and capitalisation.

A more immediate challenge for the banking sector is the likelihood of a negative impact from major corrections and continuing volatility in regional stock markets. The Dubai Financial Market was down about 44% YTD and the Abu Dhabi Securities Exchange down about 23% YTD as of 21 October 2008. Most UAE banks have substantial exposure to domestic and regional equities. Many banks also have investments in fixed income securities and hedge funds, which have likewise been negatively impacted by the global credit crisis. The impact will partly be seen in Q3 results due out soon, although the worst of the market volatility occurred in October.

The Dubai property market has seen spectacular growth in recent years but there is increasing concern that a correction will occur in the short- to medium-term. Stress in the local interbank market is likely to have a negative impact on the availability of residential mortgages and funding for property developers, which would dampen demand as supply is forecast to increase. UAE banks have exposures to property lending (residential, commercial and investment), although direct exposures are capped by the CBUAE to 20% of their deposits. The CBUAE's classifications for lending are opaque and it is possible that the banks' property lending exposures exceed the cap. Furthermore, many banks have significant additional exposure to the property market through proprietary real estate development and investment activities.

The declining oil price will negatively impact business sentiment and domestic economic activity (Brent was priced around USD67 a barrel on 21 October 2008). This could result in the postponement or cancellation of some major projects. However, Fitch estimates that Abu Dhabi would continue to run a budget surplus at a price as low as USD31/bl. As majority owner of the two largest banks in Abu Dhabi (via ADIC) and with a number of other UAE banks having significant government ownership, this gives further confidence in the authorities' willingness and ability to support its banks.

Bank results for the year to end-September 2008 will be published soon and Fitch expects to see slower growth in loans and deposits, higher funding costs and negative investment portfolio mark to market valuations. Fitch will review the results and may comment further on the sector's performance.