Investment banks bring money home

One trillion dollars of Gulf wealth, give or take a few billion, is currently invested overseas. And that is thanks in no small measure to the work of Gulf-based investment banks, which made windfall profits in the process of depriving the region of the capital it so desperately needed to invest in a broad-based, diversified economy.

Today, the tide appears to be turning. A new breed of Gulf investment banks is emerging, whose main, or only, focus is the Gulf. Their asset management divisions invest exclusively in Gulf markets - mainly equity, but also real estate and fixed income. And their corporate finance divisions are staffed by analysts and bankers who help local businesses tap into local markets for equity and debt funding, as well as advising on mergers and acquisitions (M&A).

None of the main local players is more than eight years old. Of the international banks, HSBC is one of a tiny handful with a significant investment banking presence in the region.

"If you look at what was the case three or four years ago, we hardly had any investment banks dedicated to the region," says Anthony Mallis, CEO of Securities and Investment Company (SICO), a Bahrain-based investment bank that focuses on the Gulf. "Investment banks were very much focused on ex-GCC [Gulf Cooperation Council]. Today, there are few more players like ourselves."

Others agree that a sea change is occurring. "We are at a very interesting time for financial markets and investment banking in the region," says Ziad Makkawi, executive managing director of Shuaa Capital, a Dubai-based investment bank. "We have seen many false starts to investment banking over the past decade. I really feel that this is the real thing."

Maha al-Ghunaim, CEO of Global Investment House, a Kuwaiti investment bank, is similarly bullish. "When we established ourselves five years ago, we realized there was a huge need for investment banking in every sense of the word. Today, demand for our services is very high."

A quick look at the recent financial performance of these three banks makes a compelling case for their optimism: all reported triple-digit profit growth last year. Crucially, this has come at a time when many of their more established counterparts investing in mature markets have seen earnings nosedive.

Take the case of Shuaa, the Dubai-based investment bank listed on the Dubai Financial Market. Profits for the six months to September 30, 2003, were 34.3 million dirhams ($9.3 million), compared to 8 million dirhams for the same period in 2002. That's an increase of some 329 percent, albeit from a low base. It's a similar story elsewhere in the Gulf.

Contrast that with the fortunes of Bahrain International Bank (BIB) and BMB Investment Bank in Bahrain. Both have been established for decades, both have focused on investing Gulf money in the United States, Europe and Japan - and both are on the verge of extinction after recording huge losses in the three-year bear market that began with the bursting of the US dotcom bubble in March 2000.

The stellar performance of the "new" Gulf investment banks throws up a series of important questions. Where have their profits come from? Are they sustainable? And what are the prospects for the sector over the coming three to five years?

The first question is the easiest to answer. Regional stock markets have been booming in the last 12 months - the Saudi market rose by more than 80 percent by the beginning of December 2003, while the Shuaa Capital GCC index was up some 50 percent for the year in the first 11 months.

This has fueled profits in proprietary trading, asset management and corporate finance: core areas for most of the regional players.
"Most of these investment banks have been pretty profitable of late," says Darren Stubing, chief banks analyst at ratings agency Capital Intelligence (CI). "They had a strong 2003; they are really riding on the back of strong stock markets throughout the Gulf."

Ziad Makkawi at Shuaa recalls that back in the late 1990s, when shareholders took the decision to create a regionally focused investment bank, Gulf equity markets were in the doldrums. But shareholders forecast an upturn as the regional economy - and its capital markets - reached maturity. They have been proved right. Today, Shuaa and its handful of peers are reaping the benefits of their bold strategy.

"This strategic focus was a result of our view that Arab and GCC markets were at the doorstep of a fundamental change in scope and structure," says Makkawi. Since then, political and economic developments have helped to accelerate this process, resulting in boom times for the likes of Shuaa, SICO and Global.

"Of course, September 11th helped. Of course, the low interest rate environment helped. And the general state of the global economy worked very much in our favor," says Makkawi. "All of a sudden, regional investors became very interested in their local and regional markets. This increased demand for regional products and regional investment opportunities was not met by supply. Our job is to manufacture vehicles that will offer these opportunities, and to have expertise at the regional level."

But what happens when the Gulf's raging equity bull market ends, as it surely must sooner or later? Can these banks remain profitable in a downturn? All three say yes, and they insist that fee income will be the bedrock of future prosperity, not speculative equity trading.

"That is obviously a risk," says SICO's Mallis. "The risk we are taking is that GCC markets will go down or stay flat. But we are trying to diversify our sources of revenue, so that we are not just taking equity positions.

"We are very much focused on areas such as corporate finance and debt raising. We think that through that sort of model, we are far better balanced." In 2002, SICO generated significant fee income when it advised Aluminium Bahrain on its successful floating rate note issue, as part of a wider $1.5 billion financing.

Global CEO Maha al-Ghunaim stresses that trading contributed only a tiny fraction of the bank's profits of $34 billion in the first nine months of 2003. This despite the fact the benchmark Kuwait Stock Exchange index rose by some 70 percent over the period.

"Global doesn't make any significant money from the local market," she insists. "Many investment companies in the region use their capital to invest in the local market. When the market is great, they do great. If it is bad, they do bad."

By contrast, she says some 90 percent of Global's profits are based on fees from corporate finance work, or from commissions on selling funds. (The Kuwait Central Bank insists that every institution selling its own funds must invest five percent of the value of the fund. As such, Global does have some exposure to the local equity, fixed income and money markets.)

Significantly, CI analyst Darren Stubing shares the banks' broadly optimistic outlook, at least to an extent. "The big question is: Will these profits continue? Probably not at the strong level of the last year or so, especially if you look at Kuwait and Saudi Arabia. Sooner or later, these markets are going to come back a little bit."

But he adds: "Having said that, [these banks] are run fairly efficiently. We don't expect any major crash. Even if there is a major correction, they should see more fee income coming on the back of the capital market development, from areas such as corporate finance and bond issuance."

Fee income from corporate finance will certainly prove important if Gulf stock markets witness a sharp correction (a move that would reduce demand for asset management services and turn trading profits into losses). But local investment banks must heed the lessons of their counterparts in New York and London.

Investment banks such as Merrill Lynch and Lehman Bros. were forced to fire literally thousands of corporate financiers as transactions (mainly IPOs and M&A) dried up in the post-millennium bear run. Investment banking tends to be a highly cyclical industry.

Perhaps the more significant question is not cyclical, but structural: How will the industry develop over the next three to five years? Will windfall profits attract a rush of new entrants - both local and foreign - to steal market share? Or will a fast growing market fuel the pioneers' continued expansion as they exploit the benefits of first-mover advantage?

Karim Souaid, head of corporate finance at HSBC Financial Services Middle East, the bank's regional investment banking arm, warns that it will not be all plain sailing in the years ahead. The region's equity markets remain small, fragmented and illiquid by international standards, despite impressive recent gains.

As such, HSBC's corporate finance team has focused on advisory work in recent years. Crucially, Souaid says that demand for this type of work is limited - and that fees are small when it does come along.

"People do not like to pay for just intellectual capital. In the Middle East in particular, people do not like to pay for just words. They cannot see tangible results. When you raise capital through a private placement or an IPO, he can see tangible results into his own coffers."

Even then, though, margins are tight. Success fees in the US and Europe are around seven percent; in the Middle East, the figure is nearer two or three percent. The main reason is that regional banks are still awash with liquidity. "You are not bringing them a rare commodity," Souaid says.

Some regional investment bankers argue that the current oversupply of capital won't last: structural changes in the financial and economic landscape will lead to a shortage of liquidity over the coming five years. This is when regional investment banks will come into their own.
"That is one of the reasons I'm positive about the future," says Anthony Mallis at SICO.

Specifically, he believes the new Basel II international banking regulations will force Gulf banks to be far stricter in their lending habits. "I think that the pressure many borrowers will face with Basel II is that banks are going to become a bit more careful with their capital. The traditional model was to go to your friend the banker and say 'I would like an overdraft.' That is going to change. Is it going to happen overnight? No. But banks are going to become a little bit more demanding."

At the same time, demand for medium- and long-term financing will surge as Gulf economies expand. Project financiers warn that for the first time in decades, bank lending may not be able to meet demand for all the Gulf's multibillion-dollar infrastructure and energy projects.

HSBC's Souaid says that there are a number of significant bright spots on the horizon: "This is going to be a very interesting time," he forecasts. In particular, the wave of privatization that is beginning to sweep through the region will present many opportunities, particularly in telecommunications.

Of course, this will bring more competition. Regional commercial banks such as National Bank of Kuwait and National Bank of Abu Dhabi are already actively targeting investment banking. At the same time, developments such as Bahrain Financial Harbor and Dubai International Financial Center hope to bring "bulge bracket" global investment banks to the region. This could squeeze fees still further.

But the consensus among the Gulf's community of investment bankers is that a few new entrants will help build critical mass, not hinder their progress. Indeed, these new competitors could also become clients.

"The more the merrier," says Shuaa's Makkawi. Anthony Mallis at SICO shares that view: "I think the pie is growing. And that pie will have to be served by a growing number of professional players."