Gulf banks face good prospects for franchise growth and revenue diversification

"The booming regional economy is clearly an opportunity for banks to make further progress in building their customer franchises and diversifying revenues," said Standard & Poor's credit analyst Emmanuel Volland, author of the report.

At the same time, most banks will be challenged to repeat their stellar financial performances of 2005, as regional stock markets suffered heavy losses in the first half of 2006. In addition, geopolitical risk has increased in the Middle East.

"We nevertheless believe that Gulf banks will continue to display solid financials, capitalization, and liquidity in the foreseeable future," said Mr. Volland. "They stand to benefit from huge business volumes, a low cost of funds and labor, and the absence of income tax."

With the assignment of nine new ratings over the course of 2006, Standard & Poor's rapidly extended its ratings coverage in the Gulf, where it now rates about 30 banks--including most of the 20 largest.

Extraordinary growth of the high-yield and low-risk consumer-lending business line is a crucial element supporting the profitability and, ultimately, the ratings on most banks in the region, particularly in Saudi Arabia and Kuwait.

Looking back at 2005, the report notes several trends in the Gulf banking system: rapid asset growth and an upsurge in bank profits; a phenomenal increase in debt issuance; and accelerated growth of Islamic finance, with the creation of new Islamic banks and the emergence of new products.

Geographic expansion appears inevitable, as Gulf banks remain small by international standards, are constrained by an underdeveloped operating environment, and face increasing competition on their own turf from foreign banks.

"In the longer term, as the region moves to a single currency, we predict more M&A and cooperation among the region's banks," added Mr. Volland.

The positive developments of the past few years bear the risk of complacency. Gulf banks may be underestimating their structural weaknesses and challenges: limited size and diversification, and an underdeveloped credit culture and weak corporate governance.

Standard & Poor's believes banks should take advantage of this current rosy period to review their business models, strengthen risk management, and develop new business lines. Private banking, insurance, Islamic banking, venture capital, and corporate finance are especially promising.