UAE Banks Put To The Test

Transcription

1 August 1st, 2010 Banks & Diversified Financials Sofia El Boury Ghida Obeid Economics Khatija Haque The slow recovery of private sector credit growth in H1 10 is one of the key factors undermining the UAE s economic recovery. We believe much of the risk aversion on the part of banks stems from uncertainty about potential future losses and writedowns. Our stress test on a sample of eight UAE banks, which account for almost 70% of FY09 banking system assets, suggests that on average, the banking sector is sufficiently capitalized to withstand significant deterioration in asset quality. Under our base case, average total CAR for our sample at 14.9% is well above the 12% UAE minimum, and average Tier 1 capital at 9.8% is above the 8% UAE minimum. Under our conservative "worst case" assumptions, average total CAR drops to 11.8% and average Tier 1 CAR falls to 6.5%; both are still above the Basel II international standards. Additional capital injections would be required for individual banks in all our scenarios, ranging from AED 2.5bn (USD 669mn) in our base case up to AED 15.8bn (USD 4.3bn) in our worst case. We believe that the authorities have the capacity to provide this financial support, if ever required. In our view, additional measures could be taken by the authorities to clean up UAE banks balance sheets, to restore confidence and encourage banks to resume lending to households and businesses. In particular, the Irish approach of removing high-risk assets from balance sheets and replacing them with low-risk government securities should be considered in the UAE context, in our view. However, broad structural and economic reform, including greater transparency by banks, is likely to be the most effective tool for restoring confidence and improving access to funding, as well as encouraging greater investment and economic growth over the longer-term.

2 Contents EXECUTIVE SUMMARY... 3 POST-CRISIS RECOVERY IN PRIVATE SECTOR CREDIT HAS BEEN SLOW... 5 OUTBREAK OF THE CURRENT CRISIS AND POLICY RESPONSES TO DATE... 5 WHAT HAVE UAE BANKS DONE WITH THEIR LIQUIDITY?... 6 IS THE UAE BANKING SECTOR SOLID ENOUGH TO WEATHER THE STORM?... 7 AIMS AND METHODOLOGY... 7 BASE CASE SCENARIO IMPACT ASSESSMENT... 9 FOUR ALTERNATIVE SCENARIOS...10 RESULTS...11 THE AVERAGES LOOK GOOD, BUT THE DEVIL IS IN THE DETAIL...12 DEALING WITH THE FALLOUT OF A FINANCIAL CRISIS: DRAWING ON INTERNATIONAL EXPERIENCE...15 DE-RISKING IRISH BANKS...15 SPANISH BANKS RESTRUCTURE AND TAKE STRICTER PROVISIONS CONCLUSIONS AND RECOMMENDATIONS...17 SO WHAT COULD BE DONE TO ENCOURAGE BANKS TO RESUME LENDING?...17 APPENDIX...18 UAE FY09 ASSET QUALITY METRICS VS. OTHER ECONOMIES...18 UAE FY09 CAR VS. OTHER ECONOMIES...18 August 1st,

3 Executive summary The UAE s economy and banking system were not immune to the global financial crisis. Although the worst of the recession appears to be behind us, UAE banks remain risk averse and reluctant to extend credit to the private sector. The latest UAE Central Bank statistics show that bank loans grew a mere 0.8% in H1 10, down from 1.5% in H1 09 and 24% in H1 08. We believe much of this risk aversion on the part of banks stems from uncertainty about potential future losses and write-downs. Our analysis aims to estimate just how big these potential losses may be, and whether UAE banks would be able to absorb them if they materialize. We have focused on what we consider to be the riskiest assets on UAE banks balance sheets: Real estate and personal loans extended in 2008 at the peak of the credit and real estate boom in the country ; Potential losses associated with banks exposure to Saad and Al Gosaibi and Dubai World ; And renegotiated loans, which appeared on most banks' FY09 financials 1. Finally, we have taken into account the fact that Dubai-based banks incur a higher risk associated with their real estate exposure than Abu Dhabi-based banks. Our base case suggests that UAE banks are, on average, capable of absorbing the potential losses associated with more stringent default assumptions, thanks largely to the authorities efforts to strengthen banks balance sheets since the onset of the crisis. The implied Non-Performing Loan (NPL) ratio rises from 3.3% to 8.4%, while total Capital Adequacy Ratio (CAR 2 ) remains healthy at 14.9% and Tier 1 capital remains above regulatory requirements at 9.8%. Although Emirates NBD and ADCB would be the only banks needing a combined AED 2.5bn (USD 669mn) of additional Tier 1 capital to meet the stringent UAE requirements, all the banks in our sample comply with Basel II standards. In our worst case scenario ( #4) where we assume what we considered to be the maximum default rates on both real estate and personal loans extended by banks in 2008, average total CAR is marginally below the Central Bank's requirement, while the average Tier 1 capital ratio remains above the Basel II floor. Summary conclusions: Avg NPL ratio (%) Avg Total Capital (%) Avg Tier 1 Capital (%) Cash provision shortfall for 100% NPL coverage (AED bn) Tier 1 capital requirements (AED bn) Actual FY Base case Scenario Scenario Scenario Scenario Scenario Source: SHUAA Capital 1 Except Abu Dhabi Commercial Bank (ADCB) and Dubai Islamic Bank (DIB) out of our eight UAE banks sample 2 Total capital adequacy is Tier 1 plus Tier 2 capital. The UAE regulatory minimum was set at 12% by end-june 2010, and the Basel II minimum is 8%. For Tier 1 capital alone, the UAE minimum requirement is currently 8% and the Basel II minimum is 6%. August 1st,

4 While the banks on average are well capitalized, some individual banks would need additional capital injections to meet the central bank s regulatory requirements in all our scenarios. In scenario #4 for example, the average NPL ratio rises to a still reasonable 12.3%, but five out of the eight banks would then need combined core capital injections of AED 15.8bn (USD 4.3bn) to meet the UAE's regulatory minimum. However, in this (unlikely) event, we have no doubt that the UAE authorities would provide the required financial support to these banks, particularly as the government has already stepped in to recapitalize some UAE banks at the height of the financial crisis. Following our analysis and before recommending steps that local authorities could take to encourage banks to lend, we considered recent steps that have been taken by other countries whose banks have been heavily exposed to a sharply contracting real estate sector: Ireland and Spain. Spain has focused on restructuring and merging its most exposed banks and implementing stricter provisioning criteria, while Ireland recapitalized its banks and transferred the toxic real estate assets from commercial banks to a specially created National Asset Management Agency. Adopting the Spanish approach would mean significant up-front costs in terms of greater provisioning for UAE banks our base case analysis suggests AED 42.5bn would be needed to ensure 100% NPL coverage, although this would rise to AED 71.3bn under our worst case scenario. This would not only have a negative impact on banks profitability in the short term, but would leave the banks relatively vulnerable in the event of a negative shock. The Irish approach is one that is in our view more appropriate for the UAE, particularly considering the relatively strong fiscal position the UAE benefits from, especially compared with the high budget deficits and debt levels in many European countries. By transferring banks riskiest assets into a state-managed agency, and replacing them with lower risk government securities, the banks would be in a much stronger position to resume lending to key sectors of the economy and support the nascent economic recovery. In our view, some combination of the two approaches would most likely be the most optimal solution. Supply-side measures to encourage bank lending, such as government guarantees to support financing to sectors and businesses with long-term strategic importance, could also be considered. However, we believe such supply-side incentives should be used with caution, to ensure that capital is allocated efficiently, and to sectors and businesses that will generate the greatest economic value going forward. In our view however, broad structural and economic reform to encourage private sector and foreign investment in the UAE is likely to yield greater benefit over the longer term. Structural reforms, including greater transparency, improved corporate governance and a stronger regulatory framework in the financial sector and broader economy would contribute to greater investor confidence and ultimately improved access to funding (both for banks and other corporate entities) at better terms. In a post-crisis world where commercial banks are more risk averse, their ability to attract long-term funding at good rates is a key element for sustainable credit and economic growth. August 1st,

5 Post-crisis recovery in private sector credit has been slow Outbreak of the current crisis and policy responses to date Private sector credit growth in the UAE declined sharply in 2009 as a result of both external and UAE specific developments. The global financial crisis and subsequent liquidity crunch was a catalyst for the sharp decline in the UAE s real estate sector from Q4 08. The tight liquidity conditions and high risk aversion also contributed to the inability of UAE-based government and corporate entities to refinance debt falling due at reasonable rates, triggering several high profile debt restructurings. The sharp decline in UAE credit growth in 2009 was expected, considering the weak economic environment. The additional provisions booked to reflect risks on existing risky exposures as well as in anticipation of losses associated with high-profile debt defaults and restructurings (especially related to Saad/ Al Gosaibi and Dubai World (DW)) had an undeniable impact on banks willingness and ability to lend to the private sector. Many governments in the region, including in the UAE, took measures to strengthen banks' balance sheets and improve liquidity at the height of the financial crisis. In Qatar, the government used a two-pronged strategy to clean up domestic banks balance sheets: they purchased USD 1.8bn worth of banks local equity portfolios as well as USD 4.1bn of the real estate assets of nine local banks. In return, banks received a mixture of both cash and long-term government bonds, with the option to repurchase some or all of their real estate portfolios. 3 In the UAE, the Central Bank tackled the crisis by providing a blanket guarantee on local banks deposits and an emergency interbank facility to alleviate short-term liquidity needs. The Ministry of Finance followed suit with a AED 70bn long-term deposit facility, AED 50bn of which was injected into UAE banks balance sheets with an option to convert these funds into Tier 2 capital, while the remaining AED 20bn is still available. In addition, Abu Dhabi s government supported its domestic banks by offering AED 16bn non-dilutive Tier 1 capital to five Abu Dhabi players: National Bank of Abu Dhabi, Abu Dhabi Commercial Bank, Union National Bank, Abu Dhabi Islamic Bank, and First Gulf Bank. With most of the uncertainty surrounding the DW debt restructuring being resolved following the March 25th, 2010 announcement, we had expected private sector credit in the UAE to recover during Q However, this recovery has been slower than expected, and is lagging other countries in the region, such as Qatar. Although we do not have comprehensive data on private sector credit beyond April 2010, commercial banks overall loans and advances added a mere 0.4% in Q2 10, implying that private sector credit growth has been weak during that period. 3 Source: IIF country report: Qatar; September 2009 August 1st,

6 60 UAE private sector credit growth Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 % YoY Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 Source: UAE Central Bank, SHUAA Capital What have UAE banks done with their liquidity? In Qatar s case, it has been argued by some commentators that on average, banks were more conservative in their lending prior to the financial crisis, making them less vulnerable. Moreover, the government s recapitalization measures were sufficient to allow banks to start lending again as soon as economic conditions started to improve. Banks in the UAE also benefited from significant capital and liquidity injections. However, it seems that they have been more risk averse than their Qatari counterparts, preferring to hoard their cash, or improve their net foreign asset position by paying down foreign debt and accumulating foreign assets. Most of UAE banks' loans originated in FY09 appear to have been extended to the government and public sector enterprises, rather than to the private sector. This phenomenon of the government s crowding out of private sector borrowing suggests, in our view, either a flight to quality in that the government is seen as a safer bet than the private sector; or a reflection of the fact that most local banks are owned by the government or prominent families and these stakeholders have priority over whatever funds are available for lending. We favor the latter explanation Public sector credit growth crowds out the private sector Public sector credit Private sector credit 40 % YoY Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 Source: UAE Central Bank, SHUAA Capital * October and November 09 data is not available August 1st,

7 Is the UAE banking sector solid enough to weather the storm? Aims and Methodology Based on reported banking statistics, the UAE banking sector appears to be well capitalized, and with manageable NPL ratios. Our paper considers how UAE banks would fare under stringent default assumptions. We selected a pool of eight leading UAE banks as a sample for our analysis. These eight players, which accounted for almost 70% of UAE banking system total assets as of 2009, are the following: Emirates NBD (ENBD), National Bank of Abu Dhabi (NBAD), Abu Dhabi Commercial Bank (ADCB), Mashreqbank (Mashreq), First Gulf Bank (FGB), Dubai Islamic Bank (DIB), Union National Bank (UNB) and Commercial Bank of Dubai (CBD). Within this universe, we made the distinction between Abu Dhabi and Dubai banks as the latter are exposed to greater risks, specifically due to their exposure to Dubai s real estate sector. Our starting point is to identify the key risks threatening UAE banks solvency today. On the balance sheet, real estate (RE) financing and personal loans are unsurprisingly the primary suspects. In our view, property and personal loans originated in 2008 are the riskiest exposures on banks balance sheets. Those loans were extended in a frantic economic climate marked by low interest rates and stretched liquidity positions also marked the peak of the property boom in the UAE (as shown in the graph below). Finally, we note that lending practices in pre-crisis 2008 were much more relaxed, with relatively weak creditworthiness assessment procedures in place and "name lending" very common; making most loans extended in 2008 riskier than those extended post-crisis. 250 Dubai housing price index: quarterly real estate loans have lost on average 33-50% and are currently in negative equity Index Points real estate loans remain in positive equity hence were not incoporated in NPL additions 0 Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09 Q4 09 Q1 10 Q2 10 Index points % change 17% 3% 4% 42% 16% 5% -8% -41% -9% 7% 1% 3% -4% Source: Colliers International August 1st,

8 Interestingly and as shown in the graph below, 55% of our pool's FY08 loan additions were extended to the real estate sector (23%) and to the consumer segment (31%). FGB displayed the highest share with 72%, followed by UNB and ADCB with 63%. On the other hand, only 27% of Mashreq's FY08 loan additions were intended for real estate and personal loan financing. These statistics are important as the outcome of our "stress test" is directly linked to the lending patterns of each of these banks during % 70% 60% 50% 40% 30% 20% 10% RE & Personal loans as % of FY08 total loan additions 7% 20% 27% FY08 RE additions FY08 Personal Loan additions Total 24% 26% 23% 10% 34% 49% 50%. 33% 18% 13% 45% 57% 63% 63% 43% 35% 29% 20% 72% 55% 49% 31% 22% 23% 0% Mashreq DIB ENBD NBAD CBD ADCB UNB FGB Total Source: Banks' financials, SHUAA Capital We also considered other selected risks in our retrospective. Doubtful exposures to Saad and Al Gosaibi groups and to DW entities have been taken into consideration, as well as the black box represented by "renegotiated loans", significant on banks balance sheets by the end of We estimated all these risky assets at AED 148bn, that is 20.4% of our pool's aggregated loan book as of FY09. FY 09 aggregated gross loan book of our pool RE & Personal loans FY 08 additions 14.1% Estimated DW exposure 2.9% Estimated Saad/ AHAB exp 0.5% Reported FY 09 renegotiated loans 2.9% Other loans 79.6% Source: Banks' financials, SHUAA Capital August 1st,

9 Average Commercial Bank of Dubai Union National Bank Dubai Islamic Bank Abu Dhabi Commercial Bank MashreqBank First Gulf Bank National Bank of Abu Dhabi Emirates NBD Our base case scenario assumes the following: Renegotiated loans FY08 RE loan additions FY08 personal loan additions DW est. exposure Dubai banks est. default rate (%) Abu Dhabi banks est. default rate (%) Source: SHUAA Capital The next step in our methodology was to consider various scenarios where the above key risks were assigned different rates of default translating to further provisioning charges and direct losses. In the cases where additional provisioning was necessary, we measured the impact this would have on banks asset quality ratios (NPLs and provision coverage), capital adequacy levels (Tier 1 and total capital) and profitability. Base Case Scenario Impact Assessment Under our base case scenario, the NPL ratio of our pool of UAE banks jumps to 8.4% from actual 3.3% as of FY09. NPL ratio impact assessment 1.2% 1.5% 2.2% 2.4% 3.3% 3.5% Source: Banks' financials, SHUAA Capital On capital adequacy, seven out of eight banks remain well capitalized with average total CAR going down to a still comfortable level of 14.9% from an actual 19.1%. Only ADCB's total capital ratio stands marginally below the Central Bank's 12% minimum and would need just AED 190mn (USD 52mn) in additional capital to meet this requirement. Source: Banks' financials, SHUAA Capital 5.2% 6.0% 6.7% 7.3% 7.7% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% Average Commercial Bank of Dubai Union National Bank Dubai Islamic Bank Abu Dhabi Commercial Bank MashreqBank First Gulf Bank National Bank of Abu Dhabi Emirates NBD 7.2% 7.9% 7.9% 8.4% Total CAR impact assessment 11.9% 13.4% 14.9% 15.2% 14.9% 14.9% 16.7% 17.5% 17.4% 16.7% 17.6% 9.7% 18.3% 19.1% 18.7% 10.7% 20.2% 20.2% Actual FY09 Esti mated 5.0% 10.0% 15.0% 20.0% 25.0% 20.7% 11.5% Actual FY09 Esti mated 22.6% August 1st,

10 Similarly, average Tier 1 capital would still be above the Central Bank's minimum requirement at 9.8% down from an actual level of 14.2%. ADCB and Emirates NBD would require AED 2.0bn (USD 535mn) and AED 492mn (USD 134mn) of core capital respectively. Average Commercial Bank of Dubai Union National Bank Dubai Islamic Bank Abu Dhabi Commercial Bank 6.5% MashreqBank First Gulf Bank National Bank of Abu Dhabi Emirates NBD Source: Banks' financials, SHUAA Capital However, it is important to note that in our base case scenario, all the banks in our pool comply with Basel II international standards on both core and total capital. Four alternative scenarios We derived four alternative scenarios from our base case picture by increasing the default rate on each of the key-risk factors (renegotiated loans, real estate, personal loans). As we assume renegotiated loans include a portion of real estate and personal financing, we set the maximum default rate on that category at 50%. We also distinguish Dubai from Abu Dhabi banks for real estate financing, as the Dubai real estate slump puts Dubai-based lenders more at risk on that front. Scenario #4 is our worst case, where we have set maximum default rates on real estate and personal loans extended in 2008 at 100% for Dubai banks, and at 70% and 60% respectively for Abu Dhabi banks. We have conservatively maintained the assumed haircut on DW at 20% in all scenarios as the proposed debt restructuring agreement suggests losses of that magnitude at worst. Table of assumptions: Renegotiated loans FY08 RE loan additions FY08 personal loan additions DW est. exposure Dubai banks - Estimated default rate (%) Base Case Scenario Scenario # Scenario # Scenario # Scenario # Abu Dhabi banks - Estimated default rate (%) Base Case Scenario Scenario # Scenario # Scenario # Scenario # Source: SHUAA Capital Tier 1 Capital impact assessment 7.8% 8.7% 9.8% 9.7% 11.2% 12.4% 12.4% 12.0% 11.8% 11.9% 13.1% 14.2% 14.1% 14.0% 5.0% 10.0% 15.0% 20.0% 25.0% 15.5% 16.0% Actual FY09 Esti mated 19.2% August 1st,

11 Results The results of our analysis show that from the base case scenario to scenario #4, the average NPL ratio for the eight UAE banks gradually increases from 8.4% to a maximum of 12.3%. 14.0% 12.0% NPL ratio impact assessment 10.6% 12.3% Commonwealth of Independent States FY 09 Actual NPL ratio (%) % 8.4% 9.1% 9.5% 8.0% 6.0% CCE MENA Sub-Saharan Africa % 2.0% 3.3% UAE Advanced Economies Western Hemisphere Developing Asia % Actual FY 09 Source: IMF, SHUAA Capital Base case Scenario Scenario 1 Scenario 2 Scenario 3 Scenario % In terms of solvency and despite all the stress on NPLs and provisioning under our different scenarios, the UAE banking system effectively proves its capacity to absorb significant losses. In fact, average total CAR ranges between 14.9% and 11.8% and remains well above the regulatory minimum set by Basel II (8%), although the 12% UAE floor is marginally breached in scenario #4. Total Capital impact assessment 20.0% 19.1% 15.0% CB min. requirement 14.9% 14.4% 14.1% 13.2% 11.8% 10.0% Basel II min. requirement 5.0% 0.0% Actual FY 09 Base case Scenario Scenario 1 Scenario 2 Scenario 3 Scenario 4 Source: SHUAA Capital August 1st,

12 Average Tier 1 capital for our sample remains well above Basel II requirements (6%), and would only be below the UAE minimum in scenario #4. Tier 1 capital impact assessment 16.0% 14.2% 14.0% 12.0% 10.0% 8.0% 6.0% CB min. requirement Basel II min. requirement 9.8% 9.2% 8.9% 8.0% 6.5% 4.0% 2.0% 0.0% Actual FY 09 Base case Scenario Scenario 1 Scenario 2 Scenario 3 Scenario 4 Source: SHUAA Capital The averages look good, but the devil is in the detail... Our findings are summarized in the table below. Table of results Avg NPL ratio (%) Avg Total Capital (%) Avg Total Capital excl. injections in 08/09 (%) Avg Tier 1 Capital (%) Cash provision shortfall for 100% NPL coverage (AED bn) Capital injections required to meet 8% Tier 1 minimum (AED bn) Actual FY Base case Scenario Scenario Scenario Scenario Scenario Source: SHUAA Capital Even though the average CARs remain above the regulatory floors in our base case, some of the banks in our sample would need further core capital injections in all our scenarios. The amounts range between AED 2.5bn (USD 669mn) in the base case to AED 15.8bn (USD 4.3bn) under our most conservative scenario #4. However, column 3 in the table above illustrates the importance of the authorities' capital injections to the banking system at the height of the liquidity crisis in the form of core Tier 1 capital (AED 16bn) and Tier 2 MoF long-term funds (AED 50bn). Without these capital injections, average total CAR would already be below the 12% UAE regulatory minimum, and would be below the Basel II floor of 8% in all our scenarios. August 1st,

13 According to the various scenarios and implied NPL ratios, our pool of UAE banks would need to recognise between AED 42.5bn (USD 11.6bn) and AED 71.3bn (USD 19.4bn) in additional provisions to achieve 100% NPL coverage. Fully writing-off banks riskiest exposures would have a significant negative impact on their short-term profitability, which would not be well-received by shareholders. On the other hand, it may be argued that the thorough immediate clean-up of UAE banks would send a highly positive signal to the international investor community, as it would contribute to improved transparency and help to restore confidence in the UAE banking system. AED bn Tier 1 capital requirements based on UAE Central Bank floor of 8% 0.5 Emirates NBD 2.0 ADCB Base case scenario 3.4 Emirates NBD 2.0 ADCB 1.6 Emirates NBD 3.2 ADCB DIB CBD 2.0 Emirates NBD ADCB 1.2 CBD Emirates NBD Scenario 1 Scenario 2 Scenario 3 Scenario FGB 7.3 ADCB 0.7 DIB 1.7 CBD Source: SHUAA Capital The chart above illustrates which banks would need additional Tier 1 capital, based on our set of assumptions, to meet the Central Bank's requirements. Emirates NBD and ADCB would require negligible combined core capital injections of AED 2.5bn (USD 669mn) in the base case, increasing to AED 5.4bn (USD 1.5bn) in scenario #1. In scenario #2, Emirates NBD, ADCB, DIB, and CBD would fall AED 5.1bn (USD 1.4bn) short, while in scenario #3, the same banks excluding DIB would need combined core capital injections of AED 9.2bn (USD 2.5bn). In scenario #4 (the unlikely scenario where we assumed our maximum default rates on real estate and personal loans extended in 2008), Mashreq and UNB are the only ones complying with both the Tier 1 (8%) and total capital (12%) requirements set by the Central Bank. While UNB's capital base proves resilient to our series of tests,, Mashreq benefits from its relatively limited exposure to 2008 real estate and personal loan financing. As mentioned earlier, only 27% of the bank's new loans were extended to both segments, compared with an average of 58% for the other seven banks. In this scenario, NBAD meets the Tier 1 requirements but needs an additional AED 900mn in Tier 2 capital to meet the 12% minimum for total CAR. And while FGB would need a mere AED 95mn of core capital to meet Central Bank standards, the other four banks require AED 15.7bn (USD 4.3bn) of extra Tier 1 capital. August 1st,

14 We note that the UAE's minimum CAR requirements (both for Tier 1 and total capital) are much stricter than Basel II international standards, which the European Central Bank (ECB) has used as the benchmark in its recent stress tests on European banks. Based on Basel II Tier 1 capital requirement of 6%, only ADCB would require additional funds, estimated at a mere AED 654mn (USD 178mn) under scenario #2 rising to AED 3.5bn (USD 955mn) in scenario #3, along with AED 578mn (USD 157mn) for CBD. Our worst case scenario would find three lenders in our pool falling short: Emirates NBD (AED 1.9bn), ADCB (AED 4.8bn), and CBD (AED 1.1bn) would require core capital additions estimated at AED 7.7bn (USD 2.1bn). 6.0 Tier 1 capital requirements based on Basel II floor of 6% AED bn ADCB ADCB CBD ENBD ADCB CBD Scenario 2 Scenario 3 Scenario 4 Source: SHUAA Capital We have no doubt that the UAE government stands ready to provide any additional capital that may be required to ensure that these individual banks remain sufficiently capitalized. Indeed, the authorities have already injected AED16bn in non-dilutive Tier 1 capital into Abu Dhabi banks at the height of the financial crisis. The estimated core capital shortfalls are, even in our worst case scenario, undoubtedly manageable, especially when we consider that the Ministry of Finance still holds AED 20bn (USD 5.5bn) out of the original AED 70bn emergency facility. August 1st,

15 Dealing with the fallout of a financial crisis: drawing on international experience UAE banks are not alone in facing the consequences of the global financial crisis. Authorities around the world have responded in different ways to stabilize and limit the impact of the crisis on their own banking systems and economies. We believe the cases of Ireland and Spain are worth examining in particular, as like the UAE, the Irish and Spanish banks were highly exposed to collapsing domestic real estate markets. De-risking Irish banks Ireland s financial sector was heavily exposed to the real estate sector, which had fuelled the Celtic Tiger s growth in the decade preceding the financial crisis. More than 75% of the six Irish banks total loans were reportedly secured against property 4. Some banks, such as Anglo Irish Bank had most of their loan portfolio extended to developers and builders, the riskiest group of real estate borrowers. The Irish government used two key measures to prevent the country s largest banks from going insolvent: 1/ They capitalized the banks in return for equity, in some cases (such as Anglo Irish) nationalizing the banks outright, 2/ They created a National Asset Management Agency (NAMA), to take on the riskiest assets of the banks, mainly real estate backed loans, in return for government securities. These loans, with an estimated face value of EUR 80bn as of March 2010, were purchased at a discount by NAMA, and will be managed over a 7-10 year period to maximize the return for the taxpayer. The loans taken on by NAMA were not all non-performing; they were simply the highest risk loans on the banks balance sheets. The aim of these measures was not to liquidate or write off the banks portfolios, but to remove these high risk assets from banks' balance sheets and replace them with low risk government securities. In doing so, banks would be encouraged to resume "normal" lending to businesses and households, thus supporting an overall economic recovery in Ireland. As the process of transferring the loans to NAMA was only started in March 2010, and will take several months to complete, it is still too soon to say how effective this measure has been in contributing to private sector credit growth in Ireland. It is important to note that the financial crisis and collapse in the Irish real-estate sector also had a significant and direct impact on the country s fiscal position. During the boom years, the Irish budget became overly-reliant on revenues from real estate taxes and fees, which were used to finance increased expenditure in other sectors (health, education and social spending). As a result, when the financial crisis hit, Ireland had to deal with the double whammy of bailing out its insolvent banks as well as financing a gaping hole in its budget revenues. The Irish government budget balance consequently moved from a small surplus in 2007 to 14.3% of GDP deficit in Source: NAMA, Eurostat, Wikipedia 4 Irish Independent, January 16, 2009 August 1st,

16 Spanish banks restructure and take stricter provisions. Spain s banking system was relatively immune from the US subprime crisis, and has only started tackling the issues facing its banking sector in the last few months. About 45% of Spain s financial sector is made up of small, regional, unlisted savings banks known as cajas. Many of these have large exposures to Spain s real estate sector, which has also experienced a sharp contraction since Q4 2008, and have found it very difficult to roll over their maturing debt in the wake of the Greek crisis. The Spanish authorities are encouraging the cajas to restructure and merge with each other and with the larger commercial banks, to reduce inefficiencies and improve their balance sheets. In addition, the central bank has introduced stricter provisioning rules: lenders now have to set aside provisions for the full value of each bad loan within one year of default, rather than the previous 2-6 year provision period. However, the value of underlying assets can be taken into account when calculating the provisions, albeit at a discount which depends on the type of asset on which the loan is secured. Provisioning requirements on real estate assets that have been held for over 2 years have also been increased, which has had a big impact on the cajas. Even with the restructuring of the banking system, it is expected that some banks and cajas will need to be recapitalized, although estimates vary depending on the assumptions made. In its April 2010 Global Financial Stability Report, the IMF estimated the cajas would need about EUR 17bn of capital under an adverse case scenario ; these estimates were made under the old provisioning rules so under the new provisioning rules, we would expect this figure to be higher. However, in its recently released stress test on European banks, the ECB indicated that seven European banks (five of them Spanish) would need only EUR 3.5bn of additional capital. This difference in estimates reflects the very different underlying assumptions made by the IMF and the ECB. Source: IMF, Financial Times August 1st,

17 Conclusions and recommendations Based on our stress test, we believe UAE banks are overall sufficiently capitalized to face significant deterioration in their asset quality. Even in our worst case scenario, the average total capital ratio is only marginally below the 12% UAE minimum; and average Tier 1 capital of our pool remains above the 6% Basel II floor. This is a better than expected result, and should help alleviate some concerns about the robustness of the UAE banking system. Nevertheless, under our most conservative default assumptions, the average NPL ratio for our sample rises to 12.3% from the current 3.3% and five out of our eight banks would require up to AED 15.8bn (USD 4.3bn) of additional Tier 1 capital in order to comply with Central Bank's regulation. We are confident that in this unlikely event, the required financial support will be provided by the authorities. As private sector credit growth is critical for a sustained economic recovery in the UAE, the current situation should be addressed directly. Uncertainty about the extent of future provisions and questions over banks ability to absorb potential losses will otherwise linger, undermining confidence and making it more difficult for banks to attract much needed funding to grow their loan books. So what could be done to encourage banks to resume lending? We believe the Irish solution is one that should be seriously considered. Indeed, the UAE enjoys a relatively strong fiscal position that should enable it to fund the creation of a government-backed "bad bank" to host local lenders' most toxic assets. Qatar has implemented a similar solution for banks' local equity and real estate exposures, which appears to have been relatively successful. By removing some of the riskiest assets from UAE banks balance sheets and replacing them with lower risk government paper, or cash, banks will be in a much stronger position to attract funding and resume lending to households and businesses. On the other hand, Spain s conservative, immediate provisioning route would severely impact banks earnings and profits should it be adopted in the UAE. Our analysis suggests an additional AED 42.5bn (USD 11.6bn) AED 71.3bn (USD 19.4bn) would allow banks to ensure 100% NPL coverage under our five scenarios. This would also leave the banks vulnerable in the event of new, unexpected negative credit events. However, this does not mean that the UAE authorities should rule out this option altogether - perhaps a combination of more rigorous provisioning requirements together with isolating banks' "toxic" assets would be a feasible alternative. Other measures the government could implement to boost bank lending could include offering incentives, such as government guarantees, to support lending to sectors and businesses with long-term strategic importance. However, we believe such supply-side incentives should be used with caution, to ensure that capital is allocated efficiently, and to sectors and businesses that will generate the greatest economic value going forward. In our view, broad structural and economic reform to encourage private and foreign investment in the UAE is likely to yield greater benefit over the longer term. Structural reforms, including greater transparency, improved corporate governance and a stronger regulatory framework in the financial sector and broader economy would contribute to greater investor confidence and ultimately improved access to funding (both for banks and other corporate entities) at better terms. In a post-crisis world where commercial banks are more risk averse, their ability to attract long-term funding at good rates will be a key element for sustainable credit and economic growth. August 1st,

18 APPENDIX UAE FY09 asset quality metrics vs. other economies NPL ratio (%) Qatar Oman KSA UAE Morocco Lebanon Jordan Average Kuwait Egypt Provision cover (%) Jordan Lebanon Kuwait Morocco UAE Average Saudi Arabia Qatar Egypt Oman Source: SHUAA Capital, IMF UAE FY09 CAR vs. other economies Total Capital Adequacy Ratio (%) UAE Commonwealth of Independent States Western Hemisphere Sub-Saharan Africa Central and Eastern Europe Middle East and North Africa Developing Asia Advanced Economies Source: SHUAA Capital, IMF August 1st,

19 Research Economics Khatija Haque Strategy Ahmad M. Shahin Banks & Diversified Financials Sofia El Boury Ghida Obeid Real Estate & Construction Roy Cherry Taher Safieddine Transportation & Logistics Kareem Z. Murad Heavy Industries & Utilities Jessica Estefane Kareem Z. Murad Telecom, Media & Technology Simon Simonian, CFA Technical Analysis Adel Merheb Data Ahmad M. Shahin Nicole Chamat nchamat@shuaacapital.com Design Jovan Ruseski jruseski@shuaacapital.com Client Services: 800 SHUAA (74822) UAE only Saudi Arabia only +971 (4) International clientservices@shuaacapital.com Sales Trading Desk: +971 (4) (2) tradingdesk@shuaacapital.com August 1st,

20 This page was intentionally left blank This document has been issued by SHUAA Capital for informational purposes only. This document is not and should not be construed as an offer or the solicitation of an offer to purchase or subscribe or sell any investment or subscribe to any investment management or advisory service. This document is not intended as investment advice as to the value of any securities or as to the advisability of investing in, purchasing, or selling any security. SHUAA Capital has based this document on information obtained from sources it believes to be reliable. It makes no guarantee, representation or warranty as to its accuracy or completeness and accepts no responsibility or liability in respect thereof or for any reliance placed by any person on such information. All opinions expressed herein are subject to change without notice. This document may not be reproduced or circulated without the prior written consent of SHUAA Capital.