Global Banking. Gulf Islamic Banks Resilient Amid Global Credit Woes. Special Comment. Moody s. Summary Opinion. November Table of Contents:

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1 Special Comment Moody s Global Banking November 2008 Table of Contents: Summary Opinion 1 Liquidity management is structurally difficult at Islamic banks and is even tougher now 2 Islamic banks investment portfolios have been impaired, but cyclicality has been expected and therefore mitigated 4 Accounting for investment portfolios ups and downs: a new level playing field 5 Islamic banks tend to be more exposed to property risks: is this excessive given current market conditions? 5 Islamic banks have always displayed funding imbalances, but this has worsened as the crisis reaches its peak 7 Appendix 1: Summary Rating Rationales for Rated Islamic banks 9 Appendix 2: Rated Islamic Banks Financial Performance So Far in Moody s Related Research 18 Analyst Contacts: Paris Anouar Hassoune Vice President/Senior Credit Officer DIFC Khalid Howladar Vice President/Senior Credit Officer Antoine Yacoub Associate Analyst 0 Faisal Hijazi Business Development Officer Limassol Mardig Haladjian General Manager/ Senior Vice President Gulf Islamic Banks Resilient Amid Global Credit Woes Summary Opinion Islamic financial institutions (IFIs) in the GCC 1 have displayed strong resilience amid the current global financial debacle. One obvious reason for their proven ability to weather the storm is embedded within the core principles of Islamic banking: both speculation (maysir) and interest rates (riba) are prohibited. The sub-prime crisis has been driven by a number of factors that in combination led to the accumulation of risks, which were again magnified through the use of complex, often highly structured financial products all of which were explicitly riba-based. However, it is not because IFIs risk management architecture and culture were more robust that they avoided carrying toxic products on their books; structurally, they have simply been banned from investing in such asset classes, as per the core principles they abide by. IFIs are not risk-immune, as this report contributes to demonstrate; but their current capacity to resist this crisis has been bolstered by the lack of investment in such securities. Strong growth and conservative approach stand IFIs in good stead Global Islamic banking assets grew around 27% in 2007 and growth of 20-30% is expected this year as well. On the contrary, 2009 will likely be a tough year for Islamic banks: we expect that the growth rate of their combined assets will decelerate, probably in the range of 10% to 15%. Early signals for financial performance and liquidity in the fourth quarter of 2008 so far have show signs of slowdown, if not stress. However, IFIs benefit from a number of buffers (including ample capital and strong retail platforms) that will enable them to continue growing, albeit at a slower pace, before resuming more rapid growth, most probably within an 18-month timeframe. Short term, in times of crisis, clients may find it more comfortable doing business with an Islamic bank: such institutions are perceived as focusing on the basics of financial intermediation and depositors may therefore view them as safer havens less prone to excessive financial innovation. 1 Gulf Cooperation Council countries are: Saudi Arabia, the United Arab Emirates, Qatar, Bahrain, Kuwait and Oman.

2 Paradoxically, Islamic banks reputation has benefited from the current crisis (with some exceptions though), reflecting their conservative approach to business, a close proximity to their domestic and regional deposit franchises, their balanced and ordered appetite for growth and their focus on basics of banking as opposed to innovation, with emphasis on their domestic market first. All these factors, which used to be perceived as weaknesses before the credit crisis began, are now being used as shields against the potential damages of imported stress. No man is an island That said, IFIs do not operate in isolation from their local, regional and even international environments. They are part of it, as an ethical subset of the more globalised and interdependent financial markets. As such, they have been facing three series of cyclical challenges, which again reflect their current structural strengths and weaknesses: Managing short-term liquidity has been made more difficult; Investment portfolios, concentrated on illiquid and cyclical asset classes, have been impaired; Access to long-term funding has been postponed, forcing banks to reduce the maturity profile of their assets. However, despite such constraints, which are expected to be temporary, Islamic banks have had the capacity to resist, thanks to a few buffers: Their credit portfolios have been essentially domestic, with limited pressure on asset quality so far; Their entrenchment in the retail banking arena, with high customer loyalty and deposit stability, limits the probability of massive bank runs; High capitalisation and ample core liquidity often provide a relatively higher amount of confidence to counterparts. Liquidity management is structurally difficult at Islamic banks and is even tougher now Liquidity management is far from being an easy task for IFIs. Despite the efforts of the Central Bank of Bahrain (CBB) and others to provide a range of liquid instruments in which Islamic banks can place their surplus cash, there is still a great shortage of liquid instruments, which means IFIs tend to be more illiquid than their conventional peers and have more non-earning assets on their books. Indeed, most instruments used for liquidity management purposes are interest-based. Typically, Islamic banks would place their excess cash reserves into short-term interbank murabahas, at a cost compared to conventional banks. Indeed, short-term murabahas resemble money market interbank placements, but as murabaha contracts make it necessary for commodity brokers to be involved, costs for managing liquidity may be high. As a consequence, IFIs are truly and often more visibly subject to the constant trade-off between profitability and liquidity in a binary way. Contrary to conventional banks, which benefit from a continuum of asset classes displaying different characteristics in terms of liquidity and profitability, IFIs at this stage of the development of the Islamic financial industry have a very limited choice available to them: profitable but highly illiquid asset classes (such as credit exposures and Sukuk); or highly liquid short-term murabahas with international investment-grade banks, but at a cost. Fortunately, yields on Islamic assets in many markets are sufficient for the cost of managing liquidity, because borrowers are often willing to pay a premium for the Islamic nature of the banking relationship they build with the IFI. In the future, however, as the industry matures, margins may come under pressure and the trade-off between liquidity and profitability may lead to an increase in IFIs risk appetite, unless instruments for liquidity 2 November 2008 Special Comment -

3 management purposes are designed for the benefit of IFIs. In Saudi Arabia, the Saudi Arabian Monetary Agency (SAMA) has developed an ad-hoc instrument called mutajara, which behaves like a repurchase agreement (repo). Contractually, it is a term deposit with SAMA or other financial institutions, but 75% of this deposit can be repoed at SAMA at any point in time for liquidity purposes. In Bahrain, the CBB is also working on developing a Shari ah-compliant repo scheme. Finally, the Sukuk market is growing fast. Governments and government-related institutions have made it clear on several occasions that their role on the Sukuk market will not be limited to that of a benchmark-setter; issuing sovereign and public-sector Sukuk would also contribute to enhancing the overall liquidity of the market. IFIs need this to weather possible liquidity shortages in light of unforeseen events. For instance, during the financial crisis in Turkey during , IFIs faced severe liquidity problems and one, Ihlas Finance, was closed. There s no such a thing as an Islamic money market. Islamic banks do lend to each other, but not exclusively to each other. Islamic banks and their conventional counterparts stand in a close interdependence via the global money market. Islamic banks rely heavily on conventional counterparties, and therefore their treasuries are currently feeling the stress in the money market. On the interbank market, Islamic banks and their conventional counterparts have always had close links, borrowing from each other in a Shari ah-compliant manner, through plain-vanilla interbank murabahas, wakala arrangements and structured, enhanced deposit schemes. In other words, the Islamic money market is still an integral part of the regional, and increasingly international, interbank marketplace. It is not isolated whatsoever. When liquidity starts to come under pressure on the money market, Islamic and conventional banks alike find it difficult to place excess funds and to borrow on a short-term basis. Islamic banks and conventional ones are equally affected when systemic risks tend to rise. This is where shareholders and regulators tend to step in, by providing liquidity. Fortunately, Islamic banks in the GCC operate in banking environments that are very much protected and supported by their respective regulators and governments, which have so far been supplying relatively large amounts of funds to restore confidence in banking systems. In the region, interbank liquidity has been under pressure, especially in the UAE and Bahrain. That said, the region s central banks have intervened, either by injecting cash or by stating that they will do so in case of need, or by guaranteeing deposits or all of the above. This is easier than in Western economies because the region s central banks account for a high proportion of assets in comparison to the size of their respective banking systems and economies. We consider GCC regulators as highly supportive to their banks, and support starts with the willingness and capacity to liquefy the interbank markets when needed. Historically, Islamic banks in the GCC have kept very large proportions of core liquidity on balance sheet, in the form of short-term international murabahas and central bank deposits, at the expense of forgoing some extra revenues. This proved to be a wise choice in a region prone to ample cycles and recurring shocks, given that their investment portfolios, which are highly concentrated, tend to become more illiquid as stress situations worsen. Such a luxury of keeping wide amounts of cash and cash equivalents on balance sheet at all times was made possible by a clear advantage in terms of margins, which are usually large and stable thanks to the lucrative retail business line. Gulf liquidity is more oil price-driven than in more mature economies where it is negatively correlated to market interest rates: this is a clear buffer against global credit vagaries and liquidity crunch. In addition to that, Islamic banks funding continuum is dominated by domestic retail and corporate deposits, not wholesale funds. Under normal conditions, such short-term funding mix is a negative, because it exposes the bank to profit rate risk and widening maturity mismatches; but when wholesale liquidity dries up, Islamic banks retail entrenchment is a factor of stability. In summary, Islamic banks do not operate in isolation. They are part of the local, regional and increasingly global economy. In this respect, although they are less sensitive to the monetary fluctuations of the West, they remain dependent on the real economic cycle. As the financial crisis gradually turns into a real economic downturn, asset quality will ultimately deteriorate and Islamic banks high exposures to the property sector 3 November 2008 Special Comment -

4 could turn out to become a curse rather than a blessing. It is true that Islamic finance has been more resilient because of the ban on interest, which has resulted in Islamic financiers steering clear of toxic repackaged credit instruments; however, the Shari ah-compliant financial model is not a panacea either. Islamic banks investment portfolios have been impaired, but cyclicality has been expected and therefore mitigated Islamic banks carry four main asset classes within their investment portfolios: property, equity, Sukuk and managed funds (which include underlying assets mainly comprising infrastructure, private equity, real estate and stocks). Such assets have all lost value over the past few months. The Gulf property and equity markets are volatile, and spreads on Sukuk have widened considerably. No matter how accounting is performed to reflect unrealised losses on investment portfolios, economically capital remains the ultimate buffer against investment losses. This is one of the reasons why Islamic banks have such a high amount of capital. In most cases, they are very highly capitalised and, as they do not use Tier 2 capital, their equity base is most often of strong quality. This is also a link here with their lack of diversification: the more a financial institution displays concentration risks and high correlations between its business lines and asset classes, the more it needs to set aside sufficient capital buffers. Gulf IFIs need and want to expand, but risks are building up across the board. In such a context, Islamic banks paradoxically need even more capital. Before the crisis, most GCC IFIs were planning for more leverage and more investment as well as credit gearing, with some common understanding that they were overcapitalised. The picture has now dramatically changed, and their shareholders seem willing to provide additional equity, although this is an expensive thing to do. Compared to previous years, the price-volume picture has also changed. Back in 2006, despite the equity crash, banks in the GCC, including Islamic banks, benefited from both positive price and volume effects, with fast-growing credit and investment portfolios, at a time when margins widened as a result of widely available (thus cheap) funds, and increasing profit (interest) rates saw only a positive volume effect, with credit and investments growing unabated, but margins either stabilising or declining. In 2008, and even more in 2009, volumes are expected to grow more slowly and margins to shrink, because of more expensive funding, safer and shorter-term credit, as well as negligible if not negative investment returns. We therefore expect Islamic banks profitability to stabilise or grow only slowly, and profit ratios to deteriorate. Of course, this applies to the industry as a whole, and some outliers will likely emerge, especially those institutions that have already managed to increase diversification by name, sector, business line and geography. Only a few names, such as Kuwait Finance House, will likely display superior resilience thanks to the granularity of their business models and portfolios. The Islamic banks Moody s has rated so far have all been penalised by their investment portfolios. Stock markets have crashed, just as they did in 2006, but contrary to the previous equity correction, this time Islamic banks have not had the opportunity to sell their stocks ahead of the crisis on a large scale. Finding suitable alternative asset classes to replace impaired ones is difficult, as most global markets have been hard hit by the crisis. Most investors in regional stocks have lost money, including banks. On the Sukuk market, the same effect was recorded: as Sukuk are not liquid, Islamic banks found it difficult to find buyers of impaired Sukuk at satisfactory prices. Therefore, on both asset classes (equity and debt), IFIs have so far often preferred to stick to their portfolios and to account for the (still virtual) losses. Those that apply IFRS take unrealised losses on their portfolios available-for-sale directly to equity (which is the accounting treatment for the bulk of these investments); conversely, those IFIs that comply with the standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) previously took unrealised losses into the P&L. This distorted both consistency and comparability between conventional banks (IFRS-based) and Islamic banks (AAOIFI or IFRS-based), and even between Islamic banks themselves. This needed some revision, which came into place in October November 2008 Special Comment -

5 Accounting for investment portfolios ups and downs: a new level playing field The revision to accounting standard FAS 17 of AAOIFI (Guidance Statement on Accounting for Investments and Amendment in FAS 17) is clear and straightforward. To summarise it, any movement in Islamic banks investment portfolios accounted for as available-for-sale (AFS), i.e. marked to market (in line with fair value accounting), can now be absorbed by equity, without transiting through the income statement (P&L), except if there is permanent impairment (in which case the loss should be taken into the P&L); and except properties that cannot be subject to a negative fair value (FV) reserve (for real estate, FV reserve is minimum zero, and any further decline in price should be recognised in the P&L). Prior to this, cycles in investment values were absorbed by revenues (in the P&L), not by capital (on the balance sheet). This makes FAS 17 closer to IFRS 39 and now places Islamic banks accounting of investments on about the same grounds as conventional banks. In times of fast asset price decline, Islamic banks used to suffer from P&L volatility, whereas conventional banks using IFRS were/are subject to some cyclicality of equity through their FV reserves. Economically, this is equivalent, because ultimately today s profits are tomorrow s equity, and, as regards the value of the firm, it does not matter whether asset price movements are captured by the P&L or by capital. However, from an accounting perspective, the P&L has given its structure less capacity to absorb wide asset price volatility than equity; and the risk of an Islamic bank showing a loss increases under the old FAS 17, with limited fair comparability with its conventional peers. Profits are more sensitive and more widely looked at and commented on than a bank s equity position all the more as Islamic banks are highly capitalised, and can better absorb the shock than their income statement, which should reflect more the banks business production rather than asset price cycles. In addition, for all readers of financial statements, this isolates the impact of the crisis in a separate box (the investment FV reserves), which makes it easier for us to read and quantify. The revised FAS 17 makes absolute sense for clarity, consistency and comparability, although economically it is neutral. However, it also removes pressure on Islamic banks at a time when attention is overly focused on profits, and probably not enough on balance sheets. For those in the analytical world, the main difference between analysing a bank and analysing another corporation (say in an industrial sector) is that a bank should be looked at from a balance sheet perspective, the P&L being second in line, whereas an industrial corporation should be looked at from a cash flow and P&L perspective, with the balance sheet coming second. What AAOIFI does here in revising FAS 17 is obviously adopting a more analytical view of accounting, not just a Shari ah perspective. This is another signal that the Islamic financial industry is becoming more mature, whereby various aspects and perspectives do not contradict but, rather, enrich each other. Islamic banks tend to be more exposed to property risks: is this excessive given current market conditions? A crash in the real estate market might be more damaging for GCC financial institutions, especially Shari ahcompliant ones. That said, property markets do not behave like stock markets. More sensitive politically, especially in small Muslim countries where family homes have a very profound social value, we assume that the Gulf property markets are likely to be managed by their respective governments. However, in order to gain a better grasp on relevant orders of magnitude, we have run several scenarios. One simple conclusion of these was that a 50% decline in GCC property prices, along with the associated economic slowdown, would consume between 10% and 50% of banks equity, with Islamic banks generally standing at the upper end of this bucket. It would take on average one to two years of record profits to absorb such a shock. Most banks would survive a property crash. Some of the smaller financial institutions would fall below investment grade, but would probably be saved by governments or government-related entities or other financial institutions eager to grow externally at a cheaper price. However, it would be a confidence shock to Islamic bankers if a Shari ah-compliant institution were to fail. 5 November 2008 Special Comment -

6 In order to have a more complete picture of Gulf banks direct exposures to the property market, please refer to Tables 1 and 2 below. What Table 2 shows is that the proportion of real estate lending in total lending in the GCC was 13% overall at year-end 2007; in Saudi Arabia it was 7.1%, which is far below average. In terms of ranking, only Omani banks are less exposed to the property market than Saudi banks; in all other four GCC countries, banks are more exposed to the real estate market than in Saudi Arabia. In terms of trends, as shown in Table 1 below, Saudi banks exposures to property in their lending books has been stable in the 7%- 9% bucket; in Kuwait, Qatar and Bahrain, lending for real estate and construction purposed has increased sharply; in Oman and in the UAE, it has slightly declined in proportion. Overall, this means that direct real estate risk for banks in Saudi Arabia is on the lower side compared to most GCC countries, Oman being the safest. Table 1 % of Real Estate and Construction Exposures in Lending Portfolios ( ) % KUWAIT QATAR KSA OMAN UAE BAHRAIN % 3.2% 8.9% 7.1% 14.6% 9.4% % 3.6% 9.2% 6.9% 14.2% 8.8% % 7.6% 8.4% 6.5% 11.9% 7.5% % 11.6% 6.7% 6.4% 11.0% 6.9% % 13.7% 6.9% 6.6% 10.6% 9.6% % 15.4% 7.5% 5.8% 10.1% 12.1% % 17.0% 7.1% 5.8% 11.1% 18.8% Table 2 % of Sector Exposures in Lending Portfolios (YE2007) % KUWAIT QATAR KSA OMAN UAE BAHRAIN GCC Real estate and construction 30.1% 17.0% 7.1% 5.8% 11.1% 18.8% 13.1% Retail and personal loans 33.6% 30.0% 33.0% 39.9% 25.2% 35.7% 30.2% Trade and commerce 9.0% 11.0% 20.9% 11.9% 16.8% 17.6% 16.4% Industry 5.1% 2.2% 10.5% 18.4% 8.5% 10.4% 8.5% Non-bank financial institutions 11.4% 6.7% 10.5% 4.3% 5.2% 4.1% 7.8% All other lending 10.8% 33.2% 18.0% 19.8% 33.3% 13.4% 24.0% TOTAL 100% 100% 100% 100% 100% 100% 100% In the GCC overall, Islamic banks tend to have higher direct and indirect exposures to the property market than their conventional peers. Real estate financing and investments are one of Islamic banks preferred habitats. However, some disparities remain from one country to another. Islamic banks in Saudi Arabia, for instance, have only a marginally higher appetite for property exposures than non-islamic Saudi banks. Even when adjusted for indirect exposures to properties, the proportion of real estate exposures to total lending portfolios, assets or equity is not excessive. Conversely, in Dubai, which is no more an oil economy, real estate has been one of the main drivers of economic growth: therefore, it is only natural that their exposures to domestic and regional properties be higher than average. It is in Dubai, and the UAE at large, where real estate risks are the highest for financial institutions, especially Islamic ones. However, it is also there where all Islamic banks are sponsored if not controlled by their respective regional governments. Both large exposures to property risks and government support are factored into our ratings. We expect that in the UAE drops in fixed assets value will not happen imminently, but after a time lag of three to six months. The drop is expected to first start hitting the off-plan properties. It appears that high-end properties prices are currently softening and that prices of middle- to 6 November 2008 Special Comment -

7 lower-end properties are rising (with more demand chasing affordable accommodation in the current environment). Efficiency ratios of property-biased financial institutions such as Islamic banks will likely deteriorate as expenses continue to increase (in the wake of still high inflation), and operating income is due to slow or maybe fall for some banks. Mortgage lending has slowed down sharply since the summer, and LTV ratios have fallen significantly to below 80%. There are several reasons why Saudi banks in general and Islamic ones are no exception would be less vulnerable to a real estate shock. First is regulation: SAMA tends to cap exposures to given sectors, especially properties, and monitors such exposures with care. Second is the absence of a mortgage law, which significantly constrains banks appetite for financing residential and commercial properties on a wide scale. Third, Saudi Arabia is a vast country that results in more natural diversification in the property sector than some smaller neighbouring countries. Fourth, there has been comparatively less pressure on the Saudi property market than in some other MENA countries, as a result of less speculation, less volatile pricing and more genuine demand for both houses and commercial properties, driven by demographics more than by investors sentiment. Islamic banks have always displayed funding imbalances, but this has worsened as the crisis reaches its peak Until recently, Islamic banks were focusing on longer-term liabilities, raising the money through longer-term Sukuk. This was because they needed to have access to longer-term financing, in order to match the lengthening of their assets maturities (in line with good asset-liability management practices). However, since the third quarter of 2007, the Sukuk market has dried up. Spreads went through the roof across the rating spectrum, and it is now unaffordable to issue Islamic bonds. Most of them have been postponed indefinitely. As a result, Islamic banks have had to curb longer-term lending. As much as Islamic banks do not operate in isolation, the Sukuk market is not isolated from the rest of the credit universe. It relies on credit risk, perception of systemic risks, and liquidity. All these components have deteriorated, sending spreads up. After expanding robustly in 2007, the Islamic bond Sukuk market has been experiencing a marked slowdown in issuance this year, with widening spreads fuelled by factors such as increased liquidity risk, concerns about its compliance with Islamic law and the increased perception that Gulf countries are not immune from the global credit crunch and heightened systemic risks. The Sukuk market is not stagnating, but growing at a slower pace compared to 2007, when the amount of Sukuk issued totalled US$47 billion. That brought the amount outstanding in the market to almost US$100 billion. So far in 2008, issuance is at about US$20 billion, and we do not expect this number to change very much by the end of this year. A 40% decrease in issuances, in contrast to a 90% increase last year, is the signal of a clear and obvious slowdown. On the price side, spreads on Sukuk appear to have widened more compared to conventional bonds in the same rating category. This means that the value of traded Sukuk have dropped more in relative terms than equivalent conventional bonds. In order to understand some of the reasons for the widening in Sukuk spreads, one must bear in mind that spreads are a measure not only of credit and systemic risks but also of liquidity risk. When liquidity dries up as it has during the financial turmoil investors retreat into safer asset classes such as US Treasuries, with illiquid assets being the first hit. The Sukuk market is not a liquid market and therefore it has been penalised because of its lack of liquidity. In addition, in February 2008, AAOIFI s Shari ah Supervisory Board issued a fatwa stating that a majority of the Sukuk issued so far are Shari ah-compliant by form more than by substance. This has obviously cast some doubt on the genuine Shari ah-compliance of a number of structures in the market, forcing potential new issuers to review the manner in which they intend to issue Sukuk going forward, thus bringing even more delays in Sukuk issuances this year. As a result, issuers (including Islamic banks) are beginning to move from asset-based Sukuk, to more assetbacked Sukuk. In this, they are making the move from unsecured Islamic bond issuances to more securitised 7 November 2008 Special Comment -

8 assets. This has probably contributed to the value of the Sukuk outstanding falling while the spreads rose. However, this has most likely been just one of several factors damaging Sukuk values. There is an increasing general perception that the GCC nations are no longer immune from the global credit woes, being connected to the global economy through oil exports. The drop in oil prices has limited the financial flexibility of GCC governments to increase spending, as they have set their budgets on the assumption that oil prices would remain in the US$50-70 range, and is obviously reflected in the Sukuk as well as conventional bond markets. With issuance volume falling, difficulties in securitising assets and spreads widening, issuers have been very reluctant to go the Sukuk route at a time when investors are even unwilling to buy low investment grade assets, let alone non-investment grade paper. The appetite for Sukuk is still there from the issuer perspective, because there is a true need for long-term financing, especially from banks. However, market conditions are not sufficiently appealing for issuers particularly banks to issue Sukuk at present, making banks less inclined to fund long-term projects. This trend is completely countercyclical at a time when the Gulf economy needs physical capital and infrastructure, in the form of hospitals, ports, roads, transportation networks, houses, commercial properties, airports, universities and schools... and also needs to invest in oil, gas and petrochemical facilities. Fortunately, the impact of reduced credit from and to banks has been limited by sovereign wealth funds and governments, who are now providing support to the financial sector in the form of deposits, short-term liquidity and even capital. In particular, they are taking stakes in banks, while also investing monies in their own economies. These actions can be interpreted as sovereign wealth funds substituting themselves for the banking systems in the region, which are not at this stage in the most favourable position to optimally finance their own economies. This applies equally to Islamic banks. Note: this report also includes two appendices. Appendix 1 contains the summary rating rationales for the eight Islamic banks we rate in the GCC. For each rated bank, we comment on structural rating drivers, and provide our views on its financial performance for the nine months ended 30 September 2008, as compared to that of Appendix 2 comprises a peer comparison report, in the form of a table summarizing key financial indicators (growth, profitability, leverage and liquidity) relative to the Islamic banks we rate in the Gulf region, for both 2007 and the first three quarters of Tamweel is excluded from the comparative financial table because, as a specialized lender, its ratios might not be fully comparable to those of its commercial peers. 8 November 2008 Special Comment -

9 Table 3 Appendix 1: Summary Rating Rationales for Rated Islamic banks GCC Islamic banks rated by Moody s IFI Name Country Bank Financial Strength Rating Baseline Credit Assessment Local Currency Ratings Foreign Currency Ratings Rating Type Outlook Abu Dhabi Islamic Bank UAE D Ba2 A2/P-1 A2/P-1 Issuer Ratings Stable Al Rajhi Bank Saudi Arabia C A3 A1/P-1 A1/P-1 Deposit Ratings Stable Bank Al-Jazira Saudi Arabia D+ Baa3 A3/P-2 A3/P-2 Deposit Ratings Stable Boubyan Bank Kuwait D Ba2 Baa2/P-2 Baa2/P-2 Deposit Ratings Stable Dubai Bank UAE D Ba2 A3/P-2 A3/P-2 Issuer Ratings Positive Dubai Islamic Bank UAE D+ Baa3 A1/P-1 A1/P-1 Issuer Ratings Stable Kuwait Finance House Kuwait C- Baa1 Aa3/P-1 Aa3/P-1 Deposit Ratings Stable Tamweel PJSC UAE -- Ba2 A3/P-2 A3/P-2 Issuer Ratings Stable Abu Dhabi Islamic Bank: D/A2/P-1/Stable Structural rating drivers Moody s assigns a bank financial strength rating (BFSR) of D to Abu Dhabi Islamic Bank PJSC (ADIB), which translates into a Baseline Credit Assessment of Ba2. The D BFSR reflects ADIB s solid financial fundamentals, business model, and performance, as well its small but fast-expanding domestic Islamic banking franchise in the United Arab Emirates (UAE). Good asset quality is a result of moderate appetite for risk, and limited loan leverage as well as market risk exposures. The bank s funding mix displays better diversification than peers, which is a clear advantage under current difficult market conditions. The rating is at the same time constrained by significant concentration risks especially in the credit portfolio and by high levels of related-party lending. The rating is also challenged by the constraints attached to liquidity and balance sheet management associated with the Islamic nature of the bank s business. Higher exposure to risky sectors, including properties, raises ADIB s credit risk profile and could bring future asset quality under stress, although past rapid credit growth appears to have been curbed. Increasing competition amid a potentially volatile domestic operating environment, subject to material inflation of financial and property assets, is putting human resources under pressure in the fast-growing Islamic banking industry, generating a risk of management discontinuity. The BFSR finally reflects the challenging operating environment in the bank s domicile, where any severe price correction in the overheating property and real estate market, as well as potential regional instability could affect the profitability and asset quality of the UAE banking sector, including ADIB. ADIB s global local currency (GLC) long-term issuer rating is set at A2, a six-notch uplift from the bank s Ba2 Baseline Credit Assessment. This is based on Moody s assessment of a very high probability of systemic support in the event of need, reflecting ADIB s strong relationship with the Abu Dhabi government and its importance within the domestic banking system, as the second largest Islamic bank. The outlook on all ratings is stable. Financial performance for the nine months ended 30 September 2008 In 2008 so far, ADIB has played the volume game: its financing portfolio increased 29.5% from YE2007 to end-september, reflecting the bank s appetite for retail lending. Funding costs, also extracted from households and strong government relationships, remained under control, helping margins remain at high levels, and absorb far larger provisioning costs. Non-intermediation revenues in the form of investment and property- 9 November 2008 Special Comment -

10 related earnings have not been negatively affected, reflecting the bank s limited appetite for risky asset classes. Overall, the annualised return on assets improved to 2.11%. As capitalisation declined slightly, the annualised return on equity reached a robust 17.5%. As expected, ADIB s liquidity deteriorated compared to past years, with the bank s core liquidity ratio standing at a still strong 25.6% as of 30 September 2008, down from 37.3% at YE2007. This signals ADIB s tactics of growing faster than the market under current difficult market conditions, as a countercyclical move to gain market shares. This also signals ADIB s confidence in its newly retail-oriented strategy, betting on the fact the global credit imbalances would not directly impact the creditworthiness of the average household in the Abu Dhabi and the UAE in general. So far, such an approach has proven successful. We expect ADIB to prove right and emerge from the global crisis as a stronger institution. Al Rajhi Bank: C/A1/P-1/Stable Structural rating drivers We assign a BFSR of C to Al Rajhi Bank (Al Rajhi), which translates into a BCA of A3. The BFSR is supported by the bank s robust commercial franchise as the largest Islamic bank globally, and its leading market position in retail banking. The combination of cheap funding, good control over costs and relatively high credit leverage by Saudi standards makes Al Rajhi one of the most profitable banks in the Middle East. Appetite for market risks is also very limited and financial performance has been consistently sound over the past five years. The bank s risk management architecture and corporate governance, key weaknesses in the past, have been enhanced. The BFSR is constrained by the bank s high credit concentrations, its relatively more modest entrenchment into the corporate banking market and the increasingly competitive nature of the Islamic banking industry. The Islamic product range remains less deep and diversified than in conventional banking, while the availability of Shari ah-compliant liquidity and hedging instruments remains limited. The bank s overseas expansion and aggressive lending growth over the past four years could also weigh on asset quality indicators (which weakened in 2007), although credit risks are partly mitigated by salary assignments, the Saudi regulator s effective supervision and the strong macroeconomic environment. Al Rajhi s long-term GLC deposit rating is set at A1, which includes a two-notch uplift from the bank s A3 BCA. This is based on Moody s assessment of a very high probability of systemic support in the case of need. The outlook on all ratings is stable. Financial performance for the nine months ended 30 September 2008 As an Islamic retail bank mainly focusing on its large domestic market, Al Rajhi has been naturally protected against imported credit turmoil. A couple of years ago, it started to enhance its corporate banking capabilities, with an emphasis on plain vanilla transactional business, which is now bearing fruit. The conjunction of these two strategic advantages led the bank to record a 60% increase in its lending portfolio during the first nine months of 2008, the main driver of its 31% balance sheet growth. Funding costs have remained under control, reflecting Al Rajhi s capacity to still attract deposits at very competitive rates, the bank s main competitive edge. To grow volumes, Al Rajhi has given up some asset yield, driving margins downward, which also signals a higher proportion of corporate lending in its books. The price to pay for increasing market shares is a lower return on assets, falling to a still very strong annualised 4.7% compared to 5.6% in 2007, and a slightly declining return on equity, standing at an annualised 26.6%, compared to 27.3% in Unsurprisingly, fastgrowing lending volumes have been achieved at the expense of liquidity, with core liquidity ratios declining to 11.7% as of 30 September 2008, compared to an average of 28% from 2005 to That said, the stability of Al Rajhi s deposit base has been tested, and appears strong: the bank can afford to increase loan leverage, and is not expected to further drive down its current liquidity position. 10 November 2008 Special Comment -

11 Bank Al Jazira: D+/A3/P-2/Stable Structural rating drivers We assign a BFSR of D+ to Bank al Jazira (BaJ), which translates into a BCA of Baa3. The rating reflects the bank s good financial fundamentals, demonstrated by high profitability, improved loan quality and strong capitalisation, as well as efforts to diversify its operations away from stock market-related activities and strengthen its franchise. Given its size constraints, we find it sensible that BaJ aspires to build a niche by converting into a full Shari ah-compliant bank, building on the opportunities presented by the Saudi stock market, but at the same time diversifying its product range and customer reach. The BFSR also incorporates the bank s narrow franchise and increased competition, still developing risk management systems and corporate governance culture, and high funding and credit concentrations. Furthermore, BaJ remains heavily dependent on the Saudi stock market, with brokerage fee income equivalent to 67% of total income in 2006, but has been substantially reducing its margin lending and proprietary equity book exposure. The bank s small size and limited distribution capabilities limit its ability to compete against larger players or for big projects. BaJ s long-term GLC deposit rating is set at A3, a three-notch uplift from its Baa3 BCA. This is based on Moody s assessment of a very high probability of systemic support in the event of need. The outlook on all ratings is stable. Financial performance for the nine months ended 30 September 2008 In 2008, BaJ has materially increased its gearing ratios, with credit exposures increasing 42.6%, and its investment portfolio doubling since YE2007. Total assets grew only 8.5%, which means that BaJ has used much of its excess liquidity to leverage its assets incrementally. Unsurprisingly, its liquidity ratio dropped from 39.6% at YE2007 to 21.4% at 30 September 2008, signalling BaJ s ambition to be more involved in banking and investment intermediation rather than in brokerage and unfunded investment banking, its previous strategy. BaJ is now using its balance sheet more actively, and for this purpose is not hesitating to capture more funding volumes, at a higher price. Funding costs have indeed increased slightly, whereas asset yields have declined, bringing margins down to less than 3%, which was last registered in BaJ is opening displaying its appetite for higher market shares in the Islamic universe of Saudi banks, in line with its strategy to better serve the retail segment, without necessarily moving away from its traditional corporate clientele. BaJ has ceased to rely on trading gains and fees and commissions as the main drivers of its profitability. Therefore, its profitability ratios for 2008 so far have been more comparable to those of domestic peers, which used not to be the case in previous years. Boubyan Bank: D/Baa2/P-2/Stable Structural rating drivers Moody s assigns a BFSR of D to Boubyan Bank (Boubyan), which translates into a BCA of Ba2. Boubyan s rating reflects its currently very modest market position and franchise overall, and its limited operating track record since inception in 2004, as well as concentrations on both the asset and liability sides of its balance sheet. The rating also reflects the constraints Boubyan faces, in common with other Islamic banks, in accessing long-term funding and managing its liquidity, as well as its still limited operating diversification. Business expansion outside of pure banking intermediation is slowly improving, but it will take time to bear fruit. At the same time, the rating also captures the bank s robust asset quality and underwriting criteria to date, controlled growth reflected by its conservative loan leverage, and very good financial performance, underscored by its high levels of equity capital and strong recurring earning power, in turn underpinned by very healthy profit margins and very good fee income generation. Moody s assigns a GLC deposit rating of Baa2 to Boubyan Bank. Under Moody s joint default analysis (JDA) methodology, the rating is supported by (i) Boubyan s BCA of Ba2, (ii) Moody s assessment of a very high 11 November 2008 Special Comment -

12 likelihood of systemic support for the bank in case of need, and (iii) Kuwait s Aa2 local currency deposit ceiling. This results in a three-notch uplift in this rating from the BCA. Financial performance for the nine months ended 30 September 2008 Like ADIB in the UAE, in 2008 so far Boubyan has gone for volume: the financing portfolio has increased by a spectacular 68.7% since YE2007, reflecting the bank s appetite for both retail and corporate lending. Against all odds, funding costs declined further to 2.15% at end-september, compared to 2.85% across 2007, reflecting Boubyan s capacity raise cheaper funds thanks to its larger size and established presence in the market: Boubyan no longer needs to have recourse to the market to attract funding. In current times of difficulty, Boubyan has taken a safer path, extending credit to low-risk borrowers, which explains why yields on its credit portfolio have declined slightly. As a result, net intermediation margins remained fairly stable. Nonintermediation revenues in the form of investment and property-related earnings have increased fast, signalling Boubyan s decision to dispose of some assets earlier this year, before market conditions worsened. Overall, the annualised return on assets improved to 3.1%. As capitalisation declined slightly, the annualised return on equity reached a record 16.6%. As expected, Boubyan s liquidity deteriorated compared to past years, with the bank s core liquidity ratio standing at a still very strong 35.5% as of 30 September 2008, down from 49.0% at YE2007. Boubyan appears ready to further leverage its balance sheet with more credit exposures, and incrementally close the profitability gap with its domestic peers. Strategically, Boubyan benefits from the stronger reputation of Islamic banks in Kuwait and beyond, as well as the difficulties of some its domestic conventional contenders such as Bank of Kuwait and the Middle East, which finds it difficult to grow and compete head-on with more established players, as well as Gulf Bank, trapped in the derivatives business that brought it to the verge of collapse and triggered bailout plans from the Kuwaiti authorities. Dubai Bank: D/A3/P-2/Positive Structural rating drivers Moody s assigns a BFSR of D to Dubai Bank PJSC, which translates into a BCA of Ba2. The rating recognises Dubai Bank s improved profitability and capital adequacy, its growing franchise as well as its strong association with the Government of Dubai through its major shareholder, Dubai Group LLC a subsidiary of Dubai Holdings, which owns 70% and Emaar Properties 30%. While this association offers the bank access to a wide array of business opportunities, it also exposes it to significant related-party exposure. The rating is constrained by the bank s small and nascent franchise which leaves it vulnerable to an increasingly competitive environment as well as its large single-name and related-party concentration and the absence of geographic and business diversification. The rapid growth of the bank s financing portfolio raises its risk profile, while its liquidity profile is tightening. Dubai Bank s GLC deposit rating is A3, representing a five-notch uplift from the bank s BCA of Ba2. This is based on Moody s assessment of a very high probability of systemic support from the government in the event of need, given the bank s ultimate ownership by Dubai Holdings, which is viewed by Moody s as a government-related issuer (GRI). The outlook on all ratings is positive. Financial performance for the nine months ended 30 September 2008 Just like ADIB in Abu Dhabi and Boubyan Bank in Kuwait, Dubai Bank is heavily engaged in the race for volume: its financing portfolio increased by an impressive 82.4% since YE2007, reflecting the bank s appetite for both retail lending and government business. Funding costs did not drift; on the contrary, they declined further to 2.2%, compared to 3.7% across 2007, reflecting the fact that the liquidity crunch in the country and the region as a whole is only relative. Dubai Bank s recent strategy to go and find funding sources from retail customers was a wise choice; also, its close link with the government can be considered, under the current tough conditions, as blessing rather than a curse. It is true that the yield on its assets has declined, reflecting Dubai Bank s increased appetite for shorter-term and safer lending. As a result, net intermediation margins contracted to 3%, but this was more than offset by the volume effect. Overall, the annualised return on assets improved to 2.8%. As capitalisation declined firmly with rapid asset growth, the annualised return on equity reached a record 18.5%, which was expected and now compares well with peers. As expected, Dubai Bank s 12 November 2008 Special Comment -

13 liquidity deteriorated markedly compared to past years, with the bank s core liquidity ratio standing at an untypically low 14.4% as of 30 September 2008, down from 28.6% at YE2007. Dubai Bank is apparently taking the opportunity of the current difficult market conditions to gain market shares, at the expense of its own liquidity. It can afford to follow this path, because it has the luxury of being backed by a strong and committed government shareholder. Its private sector contenders are barely able to follow suit, and will certainly lose market share to government-related entities and Islamic banks alike. Dubai Bank is both an Islamic institution and a government-owned bank: no doubt it is well placed to carve out a stronger market position for itself once the global credit turmoil comes to an end. Dubai Islamic Bank: D+/A1/P-1/Stable Structural rating drivers Moody s assigns a BFSR of D+ to Dubai Islamic Bank PJSC (DIB), which translates into a BCA of Baa3. The rating derives from its strong franchise as the largest Islamic bank in the UAE and one of the leading Islamic financial institutions globally, together with its robust financial fundamentals, including increasing earning power, improved business diversification, and constantly improving profitability. A proactive board, assisted by a highly experienced management team, protects good and improving asset quality and presides over a robust capital base. Contrary to a number of its peers, DIB displays a satisfactory funding profile that benefits from a granular and stable deposit base, but also from good access to longer-term liabilities, helping manage nascent maturity mismatches. The rating is at the same time constrained by significant credit concentrations, by name, sector and geography, as well as sizeable lending to government and government-related entities, which, despite their credit quality, create a high level of related-party exposures and thus governance weakness. Rapid credit growth and high exposure to real estate raise the credit risk profile, and could put pressure on both future asset quality and the bank s capacity to efficiently manage planned growth. The bank s domestic operating environment is challenging: any severe price correction in the real estate market and/or further decline in stock market prices could affect future provisioning needs and ultimately both profitability and internal capital generation an even more difficult task as liquidity management constraints are more acute under current market conditions. DIB s GLC long-term issuer rating is set at A1, a five-notch uplift from the bank s Baa3 BCA. This is based on Moody s assessment of a very high probability of systemic support in the event of need, reflecting the bank s government ownership and importance within the domestic banking system, as the country s premier Islamic bank. Financial performance for the nine months ended 30 September 2008 DIB s assets have not grown in line with the market so far in The balance sheet has increased by only 3.7%, reflecting uneasy access to funding, liquidity drought, and some pressure on asset quality. That said, the composition of DIB s assets has changed: credit exposures continued their upward trend, with the lending portfolio increasing 29.3%; on the contrary, liquidity and the bank s investment portfolio shrank. As for its domestic and regional peers, DIB s liquidity ratio dropped, from 31.8% at YE2007 to a still satisfactory 17.3%. This reflects higher loan leverage, the price to pay to avoid an excessive drop in net margins. Indeed, with funding costs jumping from 2.2% to 3.1%, and asset yields declining by about 180 bp, only volumes could have offset margin compression. Therefore, DIB took the tactical view of substituting excess liquidity into cheaper credit to book loan assets more quickly than usual. Otherwise, with a static asset allocation, DIB would have suffered both a margin compression and a balance sheet decline. Unlike some of its domestic and regional peers, DIB is unlikely to be strengthened as a result of the systemic credit and liquidity pressures the UAE banking system is facing. On the contrary, given its large direct and indirect exposures to real estate, the bad publicity it suffered from the alleged wrongdoings of some of its former officers, and its close ties with the increasingly leveraged government of Dubai, DIB will likely suffer from increasing competition and find it difficult to replicate past financial performance and growth rates going forward. 13 November 2008 Special Comment -