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The result: more consolidation, diversification and competition - and further crackdowns on money laundering.

The result: more consolidation, diversification and competition - and further crackdowns on money laundering.

Back in early September visitors to the boardroom of any Middle Eastern bank were likely to be met with strong coffee and warm smiles. Profits at banks throughout the Gulf had risen an average 8 percent in 2000, and among the top 50 banks, earnings had surged more than 15 percent. The first six months of 2001 looked even better. Oil prices - the definitive indicator of economic well-being in the Middle East - had sustained an 18-month stretch at the top end of oil producers' target range. Most banks in Jeddah, Kuwait and Dubai were posting double-digit profit growth. Even niggling concerns about the stalling U.S. economy and the tardy recoveries of Asia and Latin America did little to dent expectations of a second consecutive year of near-record profits.

How those smiles have faded. Although the robust performance of Gulf banks in the first nine months of this year should still allow them to publish decent results for the whole of 2001, the scene post-September 11 looks starkly different. Banks in the six Gulf Arab states - Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates - now forecast much-reduced activity for the coming year, as key economic indicators tumble. Oil prices have slumped nearly 40 percent since the terrorist attacks on New York and Washington, and governments across the region have accordingly slashed their budget forecasts for 2002. Saudi Arabia, the Gulf's largest economy, is girding for a budget deficit of 45 billion Saudi riyals ($12 billion), or 7 percent of GDP. "Our outlook now is that we will see very little growth next year," says Said al-Shaikh, chief economist at Saudi Arabia's National Commercial Bank. "The economic picture does not look good."

To cap it all off, Arab bankers are acutely aware that fingers of suspicion are pointing at them. Western governments, probing alleged links between Arab financial institutions and terrorists, are forcing Gulf regulators to crack down. A slew of new laws to combat money laundering have put Arab bankers under the microscope - and provoked resentment.

The upshot of the banks' reversal of fortune? The overbanked Gulf is likely to see more consolidation this year; banks are bound to push harder to diversify into areas like asset management and e-finance; and foreign banks are sure to encroach further on local banks' territory.

Banks, expecting OPEC supply cuts to offset declining global demand, had counted on buoyant oil-based earnings continuing well into 2002. Between January 2000 and July 2001, Brent crude, the benchmark for two thirds of the world's oil, averaged almost $27 a barrel, near the top end of OPEC's target range of $22 to $28. Gulf governments, after suffering a succession of lean years, were looking forward to some much-needed good times. Saudi Arabia, for instance, had drawn up its budget for 2000 on the conservative assumption that oil prices would average $19 a barrel. When that average turned out to be some 40 percent higher, Riyadh racked up its first budget surplus in 19 years - SR22.7 billion, or 3.8 percent of GDP. Similarly strong oil earnings in Kuwait, Oman and the UAE underpinned economic expansion of 4.4 percent across the region in 2000.

Gulf banks reaped their share of the harvest. Strong oil prices encouraged government spending, reduced the banks' nonperforming loans and made for stellar results. The biggest bank in the region, Bahrain's Arab Banking Corp., reported profits of $127 million in 2000, up 13 percent from the previous year. The Jeddah-based National Commercial Bank, the biggest in Saudi Arabia, had a 9 percent profit increase, to $450 million. At the National Bank of Kuwait, profits totaled $330 million, up 7.6 percent from the previous year. For the top 50 banks, net profits for 2000 rose an overall 15.5 percent while return on equity rose to 14.4 percent, up from 13.2 percent in 1999.

Early indications suggest that 2001 will also prove to be a profitable year. Oil-related earnings from the first nine months provided a cushion for most Gulf economies. The National Bank of Kuwait, for example, reported a record profit of $183 million for the first half of 2001, a 12 percent increase over the same period in 2000. Over the first nine months, Saudi Arabia's banks registered a 9 percent increase in profits overall. "The immediate impact of September 11 has not been enough to jeopardize gains from the beginning of the year," says NCB economist al-Shaikh.

But the September attacks and the U.S.-led military response ripped up Gulf banks' forecasts for 2002. The outlook has turned progressively worse. Regional trade has slipped, compounded by war-risk insurance hikes imposed by maritime insurers. Consumer spending and investment are in the doldrums, while companies in the construction, transport and insurance sectors struggle to survive. And as the number of visitors has plummeted, the region's tourism and conferencing industries have taken a dive. Dubai, which invested several billion dollars in tourism to help replace dwindling oil revenues, has watched hotel occupancy rates fall by about 40 percent, according to operators in the UAE. "There's a serious worry that people simply won't come to the region for a time," says Geert van der Zande, regional head for Credit Suisse in Dubai. "Hotels here generally operate at occupancy rates of 80 to 100 percent. If occupancy is down to 40 or 50 percent, people will think twice about starting a new hotel project."

Even more worrying for the banks, interest rate cuts by the U.S. Federal Reserve Board have been mirrored by most Middle East central banks trying to preserve local currencies' pegs to the dollar. Falling interest rates have discouraged depositors and reduced yields on corporate lending. Even small-scale savers have withdrawn deposits to seek more favorable returns in local equity markets - a prime Gulf equity asset offers 7 to 8 percent in yield apart from any market appreciation - or in such traditional investment havens as real estate. "Customers are already taking away their deposits, as interest rates have dropped so much," says Mohsin Aziz, general manager in the Middle East for Pakistan's Habib Bank. "It will be difficult to get them back."

The most serious threat to the region, though, comes from the oil market. From a brief price spike to $31.05 a barrel on September 11, crude oil prices have dropped steadily amid concern that the global economy is heading into a deep recession that will seriously depress oil demand. By early October benchmark Brent crude had fallen to $20.88 a barrel, down almost one third from the September 11 high.

In an effort to shore up prices, the oil producers' cartel, OPEC, agreed on November 14 to reduce oil supplies for the fourth time that year. Over the past few years, OPEC has achieved a new, uncharacteristic unity, but the cartel's ability to control prices has weakened as its share of production has fallen, from 66 percent of the global supply in the mid-1970s to just 40 percent today. Without a parallel agreement by non-OPEC oil producers to curb oil supplies, the cartel is largely powerless to halt falling prices. Eager to maximize earnings in a declining market, key non-OPEC suppliers like Mexico, Norway and Russia have resisted OPEC's entreaties, and the price of oil has continued to fall, hitting $18.25 a barrel on December 10, down 41 percent from September 11 and 28 percent for the year.

For the Gulf, a sustained trough in the oil market would be disastrous. Oil sales account for 70 percent of Saudi Arabia's budget and 80 percent of Kuwait's. Governments and banks remain extremely vulnerable to oil export prices: Over a year Saudi Arabia gains or loses $2.5 billion for each dollar that the average export price changes. With most oil analysts predicting an oversupply of oil until at least 2005, further deterioration seems inevitable. "People are nervous," says Habib Bank's Aziz. "Nobody knows what's going to happen. All the banks are watching the oil price."

Central bankers in the Gulf are reluctant to gauge the ultimate cost to the region's banks - but it won't be good. "The crystal ball is cloudy at the moment," says Sheikh Ahmed bin-Mohammed al-Khalifa, governor of the Bahrain Monetary Authority. "The Gulf in general was in pretty good shape before September, but it's just too difficult to estimate the overall cost economically." In November UAE central bank governor Sultan bin-Nasser al-Suweidi suggested that local banks will see a slide in profits, even in 2001.

To be sure, Gulf bankers can point to some positive signals. A much-feared post-September 11 flight of foreign investments from the region has failed to materialize. Local currencies, largely pegged to the U.S. dollar, have remained stable. And across-the-board cuts in interest rates should help offset the worst of the economic slowdown. Moreover, huge infrastructure projects - including ambitious, multibillion-dollar natural-gas developments in Saudi Arabia and Qatar - remain on track, requiring huge inflows of capital that will provide significant opportunities for the region's banks. The Saudi gas sector alone could require some $25 billion in investment in the next few years. Demand for electricity in the kingdom, expected to grow 250 percent by 2020, will require the investment of about $80 billion. Gas and electricity projects represent a chance for local banks to make and syndicate loans.

Gulf bankers say they should be able to avoid a meltdown. They argue that their efforts to become leaner and more diversified in recent years, spurred by regulators' insistence that they improve their capital adequacy rates, have eased some of the pressures of falling oil prices. "No one bets on an upside oil market for very long any more," says Adnan al-Bahar, chairman of International Investor, a Kuwaiti investment bank. "Banks have built themselves a certain amount of immunity against downturns. Over the years, as the private sector has grown and the public sector has shrunk, each downturn has had a smaller impact."

Some banks, such as Saudi Arabia's Arab National Bank, have shifted their focus to personal lending and credit card facilities, developing consumer banking at the expense of corporate lending, to diversify risk and enjoy wider margins. Other Saudi banks are starting mortgage lending programs and are finding new customers through e-banking sidelines. In 2000 the National Bank of Kuwait became the first Arab bank to introduce an online trading service for conventional and Islamic mutual funds, largely aimed at the domestic retail market. Others, like Arab Banking Corp., have developed new business through Islamic banking instruments that complement their conventional financial products.

Despite bankers' claims, attempts to radically improve the quality and diversity of Gulf banking have been hobbled by the region's small economies, fragile financial markets and oil-based corporate sectors, and by the banks' own modest size: Their combined assets total just $500 billion, roughly that of one big international bank. Furthermore, competition, already intense in a region widely seen as overbanked, will increase as the Gulf monarchies continue to implement their World Trade Organization commitments, allowing greater penetration by foreign entrants.

Poor results in 2002 will undoubtedly increase the pressure on banks to consolidate, particularly in Oman, Saudi Arabia and the UAE. In the UAE 20 banks serve a population of only 2.4 million. In Oman overcrowding in the market, along with bad loans, lower interest rates and high defense spending, had begun to depress banks' performance even before September 11. In the first half of 2001, the combined net profits of Oman's four biggest commercial banks - BankMuscat, National Bank of Oman, Bank Dhofar al-Omani al-Fransi and Oman International Bank - fell 20.7 percent, to 22.7 million Omani rials ($58.97 million), compared with the same period in 2000.

Three major mergers have already taken place in the Gulf in recent years, most notably the 1999 union of Saudi American Bank with United Saudi Bank. Islamic institutions have also sought increased efficiency and cost-cutting through mergers: In 2000 Faysal Islamic Bank of Bahrain teamed up with Islamic Investment Co. of the Gulf (Bahrain) to form Shamil Bank of Bahrain, a solid local performer with assets of $2.9 billion and more than $230 million in equity.

Potential bank mergers, however, face a daunting obstacle: the vested interests of shareholders, which tend to be governments and large merchant families. "Shareholding families are not focused simply on economic gains," says NCB's al-Shaikh. "Other values, such as prestige and position, are also important. Issues such as who is going to give up his position as general manager are difficult to resolve."

Adding to the complexity of the operating climate, Gulf banks are also being required to conform to new rules on transparency. The Gulf monarchies, under pressure from Western governments to help choke off the supply of funds to militant Islamic groups, have imposed a raft of new measures to combat money laundering. Central bankers stress that money laundering has never been detected on any scale in the Gulf. Still, since September officials have gone out of their way to cooperate with the West's efforts to strangle the financial arteries sustaining militant groups. "The Gulf countries enjoy a close relationship with the U.S. and the OECD," says Abdulla Hassan Saif, Bahrain's minister of finance and national economy. "We have acted quickly to honor our responsibilities to ensure that any illegal activity will be investigated and prosecuted."

The Gulf's financial capital, Bahrain, passed tough new anti-money laundering laws before September 11, as did Qatar. Bahrain's ruler, Sheikh Hamad bin-Issa al-Khalifa, decreed that convicted money launderers would face a prison sentence of up to seven years and fines of up to 1 million Bahraini dinars ($2.7 million). Days after the September attacks, the UAE joined them. In early October banking regulators in Oman announced that they expected to adopt measures by the end of 2001. And even Kuwait, which has no specific laws governing money laundering, has hinted that it will adopt suitable measures.

As always, the test will be the implementation. Given the intense competition that exists among rival financial centers in the Middle East, regulators are wary of throttling financial performance through excessive intervention. "The feeling in the past was that there was a lot of hype surrounding money laundering," says Credit Suisse's van der Zande. "Regulators were keen not to intervene too much."

Today's highly charged political atmosphere in Washington means that Gulf central banks have little choice but to toe the line. But the crackdown on Gulf institutions - and the implication that all Arab finance houses are somehow culpable of aiding the September 11 attacks - has stoked considerable anger among bankers. Privately, they bridle at suggestions that the Gulf is a giant ATM for terrorists. "You cannot come into a region every time cracking a whip," says Abdel Aziz al-Ghurair, chief executive of Dubai's Mashreqbank. "It's unfair, and it risks sparking a backlash."

Whatever the politics underlying the new anti-money laundering legislation, bankers argue cogently that it will be difficult to honor Western-style laws in societies that despite decades of oil-funded growth remain largely cash-based. Not only do most Gulf nationals prefer to use cash wherever possible, but the large communities of foreign laborers resident in the Gulf remit millions of dollars each month to their home countries, usually in cash. Moreover, many banks' clients are based in closed East African and Central Asian economies where letters of credit are viewed as little more than worthless. "I have clients from Somalia," says Khalifa Mohammed Hassan, CEO of Abu Dhabi Commercial Bank. "Does anyone seriously expect me to accept a letter of credit from Mogadishu? I take cash, of course. But that doesn't mean I'm doing business with drug dealers."

Bankers argue that belt-tightening and greater emphasis on retail banking should see them through a difficult year in 2002. Much depends, of course, on the usual variable: the price of oil. "The challenge to bank profitability comes mainly from the drop in the interest rate environment," says International Investor's al-Bahar. "We won't see much growth in deposits. There will undoubtedly be less wholesale business and fewer opportunities that depend on government initiatives. But we'll also see new openings for private-sector investment and corporate growth. Banks will keep a conservative outlook, focus on their core retail business and look around for new opportunities. We won't see a major negative impact."