When Will Credit Start Flowing Again?

One of the great paradoxes of the GCC economy during the past years has been the continued profitability and health of regional banks combined with an extreme reluctance to lend. In Saudi Arabia, for instance, new bank lending turned negative in 2009 for the first time since 2001. The caution has persisted in spite of historically low interest rates and solid support, much of it deliberately pre-emptive, on the part of the regional central banks and governments.

The reasons for this state of affairs are obvious enough: the past two years have offered the Gulf region one of the most extraordinary roller-coaster rides in its economic history. This has resulted in both lenders and borrowers treading with extreme care, being left to hedge seemingly major risks with imperfect understanding of their magnitude. As ever, the natural reaction has been to err on the side of caution.

At the same time, exposures to sectors such as real estate, as well as troubled corporates, have resulted in considerable asset depreciation. The extraordinary take-off of many previously almost unknown financial sector products and services have created new risks, leaving banks to worry about the quality of their consumer loan, credit card and mortgage portfolios. On the positive side, however, none of these areas are nearly as large (in relative terms) as in the more mature and leveraged Western markets.

The cyclical risks have been compounded by governance failures. Much of the growth during the past decade took place in an imperfectly regulated environment. This was partly because regulators were left to play an inevitable game of catch-up with rapid innovation and growth in the markets, partly because the expansion was supported by standards and practices that were based on convention, much of it outdated, rather than formal risk-management.

The government regulators have to varying degrees helped manage and overcome these problems but their powers, remit and resources still vary among countries and sectors. The crisis has, among other things, served to challenge, even discredit, practices such as name lending and more generally a mode of doing business in a way that prioritized relationships and informal agreements over formal vetting, systematic credit assessment and systematic risk management.

While the crisis has forcefully repudiated the old model, a new one is still taking shape. And creating some of its building blocks in the form of more credit bureaux, rating agencies and other auxiliary services will take time. Banks will require more information and greater assurances but in a competitive environment, it will take some time for clear standards to emerge. The short-term consequence has been heightened risk-aversion.

In addition to invalidating many of the pre-crisis practices in the regional (not to mention global!) financial sector, the crisis has painfully revealed the lack of procedures for dealing with defaults and comparable difficulties, hence further diminishing the appetite for new risks. Economic efficiency is in important ways related to the ability of an economy to address and rectify failures. A good bankruptcy law is no less important than a clear process for registering and licensing companies.

In that sense, the progress made to restructuring the debts of Global Finance House, the Investment Dar, and Dubai World are of critical importance in terms of creating precedents and a better understanding of how to deal with challenges, especially when the regulatory framework on such issues is unclear or incomplete. The steps taken in this area are particularly important in convincing markets of the manageability of such challenges and making the risks associated with such events much more measurable. Moreover, they represent “learning by doing,” boosting the pool of qualified human capital and a general understanding of stressful situations and their implications. The crisis has also forced companies and governments to become much more explicit about guarantees and support mechanisms available at times of difficulty.

In terms of the resumption of bank lending, two things matter: the willingness and the ability to extend credit. Here, the way forward still looks rather uneven for the Gulf region. In general, the willingness to lend appears to be staging a fairly convincing recovery. The regional economy appears to be through the worst, the confidence in the crisis-management capabilities of the regional governments and regulators has been boosted by their ability to withstand a major challenge. The macroeconomic backdrop has been supported by the recovery and relative stability of the oil price. Even the regional banks have had a chance to regroup and deal with some of the challenges thrown up by the crisis. 2009 was a difficult year but there seems to be a reasonable basis for expecting that 2010 will be better.

The technical ability to lend will continue to be affected by regulatory and broader economic pressures. Regulatory pressures are likely to remain elevated in especially the UAE where the Central Bank has been pushing more conservative regulations, among other things new provisioning norms that will significantly reduce the amount of time for loans to be considered sub-standard. At the same time, banks were mandated to book at least 50% of their estimated Dh10.6bn exposures to the Saad and Al Gosaibi groups as provisions. The aggregate NPL provisions of the 24 national banks in the UAE almost tripled from Dh4.5bn in 2008 to Dh12.9bn in 2009. Although the outlook has now improved, the UAE banks will need a period of regrouping and consolidation.

Efforts are also underway to recapitalize banks and to bring loan-to-deposit ratios to more comfortable levels. Most UAE banks still exceed the Central Bank’s recommendations, which will continue to curb their ability to lend and will maintain pressure on the cost of attracting of attracting adequate deposits. Even more generally, banks still harbor residual worries about the stickiness of some of the deposits that the period of risk aversion in late 2008 brought in. Asset depreciation still remains a risk, especially in some housing markets, although the downside risks are beginning to look more manageable.

While the clouds have not parted altogether, the outlook for regional banks is beginning to look more promising. Probably the greatest optimism is seen in Saudi Arabia, where banks are raising funds for expansion and where the loan-to-deposit ratios are at a seemingly very comfortable level. As a in the broader economy, Saudi Arabia, along with Qatar, are likely to lead the regional recovery, whereas the UAE and Kuwait still look set for a much more gradual recovery. Even there, however, 2010 has the potential to become a year of normalization and renewed growth, however modest.

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