gcc banking sector detailed report

Global Research

Sector

GCCGCC Banking SectorMay 2005

Global Investment House KSCCEquity Research Souk Al-Safat Bldg., 2nd Floor P Box 28807 Safat .O. 13149 Kuwait Tel: (965) 240 0551 Fax: (965) 240 0661 Email: [email protected] http://www.globalinv.net Global Investment House stock market indices can be accessed from the Bloomberg page GLOH and from Reuters Page GLOB

Omar M. El-Quqa, CFAExecutive Vice [email protected] Phone No:(965) 2400551 Ext.104

Shailesh Dash, CFAHead of [email protected] Phone No:(965) 2400551 Ext.196

Pravin BokadeSenior Financial [email protected] Phone No:(965) 2400551 Ext 229

Raghu SarmaFinancial [email protected] Phone No:(965) 2400551 Ext 273

Faisal Hasan, CFAFinancial [email protected] Phone No:(965) 2400551 Ext.304

Table of Contents

Major Highlights .............................................................................................................................................................. 1

Islamic Banks in GCC .................................................................................................................................................. 10

Role of Foreign Banks .................................................................................................................................................. 13

Competitive Strategies & Other Developments ....................................................................................... 15

Financial Performance ................................................................................................................................................ 19

Outlook .................................................................................................................................................................................... 23

Valuation & Recommendation Summary .................................................................................................... 28

Global Research - GCC

Global Investment House

1. Major HighlightsThe GCC region has been an important nancial center for decades, with the oil and gas industry playing a critical role. The region has a longstanding active tradition in commerce and nance. Banking has played an important part in the growth of the region for a long time. Recent years have witnessed a growth in both the size and sophistication of the regions banking industry. The 45 listed banks across the six GCC countries, which we are covering in this Report, had an aggregate asset size of US$354.3bn at the end of 2004, having grown by 14.8% over 2003. These banks had aggregate net prot of US$8.9bn in 2004, having grown by a healthy 38.6% over 2003. The major highlights of the regions banking industry are as follows: i. Controlling ownership by government and inuential families The shareholding structures of the GCC banks are often dominated by two groups of owners governments or government agencies, and inuential ruling or merchant families. Kuwaiti families own the major Kuwaiti banks National Bank of Kuwait (NBK), Commercial Bank of Kuwait (CBK), and Gulf Bank (GB); while the large Saudi bank National Commercial Bank (NCB); and banks in UAE Emirates Bank International (EBI), National Bank of Abu Dhabi (NBAD) and Abu Dhabi Commercial Bank (ADCB) are majority-state-owned. In Oman and Qatar, the governments own major stakes in the local banks. Government ownership enables them to intervene and support their banks during a crisis. On the other hand, shareholdings of leading business families leave banks vulnerable to potential relatedparty lending and shareholder meddling in credit policies. Foreign ownership is more limited in the banking sectors of the GCC, compared to other emerging market regions. ii. Low business diversication The business diversication of the GCC banks remains relatively poor. Plain vanilla credit products and services constitute the bulk of the regions banking activities, with particular focus on short-term loans. Investment activities are almost restricted to government bills and bonds, along with investment-grade securities in mostly international markets. Trading positions are generally limited. Stock markets in the GCC remain relatively small and underdeveloped, though there seems to be an increasing tendency towards investing in GCC stock markets as well; while the bond markets consist almost exclusively of government paper. Activities such as sophisticated structured nancing, advisory, asset and fund management, duciary and custody services are at a nascent stage, and do not contribute signicantly to prots, which remain highly reliant on interest margins. Top-tier banks are now placing particular emphasis on the development of domestic asset management competencies. With economic diversication, modernization and liberalization, banks are under pressure to respond to more sophisticated client needs. As a result, some banks are developing aggressive programs to widen their product range. This is reected in an increasing tendency for the banks to offer more fee-rich products, to reduce their reliance on interest margins. Such initiatives are made easier by new communications and upgraded IT networks. Internet

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banking has reached a high level of use in the GCC, compared with other emerging markets. Great strides have been made in recent times in the breadth and sophistication of the GCC banks services, including diversication in products aimed at addressing different customer segments corporate lending, project nancing, and the relatively new retail banking segment. iii. Constrained by relatively small size The GCC banks are characterized by their relatively small size by international standards. While the balance sheet sizes of most banks in the region have grown in recent years, reecting their business growth, they are still small compared to their Western counterparts. As a result, banking systems in the GCC remain fragmented. GCC banks are, therefore, primarily domestic players. Their international business is concentrated in trade nance, intra-regional money market placements, and government and investment-grade corporate bonds in the US and Europe. The lower exposures abroad have also been exacerbated in recent years by the growing business at home. The foreign assets as a proportion of total assets have generally trended down for the GCC as a whole (see Chart later in this section), though Kuwait, Oman and Qatar are exceptions to this general trend. Efforts in the GCC to create a fully integrated regional banking market have not been successful so far, particularly for retail credit and funding. Legal barriers to entry and family ownership are certainly the main causes of the very slow emergence of a regional playing eld. Most banking activities remain domestic in nature, except for large government-related infrastructure, power and water projects. But most of the GCC banks are excluded from the nancing of such big-ticket deals, either because they are too small, or because of their limited international franchise and narrow commercial networks. As a result, major international banks dominate project nance and syndication business, with only Arab Banking Corporation (ABC) and Gulf International Bank (GIB), the two off-shore banking units in Bahrain, reportedly having a signicant presence in this segment. Also, the banks in Saudi Arabia benet from their larger and more diversied domestic market and, as such, face less business concentration risks than do their neighboring peers. iv. High concentration Banking businesses in the six GCC countries are concentrated locally. The single notable exception to this trend has been the asset concentration prole of banks in Bahrain, thanks to the many Offshore Banking Units (OBUs) operating from that country. These OBUs carry on all banking activities with non-residents, mostly in foreign currency. They do not deal in any way with residents of Bahrain, other than the Government of Bahrain and its agencies, and with licensed banks. The aggregate foreign assets of banks in the six GCC countries, while growing at a CAGR of 4.9% during 2001-04, have generally trended down as a proportion of the total assets of the banks during the period, indicating a larger concentration of their business in their respective geographies. This could also have been a result of the resurgence in all the GCC economies during the said period.

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Chart 1-1: GCC Banks - Concentration of Assets

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Foreign Assests/Total Assets (%)

2001

2002Bahrain Qatar GCC Average

YearKuwait Saudi Arabia

2003 Oman UAE

2004

Source: Global Research

Besides, a limited number of players dominate each banking system, particularly in the retail eld, where market shares remain stable. Consequently, oligopolistic behavior tends to appear, with non-price competition prevailing over price competition. In Oman, for example, the interest rates charged to retail customers are close to the maximum authorized by the Central Bank of Oman, showing that competition mainly centers on the quality of supply, collateral requirements, and general marketing and commercial strengths. In the other ve GCC banking systems, yields on retail lending are within the 6-8% range on average, and are slowly trending downward, showing more the effect of a low interest rate environment, than more intense price competition. The most price-competitive market is undoubtedly that of the UAE, which is overbanked, with 47 nancial institutions serving a population of about 4.3 million inhabitants. v. High capitalization As far as capitalization is concerned, the GCC banks usually keep high capital bases as a cushion to absorb unexpected losses. The median capital adequacy ratio (CAR) for the GCC banks was estimated to be 16.5% in 2004. Banks in Oman and Qatar had a higher CAR. It could indeed be necessary for the GCC banks to maintain such high levels of capital, given the uncertain economic and geopolitical environment. Over the years, the GCC banks have distributed a large share of their prots to shareholders. This has not been detrimental to the banks so far, as their nancial performance has been satisfactory. In the medium-term too, this may not pose much of a problem, with the banking sector expected to turn in consistently robust nancial performance on the back of improving spreads and protability. vi. High protability The GCC banks have shown consistently high nancial performance in the past decade. They achieved an average return on assets of about 1.5%-2% during this period, which compares favorably with international standards. This provides the banks the cushion to ward off nancial crises.

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The most protable banks are those in Saudi Arabia, Kuwait, and UAE. The Return on Average Assets (RoAA) of Saudi banks in 2004 ranged between 1.9% and 4.1%, while that of Kuwaiti banks ranged between 1.4% and 3.3%, while for the UAE banks, it ranged between 1.1% and 4.2%. The GCC average RoAA in 2004 was 2.6%. Strong prot generation has resulted from high margins, low cost of funds and labor, and the absence of income tax. Besides, pricing on deposits is often xed or adjusted less rapidly than on the asset side, so interest margins are closely correlated to trends in interest rates. While GCC countries remain small, outward-oriented economies still heavily reliant on oil and gas, contagion effects in the aftermath of a global or regional recession have not shaken banks to pose a threat to their respective economies. The notable exception to this stability in performance is Kuwait, which was hard hit by the Gulf War in 1990-1991.Chart 1-2: GCC Banks - Profitability

3.5% 3.0% 2.5%ROAA (%)

2.0% 1.5% 1.0% 0.5% 0.0% 2001Bahrain Qatar Gcc Average

2002

YearKuwait Saudi Arabia

2003Oman UAE

2004


vii. Improving asset quality Asset quality has improved in the recent years. Non-performing loans for banks across GCC have trended down in the last three years more than halving from 7.9% of gross loans in 2001 to 3.5% of gross loans in 2004. While the NPLs as a proportion of gross loans remain the highest for Oman, the ratio has been the lowest for Saudi Arabian banks. However, the NPLs/gross loans ratio saw the steepest fall in the case of banks in UAE during 2004 from 9.4% in 2003 to 3.5% in 2004 (based on the gures available for seven of the 12 UAE banks covered in this Report). Improving management of credit risk, limited appetite for the most risky sectors and products, satisfactory economic environment, and high liquidity of recent months have been at the root of this positive trend. Improving diversication of banking business has also contributed to the decline in non-performing loans.

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Chart 1-3: GCC Banks - Asset Quality18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 2001 Bahrain Qatar GCC AverageSource: Global Research

NPLs/Gross Loans (%)

2002

Year Kuwait Saudi Arabi

2003 Oman UAE

2004

viii. Strong funding prole The GCC banks have traditionally been characterized by strong funding proles. The largest banks are net placers of funds in the international markets. Signicant differences exist among the six countries, however. The main source of funding so far has been customers deposits. Customers deposits have traditionally constituted a high proportion of the total liabilities of banks. Customers deposits constituted about 80% of the total deposits and 60% of the total liabilities in Kuwait in 2004, while these gures were 87% and 75% respectively for Saudi Arabia, and 88% and 71% respectively for UAE. The highly stable customer deposits have meant steady deposit-base and low cost of funds for the banks. But this is set to change. The banks lending portfolios are experiencing a gradual increase in maturity following the rapid expansion of consumer loans accelerating the need for longer-term funds. In addition, large infrastructure projects pertaining to utilities development, triggered by demographic trends, and enhanced economic reforms toward more liberalization have fueled demand for longterm project nance. As a result of high credit growth, GCC banks funding is gradually shifting away from a focus on customers deposits. Alternative funding is developing through certicates of deposits, syndication, and even international bond issues. It is worth noting that the $450 million three-year Eurobond issue of National Bank of Kuwait in early 2002 was the rst bond issue for a GCC onshore bank. The NBK bond issue has set an important benchmark, which other banks in the region could be following. Recent years have seen more such issues. Some of the long-term bond offerings, completed in the recent past as well as those proposed in 2005, are as under: Table 1-1 : Long-Term Bond Offerings by GCC BanksGulf Bank Mashreqbank Bank Muscat Emirates Bank Mashreqbank Saudi British Bank Saudi Hollandi Bank Source: Global Research.

Bank

Country

Kuwait UAE Oman UAE UAE Saudi Arabia Saudi Arabia

Type of OfferingSubordinated Loan EMTNs EMTNs FRNs EMTNs FRBs FRNs

Year2004 2004 2004 2005 2005 2005 2005

Amount in $mn150 300 250 750 325 650 187

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ix. High proportion of non-interest bearing deposits The GCC banks have a key advantage in funding, that is, access to a large amount of noninterest-bearing deposits (NIBs). The main driving force behind the large amounts of NIBs, seems to be the religious tenets in Islam. In Islam, receiving interest on a deposit is considered unlawful and many customers do not accept any remuneration on their current accounts. Consequently, the proportion of NIBs in total deposits has been substantial. For example, at the end of 2004, NIBs have been estimated to represent about 35% of total customer deposits in Oman, and about 50% in Saudi Arabia. For all six GCC countries, the proportion of NIBs in customer deposits has been estimated at 35-40% at the end of 2004. x. Healthy liquidity prole The GCC banks have traditionally seen a healthy level of liquidity, partially as a result of the boom in oil prices in the 1970s, as well as a low level of leverage. Thus, the regions banks never had to compete ercely to attract customer deposits. Another characteristic is the high stability of these deposits, despite periodic geopolitical pressures and recurrent episodes of strife in the region. xi. Unrealized potential of corporate banking Competition in corporate banking in GCC has been erce for decades. But it has been a competitive, cyclical and narrow business line in the region. The GCC banks have been involved in corporate banking far longer than in retail banking, the latter being only about a decade old. Consequently, the GCC banks loan portfolios are still dominated by corporate and public sector loans. While large international players have always been active in the region for nancing large corporations and projects, they have been far less involved in the mass retail market, because of the costs, risks, and limitations of building up a large physical presence. With the noticeable exception of Saudi Arabia, GCC corporate banking markets remain narrow, and attractive new deals are scarce. In Kuwait, for example, new good-quality corporate loans have been limited in the recent past, at least up to the end of the war in Iraq. Since then, improved business environment has beneted Kuwaiti banks, with the bulk of supply to the Iraqi market transiting through Kuwait and increasing momentum in Kuwaiti project nancing. More systematic use of market segmentation is another major feature of corporate banking in the GCC countries. The GCC banks have tended to specialize in specic market segments. Since the mid-1990s, traditional segmentation has tended to distinguish between SMEs, midmarket rms, and large corporations. The latter segment comprises multinational companies, government-related or family conglomerates, and public sector enterprises in strategic sectors such as hydrocarbons, petrochemicals, and power and water. Despite several deterrents, there are good opportunities to provide far wider range of corporate banking products and to develop the small and midsize enterprise (SME) segment business. Major GCC banks are indeed moving towards a comprehensive corporate relationship management business model from the credit-focused approach followed so far.

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Regulatory limits and size drastically restrict the ability of the regions banks to take large exposures. The GCC banks also face concentration risks in a limited number of sectors. With hydrocarbon sectors ush with liquidity, lending is mostly concentrated on private sector corporate clients in the real estate and construction sectors, in particular. As a result, any signal of fragility in one key industrial sector has tended to have a severe impact on banks asset quality and ultimately on their creditworthiness. Data are hard to come by on the respective levels of corporate and retail NPLs. But as retail sticky loans are low (estimated at not more than 2-4% in all six GCC countries), it would seem that, given the estimated average NPL ratio of 3.5% for GCC in 2004, the corporate loan portfolio is signicantly riskier, with the consolidated corporate NPL ratio estimated to be close to 10%, pushed up by the high level of delinquencies in the SME loan book. In their corporate banking business, most GCC banks suffer from a widening of maturity mismatches between funding and lending. One key trend in the corporate loan portfolios is the lengthening of their maturity proles. The changing structure of the GCC economies toward larger, more complex, and more integrated projects (for example, independent water and power projects, or gas exploration, exploitation, and transportation projects) provides incentives to accept longer tenors. But, access to long-tenor funding sources has been limited. Over-reliance on retail, corporate, and government deposits, which are short-term by nature, has led to widening gap between the average duration of assets and deposit-dominated funding structures. This has led to awareness on the banks part of the necessity to raise longer-term funds to be able to meet the longer-maturity proles of the loan book. xii. Retail banking coming into its own The GCC commercial banks have been witnessing a major evolution of their business models. While 20 years ago they were mainly serving large corporates related to the oil sector, as well as a limited number of high-net-worth individuals, they now show a much wider scope of banking activities. The wider access of banks to the retail-banking segment over the last 10 years has largely contributed to this evolution toward universal banking in the GCC. Banks in the GCC have beneted from the shift to retail banking on many fronts. Retail banking has been a protable means of revenue diversication out of the more risky commercial banking, given the limited amount of risks it carries. It has also been a major stabilizer for banks bottom lines through the business cycles, thus placing the GCC banks in a position to become more resilient to internal and external shocks. Simultaneously, the development of the retail franchise turned out to be a strong lever for capturing cheap deposits with limited efforts. To cope with this, banks in the region have made heavy investments in conventional and electronic delivery channels, as well as in risk management systems and marketing know-how. The main reasons for the booming retail banking are the demographic characteristics of the region and the populations social habits. A young and fast-increasing population at an early stage of its life cycle naturally fuels demand for credits, all the more so as a very high proportion of young nationals are encouraged to nd jobs in the public sector, as protected civil servants, with relatively high wages. Early marriage leads to a strong demand for homes, and, consequently, for consumer and housing loans. The GCC banks, however, mainly deal with employed nationals and white-collar expatriates currently. Banks, especially in smaller

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GCC countries, tend to direct their lending toward the protable upper-tier category. It is estimated that customers with nancial assets of more than $25,000 still contribute more than two-thirds of the GCC banks prots in the retail segment. Even though it is yet to become mass-based, the retail-banking business in GCC is slowly coming into its own.xiii. Mortgage lending in early stages

Mortgage credit is far less developed than other types of retail loans in GCC banks, because of the difculties that banks have in initiating court proceedings and in foreclosing on residential real estate collateral. In addition, mortgage loans supplied by private-sector banks are crowded out by state-owned specialized credit institutions, which provide nationals with interest-free nancing for housing purposes, as a public service. In Kuwait for example, private-sector commercial banks grant only supplemental lending for housing, whereas the Savings & Credit Bank and Kuwait Real Estate Bank hold a quasi monopoly on housing loans. The situation is almost similar in the rest of the GCC countries as well. xiv. Islamic banking Islamic banks follow the Sharia principles. These banks have a clear competitive advantage over their conventional competitors. While conventional banks attract all kinds of depositors, Islamic banks customers are more sensitive to the Islamic Sharia principles. As a result, Islamic banks have access to larger volumes of NIBs relative to their asset size, than do the conventional banks. This leads to very high spreads for the Islamic banks. As a consequence, many conventional banks have developed Sharia-compliant un-remunerated deposits in recent years. This is particularly true in Saudi Arabia, where conventional banks target aggressively Sharia-compliant deposits through Islamic windows that compete with the only Islamic bank in the kingdom Al Rajhi Bank. Similarly, in UAE too most banks have either already launched or have plans in the near-term to launch Islamic banking products, either through a separate Islamic window or a subsidiary. These products are expected to compete with those offered by the three existing listed Islamic banks in UAE Abu Dhabi Islamic Bank, Dubai Islamic Bank and Sharjah Islamic Bank. Islamic banking is turning into a fast-developing, highly-protable banking product. The Islamic banks have also given rise to hybrid funding instruments. One such instrument is the prot-sharing investment account (PSIA), which exhibits a combination of debt- and equity-like features in the same instrument. xv. Nascent stage of capital markets A limited role played by the capital markets, which are still at early stages of development, constrains the banks ability to expand at a time when they must raise additional funds to meet their growing nancing needs and increasing competition. Banks have so far met the bulk of the nancing needs of companies active in the GCC region. This is a result of the lack of disintermediation in the region, and the narrowness of regional capital markets. Indeed, very few companies have resorted to bond issues, either on the domestic or international debt markets. There is a clear preference by companies for bank bilateral or syndicated borrowing. The coming days could, however, see changes in the scenario, with capital markets in the region becoming deeper and more efcient. Many family businesses are seeking listings on regions stock exchanges. More government companies are either being sold to the public or listed as possible candidates for privatization. In addition, new capital market laws are

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being implemented and existing laws strengthened to allow domestic companies of large and medium size to raise additional funds through tradable debt.xvi. Benefit of high growth trajectory of GCC countries

All the six GCC countries have seen a high trajectory growth over the last two years. This has predominantly been on the back of high oil prices. Budget surpluses and growing populations have made the respective governments go for higher spending on infrastructure and utility projects. Big-ticket projects that have either been announced or are being executed benet the banks in the region tremendously, as these offer the banks sizeable and protable project nancing avenues. xvii. Strong systemic support by governments Government support for banks is strong, reecting the dominant role of the governments in the GCC economies. Besides the central banks offering liquidity support in times of need, the GCC governments have both injected capital and replaced doubtful loans with government bonds. This has been more so where the governments hold a major shareholding in the bank. There have been examples of such support being extended in most of the GCC countries, including Bahrain, Kuwait, Qatar and UAE. xviii. Poor disclosure levels The GCC banking sector suffers from low levels of disclosures. The GCC banks need to address some accounting- and disclosure-related issues. Banks are not used to sharing information on their largest debtors, either in each domestic market, or on a regional basis. The banking secrecy has been a potential breeding ground for frauds or large defaults. In 2002, there was the case of Solo Industries, which allegedly raised $350mn by fraudulent means from banks operating in the UAE. Then there was the case of the default of Ahmed Mannai Corporation in Qatar, which forced 18 regional banks to restructure its $300mn of debt. The collapse of the ARTG group caused signicant losses in Oman. Supervisors have been often aware of large credit concentrations. But the banking systems have lacked swift and timely measures to avoid solvency problems. Similarly, shareholding structures are often undisclosed, details on impaired assets and provisioning policies remain limited, and Islamic banking accounting principles and practices lack regional standardization, which makes comparability with traditional banks difcult. The banking regulators are only too aware of these systemic aws and their repercussions on the banking sector as a whole.

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2. Islamic Banks in GCCIslamic banks today represent the majority of Islamic nancial institutions, which are spread worldwide. The emergence of Islamic banking was a result of a revival of interest to develop an Islamic economic system as well as the increasing demand from Muslims worldwide for products and modes of investment that are in compliance with Shariah principles. The pioneering establishment of Islamic banks had been the catalyst for growth and provided the foundation for the development of the Islamic nancial services industry as a whole. Though the Islamic nancial institutions are spread across the world, they are primarily concentrated in the Middle East region. In our report, we are primarily covering listed commercial Islamic banks in the GCC region. As of December 2004, the total asset size of these banks was estimated at US$48.8bn. In 2004, the aggregate net prot of these listed banks was at US$1.3bn, which represented a growth of about 45% over the previous year. The table below shows some of the major listed commercial Islamic banks in the GCC region.Table 2-1: Listed Islamic Banks in the GCC regionName of the Institution Dubai Islamic Bank Sharjah Islamic Bank Kuwait Finance House Bahrain Islamic Bank Bahraini Saudi Bank Qatar Islamic Bank Al Rajhi Banking & Investment Corp Qatar International Islamic Bank Abu Dhabi Islamic BankSource: Zawya.com, Company Websites.

Country UAE UAE Kuwait Bahrain Bahrain Qatar Saudi Arabia Qatar UAE

Year of Incorporation 1975 1975 1977 1979 1983 1983 1985 1990 1997

Performance of listed Islamic banks

Islamic nancial institutions (IFIs) in the Gulf Cooperation Council (GCC) countries are posting spectacular growth. Deposits with IFIs have more than doubled in the ve-year period from 1998 to 2003 while the net prot also more than doubled during the same period. As Islamic banks are different from conventional banks, it would be interesting to compare the performance of the listed Islamic banks in the GCC region. Islamic banking is often subject to variety of questions and perceptions on protability, liquidity and capital adequacy measure. According to the World Islamic Banking Competitiveness Report (WIBC) most of the Islamic banks are growing faster than their respective conventional banking peers. Comparing the returns on assets of Islamic retail banks to leading conventional banks in their markets show that while some have strong protability, others have under-performed as compared to their conventional peers. There are several factors that have a signicant impact on the banks nancial performance. Average wealth levels, level of competition and labour costs have a signicant effect on the overall level of prots enjoyed by the banking sector, including the Islamic banks. In addition, the business model of the banks also made huge differences to their revenues. This can be illustrated from the fact that as with the conventional banks, Islamic banks that focus on retail customers perform better than those focusing on corporate banking. The case in point is that of Al Rajhi Banking & Investment Corp which has successfully leveraged retail

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banking potential as it has one of the largest branch and ATM networks in Saudi Arabia. The customers perception about the Islamic banking products and their appetite for returns on Islamic banking products also makes serious difference to the Islamic banks. The other factor which bodes well for the Islamic banks was that Islamic banks have often enjoyed protection from competition and have traditionally enjoyed monopoly in their respective regions. In some countries, they enjoy regulatory advantages such as higher lending limits. But now, most of the countries have brought out amendments in their Islamic banking regulations so that the Islamic banking industry is better supervised and regulated.Table 2-2: Comparative Ratios of Islamic Banks in GCC (as of FY2004)BIsBROAE ROAA Net Spread Net Interest Margin Cost to Operating Income Capital Adequacy Ratio Source: Global Research 8.0% 1.52% 1.94% 2.11% 55.3% -

BSB16.2% 1.48% 2.01% 2.71% 60.3% -

KFH24.4% 2.30% 3.00% 2.60% 27.9% -

DIB21.80% 1.70% 2.40% 2.50% 44.10% -

ADIB8.90% 1.10% 2.70% 2.80% 56.20% -

SIB11.00% 2.30% 2.60% 2.90% 45.00% -

QIIB22.40% 1.89% 3.10% 3.13% 43.10% 14.71%

QIB28.80% 4.34% 4.48% 4.68% 27.20% 29.80%

AlRajhi

37.20% 4.10% 6.50% 5.10% 32.20% 18.80%

Here it should be noted that banks which have a signicant retail customer base such as Al Rajhi Banking Corporation, Qatar Islamic Bank (QIB) and Kuwait Finance House (KFH) enjoy superior returns on their equity. Al-Rajhi Bank had the highest Return on Average Equity of 37.2% followed by Qatar Islamic Bank (28.8%) and Qatar International Islamic Bank (22.4%). At the same time, Qatar Islamic Bank was highly efcient in utilizing its assets as it had the Return on Average Assets of 4.34% followed by Al-Rajhi with 4.10%. It has been observed that, most of the Islamic banks have higher spread and net interest margin as compared to their Islamic banking counterparts in the region. Al-Rajhi is at the forefront in this regard as it has net spread of 6.5% and net interest margin of 5.1% followed by Qatar Islamic Bank with 4.48% and 4.68% respectively. The protability of Islamic banks depends signicantly on how efciently they manage their resources. Many Islamic banks are now resorting to implement cost-saving measures and are reeling out new cost-cutting initiatives to improve their bottom-lines. One of the major reasons of the high protability of some of the banks such as Kuwait Finance House, Qatar Islamic Bank and Al Rajhi Bank can be seen in their cost structure as they have a lower operating cost to operating revenue ratios. QIB has the lowest operating expenses as a percentage of total operating income at 27.2% followed by KFH with 27.9%. Both the banks in Bahrain have much higher cost to operating income in FY2004. For most of the banks, the higher total operating expense to operating revenue ratio implies that the Islamic banks still have a lot to achieve in terms of operating efciencies. The silver lining is that it directly shows which area to improve in order to improve their protability. Most of the Islamic banks are trying to contain this ratio by generating incremental revenues through e-initiatives such as Internet Banking, Mobile Banking etc. This makes it easier for banks to shift the customers from branch banking to ATM-banking or e-banking. Asset quality in the recent past has been a cause of concern for some of the Islamic banks in the region. One of the problems that is faced is that most of the banks are wary of giving information about the asset quality which makes it difcult to analyze banks assets and NonPerforming Loans (NPL) structure. However, the number indicates that some of the banks

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have very high NPLs such as Bahraini Saudi Bank and Qatar Islamic Bank. We expect the NPL levels to go down in future as the Islamic banks are concentrating their efforts towards retail banking especially consumer loans and credit cards which have relatively lower level of delinquencies. However, the good point is that banks have been maintaining adequate provisions in order to counter the problem of high NPLs. Abu Dhabi Islamic bank has a very low provisioning level as it is a new entrant in the market. As it increases its lending, it will have to increase its provisioning. We expect the provisions to increase as the banks increase their lending activity to take advantage of the increased demand for consumer nance. The corporate sector in the region is also going in for major capacity expansions to take advantage of the tremendous opportunities available in the region. This is likely to call for increased cushion of safety by the Islamic banks.Table 2-3: Asset Quality of Islamic Banks in GCC (FY 2004)(Amt in US$ 000)Total Assets Gross Loans Provisions Net Loans Non-performing Loans NPL / Gross Loans Provisions / NPL

BIsB677,701 457,610 (5,365) 452,245 10,034 2.2% 53.5%

BSB340,719 244,425 (108,416) 136,008 167,154 68.4% 64.9%

KFH11,895,747 5,530,337 (491,002) 5,039,335 N.A. -

DIB8,326,834 6,994,379 (197,185) 6,797,194 N.A. -

ADIB3,450,910 3,060,262 (20,145) 3,040,117 N.A. -

SIB939,648 847,099 (49,258) 797,841 N.A. -

QIIB264,286 731,044 (20,879) 710,165 22,802 3.1% 91.6%

QIB2,111,813 1,218,681 (62,363) 1,156,319 81,868 6.7% 76.2%

Al-Rajhi20,761,273 18,203,401 (846,292) 17,357,109 253,547.5 1.4% 333.8%


Islamic banks have traditionally maintained adequate coverage ratios, higher than those of their conventional peers. Though some of the banks have remained laggards in this respect. Al Rajhi Bank has the highest coverage ratio of 333.8% on account of its low level of NPLs coupled with high provisioning. Non-performing loans of the Al-Rajhi Bank was just 1.4% of the gross loans in 2004. The capital adequacy of the banks have gained increased attention through the initiatives taken by Central banks and the Basel Committee in standardizing the norms. Islamic banks have kept a high equity to total assets ratio in order to provide comfort to their customers, correspondent banks and regulatory authorities. However, as banks increase their operations and increase in size their equity to total asset gradually declines as the growth in equity is not able to match the pace of growth in assets. The older and established players such as Al Rajhi Banking & Investment Corp and Kuwait Finance House have lower equity to total assets ratios although they are still in the comfort zone. The BIS capital adequacy ratio proposed by the Basle Committee is 8% although some of the regulatory authorities have kept this ratio more stringent at 12%. It should be noted that Islamic banks have very high capital adequacy ratios which are being improved further by way of increase in their capital. Going forward, the banks which will use its capital efciently, will survive the onslaught of competition. While Islamic Financial Institutions (IFIs) have enjoyed above-average growth rates in the recent past, this has been partly due to favourable market factors and regulatory advantages. However, going forward, Islamic banks need to signicantly change their strategies to make it more competitive. Islamic banks, which have enjoyed monopoly or duopoly positions in their markets, may not nd the going easy as the competitive landscape is becoming more intense in all countries in the GCC region. Islamic banks need to improve their capabilities across multiple dimensions, chiey corporate governance, product innovation, branding and treasury operations, etc. 12 GCC Banking Sector May 2005



3. Role of Foreign BanksForeign ownership is more limited in the GCC banking sector, compared to that in other emerging markets. While several international banks are active in this region, they do not represent a material share of the domestic markets, with the notable exception of Saudi Arabia. For instance, till recently foreign banks were not allowed in Kuwait, while in Saudi Arabia, no foreign bank has a majority ownership but several major domestic players, such as Saudi Hollandi Bank (SHB), Saudi British Bank (SBB), and Al Bank Al Saudi Al Fransi (BSF) have active minority foreign shareholders. These domestic banks often enter into management agreements whereby the banking policies, products and information systems of the partner institution are installed in the Saudi bank, which also benets from managers seconded by the international partner. Foreign banks have been operating in the GCC region with their regional counterparts for a number of years. In Bahrain, Oman, UAE and Qatar, international banks have been operating freely but Saudi Arabia and Kuwait have recently started receiving international banks with open arms. Central Bank of UAE had declared in 2003 that it was ready to allow the operations of more foreign banks on a reciprocal basis. It also is considering allowing more branches to foreign banks operating currently in the UAE. The UAE has 28 foreign banks but no new licenses have been issued to a foreign bank for 20 years now. In the recent past Saudi Arabia has also liberalized the banking sector and issued licenses to a number of international banks such as HSBC, Deutsche Bank, etc. In addition, the Saudi Arabian Monetary Agency (SAMA) has issued operating licenses to the Emirates Bank Group and National Bank of Kuwait. We believe that Saudi Arabias membership of the WTO in the future might persuade it to bring down the barriers to foreign competition. Similarly, Kuwait has also liberalized its banking system and issued license to three foreign banks, e.g., BNP Paribas, HSBC and National Bank of Abu Dhabi. GCC central banks have been slow in issuing new banking licenses, particularly to foreign banks, thereby limiting competition. Dominant government and family ownership constitute a degree of protection against the increasing competition from foreign banks seeking to enter these markets. The legal framework brings additional protection to these banking systems. The limited competition and presence of foreign banks is likely to change gradually, though, as a general trend toward globalization, especially in compliance of World Trade Organization (WTO) agreements entered into by the GCC countries (except Saudi Arabia). Table 3-1 : Foreign Banks Shareholding in GCC BanksName of the Bank International Bank of Qatar, Qatar Ahli Bank, Qatar Foreign Bank National Bank of Kuwait - Kuwait Ahli United Bank - Bahrain CALYON Corporate & Investment Banque Saudi Fransi, Saudi Arabia Bank Saudi British Bank, Saudi Arabia HSBC Holding BV Bank Al Jazira, Saudi Arabia National Bank of Pakistan Arab National Bank, Saudi Arabia Arab Bank - Jordan SAMBA Financial Group, Saudi Arabia Banque du Caire - Egypt Bank Melli - Iran Saudi Investment Bank, Saudi Arabia JP Morgan Chase Mizuho Corporate Bank Saudi Hollandi Bank, Saudi Arabia ABN Amro BankSource: Banks Annual Reports.

% Equity Stake 20% 40% 31% 40% 6% 40% 2% 1% 8% 3% 40%

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Banking sector in the region has witnessed tremendous developments in recent past. Bahrain, Dubai, and Qatar are developing dedicated nancial districts and environments to foster banking and nance. Bahrain Financial Harbours rst phase is moving at full speed, to be completed by October 2005. Dubai International Finance Centre has been established to be the regional nancial hub. Its scope of operations would include asset management, Islamic nance, regional nancial exchange services, insurance and re-insurance and back-ofce operations. Thus, we believe that banking sector in the region is on the threshold of a new era, where foreign banks are likely to give tough time to local banks. The growth opportunities are abound in the region for players who are willing and ready to meet the challenges. Some of the areas ready to be tapped are private banking, small to medium enterprise (SME) banking, upper-mass banking for the growing middle class, bancassurance, mortgages, and Islamic banking. The potential business segments lure many foreign banks to enter the banking industry in the region. The Bank of China, which was named as the largest emerging market bank by Euromoney, opened its representative ofce in Bahrain in 2004 to cater to the regional markets. At the same time, banks such as HSBC and Deutsche Bank are in the process of setting up their presence in Saudi Arabia. In addition to this, the number of international investment banks interested in securing GCC mandates is growing. Royal Bank of Scotland is focusing on lucrative projects in Qatar. Some of the international banks which are active in GCC project related and asset-backed nance market are HSBC, BNP Paribas, Societe Generale, Standard Chartered Bank and Calyon, etc. Broadly speaking, the GCC banking sector is expected to become more liberalised, transparent and better governed and regulated. Thats good news for banking customers, investors, and banking and nance professionals from all over the world with a stake in the GCC market. Seeing how closely the regions banks are connected to the economies of the GCC countries, this is good news for the GCC economic growth too.

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4. Competitive Strategies & Other DevelopmentsExpansionary moves gaining ground The banking sector is one of the most happening sector in the GCC region. Despite the diversity of the banking units in the GCC countries, the markets of these countries still have tremendous potential in terms of services offered. The booming economy has aroused unprecedented interest from across the world in recent years and encouraged banks to expand their products and service offerings. Rising oil prices, strong economic fundamentals, and growing business condence in the region kept the regions banking industry on a strong growth trajectory. The competition in the banking industry remains extremely intense and thus introduction of value added products become necessary. With the booming economy and entry of foreign banks, banks in region are trying to become more competitive. Some are looking at organic growth while others believe in inorganic growth. The examples are abound in this respect. After acquiring 48% in Kuwait based Bank of Kuwait and Middle East, Bahrain based Ahli United Bank, acquired 40% stake in Qatar based Ahli Bank of Qatar. AUB was also instrumental in taking equal stake in Future Bank along with two top Iranian banks namely Bank Melli Iran and Bank Saderat Iran. Similarly, Bank Muscat stared its operation in Bahrain by establishing Bank Muscat International. The new bank is established to enable Bank Muscat to undertake expansion in the Middle East and North Africa (MENA) region through a base in Bahrain. Qatar National Bank (QNB) acquired London based wealth management rm Ansbacher Holdings Limited, which in December 2004 opened its rst Mideast ofce at the Dubai International Finance Centre (DIFC). In 2004, Emirates Bank opened its rst branch in Saudi Arabia and will explore the possibility of expanding its operations in other GCC countries in the near future. Kuwait Finance House has expanded its full-edged banking operations in Bahrain under KFH (Bahrain) and it also owns 62% in Bahrain-based Kuwait Turkish Evkaf Finance House. KFH has also got a license to start Islamic banking operations in Malaysia. Apart from this, banks such as National Bank of Kuwait and National Bank of Bahrain are looking to expand their operations in Saudi markets while National Bank of Abu Dhabi has got license to operate in Kuwait. Kuwait has opened its banking sector to foreign banks while UAE has also announced its intention to issue licenses to international banks. We believe that, we are going to witness lot more activities in the banking sector in the region in future. Thrust on retail banking Retail banking has become the buzzword in the Middle East banking sphere. Most banks in the GCC region have identied the retail banking segment as a key to improve margins and enhance fees and commissions income. This thrust on retail banking is justiable considering the fact that margins for commercial and corporate banking have been compressed in recent years due to severe competition in the banking sector from both domestic as well as international banks. The thrust on retail segment is also necessary to increase their interest income as well as to increase their fee based income. This will also help the bank to derisk their business model by diversifying the sources of revenue. As mentioned earlier, most of the banks in the region are looking forward to increase their non-interest income as this

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source of income has generally been low as compared to the global standards. For Kuwaiti banks, this ratio was around 37.5% of the total operating income while for banks in Bahrain it was around 41% in FY2004. We believe that, going forward, most of the banks in the region are expected to boost their non-interest income from retail side. To acquire more number of customers, banks are offering a number of innovative products and services. Private Banking not too behind as well The entire GCC region has a large number of High Networth Individuals (HNIs). This offers excellent ground for banks to tap the market for private banking. As per one estimate, there are around 200,000 to 225,000 multi-millionaires in the GCC region. By 2008, the Middle East is predicted to account for US$1.5trillion of the worlds private wealth. Private banking is generally considered to be a low risk and high return business. Thus there is intense competition from both regional as well as foreign banks to manage private wealth. Private banking has always been a lucrative business for the regions banks and nancial institutions as it has the potential to enhance banks bottomline tremendously. Since GCC has more afuent people, there is a large demand for these services. The past two years has seen a number of new players in the private banking sector, as well as more established players moving into wealth management business. Generally, foreign banks such as BNP Paribas, Citibank, UBS, HSBC etc. are more active in this segment. In addition, regional banks have also become more active in the private banking. The vast market potential was behind Bahrain-based TAIB Banks decision to reposition itself from an investment bank to a fully-edged private bank. TAIB aims to provide the complete range of wealth-management services, from various investment products to brokerage and trust services, targeting clients between US$3-US$15mn to invest. Foreign banks are more active in private banking because of their expertise in this segment. However, some of the local banks that offer private banking may be too small to provide the complete range of products of private banking service. At the same time foreign banks though they are able to provide most advanced may not be able to tap the market fully because of their lack of knowledge about the regional market. Some banks are striving for middle path and have tried partnership route with international wealth management experts. Ahli United Bank (AUB) is one that has taken the partnership route for its asset management business. The bank has allied with Mellon Global Investments to offer private banking services to its clients. In another development, Qatar National Bank has acquired London based wealth management company called Ansbacher Holding. Regional banks have a great opportunity to target the customers as they know the customers well and they also have good understanding of the local market dynamics. Technology Initiatives To strengthen and streamline their operations most of the banks in the region are in the process of implementing core banking solutions. This should result in the banks efciently and cost effectively handling the customers needs. The number of regional banks providing online services has increased rapidly since the past few years. In the beginning of 2003, there were just under three million regular online banking users in the Middle East. This number has grown rapidly and online banking transactions have grown to represent around 19% of all banking transactions in the region. E-statements, internet banking, SMS services made banking more convenient for the banking customers in the region.

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Burgan Bank in Kuwait is at the forefront of providing these services with its Bee Bank brand. The UAE has its very own internet bank - meBANK - which has evolved into a fullservice convenience bank giving its bricks-and-mortar counterparts a run for their money with its unique strengths and aggressive marketing strategies. In Oman, the rst online internet banking service - NetB@nk - was successfully implemented by National Bank of Oman. Doha Bank launched a short message service (SMS) facility incorporating around 15 banking services including alerts in Arabic and English. Citibank UAE launched internet kiosks at several branches in association with Emirates Internet & Multimedia to make its online services more easily accessible to its customers where they are. Habib Bank Zurich launched its highly secure web and WAP-based e-banking services. Dubai Islamic Bank launched the regions rst mobile banking service in Arabic with 36 features like account debit alert, account balance and previous transaction information to allow users to manage their accounts via their mobile phones. In Kuwait, NBK has established a state-of-the-art call centre to serve its customers while Burgan Bank continued to offer other e-banking services to its clients. Most of the banks have upgraded their IT systems and implemented new core banking solution. As the technology is making matters easy for banks it exposes banks with certain risk also. For example, UAE was hit by ATM fraud in 2003. This forces the banks to implement IT security systems in their operations. It is widely believe that the regions IT security market could be worth around US$500mn in the next three years. Saudi Arabia is the biggest market followed by the UAE. Some of the banks have followed innovative approach in IT Security Systems, for example, Dubai Bank installed biometric technology at its Tijori safety deposit vaults. Overall, risk management has assumed critical importance and the market is currently seeing an inux of specialised services to cater to the security needs of the banking industry. Regulating money laundering One of the major issues that affected the banking industry in the Gulf in recent years was that of money laundering. Most of the Governments in the GCC region took serious steps to curb these practices. For example, Bahrain Monetary Agency has issued anti-money laundering rules for capital markets. Saudi Arabia banned 24 investment rms operating in the kingdom without a license and offering very high interest rates. Saudi Arabian Monetary Agency, adopted stringent rules to prevent money laundering. Similarly, the Central Bank of UAE has also instituted a new supervisory policy to improve bank risk prole and ght money laundering. Project nancing opportunities the boom area Banks in the GCC region have lot of opportunities by way of project nancing deals. There is a tremendous infrastructure boom in the region and the large banks are rightly placed to benet from these opportunities. As per one estimate, deals with a total value in excess of US$14bn were closed in 2004, which was close to double the roughly US$8bn worth concluded in 2003. Going forward, the tremendous volume creates enormous opportunities for lenders to the region. The petrochemical is the most promising sector in the coming years for deal ow, with a host of projects across the region looking for nance. Apart from petrochemical, other promising

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sector for banks are electricity, water, power, and port projects across the region. Government diversication plans and benign economic conditions are also accelerating downstream industrial projects, many of which have been on the table for a considerable period. Thus the volume of project nance required over the next year or two will be unprecedented. Several positive trends have emerged during the past few years, which indicates that the market is developing in such a way as to be able to fulll the huge requirements of clients. Important trend is that most of the banks, both regional and international, have been joining mandated arranger groups on the GCC deals. International banks that had scaled down their presence in the region are returning vigorously. They are being lured by the opportunities in the region, healthy economies and the track record of existing projects. At the same time, we have been witnessing that regional banks capacities and their appetite for cross border lending are growing rapidly. Various local institutions have been working hard to build structural capabilities and are also entering into number of transactions. Banks in the GCC region have started deploying their balance sheets towards structured nance while banks such as National Bank of Abu Dhabi are stepping up such activities after a brief period of lull. Since the last few years many of the banks based in GCC region have become aggressive in increasing their revenue stream. Qatar National Bank and Ahli United bank were the most active cross border project lenders in recent times. At the same time Kuwait based Kuwait Finance House and National Bank of Kuwait also ventured overseas. Some of the other active banks in cross border project nancing included Dubai Islamic Bank, Commercial Bank of Qatar and Mashreq Bank among others.

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5. Financial PerformanceGCC banking sector showed improved performance on the back of strong macro-economic performance (thanks to high oil prices), increased liquidity in the banking system and improvement in both, interest and non-interest based income of respective banks in the banking sector. The banking sector penetration in the GCC increased as, banks in respective economies increased their branch network, especially to cater to the lucrative retail segment of the industry. Saudi Arabia stands out with the number of branches close to 1000 (for listed banks) which is understandable keeping in mind the sheer size of the economy and the geographic area the banking sector needs to cater to. The operating income per employee of the banking sector in GCC in 2004 ranged from US$0.12mn in Oman to US$0.32mn in Kuwait with the average being US$0.26mn for the entire banking sector in the GCC. However, it is to be noted that one of the bank in Oman (NBO) had a very small operating prot which depressed the overall Omani sectors operating prot per employee.Table 5-1:Comparison of Operating Performance of the GCC Banking Sector* (FY 2004)US$ mn No. of Branches No. of Employees Operating Income (Net of Provisions) Operating Expenses Operating Prot Operating Income Per Employee Operating Expense Per Employee Operating Prot Per Employee Kuwait # 203 6,841 2,221 (610) 1,550 0.32 (0.09) 0.23 Saudi Arabia 954 20,397 5,857 (2,060) 3,796 0.29 (0.10) 0.19 Oman 277 4,416 539 (320) 210 0.12 (0.07) 0.05 Qatar 101 2,850 800 (256) 544 0.28 (0.09) 0.19 UAE Bahrain 330 12,373 2,766 (984) 1,783 0.22 (0.08) 0.14 78 2,121 482 (225) 256 0.23 (0.11) 0.12

Source : Banks nancial statements & Global Research * Only listed banks covered in this Report have been considered. # For sectors aggregate branch network we have excluded KREB as data for the bank are not available.

The operating expenses per employee in the GCC averaged at around US$0.09mn for the combined GCC banking sector which increased as compared to the previous years. This is attributed to the increase in the staff costs as well as general and administration expenses as the banks increased their marketing efforts, added new branches and expanded their employee base. Kuwaiti banking sector reported the highest operating prot per employee of US$0.23mn per employee as the Kuwaiti banks improved their efciency through costcutting initiatives coupled with the marked improvement in their operating income. We expect the GCC banks to increase their branch network, number of employees in the wake of upcoming competition from foreign banks and also to utilize economies of scale, and be more competitive regionally. They would also try to improve their operating expenses per employee so that they are on a better footing once the competition hots up further in the region. However, we expect the staff expenses to increase as the banks try to retain the staff from poaching by the competitors and also expand their staff strength in wake of expanding operations.

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GCC Banking Sector Credit Portfolio

In 2004, GCC listed banks had a net aggregate credit portfolio of US$185.9bn. However, again Saudi Arabian banking sector eclipsed the other with the net loans of US$75.9bn in 2004. The total non-performing loans (NPLs) of the GCC sector combined amounted to US$6.9bn while the provision for loans losses amounted to US$8.7bn in 2004. GCC banks have been following a conservative policy regarding provisioning for loan losses. In 2004, the average coverage ratio (PLLs-to-NPLs) was 126% with Saudi Arabia leading the pack with the average coverage ratio of 177% in 2004. Kuwait banking sector and UAE banking sector too had the coverage ratio of more than 100% in 2004 while Oman, Bahrain and Qatar had an average coverage ratio in the comfortable range of 80%-90%.Table 5-2: Asset Quality of GCC Banking Sector* (FY 2004)(Amt in US$ mn) Gross Loans Provisions Net Loans Non-performing Loans NPL / Gross Loans Provisions / NPL Kuwait 35,038 (2,037) 33,001 1,342 4.5% 121% Saudi Arabia 75,975.7 (3,028.5) 72,947.2 1,708.8 2.2% 177% Oman 8,408.9 (1,109.8) 7,299.1 1,233.9 14.7% 89.9% Qatar 13,399 (565) 12,834 675 5.0% 83.7% UAE 54,128 (1,553) 52,574 1,443 2.7% 107.7% Bahrain 7,740 (444) 7,296 539 7.0% 82.4%

Source : Banks nancial statements & Global Research * Only listed banks covered in this Report have been considered. # NPLs of KFH is not available therefore we have excluded KFH while calculating these ratios. NPLs and related ratios for UAE only for 8 banks for which data are available.

Non-Performing Loans (NPLs) to Gross Loans ratio for the combined GCC banking sector stood at 3.6% in 2004. The asset quality of banks in the region has improved considerably in the last 2 years. A favorable economic environment have kept loan losses at low levels. Rise in real estate values and better cash ow conditions for borrowers boosted prices of collateral that banks hold and reduced the percentage of non-performing loans to total loans in 2004. Banks in the GCC region have become increasingly prudent at improving the quality of their earnings and have raised provisions, thus bringing down the NPLs. Despite the sheer size of the loan book, Saudi Arabian banking industry had the lowest NPLs to Gross Loans ratio of 2.2% in 2004. It is impressive to note that the top-2 countries in terms of the gross loan portfolio, Saudi Arabia and UAE had the lowest NPLs to Gross Loan ratio in 2004 at 2.2% and 2.7% respectively. Oman had a very high NPLs to Gross Loan ratio of 14.7% in 2004. Asset quality of Omani banks has been a cause of concern which led to the restructuring of the balance sheets over the past few years. A substantial effort on the part of banks and regulatory authorities has brought about a marked improvement for the sector in this respect. However, still much needs to be done if the banking sector in Oman has to bring its NPLs to Gross Loans ratio in line with its peers in the GCC region. However, increasing provisions have also kept pace with the increase in NPLs, this has denitely helped in reducing the systemic risk in the banking sector.

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Comparative Indicators

Loans to Deposits Ratio... Customers deposits remained the main source of funding for the GCC banks, providing an average of more than 85% of their total deposits. Kuwait had the highest customer deposits to total deposits ratio of 95.4% in 2004 while Qatar had the lowest ratio at 74.6%. However, it should be noted that there was a growth rate in customers deposits in the GCC banking sector could have been much higher but for the low interest rate scenario (although increasing) and the increasing preference of the GCC investors to invest their money in the high-yielding mutual funds and rapidly growing stock markets.Table 5-3: Comparative Financial Indicators of GCC Banking Sector* (FY2004)Kuwait Profitability Indicators Return on Average Equity Return on Average Assets Interest Exp / Interest Income Interest Income / Avg Int earning assets Interest Exp / Avg Int bearing liabilities Net Spread Net Interest Margin Non Interest Income / Operating Income Dividend Payout Ratio Efficiency Indicators Cost to Operating Income Staff Expenses / Operating Income Liquidity Indicators Net Loans / Customer Deposits & Deposits from FIs Customer Deposits / Total Deposits Capitalization Indicators Capital Adequacy Ratio Equity to Total Assets Equity to Gross Loans 20.6% 2.4% 45.3% 4.9% 2.3% 2.6% 2.7% 42.5% 62.3% 29.3% 17.2% Saudi Arabia 26.4% 2.7% 25.0% 4.6% 1.2% 3.5% 3.0% 39.1% 55.8% 38.6% 21.7% Oman 9.3% 1.2% 29.1% 6.0% 2.1% 3.9% 4.2% 23.7% 57.0% 59.4% 24.2% Qatar 20.4% 2.9% 32.7% 4.8% 1.7% 3.1% 3.2% 35.3% 52.1% 34.7% 16.2% UAE 17.4% 2.4% 37.6% 4.5% 1.8% 2.7% 5.0% 43.8% 41.1% 35.6% 20.8% Bahrain 13.6% 1.7% 35.9% 3.6% 1.5% 2.0% 2.3% 41.0% 70.3% 50.2% 27.9%

83.4% 95.4% 16.5% (#) 13.0% 22.9%

63.0% 87.2% 16.2% 10.5% 19.5%

105.0% 89.2% 25.2% 15.0% 18.2%

65.0% 74.6% 25.9% 16.5% 31.5%

90.1% 88.4% 16.4% 12.0% 18.1%

92.7% 79.8% 24.8% 13.7% 24.9%

Source: Annual Reports & Global Research * Only listed banks covered in this Report have been considered. # For sectors average CAR we have excluded ABK, KFH and KREB as data for these banks are not available. CAR in respect of UAE banks is the median value for 5 banks for which data are available.

The GCC banking sector had a comfortable loans to deposits ratio with only one sectorOman reporting the loans to deposit ratio of more than 100% in 2004. However, this ratio in some countries is also signicantly affected by the regulatory statutes wherein the banks are dictated to maintain a cut-off rate for the loans to deposits ratio. Saudi Arabia and Qatar had the lowest loans to deposit ratio at 63% and 65% respectively which provide the banking sector in these countries with a very good opportunity to expand their lending operation and take advantage of the booming economy especially in the areas of high-margin retail lending.

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Capitalization GCC banks are adequately capitalized by international standards. All the banking sectors in the GCC region had the Capital Adequacy Ratio (CAR) much above the BASEL norm of 8%. Qatar banking sector led the region with the capital adequacy ratio of 25.9% in 2004 followed by Omans banking sector with the CAR of 25.2%. The peer groups average equity-to-total assets for the combined GCC banking sector was more than 10% in 2004, with the Qatari banking sector reporting the highest ratio amongst the peer group of 16.5% compared to Saudi banking sector which reported the smallest ratio of 10.5%. We expect the capitalization ratio of the GCC bank to remain at the comfortable levels even though they increase their lending activities. However, we feel that the impending implementation of Basel-II norms will put pressure on GCC banks to improve their risk management practices and measurement. This also calls upon the central banks and banking regulators to proactively assist the banks in their respective countries, to adopt the reviewing of banks internal capital adequacy assessments and to review and act if the banks capital fall below the level appropriate to its risk characteristics. Protability The peer groups protability measures improved in 2004 as a result of ourishing economic conditions created by high oil revenue, higher government expenditure and subsequently greater private sector activity, hence increasing the domestic liquidity. The GCC banking sectors average ROAA and ROAE stood at 2.2% and 18% in 2004 respectively. Saudi banks had the highest ROAE amongst the GCC banks at 26.4% while the Qatar banking sector led in terms of the ROAA which stood at 2.9%, followed by Saudi Arabia at 2.7% in 2004. The GCC banks have been able to widen their spreads in 2004 on the back of rising interest rates coupled with the increase in the non-interest bearing deposits in the GCC banking sector. Spreads in the GCC banking industry has ranged from 3.9% in Oman to 2.0% in Bahrain. The presence of the huge chunk of Islamic deposits in Saudi Arabia is evident from the fact that it has the lowest Interest Expense to Interest Income ratio (Commission Expense to Commission Income as called in Saudi Arabia) of 25% in 2004. GCC banks have managed the low interest rate environment of the past few years quite effectively and any pressure on margins now is likely to be offset by growing loan demand. GCC banks are also looking at cost-cutting as means of boosting protability. The GCC banking sector combined have the cost to total operating income above 30% levels which gives them the opportunity to improve protability by containing their costs. The bank have also used the growth in their protability and improved margins to reward their shareholders. The dividend payout in the GCC banks was above 50% with the exception of UAE which stood at 41.1% in 2004. Bahraini banks led the GCC region with the average payout of 70.3% followed by Kuwaiti banks at 62.3%. Most of the Saudi banks have also distributed liberal stock and cash dividends in 2004.

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6. OutlookOver the medium-term, we maintain a positive outlook on the GCC banking sector. Some of the major trends going forward are as follows: i. Oil prices expected to rule at high levels Oil prices are expected to remain at high levels, if not at the currently ruling record-high levels. Budget surpluses and domestic compulsions of growing populations, which would continue to put pressure on the available infrastructure, would necessitate increasing infrastructure spending from the governments. While this would provide opportunities to the banks by way of taking part in loan syndications and increasing fee-based incomes, the growing populations could also favorably impact the retail end of the market, with increased retail accounts for consumer loans, etc. ii. Regulatory reforms to pick up pace It is likely that GCC regulators will make the legal framework of banking more attractive. One of the regulations being discussed in several GCC countries currently, for example, is the setting up of a clear, appropriate, and efcient framework for mortgage lending. Banks are known to favor a more transparent and practicable system of foreclosure of collateral, as such operations have proved to be very difcult to execute, particularly where residential real estate is involved. Speedier reforms in such areas could go a long way in making the banking system more eet-footed and enable it to take part in emerging opportunities. iii. Increasing competition All GCC countries, except Saudi Arabia, are members of the WTO. Under the treaty, nancial services will remain protected at least until 2005, limiting foreign competition in the shortterm. However, entry barriers are bound to be lifted in the longer term, and many institutions are preparing to face increasing foreign presence. Kuwait, for example, is believed to have already issued licenses to BNP Paribas, HSBC and NBAD to open branches in the country. Similarly, Saudi Arabia has issued licenses to BNP Paribas, Deutsche Bank and J P Morgan Chase for commercial banking, besides allowing HSBC for investment banking. Foreign banks are already operating in the other GCC countries. Not only are banks in the GCC preparing to face the potential impact on competition of their countries full accession to the WTO, but the authorities in the GCC countries have also agreed to open their doors to regional banking players. Central Banks have agreed to allow the regional banks to operate in their respective countries provided they comply with specic requirements. They must be majority owned by GCC nationals, have a sufcient capital base (minimum of $100mn), and should have been established for a minimum of 10 years in their country of origin. For example, the Saudi authorities recently granted banking licenses to Bahrain based GIB and Dubai-based EBI. NBK and NBB have also recently received licenses to open branches in Saudi Arabia.

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iv. Rapid expansion of retail banking Enhanced physical expansion and improved electronic delivery channels are expected to enable banks to have an increased focus on retail banking in the coming years. Growing populations in all the six GCC countries would only make it imperative. The banks have already invested heavily in putting the necessary infrastructure in place. The sophistication of products on offer too is expected to go a few notches higher, with increasingly demanding customers. v. Solid nancial performance to continue All the banks are expected to continue with their robust nancial performance in the mediumterm. The numbers are expected to be driven by increasing spreads, product diversication, improved delivery channels, forays into Islamic banking by almost all the banks, growing participation by almost all the banks in big-ticket, long-term project nancing, and thrust on fee-based activities. vi. Capitalization levels to remain high The capitalization levels are expected to remain high in the medium-term, enabling participation by the banks in long-term project nancing deals. This could also correct the asset-liability mismatches and skew the loan book towards the longer-end. Many banks across the six GCC countries are believed to be mulling over raising long-term nancing through debt. vii. Capital market and real estate exposures could pose risk Name lending and margin lending are reportedly common practices in the GCC banking systems. However, these factors could impact negatively on the asset quality of the banks should an economic downturn occur. As for customers involved in margin borrowing, any downturn in the stock markets could hit them hard, thus weakening the current soundness of banks retail portfolios. Most banks in the GCC seem to be aware of this issue, as well as that of booming real estate prices, and have so far chosen to react to it by increasing collateral, under the close supervision of the central banks. A possibility of these portfolios turning riskier going forward cannot, therefore, be ruled out. viii. Retail loan accounts could turn riskier too It is possible that asset-quality problems could arise with the existing retail loan portfolios of the GCC banks slowly maturing in the coming years. In such a situation, banks would have to grant credit to second- and third-rung customers, who might not have the same credit prole as the top-rung ones of the existing portfolios. Indeed, uncertainties regarding the ability of GCC governments to provide stable, well-paid jobs for all young citizens entering the labor market are severe constraints to their tenability to continue as safe accounts. If the private sector is able to throw up more jobs going forward, the overall prole of the average bank customer will undoubtedly become riskier, thus giving banks two alternatives. Banks could either continue to offer retail credit to only the top-quality customers, at the risk of ignoring the consumption needs of a large chunk of the population. The alternative to this could be to extend credit beyond the safe, upper-class segments, and, thereby, turn themselves into

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mass-market nancial institutions. The latter, however, comes with the risk of triggering asset-quality deterioration, warranting more focused efforts in credit-risk management, and pursuing more aggressive recovery efforts. ix. Higher M&A and cooperation among GCC banks

There are moves towards national and regional consolidation in the GCC banking industry. In Oman, for example, the central bank has been actively promoting mergers among banks, which are among the smallest in the region. Among bank acquisitions in the recent past, Ahli United Bank (AUB), Bahrain has acquired 40% stakes each in BKME, Kuwait and Al Ahli Bank of Qatar. Similarly, National Bank of Kuwait (NBK) has acquired 20% in International Bank of Qatar (IBQ), formerly Grindlays Qatar Bank. The IBQ stake is considered strategically important for NBK, given the countrys huge project nance needs in energy and infrastructure projects, in addition to the signicant potential to expand retail and private banking operations. In a few of these countries, the largest banks have reached a stage where their future domestic organic growth is expected to slow down. Banks in Kuwait and Oman, for example, could see relatively lower future domestic organic growth. A domestic takeover of one of the smaller banks by the major players would deliver only marginal economic benet for the large bank, but it would be a valuable opportunity to overcome the constraints of size for the smaller competitor. NBK, for example, is known to be interested in acquiring banks in India and Turkey; National Bank of Bahrain is reportedly planning to enter Saudi Arabia. NBK and the International Finance Corporation, the private lending arm of the World Bank, are also believed to be close to nalizing their purchase of a stake in the Credit Bank of Iraq. The deal, which has been approved by the Central Bank of Iraq, but not yet publicly announced, is known to give NBK a 75% stake in the bank, while IFC will hold a 10% stake and Credit Bank of Iraq will hold the remaining 15%. In the UAE and Bahrain, domestic mergers are expected to be a rst step, as these markets are over-banked and offer potential take-over targets. For example, Ahli United Bank (AUB), the largest onshore bank in Bahrain, is the result of several mergers and acquisitions. The move toward regional players would eliminate the less efcient banks, enabling local banks to reach the critical mass needed to handle big syndicated and project nance transactions, and enhance regional presence. This would also give the regional banks the ability to resist foreign competition, expected to hit the region in the medium-term. This, however, calls for the consolidation decisions to be taken on broader nancial rationale, rather than on narrow political, family, and nationalistic grounds. Besides M&A, the strategy to look outwards also involves opening of branches in the rest of the GCC/MENA countries, often beyond. NBK, for example, inaugurated a new branch in Amman, Jordan in 2004. It also opened its 9th branch in the mountain resort of Aley in Lebanon, a popular Kuwaiti holiday destination. NBK also has plans to establish a new branch in Jeddah in Saudi Arabia, in addition to a representative ofce in China, soon. Mashreqbank, similarly, has plans to expand its presence in Qatar.

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x. Increasing product diversication Diversication is a key challenge for almost all the GCC banks. Banks have begun expansion in their offerings of retail products and services. Extending their operations into a variety of sectors will lead to a lower dependence on government spending and more involvement in the private sector, provided that economic reforms are effectively implemented. Finally, geographic diversication out of the region would improve banks risk prole in the mediumterm. But, it is likely that diversication will be directed toward the comparative advantages held by the GCC banks, namely retail and Islamic banking activities. xi. Islamic banking to grow rapidly With the exception of a few banks, all the GCC banks have either entered the Islamic banking or are about to do so. The model followed for the Islamic banking foray could be different, though ranging from offering these services as a part of their existing operations, to having a separate division offering these specialized products, to oating a separate Islamic banking subsidiary. xii. Private banking, insurance and corporate nance to head revenue growth Banks are expected to increasingly focus on fee-based activities, like loan syndications, funds management, offering insurance products, including bancassurance products, managing IPOs, etc. Private banking too could turn out to be a protable revenue stream going forward. xiii. Funding structure of banks to diversify The funding structure of Gulf banks is undergoing signicant changes with the evolution of the banks asset structure and the introduction of more sophisticated renancing techniques. The trend is largely being driven by the boom in retail banking and project nance, which could lead to the banks increasingly resorting to long-term funding. The increased diversication in funding is a positive development. This is expected to help the banks address one of their main weaknesses that of maturity mismatches. The GCC banks could rely more and more on bank loans, syndications, local bonds, Islamic sukuks, Eurobonds, etc. for their funding. The GCC economies are enjoying a period of high oil prices, which are fueling government surpluses and boosting liquidity. High liquidity has led to better wages, which in turn have driven a signicant and sustained demand for alternative investments from the regions institutional and individual investors. Furthermore, bear-market conditions in the international capital markets during 2000-03, and the effects of 9/11, were strong incentives for the GCC investors to repatriate overseas funds, or at least limit the outward remittances. The available funds need to be invested in new, lucrative investments. The local equity and bonds/sukuks/Eurobonds issued by the GCC banks provide one such lucrative investment avenue for the regions liquidity. In this context, incentives have been high for banks to tap local and international debt markets. The historically low interest rate environment is also supportive. Interest rates in the GCC very closely track those in the US, as the GCC currencies are pegged to the US dollar, in preparation for the proposed 2010 GCC monetary union. Raising cheap long-term funds could also give a competitive advantage in the medium-term, as interest rates have begun to now increase.

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xiv. Increasing moves towards comprehensive corporate relationships The coming years could see major GCC banks increasingly moving toward a comprehensive corporate relationship management model from a credit-centric approach followed so far, as credit itself has become secondary to fee-based businesses. With high oil prices and budget surpluses reaching record levels, there is a strong inow of new projects across the region. This is set to change the face of corporate banking in the region. Not only have volumes of bank nancing been rising, but also the complexity of corporate lending has increased. From simple lending to large and relatively strong counterparts, corporate banking has moved towards greater sophistication and has now stretched beyond straight forward bilateral credit and syndication to corporate nance namely, trade nance, corporate treasury, cash management, nancial advisory, merchant banking, institutional investment on behalf of corporate clients, and structured nance. xv. Changing risk prole of the banks The public sector in the GCC has been the regional banks main client and, in many cases, its main shareholder too. With further economic diversication, dependence on government for capital and deposits could be reduced. The extent to which banks risk proles will be affected will depend on the soundness of the private sector that will emerge, its diversity, the related regulations, and the banks adaptation to the changing business scenario. What could be lost in terms of safety with respect to government exposures, could be more than made up in terms of credit diversication, enhanced business opportunities, and a widened product range. Nevertheless, the presence of the government is expected to continue in the eld of regulation, supervision, and intervention to prevent or correct bank crises and systemic risks. All GCC countries, except Saudi Arabia, are members of the WTO. Financial services, under this agreement will remain protected at least until 2005, limiting foreign competition in the short-term. However, entry barriers are bound to be lifted in the longer term. Kuwait and Saudi Arabia have already taken the rst steps in granting licenses to foreign banks. Increasing competition will mean new sources of risk for the banks. The net effect of all these factors could be accelerated modernization and sophistication of the banking sector in GCC. Over the long-term, this could only improve the overall business and risk proles of the GCC banks. xvi. New risk management techniques to come to fore

The changing risk prole of the banking system calls for a change in the risk management tools and techniques used. Leading banks of the GCC countries are investing heavily in IT to upgrade distribution channels, and to streamline tools and procedures for risk monitoring. Techniques such as data mining and warehousing, credit scoring, electronic record of defaults and recoveries for statistical purposes, and Value-at-Risk measurement are expected to become increasingly common, at least among the top-rung players. As banks in the region move to adopt the Basel II Capital Accord, current efforts in this direction should make this process easier. The sophistication in risk management tools and techniques is expected to be in step with the increasing complexity of nancial transactions in the region.

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7. Valuation & Recommendation SummaryOut of a total of 45 banks covered in this Report, equity valuations of 28 banks have been done. A combination of Dividend Discount and Peer Comparison Methods has been employed for the valuation the former with an 80% weightage and the latter with a 20% weightage to arrive at a Composite Value for each of the banks. A summary of the values arrived at for each of the banks, along with the recommendation rationale for each of them, follows.

BahrainAhli United Bank

We believe that AUBs net interest income is expected to improve strongly due to the further hardening of the interest rates. The bank is expected to grow in an inorganic way and is expected to become a pan-GCC bank in near future. Over the medium term, AUB is expected to post stellar performance buoyed by the improvement in its core and non-core businesses. We had recommended a price target of 68 cents for the bank in Dec 2003 when the stock was quoting at 57 cents. Since then the stock moved up as per expectations and reached our target price in August 2004. Currently, AUB is trading at 1.6x of its estimated book value and 17.2x of its estimated earnings of 2005. We have revised upwards our earlier projections due to better FY2004 results of the bank and improved market conditions. The estimated fair value of AUBs stock works out to US$1.00 based on DDM and peer group valuation method, which is higher by around 12.3% vis--vis the

gcc banking sector detailed report

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