Commentary
In a volatile Middle East, the Omani port of Duqm offers stability, neutrality, and opportunity. Could this hidden port become the ultimate safe harbor for global trade?
Giorgio Cafiero, Samuel Ramani
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Source: Getty
Commentary
Arab Banks Pay the Price for International Exposure
Arab banks, including Islamic banks, have suffered less than those in other regions from the crisis, but they still are vulnerable due to the loss of asset value.
By Andrew Cunningham
Published on Jul 7, 2009
The economic and financial crisis that has been decimating banking systems in the United States and Europe so far has had only a limited impact on Middle Eastern banks. Profitability is down, there have been a few defaults and a couple of failures (and there would have been more if some central banks had not moved quickly to inject capital and liquidity into local institutions), but on the whole, the region’s banks have not suffered the wrenching losses that have afflicted their Western counterparts.
The problems that have occurred have been in the Gulf rather than in the Middle East’s less-developed banking systems. In October 2008, the Kuwait-based Gulf Bank collapsed when a customer defaulted on an obligation arising from a derivative instrument. In May 2009, a Kuwaiti investment company defaulted on a sukuk (Islamic bond) obligation, and in the same month the International Banking Corporation (a small Bahraini investment bank) defaulted on trade finance debts. In 2008, two of the largest and most venerable Gulf banks, Arab Banking Corporation and Gulf International Bank (both based in Bahrain), needed massive capital injections to cover losses on securities issued by western financial institutions and companies.
The general pattern for Arab banks, however, has been far less extreme. Seven of the twelve Saudi banks that have reported results for 2008 showed lower net profits, usually as a result of huge write-downs in the value of financial instruments issued by western companies, but all were able to take those losses in stride and remain well capitalized. Leading local banks in Bahrain showed reduced profits but remained profitable. The picture in the other Gulf states has been similar.
Such resilience is not entirely attributable to strong balance sheets going into the crisis; central banks have been intervening heavily, either openly or behind the scenes. In February the government of Abu Dhabi injected over $4 billion in new capital into its five banks, some of which are state-owned and some privately-owned. In September 2008, the Central Bank of the United Arab Emirates (the federal body that oversees banks throughout the seven Emirates) set up a $14 billion liquidity facility, injecting about half of it the following month. In June 2009, the Central Bank of Qatar set aside $4 billion to buy up troubled real estate assets on the books of local banks. In October 2008, the Qatar Investment Authority (the country’s sovereign wealth fund) launched a $1.5 billion plan to take stakes of up to 20 percent in local banks in order to boost their capital levels.
By contrast, banks in Lebanon, Egypt, Morocco, and Jordan seem unruffled by the global financial crisis. Banks in countries with even more rudimentary financial systems, such as Libya, Syria, and Yemen, have limited exposure to international financial markets; their performance is still overwhelmingly determined by domestic policy changes, such as privatization and state-sponsored restructuring of their balance sheets.
There are three reasons why Gulf banks have been more affected than others by the global financial crisis. First, because they are more sophisticated and internationally orientated, they had greater holdings of overseas bonds and derivates, many of which have lost substantial value over the last year and a half. Not all of these investments were in super-complex financial products such as collateralized debt obligations. The point is that all of these types of instruments?whether complex or relatively simple?have to be “marked to market” (revalued to reflect their actual market price) at the end of each reporting period, forcing the bank to recognize a loss if the value has fallen.
Second, Gulf banks tend to follow more robust accounting standards than banks in many other countries in the region, and central banks in the Gulf tend to be more rigorous in enforcing such standards. So even where banks in say, Egypt or Morocco, have been holding instruments that needed to be marked to market, they may not have been so punctilious in recognizing their losses.
Third, falling asset values have hurt Gulf banks. Extraordinarily strong oil prices and a global glut in liquidity led to a huge asset price bubble in the Gulf, in particular in local real estate markets. The liquidity glut evaporated as the world financial crisis took hold, and oil prices fell from their unrealistic levels. Asset values in the Gulf, particularly of real estate, collapsed.
The performance of the fast-growing sharia-compliant banking sector adds a particularly intriguing addendum to any analysis of Arab banks’ recent performance. Since the global financial crisis began, sharia-compliant banks (also known as Islamic banks) have trumpeted their business model as one which would enable them to outperform their conventional peers?so proving the superiority of sharia-compliant finance. Since shariaforbids the payment or receipt of interest, sharia-compliant banks have no exposure to interest-based financial instruments such as mortgage backed securities, and as all sharia finance should be based on a real underlying transaction (as opposed to notional arrangements such as credit default swaps) products are usually asset-based, supposedly giving the bank a added level of security should the borrower suffer difficulties.
While the philosophy of sharia-compliant finance is unimpeachable, the financial results of sharia-compliant banks tell a different story. Five out of eight leading sharia-compliant banks that have reported results for 2008 (including Bahrain Islamic Bank, the Saudi Bank al-Jazira, Dubai Islamic Bank, and Kuwait Finance House) recorded a fall in profits, primarily because they had to write down the value of investments?the same reason which was depressing the profits of conventional banks in the Gulf. Most of those which have reported interim results for 2009 show a continuing reduction in profits.
One reason for this is that with so many conventional assets off-limits to sharia-compliant banks, they tend to invest heavily in the real estate sector (either buying buildings directly, financing developers, or lending money to lessees and home purchasers). Real estate was the sector that gained most from the recent asset price bubble, and which has had the hardest fall after the bubble burst.
Andrew Cunningham is managing director and head of Middle East Programs at the Financial Services Volunteer Corps, a New York-based not-for-profit organization that facilitates the emergence of efficient financial systems in developing economies.
About the Author
Andrew Cunningham
Carnegie does not take institutional positions on public policy issues; the views represented herein are those of the author(s) and do not necessarily reflect the views of Carnegie, its staff, or its trustees.
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