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UAE Banks Put To The Test

August 1st, 2010

Banks & Diversified


Financials
Sofia El Boury
+9714 3199 716
selboury@shuaacapital.com

Ghida Obeid
+9714 3199 729
gobeid@shuaacapital.com

Economics
Khatija Haque
+9714 3199 752
• The slow recovery of private sector credit growth in H1 10 is one of the key factors
khaque@shuaacapital.com
undermining the UAE’s economic recovery. We believe much of the risk aversion on
the part of banks stems from uncertainty about potential future losses and write-
downs.
• Our “stress test” on a sample of eight UAE banks, which account for almost 70%
of FY09 banking system assets, suggests that on average, the banking sector is
sufficiently capitalized to withstand significant deterioration in asset quality. Under
our base case, average total CAR for our sample at 14.9% is well above the 12% UAE
minimum, and average Tier 1 capital at 9.8% is above the 8% UAE minimum. Under our
conservative "worst case" assumptions, average total CAR drops to 11.8% and average
Tier 1 CAR falls to 6.5%; both are still above the Basel II international standards.
• Additional capital injections would be required for individual banks in all our
scenarios, ranging from AED 2.5bn (USD 669mn) in our base case up to AED 15.8bn
(USD 4.3bn) in our worst case. We believe that the authorities have the capacity to
provide this financial support, if ever required.
• In our view, additional measures could be taken by the authorities to “clean up” UAE
banks’ balance sheets, to restore confidence and encourage banks to resume lending
to households and businesses. In particular, the Irish approach of removing high-risk
assets from balance sheets and replacing them with low-risk government securities
should be considered in the UAE context, in our view.
• However, broad structural and economic reform, including greater transparency by
banks, is likely to be the most effective tool for restoring confidence and improving
access to funding, as well as encouraging greater investment and economic growth
over the longer-term.
UAE Banks Put To The Test

Contents

EXECUTIVE SUMMARY ................................................................................................................... 3

POST-CRISIS RECOVERY IN PRIVATE SECTOR CREDIT HAS BEEN SLOW ................................................ 5

OUTBREAK OF THE CURRENT CRISIS AND POLICY RESPONSES TO DATE........................................................................................................................5


WHAT HAVE UAE BANKS DONE WITH THEIR LIQUIDITY?................................................................................................................................................6

IS THE UAE BANKING SECTOR SOLID ENOUGH TO WEATHER THE STORM? ............................................ 7

AIMS AND METHODOLOGY................................................................................................................................................................................................7


BASE CASE SCENARIO IMPACT ASSESSMENT .................................................................................................................................................................9
FOUR ALTERNATIVE SCENARIOS......................................................................................................................................................................................10
RESULTS..............................................................................................................................................................................................................................11
THE AVERAGES LOOK GOOD, BUT THE DEVIL IS IN THE DETAIL.....................................................................................................................................12

DEALING WITH THE FALLOUT OF A FINANCIAL CRISIS: DRAWING ON INTERNATIONAL EXPERIENCE.......15

DE-RISKING IRISH BANKS . ..............................................................................................................................................................................................15


SPANISH BANKS RESTRUCTURE AND TAKE STRICTER PROVISIONS. ...........................................................................................................................16

CONCLUSIONS AND RECOMMENDATIONS........................................................................................17

SO WHAT COULD BE DONE TO ENCOURAGE BANKS TO RESUME LENDING ? ..............................................................................................................17

APPENDIX...................................................................................................................................18

UAE FY09 ASSET QUALITY METRICS VS. OTHER ECONOMIES.......................................................................................................................................18


UAE FY09 CAR VS. OTHER ECONOMIES...........................................................................................................................................................................18

August 1st, 2010 2


UAE Banks Put To The Test

Executive summary
The UAE’s economy and banking system were not immune to the global financial crisis.
Although the worst of the recession appears to be behind us, UAE banks remain risk
averse and reluctant to extend credit to the private sector. The latest UAE Central Bank
statistics show that bank loans grew a mere 0.8% in H1 10, down from 1.5% in H1 09 and 24% in
H1 08.

We believe much of this risk aversion on the part of banks stems from uncertainty about
potential future losses and write-downs. Our analysis aims to estimate just how big these
potential losses may be, and whether UAE banks would be able to absorb them if they
materialize.

We have focused on what we consider to be the riskiest assets on UAE banks’ balance
sheets:
• Real estate and personal loans extended in 2008 – at the peak of the credit and real
estate boom in the country ;
• Potential losses associated with banks’ exposure to Saad and Al Gosaibi and Dubai World ;
• And “renegotiated loans”, which appeared on most banks' FY09 financials1.
Finally, we have taken into account the fact that Dubai-based banks incur a higher risk associated
with their real estate exposure than Abu Dhabi-based banks.

Our base case suggests that UAE banks are, on average, capable of absorbing the
potential losses associated with more stringent default assumptions, thanks largely to the
authorities’ efforts to strengthen banks’ balance sheets since the onset of the crisis. The implied
Non-Performing Loan (NPL) ratio rises from 3.3% to 8.4%, while total Capital Adequacy Ratio
(CAR2) remains healthy at 14.9% and Tier 1 capital remains above regulatory requirements at
9.8%. Although Emirates NBD and ADCB would be the only banks needing a combined AED
2.5bn (USD 669mn) of additional Tier 1 capital to meet the stringent UAE requirements, all the
banks in our sample comply with Basel II standards.

In our “worst case” scenario ( #4) where we assume what we considered to be the maximum
default rates on both real estate and personal loans extended by banks in 2008, average total
CAR is marginally below the Central Bank's requirement, while the average Tier 1 capital ratio
remains above the Basel II floor.

Summary conclusions:
Avg NPL Avg Total Avg Tier 1 Cash provision shortfall for Tier 1 capital
ratio (%) Capital (%) Capital (%) 100% NPL coverage (AED bn) requirements
(AED bn)
Actual FY 09 3.3 19.1 14.2
Base case Scenario 8.4 14.9 9.8 42.5 2.5
Scenario 1 9.1 14.4 9.2 47.8 5.4
Scenario 2 9.5 14.1 8.9 50.1 5.1
Scenario 3 10.6 13.2 8.0 58.4 9.2
Scenario 4 12.3 11.8 6.5 71.3 15.8
Source: SHUAA Capital

1 Except Abu Dhabi Commercial Bank (ADCB) and Dubai Islamic Bank (DIB) out of our eight UAE banks sample
2 Total capital adequacy is Tier 1 plus Tier 2 capital. The UAE regulatory minimum was set at 12% by end-June 2010, and the Basel II minimum is 8%. For Tier 1 capital alone, the
UAE minimum requirement is currently 8% and the Basel II minimum is 6%.

August 1st, 2010 3


UAE Banks Put To The Test

While the banks on average are well capitalized, some individual banks would need
additional capital injections to meet the central bank’s regulatory requirements in all our
scenarios.

In scenario #4 for example, the average NPL ratio rises to a still reasonable 12.3%, but five out of
the eight banks would then need combined core capital injections of AED 15.8bn (USD 4.3bn) to
meet the UAE's regulatory minimum.

However, in this (unlikely) event, we have no doubt that the UAE authorities would
provide the required financial support to these banks, particularly as the government has
already stepped in to recapitalize some UAE banks at the height of the financial crisis.

Following our analysis and before recommending steps that local authorities could take to
encourage banks to lend, we considered recent steps that have been taken by other countries
whose banks have been heavily exposed to a sharply contracting real estate sector: Ireland
and Spain. Spain has focused on restructuring and merging its most exposed banks and
implementing stricter provisioning criteria, while Ireland recapitalized its banks and transferred
the toxic real estate assets from commercial banks to a specially created National Asset
Management Agency.

Adopting the Spanish approach would mean significant up-front costs in terms of greater
provisioning for UAE banks – our base case analysis suggests AED 42.5bn would be needed
to ensure 100% NPL coverage, although this would rise to AED 71.3bn under our worst case
scenario. This would not only have a negative impact on banks’ profitability in the short term, but
would leave the banks relatively vulnerable in the event of a negative shock.

The Irish approach is one that is in our view more appropriate for the UAE, particularly
considering the relatively strong fiscal position the UAE benefits from, especially compared with
the high budget deficits and debt levels in many European countries. By transferring banks’
riskiest assets into a state-managed agency, and replacing them with lower risk government
securities, the banks would be in a much stronger position to resume lending to key sectors of
the economy and support the nascent economic recovery. In our view, some combination of the
two approaches would most likely be the most optimal solution.

Supply-side measures to encourage bank lending, such as government guarantees to


support financing to sectors and businesses with long-term strategic importance, could
also be considered. However, we believe such supply-side incentives should be used with
caution, to ensure that capital is allocated efficiently, and to sectors and businesses that will
generate the greatest economic value going forward.

In our view however, broad structural and economic reform to encourage private sector
and foreign investment in the UAE is likely to yield greater benefit over the longer term.
Structural reforms, including greater transparency, improved corporate governance and a
stronger regulatory framework in the financial sector and broader economy would contribute to
greater investor confidence and – ultimately – improved access to funding (both for banks and
other corporate entities) at better terms. In a post-crisis world where commercial banks are more
risk averse, their ability to attract long-term funding at good rates is a key element for sustainable
credit and economic growth.

August 1st, 2010 4


UAE Banks Put To The Test

Post-crisis recovery in private sector credit has been slow


Outbreak of the current crisis and policy responses to date

Private sector credit growth in the UAE declined sharply in 2009 as a result of both
external and UAE specific developments. The global financial crisis and subsequent liquidity
crunch was a catalyst for the sharp decline in the UAE’s real estate sector from Q4 08. The
tight liquidity conditions and high risk aversion also contributed to the inability of UAE-based
government and corporate entities to refinance debt falling due at reasonable rates, triggering
several high profile debt restructurings.

The sharp decline in UAE credit growth in 2009 was expected, considering the weak economic
environment. The additional provisions booked to reflect risks on existing risky exposures as
well as in anticipation of losses associated with high-profile debt defaults and restructurings
(especially related to Saad/ Al Gosaibi and Dubai World (DW)) had an undeniable impact on
banks’ willingness and ability to lend to the private sector.

Many governments in the region, including in the UAE, took measures to strengthen
banks' balance sheets and improve liquidity at the height of the financial crisis. In Qatar,
the government used a two-pronged strategy to clean up domestic banks’ balance sheets: they
purchased USD 1.8bn worth of banks’ local equity portfolios as well as USD 4.1bn of the real
estate assets of nine local banks. In return, banks received a mixture of both cash and long-term
government bonds, with the option to repurchase some or all of their real estate portfolios.3

In the UAE, the Central Bank tackled the crisis by providing a blanket guarantee on local banks’
deposits and an emergency interbank facility to alleviate short-term liquidity needs. The Ministry
of Finance followed suit with a AED 70bn long-term deposit facility, AED 50bn of which was
injected into UAE banks’ balance sheets with an option to convert these funds into Tier 2 capital,
while the remaining AED 20bn is still available. In addition, Abu Dhabi’s government supported
its domestic banks by offering AED 16bn non-dilutive Tier 1 capital to five Abu Dhabi players:
National Bank of Abu Dhabi, Abu Dhabi Commercial Bank, Union National Bank, Abu Dhabi
Islamic Bank, and First Gulf Bank.

With most of the uncertainty surrounding the DW debt restructuring being resolved
following the March 25th, 2010 announcement, we had expected private sector credit
in the UAE to recover during Q2 2010. However, this recovery has been slower than
expected, and is lagging other countries in the region, such as Qatar. Although we do not have
comprehensive data on private sector credit beyond April 2010, commercial banks’ overall loans
and advances added a mere 0.4% in Q2 10, implying that private sector credit growth has been
weak during that period.

3 Source: IIF country report: Qatar; September 2009

August 1st, 2010 5


UAE Banks Put To The Test

UAE private sector credit growth


60

50

40
% YoY

30

20

10

0
Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10
Source: UAE Central Bank, SHUAA Capital

What have UAE banks done with their liquidity?

In Qatar’s case, it has been argued by some commentators that on average, banks were more
conservative in their lending prior to the financial crisis, making them less vulnerable. Moreover,
the government’s recapitalization measures were sufficient to allow banks to start lending again
as soon as economic conditions started to improve.

Banks in the UAE also benefited from significant capital and liquidity injections. However,
it seems that they have been more risk averse than their Qatari counterparts, preferring to
hoard their cash, or improve their net foreign asset position by paying down foreign debt and
accumulating foreign assets.

Most of UAE banks' loans originated in FY09 appear to have been extended to the
government and public sector enterprises, rather than to the private sector. This
phenomenon of the government’s “crowding out” of private sector borrowing suggests, in our
view, either a “flight to quality” in that the government is seen as a safer bet than the private
sector; or a reflection of the fact that most local banks are owned by the government or
prominent families and these stakeholders have priority over whatever funds are available for
lending. We favor the latter explanation.

Public sector credit growth crowds out the private sector


60
Public sector credit
50 Private sector credit

40

30
% YoY

20

10

0
Jul-09
Jan-09

Jan-10
Mar-09

Mar-10
Apr-09

Apr-10
Jun-09
May-09

Sep-09
Feb-09

Feb-10
Oct-09
Aug-09

Nov-09
Dec-08

Dec-09

Source: UAE Central Bank, SHUAA Capital


* October and November 09 data is not available

August 1st, 2010 6


UAE Banks Put To The Test

Is the UAE banking sector solid enough to weather the


storm?

Aims and Methodology

Based on reported banking statistics, the UAE banking sector appears to be well
capitalized, and with manageable NPL ratios. Our paper considers how UAE banks would
fare under stringent default assumptions.

We selected a pool of eight leading UAE banks as a sample for our analysis. These eight
players, which accounted for almost 70% of UAE banking system total assets as of 2009, are the
following: Emirates NBD (ENBD), National Bank of Abu Dhabi (NBAD), Abu Dhabi Commercial
Bank (ADCB), Mashreqbank (Mashreq), First Gulf Bank (FGB), Dubai Islamic Bank (DIB), Union
National Bank (UNB) and Commercial Bank of Dubai (CBD). Within this universe, we made the
distinction between Abu Dhabi and Dubai banks as the latter are exposed to greater risks,
specifically due to their exposure to Dubai’s real estate sector.

Our starting point is to identify the key risks threatening UAE banks’ solvency today. On
the balance sheet, real estate (RE) financing and personal loans are unsurprisingly the primary
suspects. In our view, property and personal loans originated in 2008 are the riskiest exposures
on banks’ balance sheets. Those loans were extended in a frantic economic climate marked by
low interest rates and stretched liquidity positions. 2008 also marked the peak of the property
boom in the UAE (as shown in the graph below). Finally, we note that lending practices in
pre-crisis 2008 were much more relaxed, with relatively weak creditworthiness assessment
procedures in place and "name lending" very common; making most loans extended in 2008
riskier than those extended post-crisis.

Dubai housing price index: quarterly


250
216
206 2008 real estate loans have lost
199
200 on average 33-50% and are
178 currently in negative equity

150
Index Points

120 125 119


117 117 114 115 114
107
100
100

50 2007 real estate loans remain in positive


equity hence were not incoporated in NPL
additions
0
Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09 Q4 09 Q1 10 Q2 10
Index points 100 117 120 125 178 206 216 199 117 107 114 115 119 114
% change 17% 3% 4% 42% 16% 5% -8% -41% -9% 7% 1% 3% -4%

Source: Colliers International

August 1st, 2010 7


UAE Banks Put To The Test

Interestingly and as shown in the graph below, 55% of our pool's FY08 loan additions were
extended to the real estate sector (23%) and to the consumer segment (31%). FGB
displayed the highest share with 72%, followed by UNB and ADCB with 63%. On the other hand,
only 27% of Mashreq's FY08 loan additions were intended for real estate and personal loan
financing. These statistics are important as the outcome of our "stress test" is directly
linked to the lending patterns of each of these banks during 2008.

RE & Personal loans as % of FY08 total loan additions


80%
FY08 RE additions 72%
70% FY08 Personal Loan additions
Total 63% 63%
60% 57%
55%
49% 50% 49%
50%
. 45% 43%
40%
34% 35%
33% 31%
30% 27% 29%
24% 26%
23% 22% 23%
20% 20%
20% 18%
13%
10%
10% 7%

0%
Mashreq DIB ENBD NBAD CBD ADCB UNB FGB Total

Source: Banks' financials, SHUAA Capital

We also considered other selected risks in our retrospective. Doubtful exposures to Saad
and Al Gosaibi groups and to DW entities have been taken into consideration, as well as the
black box represented by "renegotiated loans", significant on banks’ balance sheets by the end of
2009.

We estimated all these risky assets at AED 148bn, that is 20.4% of our pool's aggregated loan
book as of FY09.

FY 09 aggregated gross loan book of our pool


RE & Personal loans
FY 08 additions
14.1%

Estimated DW
exposure
2.9%

Estimated Saad/
AHAB exp
0.5%

Reported FY 09
renegotiated loans
2.9%

Other loans
79.6%

Source: Banks' financials, SHUAA Capital

August 1st, 2010 8


UAE Banks Put To The Test

Our base case scenario assumes the following:


Renegotiated loans FY08 RE loan FY08 personal loan DW est.
additions additions exposure
Dubai banks est. default rate (%) 25 50 50 20
Abu Dhabi banks est. default rate (%) 25 50 30 20
Source: SHUAA Capital

The next step in our methodology was to consider various scenarios where the above key
risks were assigned different rates of default translating to further provisioning charges and
direct losses. In the cases where additional provisioning was necessary, we measured the impact
this would have on banks’ asset quality ratios (NPLs and provision coverage), capital adequacy
levels (Tier 1 and total capital) and profitability.

Base Case Scenario Impact Assessment

Under our base case scenario, the NPL ratio of our pool of UAE banks jumps to 8.4% from actual 3.3% as of FY09.

NPL ratio impact assessment


Average 3.3%
8.4% Actual FY09
2.2% Estimated
Commercial Bank of Dubai 9.7%
Union National Bank 1.5%
7.9%
Dubai Islamic Bank 6.0%
7.9%
Abu Dhabi Commercial Bank 5.2%
10.7%
MashreqBank 7.3%
7.7%
First Gulf Bank 3.5%
11.5%
National Bank of Abu Dhabi 1.2%
6.7%
Emirates NBD 2.4%
7.2%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%

Source: Banks' financials, SHUAA Capital

On capital adequacy, seven out of eight banks remain well capitalized with average total CAR
going down to a still comfortable level of 14.9% from an actual 19.1%. Only ADCB's total capital
ratio stands marginally below the Central Bank's 12% minimum and would need just AED 190mn
(USD 52mn) in additional capital to meet this requirement.

Total CAR impact assessment


Average 19.1%
14.9% Actual FY09
Estimated
Commercial Bank of Dubai 20.2%
15.2%
Union National Bank 20.7%
16.7%
Dubai Islamic Bank 17.5%
14.9%
Abu Dhabi Commercial Bank 11.9% 17.4%

MashreqBank 20.2%
18.3%
First Gulf Bank 22.6%
16.7%
National Bank of Abu Dhabi 17.6%
13.4%
Emirates NBD 18.7%
14.9%
5.0% 10.0% 15.0% 20.0% 25.0%

Source: Banks' financials, SHUAA Capital

August 1st, 2010 9


UAE Banks Put To The Test

Similarly, average Tier 1 capital would still be above the Central Bank's minimum requirement at
9.8% down from an actual level of 14.2%. ADCB and Emirates NBD would require AED 2.0bn (USD
535mn) and AED 492mn (USD 134mn) of core capital respectively.
Tier 1 Capital impact assessment
Average 14.2%
9.8% Actual FY09
Estimated
Commercial Bank of Dubai 14.1%
8.7%

Union National Bank 15.5%


11.2%

Dubai Islamic Bank 12.4%


9.7%

Abu Dhabi Commercial Bank 6.5% 12.4%

MashreqBank 14.0%
12.0%

First Gulf Bank 19.2%


13.1%

National Bank of Abu Dhabi 16.0%


11.8%

Emirates NBD 7.8% 11.9%

5.0% 10.0% 15.0% 20.0% 25.0%

Source: Banks' financials, SHUAA Capital

However, it is important to note that in our base case scenario, all the banks in our pool
comply with Basel II international standards on both core and total capital.

Four alternative scenarios

We derived four alternative scenarios from our base case picture by increasing the default
rate on each of the key-risk factors (renegotiated loans, real estate, personal loans). As we
assume renegotiated loans include a portion of real estate and personal financing, we set the
maximum default rate on that category at 50%. We also distinguish Dubai from Abu Dhabi banks
for real estate financing, as the Dubai real estate slump puts Dubai-based lenders more at risk on
that front.
Scenario #4 is our “worst case”, where we have set maximum default rates on real estate and
personal loans extended in 2008 at 100% for Dubai banks, and at 70% and 60% respectively for
Abu Dhabi banks. We have conservatively maintained the assumed haircut on DW at 20% in all
scenarios as the proposed debt restructuring agreement suggests losses of that magnitude at worst.

Table of assumptions:
Renegotiated loans FY08 RE loan FY08 personal loan DW est.
additions additions exposure
Dubai banks - Estimated default rate (%)
Base Case Scenario 25 50 50 20
Scenario #1 50 50 50 20
Scenario #2 - 100 50 20
Scenario #3 - 50 100 20
Scenario #4 - 100 100 20
Abu Dhabi banks - Estimated default rate (%)
Base Case Scenario 25 50 30 20
Scenario #1 50 50 30 20
Scenario #2 - 70 30 20
Scenario #3 - 50 60 20
Scenario #4 - 70 60 20
Source: SHUAA Capital

August 1st, 2010 10


UAE Banks Put To The Test

Results

The results of our analysis show that from the base case scenario to scenario #4, the
average NPL ratio for the eight UAE banks gradually increases from 8.4% to a maximum
of 12.3%.

NPL ratio impact assessment


14.0%
FY 09 Actual NPL ratio (%)
12.3%
12.0% Commonwealth of 12.1
Independent States
10.6%

10.0% 9.5%
9.1%
8.4%
8.0%
CCE 7.5
MENA 6.6
6.0% Sub-Saharan Africa 6.5

3.3%
4.0% UAE 4.6
Advanced Economies 4
Western Hemisphere 3.7
2.0%
Developing Asia 2.2

0.0%
Actual FY 09 Base case Scenario 1 Scenario 2 Scenario 3 Scenario 4
Scenario
Source: IMF, SHUAA Capital

In terms of solvency and despite all the stress on NPLs and provisioning under our different
scenarios, the UAE banking system effectively proves its capacity to absorb significant losses.
In fact, average total CAR ranges between 14.9% and 11.8% and remains well above
the regulatory minimum set by Basel II (8%), although the 12% UAE floor is marginally
breached in scenario #4.

Total Capital impact assessment


25.0%

20.0% 19.1%

14.9%
14.4% 14.1%
15.0% 13.2%
CB min. requirement 11.8%

10.0%
Basel II min. requirement

5.0%

0.0%
Actual FY 09 Base case Scenario Scenario 1 Scenario 2 Scenario 3 Scenario 4

Source: SHUAA Capital

August 1st, 2010 11


UAE Banks Put To The Test

Average Tier 1 capital for our sample remains well above Basel II requirements (6%), and
would only be below the UAE minimum in scenario #4.

Tier 1 capital impact assessment


16.0%
14.2%
14.0%

12.0%
9.8%
10.0% 9.2%
8.9%
CB min. requirement 8.0%
8.0%
6.5%
Basel II min. requirement
6.0%

4.0%

2.0%

0.0%
Actual FY 09 Base case Scenario Scenario 1 Scenario 2 Scenario 3 Scenario 4

Source: SHUAA Capital

The averages look good, but the devil is in the detail...

Our findings are summarized in the table below.

Table of results
Avg NPL Avg Total Avg Total Avg Tier 1 Cash provision Capital injections
ratio Capital Capital Capital shortfall for 100% required to meet
(%) (%) excl. injections (%) NPL coverage 8% Tier 1 minimum
in 08/09 (%) (AED bn) (AED bn)
Actual FY 09 3.3 19.1 11.8 14.2
Base case Scenario 8.4 14.9 6.6 9.8 42.5 2.5
Scenario 1 9.1 14.4 6.0 9.2 47.8 5.4
Scenario 2 9.5 14.1 5.7 8.9 50.1 5.1
Scenario 3 10.6 13.2 4.8 8.0 58.4 9.2
Scenario 4 12.3 11.8 3.3 6.5 71.3 15.8
Source: SHUAA Capital

Even though the average CARs remain above the regulatory floors in our base case, some
of the banks in our sample would need further core capital injections in all our scenarios.
The amounts range between AED 2.5bn (USD 669mn) in the base case to AED 15.8bn (USD
4.3bn) under our most conservative scenario #4.

However, column 3 in the table above illustrates the importance of the authorities' capital
injections to the banking system at the height of the liquidity crisis in the form of core
Tier 1 capital (AED 16bn) and Tier 2 MoF long-term funds (AED 50bn). Without these capital
injections, average total CAR would already be below the 12% UAE regulatory minimum, and
would be below the Basel II floor of 8% in all our scenarios.

August 1st, 2010 12


UAE Banks Put To The Test

According to the various scenarios and implied NPL ratios, our pool of UAE banks would
need to recognise between AED 42.5bn (USD 11.6bn) and AED 71.3bn (USD 19.4bn) in
additional provisions to achieve 100% NPL coverage.

Fully writing-off banks’ riskiest exposures would have a significant negative impact on
their short-term profitability, which would not be well-received by shareholders. On the other
hand, it may be argued that the thorough immediate clean-up of UAE banks would send a highly
positive signal to the international investor community, as it would contribute to improved
transparency and help to restore confidence in the UAE banking system.

Tier 1 capital requirements based on UAE Central Bank floor of 8%


8.0
7.3
7.0
6.0 6.0
6.0
5.0
AED bn

4.0 3.4 3.2


3.0
2.0 2.0 2.0
2.0 1.6 1.7
1.2
1.0 0.5 0.7
0.2 0.1 0.1
-
DIB

DIB
CBD

CBD

CBD
Emirates

Emirates

Emirates

Emirates

Emirates
ADCB

ADCB

ADCB

ADCB

ADCB
FGB
NBD

NBD

NBD

NBD

NBD
Base case Scenario 1 Scenario 2 Scenario 3 Scenario 4
scenario

Source: SHUAA Capital

The chart above illustrates which banks would need additional Tier 1 capital, based on
our set of assumptions, to meet the Central Bank's requirements. Emirates NBD and ADCB
would require negligible combined core capital injections of AED 2.5bn (USD 669mn) in the base
case, increasing to AED 5.4bn (USD 1.5bn) in scenario #1.

In scenario #2, Emirates NBD, ADCB, DIB, and CBD would fall AED 5.1bn (USD 1.4bn) short, while
in scenario #3, the same banks excluding DIB would need combined core capital injections of
AED 9.2bn (USD 2.5bn).

In scenario #4 (the unlikely scenario where we assumed our maximum default rates on real
estate and personal loans extended in 2008), Mashreq and UNB are the only ones complying
with both the Tier 1 (8%) and total capital (12%) requirements set by the Central Bank. While
UNB's capital base proves resilient to our series of tests, , Mashreq benefits from its relatively
limited exposure to 2008 real estate and personal loan financing. As mentioned earlier, only 27%
of the bank's new loans were extended to both segments, compared with an average of 58% for
the other seven banks.

In this scenario, NBAD meets the Tier 1 requirements but needs an additional AED 900mn in Tier
2 capital to meet the 12% minimum for total CAR. And while FGB would need a mere AED 95mn
of core capital to meet Central Bank standards, the other four banks require AED 15.7bn (USD
4.3bn) of extra Tier 1 capital.

August 1st, 2010 13


UAE Banks Put To The Test

We note that the UAE's minimum CAR requirements (both for Tier 1 and total capital)
are much stricter than Basel II international standards, which the European Central Bank
(ECB) has used as the benchmark in its recent stress tests on European banks.

Based on Basel II Tier 1 capital requirement of 6%, only ADCB would require additional funds,
estimated at a mere AED 654mn (USD 178mn) under scenario #2 rising to AED 3.5bn (USD
955mn) in scenario #3, along with AED 578mn (USD 157mn) for CBD.
Our “worst case” scenario would find three lenders in our pool falling short: Emirates NBD (AED
1.9bn), ADCB (AED 4.8bn), and CBD (AED 1.1bn) would require core capital additions estimated at
AED 7.7bn (USD 2.1bn).

Tier 1 capital requirements based on Basel II floor of 6%


6.0

5.0 4.8

4.0
3.5
AED bn

3.0

2.0 1.9

1.1
1.0 0.7 0.6

-
ADCB ADCB CBD ENBD ADCB CBD
Scenario 2 Scenario 3 Scenario 4
Source: SHUAA Capital

We have no doubt that the UAE government stands ready to provide any additional
capital that may be required to ensure that these individual banks remain sufficiently
capitalized. Indeed, the authorities have already injected AED16bn in non-dilutive Tier 1 capital
into Abu Dhabi banks at the height of the financial crisis. The estimated core capital shortfalls are,
even in our worst case scenario, undoubtedly manageable, especially when we consider that the
Ministry of Finance still holds AED 20bn (USD 5.5bn) out of the original AED 70bn emergency
facility.

August 1st, 2010 14


UAE Banks Put To The Test

Dealing with the fallout of a financial crisis: drawing on


international experience

UAE banks are not alone in facing the consequences of the global financial crisis. Authorities
around the world have responded in different ways to stabilize and limit the impact of the crisis
on their own banking systems and economies. We believe the cases of Ireland and Spain are
worth examining in particular, as like the UAE, the Irish and Spanish banks were highly exposed
to collapsing domestic real estate markets.

De-risking Irish banks

Ireland’s financial sector was heavily exposed to the real estate sector, which had fuelled the
Celtic Tiger’s growth in the decade preceding the financial crisis. More than 75% of the six
Irish banks’ total loans were reportedly secured against property4. Some banks, such as Anglo
Irish Bank had most of their loan portfolio extended to developers and builders, the riskiest
group of real estate borrowers. The Irish government used two key measures to prevent the
country’s largest banks from going insolvent:

1/ They capitalized the banks in return for equity, in some cases (such as Anglo Irish)
nationalizing the banks outright,
2/ They created a National Asset Management Agency (NAMA), to take on the riskiest assets
of the banks, mainly real estate backed loans, in return for government securities. These loans,
with an estimated face value of EUR 80bn as of March 2010, were purchased at a discount by
NAMA, and will be managed over a 7-10 year period to maximize the return for the taxpayer.
The loans taken on by NAMA were not all non-performing; they were simply the highest risk
loans on the banks’ balance sheets.

The aim of these measures was not to liquidate or write off the banks’ portfolios, but to
remove these high risk assets from banks' balance sheets and replace them with low risk
government securities. In doing so, banks would be encouraged to resume "normal" lending
to businesses and households, thus supporting an overall economic recovery in Ireland. As
the process of transferring the loans to NAMA was only started in March 2010, and will take
several months to complete, it is still too soon to say how effective this measure has been in
contributing to private sector credit growth in Ireland.

It is important to note that the financial crisis and collapse in the Irish real-estate sector also
had a significant and direct impact on the country’s fiscal position. During the boom years,
the Irish budget became overly-reliant on revenues from real estate taxes and fees, which
were used to finance increased expenditure in other sectors (health, education and social
spending). As a result, when the financial crisis hit, Ireland had to deal with the “double
whammy” of bailing out its insolvent banks as well as financing a gaping hole in its budget
revenues. The Irish government budget balance consequently moved from a small surplus in
2007 to 14.3% of GDP deficit in 2009.

Source: NAMA, Eurostat, Wikipedia


4 Irish Independent, January 16, 2009

August 1st, 2010 15


UAE Banks Put To The Test

Spanish banks restructure and take stricter provisions.

Spain’s banking system was relatively immune from the US subprime crisis, and has only started
tackling the issues facing its banking sector in the last few months. About 45% of Spain’s
financial sector is made up of small, regional, unlisted savings banks known as cajas. Many of
these have large exposures to Spain’s real estate sector, which has also experienced a sharp
contraction since Q4 2008, and have found it very difficult to roll over their maturing debt in
the wake of the Greek crisis.

The Spanish authorities are encouraging the cajas to restructure and merge with each other
and with the larger commercial banks, to reduce inefficiencies and improve their balance
sheets. In addition, the central bank has introduced stricter provisioning rules: lenders now
have to set aside provisions for the full value of each bad loan within one year of default, rather
than the previous 2-6 year provision period. However, the value of underlying assets can be
taken into account when calculating the provisions, albeit at a discount which depends on the
type of asset on which the loan is secured. Provisioning requirements on real estate assets that
have been held for over 2 years have also been increased, which has had a big impact on the cajas.

Even with the restructuring of the banking system, it is expected that some banks and cajas
will need to be recapitalized, although estimates vary depending on the assumptions made. In
its April 2010 Global Financial Stability Report, the IMF estimated the cajas would need about
EUR 17bn of capital under an “adverse case scenario”; these estimates were made under the
old provisioning rules so under the new provisioning rules, we would expect this figure to be
higher. However, in its recently released stress test on European banks, the ECB indicated that
seven European banks (five of them Spanish) would need only EUR 3.5bn of additional capital.
This difference in estimates reflects the very different underlying assumptions made by the IMF
and the ECB.
Source: IMF, Financial Times

August 1st, 2010 16


UAE Banks Put To The Test

Conclusions and recommendations


Based on our stress test, we believe UAE banks are overall sufficiently capitalized to face
significant deterioration in their asset quality. Even in our “worst case” scenario, the average
total capital ratio is only marginally below the 12% UAE minimum; and average Tier 1 capital of
our pool remains above the 6% Basel II floor. This is a better than expected result, and should
help alleviate some concerns about the robustness of the UAE banking system.

Nevertheless, under our most conservative default assumptions, the average NPL ratio for our
sample rises to 12.3% from the current 3.3% and five out of our eight banks would require up
to AED 15.8bn (USD 4.3bn) of additional Tier 1 capital in order to comply with Central Bank's
regulation. We are confident that in this unlikely event, the required financial support will be
provided by the authorities.

As private sector credit growth is critical for a sustained economic recovery in the UAE,
the current situation should be addressed directly. Uncertainty about the extent of future
provisions and questions over banks’ ability to absorb potential losses will otherwise
linger, undermining confidence and making it more difficult for banks to attract much
needed funding to grow their loan books.

So what could be done to encourage banks to resume lending ?

We believe the Irish solution is one that should be seriously considered. Indeed, the
UAE enjoys a relatively strong fiscal position that should enable it to fund the creation of a
government-backed "bad bank" to host local lenders' most toxic assets. Qatar has implemented
a similar solution for banks' local equity and real estate exposures, which appears to have been
relatively successful. By removing some of the riskiest assets from UAE banks’ balance sheets
and replacing them with lower risk government paper, or cash, banks will be in a much stronger
position to attract funding and resume lending to households and businesses.

On the other hand, Spain’s conservative, immediate provisioning route would severely
impact banks’ earnings and profits should it be adopted in the UAE. Our analysis suggests
an additional AED 42.5bn (USD 11.6bn) – AED 71.3bn (USD 19.4bn) would allow banks to ensure
100% NPL coverage under our five scenarios. This would also leave the banks vulnerable in the
event of new, unexpected negative credit events. However, this does not mean that the UAE
authorities should rule out this option altogether - perhaps a combination of more rigorous
provisioning requirements together with isolating banks' "toxic" assets would be a feasible
alternative.

Other measures the government could implement to boost bank lending could include
offering incentives, such as government guarantees, to support lending to sectors and
businesses with long-term strategic importance. However, we believe such supply-side
incentives should be used with caution, to ensure that capital is allocated efficiently, and to
sectors and businesses that will generate the greatest economic value going forward.

In our view, broad structural and economic reform to encourage private and foreign
investment in the UAE is likely to yield greater benefit over the longer term. Structural
reforms, including greater transparency, improved corporate governance and a stronger
regulatory framework in the financial sector and broader economy would contribute to greater
investor confidence and – ultimately – improved access to funding (both for banks and other
corporate entities) at better terms. In a post-crisis world where commercial banks are more
risk averse, their ability to attract long-term funding at good rates will be a key element for
sustainable credit and economic growth.

August 1st, 2010 17


UAE Banks Put To The Test

APPENDIX
UAE FY09 asset quality metrics vs. other economies
NPL ratio (%)
16
14.8 14.7
2008 2009
14

12

10 9.7

8 7.5
6.4 6.6
6 6.0 6.0 5.7
5.5 5.6
4.6
4.2
4 3.3
2.8 2.5
2.1
2 1.5
1.1 1.3
0
Qatar Oman KSA UAE Morocco Lebanon Jordan Average Kuwait Egypt

Provision cover (%)


160
144 2008 2009
140
127
120 114
102
100
89 90
94 92 95
88
80 83
80 75 74 79
68
63 61 64
60
49
40

20

0
Jordan Lebanon Kuwait Morocco UAE Average Saudi Arabia Qatar Egypt Oman
Source: SHUAA Capital, IMF

UAE FY09 CAR vs. other economies

Total Capital Adequacy Ratio (%)


UAE 19.2
13.7
Commonwealth of Independent States 19.1
16.7
Western Hemisphere 16.7
16.1
Sub-Saharan Africa 16.7
17.0
Central and Eastern Europe 16.6
14.6
Middle East and North Africa 13.0
14.3
Developing Asia 10.9
12.7 2008 2009
Advanced Economies 10.9
11.6

- 5 10 15 20 25
Source: SHUAA Capital, IMF

August 1st, 2010 18


UAE Banks Put To The Test

Research

Economics Real Estate & Construction Telecom, Media & Technology

Khatija Haque Roy Cherry Simon Simonian, CFA


+9714 3199 752 +9714 3199 767 +9714 3199 763
khaque@shuaacapital.com rcherry@shuaacapital.com ssimonian@shuaacapital.com

Taher Safieddine
+9714 3199 715 Technical Analysis
Strategy tsafieddine@shuaacapital.com
Adel Merheb
Ahmad M. Shahin +9174 3199 793
+9714 3199 742 Transportation & Logistics amerheb@shuaacapital.com
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+9714 3199 757
kmurad@shuaacapital.com Ahmad M. Shahin
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+9714 3199 716 Nicole Chamat
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Ghida Obeid jestefane@shuaacapital.com
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gobeid@shuaacapital.com Kareem Z. Murad
+9714 3199 757 Jovan Ruseski
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jruseski@shuaacapital.com

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