UAE Banks’ Performance and the Oil Price Shock: Indicators for Conventional and Islamic Banks

Transcription

2. UAE BANKS ’ PERFORMANCE AND THE OIL PRICE SHOCK: INDICATORS FOR CONVENTIONAL AND ISLAMIC BANKS1 Magda Kandil2 and Minko Markovski3 Working Paper No. 1284 January 2019 Send correspondence to: Magda Kandil Central Bank of the UAE Magda.Kandil@CBUAE.gov.ae 1 The views expressed in this paper are those of the authors and should not be interpreted as those of the Central Bank of the United Arab Emirates. 2 Chief Economist and Head of Research and Statistics Department, Central Bank of the UAE, Abu Dhabi. PO Box 854, UAE. Tel: +971 2 691 5645, Fax: +971 2 665 8426. 3 Senior Research Analyst, Central Bank of the UAE, Abu Dhabi, PO Box 854, UAE. Tel: +971 2 691 5795, Fax: +971 2 665 8426, e-mail: Minko.Markovski@CBUAE.Gov.ae
3. First published in 2018 by The Economic Research Forum (ERF) 21 Al-Sad Al-Aaly Street Dokki, Giza Egypt www.erf.org.eg Copyright © The Economic Research Forum, 2018 All rights reserved. No part of this publication may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher. The findings, interpretations and conclusions expressed in this publication are entirely those of the author(s) and should not be attributed to the Economic Research Forum, members of its Board of Trustees, or its donors.
4. Abstract This study attempts to identify whether the oil price fall to a “new normal” in mid-September 2014 has had an impact on banks’ performance in the UAE, such as Return on Assets (ROA) and Return on Equity (ROE) in addition to credit and deposit growth. The sample is for a sample of 22 national banks in the country over a period of 15 quarters. The oil price fall has had a negative structural break impact on all four banking indicators. In addition, the analysis evaluates the difference in ROA, ROE and credit and deposit growth by bank type, conventional vs. Islamic banks, across the sample of 22 banks. The results indicate that Islamic banks have a higher lending and deposit growth rates, however conventional banks tend to have better indicators of performance. Further, the oil price fall has impacted banks’ performance adversely, and the growth of assets and liabilities as a result of the slowdown in economic activity, fiscal consolidation, and decreasing levels of employment and corporate profitability. Further, Islamic banks, judged by lending and deposit growth, have managed to tailor their products to cater to a growing demand. However growth objectives appear to have reduced the margins of return in Islamic banks, compared to conventional banks. Keywords: Islamic banks, conventional banks, United Arab Emirates, oil price fall, banks’ performance, loans, deposits JEL Classifications: E02, E31, E51, G01, G21, G29, Q43 and Q49 1
5. 1 . Introduction The Performance of the banking system should be assessed by developments on the assets and liabilities sides of the balance sheet. These developments are very much dependent on the macroeconomic environment. In oil-producing countries, economic activity is dependent on the oil price cycle that determines government revenues and spending, and available international reserves in support of liquidity in the banking system and exchange rate stability, as evident recently in the UAE (please see Figures 1 and 2 below). During an oil price boom, the economy is in strong expansion, supported by high government spending, ample liquidity in the banking system and strong sentiment by investors and the private sector. In this environment, the banking sector thrives, capitalizing on the supply of liquidity and robust demand for credit, resulting in a pickup in the growth of deposits and credit in support of growth of the non-energy sector. The reduction in the oil price that started in mid-2014 forced a reduction in oil revenues that triggered a sharp fiscal consolidation to accommodate the oil price. In parallel, the government leaned heavily on the banking system to finance spending, drawing down deposits and increasing its borrowing. As a result, liquidity fell, coupled with a reduction in international reserves at the CB attributed primarily to a reduction in oil exports. As the oil price continued to tumble, the central bank lost international reserves in 2016 and added reserves in 2017 with the recovery in the oil price. In parallel, government revenues recovered and the government began to reverse its strategy, easing the pace of fiscal consolidation and diversifying sources of financing. Hence, banking liquidity began to recover in mid-2016 and increased further in 2017. Unfortunately, the pace of fiscal consolidation impacted private sentiment adversely and slowed down credit demand. Hence, the recovery in deposits and liquidity in the banking system was coupled with a sharp reduction in credit growth that contributed to the slowdown of non-energy growth to reach its lowest level in 2017, following high growth in 2014 before the oil price shock. Figure 1. Selected Macroeconomic Indicators Growth (in %) 2
6. Figure 2 . Selected Banking Indicators Growth (in %) Source: Central Bank of the UAE, Ministry of Finance of the UAE, Federal Competitiveness and Statistics Authority (FCSA) Similarly, since the new era of “low for long” of the oil price that started in mid-2014, the banking sector in many oil-producing countries has experienced a slowdown in deposits that impacted liquidity, coupled with a slower demand for credit that have impacted credit growth and ultimately the growth of non-energy GDP. Hence, evaluating the impact of the oil price reduction on the capacity and the efficiency of the banking sector is at the heart of the diversification strategy of economies that have been traditionally dependent on oil endowments for liquidity, investors’ sentiment, growth and employment. Against this backdrop, Khandelwal, Miyajima and Santos (2016) examine the links between global oil price movements and macroeconomic and financial developments in the GCC. They find strong empirical evidence of feedback loops between oil price movements, bank balance sheets, and asset prices. The empirical evidence also suggests that bank capital and provisioning have behaved counter-cyclically. That is, regulators may have tried to avert the risks of tighter liquidity in connection to the lower oil price by easing constraints on the banking sector and activating a counter-cyclical macro prudential response. While the interest of this research is on the capacity of the banking system in the UAE to weather the implications of the decline in the oil price, the research will distinguish between conventional and Islamic banks. Islamic banks in the GCC countries have become systemically important and continue to increase their market penetration, outpacing conventional banks’ assets, lending and deposits growth. As GCC countries continue to grow Islamic banks, it is worthwhile to address the specificity of Islamic banks in contrast to the traditional model of conventional banks. The case of the UAE is of interest for the objectives of this research. The UAE had annual real non-energy growth of 6.4% at the end of 2014. Following persistent decline in the oil price, average annual non-energy growth reached 5% and 3.2% in 2015 and 2016, respectively, further declining to 2.5% in 2017. On the other hand, banks’ deposits and lending grew by 11.1% and 8% Y-o-Y respectively as of December 2014, while on average they grew Y-o-Y by 4.6% and 5.1% respectively for 2015-17. Lending grew by 11% and 7.9% Y-o-Y for Islamic and conventional 3
7. banks respectively as of December 2014 , while as of September 2018 lending grew by 3.7% and 3.6% Y-o-Y respectively (please see Tables 1 and 2 below). Deposits grew by 15.8% and 10% for Islamic and conventional banks respectively as of December 2014, while as of September 2018 deposits grew by 6.5% and 8.9% Y-o-Y respectively. Table 1. Loans Growth in the UAE (in %) Total Banking System Conventional Banks Islamic Banks 2014 Dec 2015 Dec 2016 Dec 2017 Dec 2018 Sept 8.0 7.7 6.0 1.7 3.7 7.9 5.9 5.1 0.7 3.7 11.0 14.9 9.4 5.6 3.6 Table 2. Deposits Growth in the UAE Total Banking System Conventional Banks Islamic Banks (in %) 2014 2015 2016 2017 2018 Dec Dec Dec Dec Sept 11.1 3.5 6.2 4.1 8.3 10.0 0.2 6.6 2.4 8.9 15.9 16.7 4.9 10.1 6.5 Source: Central Bank of the UAE Clearly, the decline in the oil price resulted in decline in liquidity and government spending. The combined effect has had an adverse impact on investors’ sentiment, slowing down the demand for credit. While liquidity has improved more recently, supported by recovery of government deposits against the backdrop of diversifying sources of financing the deficit, the initial pace of fiscal consolidation, coupled with recent decline in credit growth, have weighed in negatively on economic activity, slowing down non-energy growth. The slowdown was evident across the balance sheets of both types of banks in the UAE, conventional and Islamic. Nonetheless, Islamic banking has been growing as a share of the total banking sector in the UAE. Between December 2013 and September 2018, the shares of Islamic banks in total assets, lending and deposits have increased from 17.3%, 17.3% and 19.2% respectively to 20.4%, 22.6% and 23.2% respectively (Please see Table 3 below). Table 3. Share of Total of Conventional and Islamic Banks (in %) Assets Loans Type of Bank Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Sep-18 Conventional 82.7 82.3 81.1 80.5 79.6 79.6 Islamic 17.3 17.7 18.9 19.5 20.4 20.4 Conventional 82.7 80.6 79.1 78.4 77.6 77.4 4
8. Deposits Islamic 17 .3 19.4 20.9 21.6 22.4 22.6 Conventional 80.8 80.0 77.4 77.7 76.4 76.8 Islamic 19.2 20.0 22.6 22.3 23.6 23.2 Source: Central Bank of the UAE Moreover, the potential for further growth is promising as Dubai strives to position itself as the capital of Islamic finance in the region. Further, zeroing in on indicators of financial soundness, between conventional and Islamic banks before and after the drop in the oil price, there is a case to differentiate the analysis based on the type of banks. Indeed, there is a difference in Financial Soundness Indicators (FSIs) between Islamic and conventional banks in the period pre and post the oil price fall (see Tables 4 and 5 below). For instance, both conventional and Islamic banks had a higher level of CAR or Tier 1 Capital pre the oil price drop than after. Similarly, Lending to Stable Resources Ratio increased after the chute of the oil price, reflecting slower growth of liquid assets, relative to credit growth which was initially robust as banks faced tighter liquidity. However, the liquid assets ratio (LAR) improved for conventional banks, while it deteriorated for the Islamic ones, mainly due to the strategies of Islamic banks for faster growth of investments and credit, which may have been intensified by the decline in credit demand more recently. Table 4. FSIs for Islamic banks (in %) 2013 Dec Lending to Stable 81.2 Resources Ratio Liquid Assets Ratio 20.6 (ELAR) Capital Adequacy Ratio 17.6 (CAR) Tier 1 Capital 16.7 Source: Central Bank of the UAE 2014 Dec 2015 Dec 2016 Dec 2017 Dec 2018 Sept 85.8 86.1 86.7 83.1 80.8 17.0 17.0 16.8 20.0 18.7 15.8 15.6 17.1 16.4 17.5 15.0 14.9 16.5 15.3 16.3 Table 5. FSIs for conventional banks (in %) 2013 Dec 2014 Dec 2015 Dec 2016 Dec 2017 Dec 2018 Sept Lending to Stable Resources Ratio 85.5 85.1 87.3 86.1 85.0 82.8 Liquid Assets Ratio (ELAR) 13.4 15.4 17.5 16.0 17.7 15.2 18.9 19.3 18.5 18.4 16.9 17.4 16.9 17.0 Capital Adequacy 19.6 18.6 Ratio (CAR) Tier 1 Capital 17.0 16.5 Source: Central Bank of the UAE 5
9. Based on the significance of the banking sector in the UAE , the largest in the Middle East with assets exceeding US$772 billion, it is important to understand the role of the banking sector to support the country’s strategy of further diversification and growth in the non-energy sector. More importantly, realizing differences in the business model, we aim to study the difference in the performance of conventional and Islamic banks as it relates to credit and deposit growth and other indicators of banks’ return. Specifically, the study will consider indicators of banks’ performance and financial soundness (measured by Return on Assets (ROA) and Return on Equity (ROE)) coupled with intrinsic FSIs, such as non-performing loans ratio (NPLs) and capital adequacy ratio (CAR)). The evaluation of developments in banks’ balance sheets will capture the linkages between banking indicators and the relevant UAE macroeconomic variables that capture the channels through which fluctuations in the oil price are propagated into the banking sector with a reverse causation to non-energy growth. The paper will present in section 2 the literature review, followed by section 3, where the data outline and overview are presented. In section 4, the analytical framework will be presented along with the results from the econometric analysis. Section 5 summarizes the paper’s analysis and the policy implications. 2. Literature Review The research will build on previous studies that have differentiated the types of banks based on the business model, conventional and Islamic. Olson and Zoubi (2008) distinguished between conventional and Islamic banks in the Gulf Cooperation Council (GCC) region on the basis of financial characteristics alone. They put 26 financial ratios into logit, neural network and K-means nearest neighbor classification models to determine whether these ratios distinguish between the two types of banks. Their results indicate that measures of bank characteristics such as profitability ratios, efficiency ratios, asset quality indicators and cash/liability ratios are relevant indicators that differentiate between Islamic and conventional banks in the GCC region. Abdul-Hamid and Azmi (2011) compared the financial performance between one Islamic bank and eight conventional commercial banks for the period 2000-2009. The financial measurements used in this research are profitability, risk and solvency, and community involvement. The study evaluated inter-temporal and interbank performance of the pioneer of Islamic banking in Malaysia. The authors used data for one Islamic bank for the period of 2000-2009 while the data used for eight conventional banks are from 2005 to 2009. The study found that while there is no significant difference in profitability during these two periods, the Islamic bank is relatively more liquid and less risky as compared to conventional banks. Masruki et al. (2011) analyzed and measured the performance of both Islamic and conventional banks in Malaysia over 5 years, 2004-2008. Their results showed that Islamic banks have less level 6
10. of profitability than conventional banks . Moreover, the results also indicated that conventional banks encountered high credit risk than Islamic banks. Ibrahim (2015) compared the financial performance of two UAE based Islamic and conventional banks between the years 2002 and 2006. Quantitative analysis was undertaken by looking at various sets of financial ratios that are routinely used to measure bank performance. The main ratios that were employed put a particular focus on the banks’ liquidity, profitability, management capacity, capital structure and share performance as reliable indicators of a bank performance. The findings showed that both types of banks performed reasonably well during the period studied. While the conventional bank benefitted by having an overall higher degree of liquidity, profitability, management capacity and capital structure, the Islamic bank was better with respect to performance indicators and in terms of overall stability. Ansari and Rehman looked at the performance analysis of Islamic and conventional banks located in Pakistan for the period 2006 to 2009. By utilizing eighteen different financial ratios to measure financial performance in terms of profitability, liquidity, risk and solvency, capital adequacy, deployment and operational efficiency, the authors found Islamic banks, compared to conventional banks, are highly liquid, less operationally efficient, and less risky. Metwally (1997) found similar results when they compared the performance of 15 interest-free banks and 15 conventional banks but claims that interest-free banks rely more heavily on their equity in loan financing and face difficulties in attracting deposits than conventional banks. Iqbal (2001), using data for the 1990-98 period, tested the performance of Islamic banking using both trend and ratio analysis. Islamic bank performance, compared with a “control group” of conventional banks “have done fairly well during the period under study.” According to Iqbal (2001), the growth of total deposits, including funds under management, of the Islamic bank industry grew at an annual rate of 8.8 percent during the early nineties. However, this rate of growth seemed to be declining during late nineties. Four possible reasons can explain this decline: First, during the 1980s the amount of immobilized funds was large since many Muslim clients did not want any interest dealings. As Islamic banking was introduced in the early 1990s, Muslim clients started dealing with these banks. Therefore, large amounts of immobilized funds were introduced to the formal sector. In the late 1990s, however, the growth of deposits declined since these savings found their way into Islamic banks’ coffers. Second, as Islamic banks became popular during 1990s, conventional banks started to offer Islamic products. Third, the establishment of Islamic Mutual Funds in the 1990s may have affected the growth of deposits in the 1990s. Finally, as the base gets bigger, it becomes difficult to maintain a given rate of growth (2001). Merchant (2012) examines the performance of Islamic and conventional banks based in the GCC during the period of 2008-2011 by using the CAMEL (Capital adequacy, Asset quality, 7
11. Management , Earnings, and Liquidity) testing factors. The objective of their study was twofold: First, is to analyze the performance of both types of banks during the crisis and after the crisis. Second, is to evaluate steps that have been taken by banks to reduce the effect of the crisis. Over the four-year crisis, Islamic banks were better capitalized but have performed low in terms of profitability. When both types of banks were analyzed before and after the crisis, the authors found the performance of Islamic banks, using LLR (Loan Loss Reserves) as a measurement of asset quality, to be a significant indicator of risky portfolio after the crisis. In contrast, the conventional banks’ performance, using LLR and EQTA (Equity to Total Assets), indicated a risky portfolio and improved capital adequacy. Khandelwal et al. (2016) study the nexus between global oil prices and macroeconomic and financial developments in the GCC. They find that the performance of key indicators of business and financial cycles has generally strengthened during the oil price upturns. Moreover, the timing of downwards in those variables tends to coincide with oil price downturns. The paper’s econometric analysis finds that oil prices and economic activity significantly affect bank asset quality. The existence of oil-macro-financial feedback linkages suggests greater needs to build buffers in good times in the GCC. Building buffers is essential to cushion against negative shocks. Moreover, rising capital and provisions in good times helps enhance the resilience of the financial system and reduce pro-cyclical feedback effects between asset prices and credit. Both the capital and provisioning ratios increase as indicators of business and financial cycles strengthen. Building on existing literature, the focus of the analysis in this paper is on testing whether there is a difference in indicators of performance for listed banks on the two UAE stock exchanges, based on the type of banks, conventional and Islamic, and the impact of the decline in the oil price on banks’ indicators at large. The sample comprises national banks4 only, based on indicators of performance that comprise the growth of loans and deposits as well as return on assets and equity. To assess the implications of the oil price decline, the analysis considers the period December 2013 to June 2014, using quarterly data, compared to the period after the fall of the oil price (September 2014 to June 2017). The analysis evaluates the macroeconomic channels through which the decline in the oil price has impacted the performance of the banking sector in the UAE and the specifics of the business model that may have differentiated the performance of the two types of banks in coping with the “low for long” oil price. 3. Outline and Data Description The banking data under study are for the period Q4 2013 to Q2 2017, using panel data that consist of all 22 national banks in the UAE5: 21 listed banks on either ADX (Abu Dhabi Securities 4 The UAE banking system comprises 22 national banks and 37 foreign banks (with 11 banks being wholesale only). Most of the foreign banks operating in the UAE do not have the same structure of operations as national banks. Foreign banks mostly focus on corporate customers and their capital structure is very different, as well as their assets, deposits and loan size. More importantly, national banks represent close to 90% of total assets, loans and deposits in the banking system. 5 8
12. Exchange ) or DFM (Dubai Financial Market) and one non-listed bank using quarterly observations. There are 15 conventional and 7 Islamic national banks. As of end of September 2018 conventional banks have gross assets, deposits and loans of respectively USD 615bn (79.6% of the system’s assets), USD 361bn (76.8% of the system’s deposits) and USD 345bn (77.4% of all loans). Islamic banks have USD 158bn (20.4% of all assets), USD 109bn (23.2% of all deposits) and USD 101bn (22.6% of all credit in the system), respectively. Table 6. Key indicators of Banks operating in the UAE As of September 2018 in USD Bn if not otherwise specified Total Assets Loans Deposits CAR Conventional (% of Total) 615 (79.6%) 345 (77.4%) 361 (76.8%) 18.4% Islamic (% of Total) 158 (20.4%) 101 (22.6%) 109 (23.2%) 17.5% Domestic (% of Total) 674 (87.2%) 394 (88.3%) 416 (88.3%) 17.9% Foreign (% of Total) 99 (12.8%) 52 (11.7%) 55 (11.7%) 20.4% Government Ownership 8 banks more than 50% 14 banks less than 50% Type of Banks Listed on 15 Conventional 7 Islamic Source: Central Bank of the UAE, Bloomberg, ADX and DFM The data were extracted from reports of the Central Bank of the UAE, which contain financial performance, accounting data, information about lending and deposits, as well as FSIs regarding banks’ capitalization for all of the national banks in the UAE. In addition, the macroeconomic data used were extracted from official public sources and Bloomberg (for the Brent oil price6 and share of Government ownership in the banks). The variables of interest are bank specific data that include Return on Assets (ROA), Return on Equity (ROE), loans, deposits, high quality liquid assets excluding reserve requirements (HQLA), Capital Market Funding (CMF), Non-Performing Loans (NPLs), the Capital Adequacy Ratio (CAR), Government share in the bank and banks’ size. In addition, the analysis includes macroeconomic indicators of economic performance, Brent oil price, M3 monetary aggregate, Monetary Base, the weighted growth of the 10 main trading partners for the UAE, and the US Federal Funds Rate (FFR)7. 6 The Brent price is used to proxy the UAE oil price as suggested by the IMF in the 2016 Country Report 16/266, “United Arab Emirates: Selected Issues”. 7 Considering that the UAE dirham is pegged to the US dollar, the FFR proxies the direction of monetary policy in the UAE as the policy rate adjusts to the Federal Fund Rate. 9 6 on DFM 15 on ADX
13. The analysis evaluates the difference in banks’ indicators of performance including loans and deposits growth, pre and post the fall in the oil price in June 2014, and if there is a difference in performance between Islamic and conventional banks in the UAE.8 The total market capitalization of all national banks, for the listed ones, as of 30th June 2017 is USD 97.5bn, out of which USD 58.6bn of the listed banks are on the Abu Dhabi Exchange (ADX) and the remaining banks of a total of USD 38.9bn assets are listed on the Dubai Financial Market (DFM). In total, we have 330 bank-quarter observations for all the national banks included in the study. 4. Empirical Models and Analysis 4.1. Major Drivers of the Variables of Interest The analysis considers the impact of major economic and bank-specific indicators on banking performance indicators, measured by deposit and loan growth, as well as banks’ ROA and ROE. The four regression equations that the analysis comprises include9: (1)