DEC Releases New Study on UAE Banking Sector

The Economic Policy '&' Research Center (EPRC), the operational arm of Dubai Economic Council (DEC) recently conducted an economic policy study titled "Soundness of UAE Banking Sector and Macroeconomic Conditions". The study focused on macroeconomic conditions and how they may affect soundness of UAE banking sector. The empirical investigation consisted of panel data comprising of 19 national banks operating in UAE during the period 2005-2010, data from the world economic outlook and the UAE central bank.

The study concludes that favorable macroeconomic environment is associated with lower probability of default and better loan repayments while adverse conditions are likely to increase non-performing loans and threaten bank solvency. The study proposes various policy recommendations targeted at the banking and financial sector to enhance the overall economic sustainability of the UAE/Dubai post-recession.

A brief overview was provided of the 2008-2009 global economic crises which adversely affected the UAE economy in various key sectors such as oil and gas, real estate and the financial industry. In order to combat the flagging economy, a number of measures (Expansionary fiscal policy, liquidity injections, cuts in interest rates) were adopted to prevent further worsening of economic conditions.

The macroeconomic indicators shows that the UAE economy started to slow down in late 2006 with real GDP growth rate declining from a high of 8.9% in 2006 to 5.3% in 2008 in the pre-crisis period. This trend worsened in 2009 whereby the UAE experienced negative real GDP growth rate of 3.3% However, with various government intervention measures outlined previously, the UAE growth rate recovered in the second quarter of 2010, rising from 0.9% in 2010 to almost 5% in third quarter of 2011. Similarly, due to slowing down of the economy, the UAE's inflation begun to dissipate, from a high of 12.3% in 2008 to 1.6% in early 2009 before declining further to 0.9% in 2011.

On soundness of the UAE commercial banks, in its assessment, the study uses three measures; capital adequacy ratio (CAR), percentage of nonperforming loans and returns on assets (ROA). Several findings can be discerned from the above figure; Banks tend to hold low capital ratios during the boom and higher ratios during the downturns. In 2005, the CAR was 17.4%, declining to 13.3% at the height of the real estate and construction boom. However, in the post-crisis period, the CAR rose from 19.2% in 2009 to 21.2% in 2011. The exposure of banks to the real estate sector is strongly correlated with the level of non-performing loans. In 2008, the percentage of nonperforming loans was 2.3%, however, due to the deteriorating economic conditions in the aftermath of the global financial crisis, with the percentage almost tripling to 6.2% in 2011.

Higher leverage ratios tend to decrease banks' profitability as it raises the cost of borrowing. Due to the exposure to the real estate and construction sector, the bank's profitability declined from 2.7% in 2005 to 1.5% in 2011. The EIBOR rate does not seem to have a significant effect on the banks' soundness indicators, according to the study.

According to the findings of the study, a conclusion was determined that states that there is indeed evidence of a relationship between financial soundness indicators and macroeconomic variables. In order to achieve a sound and stable banking sector further research is need to understand the macroeconomic environment in which it operates.