|Arab banks are vulnerable to shocks in real estate
|Commentary by Henry T. Azzam
One of the main risks facing Arab banks is their sizeable exposure to the region's equity and real estate markets, both directly through lending to these two sectors and indirectly through the collateral of property and stocks that banks hold on their books against personal loans. Although the large Arab banks are well equipped to deal with a major correction in the two markets, the impact on the banking sector as a whole would be noticeable if the ongoing correction in the region's stock markets is followed by a major shock in the real estate market.
Arab banks did extremely well in 2005, with many of them doubling their profitability on the year before. The positive trend continued in the first quarter this year with an average increase in profitability of around 25 percent on the first quarter 2005. Total assets of Arab banks exceeded one trillion dollar by the end of 2005, up 20 percent on the 2004 level of $883 billion. The loan portfolio of Arab banks was up by 22.3 percent last year, deposits increased by 13.3 percent last year, and shareholders equity surged by 22 percent to reach $97 billion.
With the exception of four Arab stock markets (Lebanon, Oman, Morocco and Tunisia), all the remaining stock markets of the region have witnessed a major decline since reaching their peak in the fourth quarter of last year. There has been a high degree of contagion across the markets of the region exacerbated by panic sales among retail investors. In general, investors in today's market lack the 'blind' confidence which fueled the market momentum in prior years.
After three years of booming conditions in the region's real estate sector, several markets appear to have reached overvalued levels. Real estate prices cannot keep on rising at the rapid pace that we have seen in the past two years. At current levels of prices, supply will soon exceed demand and a glut will surface. This may not yet be visible; nevertheless, most adjustments of market imbalances tend to be well under way before the imbalances become widely identified. Usually protracted periods of big surge in real asset prices are followed by a downward adjustment in these prices exacerbated by higher interest rates and tighter liquidity.
Real estate prices move much more slowly than share prices. While stock prices could correct downward by 5 percent in a single day, and 20 percent in few weeks, real estate prices often keep rising for a while even after a housing boom goes bust. So the news that the housing bubble is over will not come in the form of plunging prices. It will be more visible in the form of falling sales and rising inventories, as sellers try to sell their holding at prices that buyers are no longer willing to pay. There are early indications that the process have already started in certain countries of the region and the super money making days in the region's real estate market may be subsiding.
The limited information available on lending to the real estate sector and the scarcity of detailed data on personal loans and what portion of it is directed to the stock market make it very difficult to assess the risk and uncertainty associated with banks' exposures to these two sectors. When capital markets are surging, most banks would treat margin lending and IPO financing as a mass product, magnifying in the process their exposure to the stock market. It is estimated that around 50 percent of stock trading last year was on borrowed money and around 70 percent of the money needed to finance IPOs came from bank loans.
Personal lending of various types, including real estate and equity investment constitutes an important part of the loan portfolio of most Arab banks. It is common for banks in this part of the world to grant general purpose lending facilities without necessarily knowing how the funds will be used, exposing their retail portfolios to the vagaries of property or equity markets. If a major correction in these markets takes place, their retail portfolios could become non-performing, requiring as a result substantial provisions.
The other area where Arab banks have direct exposure to the real estate sector is retail mortgage lending. This business is far less developed in the region than in the more mature countries. For legal, cultural and religious reasons, it is difficult to foreclose on a residential mortgage loan and seize the collateral. As far as commercial mortgages are concerned, the process is easier. In a down cycle, banks end up having sizable real estate inventories on their balance sheet, with lower market value than originally stated.
Banks also tend to increase margin lending for their clients to buy shares when capital markets are rising and IPOs are flourishing. It is difficult to estimate the amount of margin lending in the region, but it is generally believed to be common, especially among the smaller banks and the sharia compliant ones. As margin loans are collateralized by equities, any decline in the stock market would spell a sell-off to reduce margin levels. Such a sell-off could cause stocks to decline even further, requiring as a result more margin calls which would keep the downward momentum rolling.
Furthermore, several Arab banks tend to have large securities portfolios on their balance sheets. It is a way to diversity earnings and generates revenues. Many generate fee income from providing brokerage and asset management services to their clients, as well as, from managing and financing of IPOs. Because trading securities and available-for-sale securities are marked to market, swings in share prices affect both banks' earnings and their capitalization.
Other than the direct exposure that banks have to the real estate and equity markets, they also have indirect exposure. The most commonly used collateral for Arab banks is real estate and stock portfolios. If the sizeable correction in the region's stock market continues, or if a major shock hits the real estate market, the value of the collateral would drop, forcing banks to take more provisions thus affecting their profits and the quality of their balance sheets. This is especially damaging in our region where capital and real estate markets lack depth and liquidity.
Banks tend to mitigate risks by usually requiring a "salary assignment" (an agreement that a client's salary and end-of-service benefits will be placed in an account at the bank) as primary collateral before granting a personal loan. Banks may also ask for real estate collateral as an additional element of comfort, but the first choice of collateral remains cash and shares. In certain Arab countries (e.g. Oman, Qatar and U.A.E.), banks are prevented from overly increasing their exposure to the real estate or equity markets by regulatory limits that the central bank imposes. Although these rules vary from one country to anther, the rationale is to have a more balanced risk/return profile when having exposure to volatile asset classes. In certain countries, there are as well central bank-suggested caps on bank's exposure to margin lending. These factors would certainly limit the effect of a shock in the real estate sector but would not mitigate it fully.
A material downturn in both the real estate and capital markets would undoubtedly affect Arab banks' profitability and capital. The banks' capital bases would be immediately and directly hit by fair-value accounting, while their profitability would be simultaneously impacted by lower business volumes, high provisioning needs, and the loss of value on the trading portfolios. The quality of assets that banks have would also deteriorate. In a down cycle, a mismanaged financial crisis may well lead to a banking crisis.
Henri T. Azzam
The Daily Star