x Abu Dhabi, UAESunday 23 July 2017

Why the banks are having a lend of us all

The Central Bank has cut the length of time that must pass before an overdue loan is regarded as non-performing but not by enough.

Banks have come under increasing scrutiny since the global financial crisis, caused in part by imprudent lending.
Banks have come under increasing scrutiny since the global financial crisis, caused in part by imprudent lending.

The Central Bank has reduced the definition of a non-performing loan to any loan where payment is more than 90 days overdue. This is not something to be celebrated. First, I do not understand how the previous definition was ever accepted, whereby non-payment for 180 days, or six months, was considered non-performing. The current reduction, although an improvement, still falls far short of the mark.

If someone does not pay me within a week, I know there is a problem. If they have not paid me within a month, I know this is a serious problem. This is true of most, if not all, businesses that I know of. Telecommunications companies will cut phone and internet services if you are a month late. Insurance companies will void your insurance if you are more than a month late on paying your premium.

Even your bank will block your credit card if you are more than a month late paying your minimum. So why are bank debtors so special? How come bank depositors get to be late 90 days before banks consider them non-performing? Mainly, it is because once a loan is classified as non-performing, then the bank must register it as a loss on its books. I wish it ended there. You see, the Central Bank could reduce the time period to one day for a non-paying account to be considered non-performing, but this will not stop the banks.

There is a well known, and easy way around this: imagine you have borrowed Dh100,000 (US$27,225) for one year at an interest rate of 10 per cent. In one year you need to pay Dh110,000 to the bank, but you are short of funds, and you can pay only Dh60,000. What can the bank do? If you pay only the reduced amount, then the bank will have to write off the remaining Dh50,000, which is considered a loss. If there is a loss, the branch manager does not get a bonus.

So the branch manager comes to you and says, why don't you put your Dh60,000 in a fixed deposit, take a loan of Dh110,000 against the fixed deposit, and then payoff the first loan? Sure, in one year maybe you'll default on the new loan, but what does the branch manager care, he'll have moved on. The example I give above is usually called a technical default, but it is extremely hard to catch as it is quite usual for people and companies to reschedule their loans. But it does illustrate how regulations alone cannot make the banking system safe.

In fact, regulations incentivise banks to behave in a more risky manner. For example, it is normal to have to make provision for 100 per cent of the principal and interest of a loan if legal action is initiated by the bank to recover any monies. The bank is therefore incentivised to delay any legal action in recovering its money. I am not trying to blame the regulations here; I am merely pointing out that the system is inherently adversarial, and that regulations alone are useless. A strong and active Central Bank is a necessary component. This is important if the UAE's banking system is to return to health.

One thing to investigate is the mystery of the disappearing Dh180 billion. Back in the summer of 2007, as the markets were skyrocketing, we saw interest rates on dirham deposits mysteriously drop to zero. The reason for this, we were told, was that foreign hedge funds were betting that the Government would have to allow the dirham to appreciate. Consequently these hedge funds began to sell dollars, and buy dirhams.

With all these new dirhams floating around, banks reduced their interest rates on dirham deposits. Then last year, at the height of the global financial crisis as banks nearly collapsed, we were told that this was due to the hedge funds withdrawing this Dh180bn, creating a liquidity squeeze. Although this all sounds plausible, and was widely reported, it is completely incorrect. Currency cannot normally just appear. It also cannot normally disappear. If a hedge fund goes to a bank, sells dollars to the bank and buys dirhams for it, then the total change of dirhams in the banking system is zero.

Assume the hedge fund bought Dh100 million. True, this would increase the number of dirhams in the system. But there is an offsetting entry from the sale of Dh100m by the bank to the hedge fund. This decreases the total amount of dirhams in the banking system. The net effect, however, is that there is absolutely no movement in the total amount of dirhams in the system. The only way dirhams can be added or subtracted from the system is by the Government. So it was not hedge funds that caused interest rates to drop to zero, it was more likely banker greed.

And it was not hedge funds that created a liquidity crunch, that was more likely risk mismanagement by the banks. To finish our analysis of the banking system, let us look at this liquidity crunch. For this, we need to agree a measure of liquidity for the banks. I will use the ratio of gross loans to customer deposits, simply because these were the ones most readily available from the information provider I use.

Looking at the commercial banks listed on the Abu Dhabi Securities Exchange, this increased dramatically from 2006, when the ratio was a conservative 99 per cent, to 102 per cent in 2007 and 112 per cent in 2008. The banks gave out more loans than they had deposits, increasing loans by about 13 per cent more than deposits over this three-year period. The picture for commercial banks listed on the Dubai Financial Market is uglier: rising from a respectable 91 per cent in 2006, to 110 per cent in 2007, up to an astounding 126 per cent in 2008. These banks effectively gave out 35 per cent more in loans than they brought in deposits during this three-year period.

For the bankers out there who will try to nitpick, saying that this ratio is not an accurate measure of liquidity, I would like to remind them that it remains a good indicator of the fact that the banks lent out far more than they raised in deposits. There is a lot going on with the banks, and new regulations are not going to do much. On Monday, I randomly picked up the financials for two banks. The first had lent its directors and related parties Dh2.5 billion. The other lent its directors and related parties Dh3.6bn. Maybe a law banning related party transactions is in order. With 52 operating banks in the UAE, there are plenty to choose from.

Dr al Sabah is a principal and the chief investment officer of Saffar. He also serves as a director of the board of Saffar Holdings; is the chairman of ABQ Zawya; and is a director of the board and a member of the audit committee of Credit Suisse Saudi Arabia; he is a director of the board of Al Awael International Securities; and a director of the board of Ali Zaid Al Quraishi and Brothers.