This analysis is by Bloomberg Intelligence Industry Analyst Edmond Christou. It appeared first on the Bloomberg Terminal.
Credit quality is weakening for major UAE banks, based on our analysis of loan staging under IFRS 9, and is likely to drive loan restructuring at large-to-mid-sized accounts, with smaller businesses and retail loans facing impairment risk. That suggests the top 10 UAE banks’ nonperforming loans could increase by at least 2-3 percentage points. Yet Covid-19’s asset-quality effect won’t become clear until the Targeted Economic Support Scheme (TESS) deferred program phases out in 1H. FAB has moved more loans to higher grades, ENBD has raised provision coverage more than ADCB for deferred exposure — limiting downside — so ADCB may strengthen coverage too. Lenders with lower affected-sector exposure, higher provisions, better-quality deferred loans and stronger capital have better prospects, with ENBD leading and DIB lagging.
NPL ratio may rise at least 2-3 percentage points
The deferred-loan program (involving 16% of top-10 UAE banks’ loans) ends in June, so borrowers with weak cash flow may face downgrades or loans migrating into lower-rated categories. By extending loan tenures and making payments more affordable, lenders may restructure exposure to reflect new cash-flow capacity for impacted sectors. Group 1 clients facing temporary stress from Covid-19 are particularly affected, with exposure largely under Stage 1 performing loans.
Our scenario model shows 20% of the top 10 UAE banks’ Group 1 deferred credit moving into Stage 2 under-watch loans, with 10% of Group 1 deemed to be impaired, and 30% of high-risk Group 2 loans become bad loans. NPLs could thus rise at least 2-3 percentage points, but cost of risk (provisioning) of about 150 bps may restore coverage.
UAE asset quality weakens on residual risk
We aggregated the top-10 UAE lenders’ loan-staging portfolios to show asset quality is weakening, with their share of Stage 3 bad loans rising to 6% in 2020 vs. 5% 2019. This reflects downgrades to existing troubled books such as NMC and Arabtec, but deferred-loan risk is yet to come. Stage 2 under-watch loans rose slightly to 6.6% of the total outstanding vs. 6.2% in 2019, largely on deferred-loan exposure.
In 2020, UAE banks increased precautionary provisions for Covid-19, strengthening Stage 1 (performing) and Stage 2 (under-watch loan) provision coverage. The increase in provisions against Stage 1 and 2 non-impaired loans is eligible to be partially added back to the capital ratio, phased over five years. Provision coverage for Stage 3 loans weakened to 53.7% in 2020 vs. 55.6% in 2019, including the acquired books.
Key metrics differentiate UAE banks in assessing risks, rewards
UAE banks’ real-estate sector loan exposure was stable at 21% of credit risk-weighted assets (RWA) in 2020, with some lenders de-risking while others gained share. Exposure to Covid-19-affected sector — service, hospitality and trade — was cut to 14% of 2020’s RWA vs. 16% in 2019. Banks with lower sector exposure, higher provisions, better-quality deferred loans and stronger capital vs. industry peers are positioned to capture upside, given downside is limited, in our view. ENBD beats on these metrics vs. lowest-ranked DIB.
Banks with soft cash-provision coverage appear comfortable in terms of collateral held against loans. Yet collateral is largely real estate, so a property-market rebound is key to avoiding second and third-order effects. We thus continue to view banks with higher cash coverage more favorably.
How UAE deferred loans may behave as TESS program phases out
About 16% of the top-10 UAE banks’ loans were subject to deferrals in 4Q, vs. 17% in 3Q. Yet deferred payments dropped 30%. The share of these Stage 2 under-watch loans rose to 15% vs. 14% in 3Q. Group 2 loans will have a long-term impact from Covid-19, while Group 1 loans are facing short-term stress. The Stage 2 loan share is greater, as it captures pre-virus pressure on some sectors, and is therefore more relevant for a lenders’ risk profile. A downgrade to Stage 2 exposure migrates loans into Stage 3 bad loans, pushing up the lenders’ nonperforming loan ratio by at least 2-3 percentage points vs. peers’ 6% average.
If some of Group 1 clients (89% of deferred loans) fail to restore cash flow and are deemed risky when the deferred program ends, exposure could be restructured as Stage 2, or impaired under Stage 3 loans.
More stage 2 in 2021; Fast recovery to avoid stage 3
Loan staging under IFRS 9 is more relevant when looking at cost of risk (provisioning), we believe, given loans can migrate into lower-grade stages if a client’s profile is downgraded, payments missed or loans restructured to adjust repayment schedules for lower levels of cash flow. When a performing loan is restructured, it migrates into Stage 2. When its downgraded further, it becomes a bad loan.
ENBD shows higher Stage 2 vs. Group 2 loans are likely, as they were already being restructured before Covid-19, though the bank has provisioned for this more vs. peers. ADCB cleaned up its legacy book with goodwill from the merger, but is still underperforming. FAB’s exposure has declined, with its share of Stage 1 performing loans at 88% in 4Q vs. 84% in 2Q as it upgraded accounts vs. peers’ Stage 1 loan shares falling.