Banks feel little urge to merge

Most analysts and senior bankers in the Middle East have agreed for more than a decade that the region needs fewer banks. And they have argued that those remaining must be either large enough to compete with international financial institutions, in providing the services demanded by corporate customers, or be small banks targeted at niche sectors.

Even though some mergers have taken place – most notably the first major cross-border deal last year which brought together the Bahrain-based Gulf International Bank (GIB) and the London-based Saudi International Bank (SIB) – neither of these goals is anywhere near being achieved. Any expectations that this long overdue restructuring had finally begun in earnest were dealt a heavy blow with the recent announcement that the proposed merger between the National Bank of Dubai (NBD) and Emirates Bank International (EBI) had fallen through.

This failure has drawn a caustic, though resigned response, from many bankers in the region and led to warnings that the region’s institutions could be vulnerable to international banks creaming off the best business by offering all their services through the internet for which they do not need a local presence.

“The dilatory response to this challenge is symptomatic of the inability of those entrusted with the responsibility for the region’s institutions to take fundamental decisions to reform one of the key sectors of the economy”, says one London-based Arab banker.

Had the negotiations succeeded, it would have been the most significant development in Middle East banking for many years. It would have been effectively the first merger of equals in the Gulf, almost certainly have prompted other banks to follow suit and would have demonstrated that Middle East banks with very different management cultures could merge. With the Dubai government owning 80% of EBI and a minority stake in NBD, it would also have shown the government’s determination to reform the sector.

The merger, which would have created the dominant bank in the UAE, was first discussed at last autumn’s IMF/World Bank meeting, with NBD’s chairman Sultan al-Owais regarded as the driving force. Since his death in January this year, it has become clear that there was more enthusiasm among EBI’s top management than at NBD. The merger committee, comprising representatives of both banks, never met and the discussions were eventually shelved in mid April.

“It could have worked had both sides been fully committed. But they came from different banking cultures. EBI was formed from a series of mergers and has expanded using the same strategy so it is used to these sorts of negotiations. NBD had never been involved in anything like this before. Moreover, while the government gave its blessing, it was scarcely a driving force in the process,” said one banker close to the negotiations.

This setback has, say bankers, only delayed the inevitable. More Arab countries are joining the World Trade Organisation, which requires the opening up of domestic financial markets to outside competition. And the need for massive investment in the technology needed for modern banking, will force Arab banks to consider mergers or strategic alliances.

“All banks in the emerging markets will have the problem of globalization and greater competition and will have to decide how they meet the challenge”, says Ibrahim Dabdoub the veteran chief executive of the National Bank of Kuwait (NBK).

The more sanguine among them believe that within 15 years there will only be room for as few as half a dozen large Arab institutions and a few niche banks. “In a liberalized global financial market, Arab banks have no choice but to consolidate. This would reduce operational costs, minimize duplication, spread huge technology expenses over a wider base and allow banks to benefit from economies of scale”, says Henry Azzam, chief economist at the Beirut investment bank, the Middle East Capital Group.

Bankers point out that the Middle East banking has come a long way in barely a quarter of a century. Its leading institutions are internationally respected and there is a new generation of extremely efficient managers. But another revolution is needed to catch up with the changes in western banking and this requires major structural reforms. John Finigan, general manager and chief executive of Qatar National Bank, told a recent conference in Doha: “Among the measures needed are domestic consolidation to increase overall effectiveness, regional expansion to heighten focus on intra-GCC [Gulf Cooperation Council, whose members are Saudi Arabia, Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates] capital flows, regional alliances to enhance the size of capital commitments, regional collaboration in technology to reduce capital costs of development and international alliances in areas such as asset management, custody and information technology outsourcing.”

He also called for “greater collaboration to enhance intra-regional capital flows, the creation of more transparent domestic money market instruments, a broader securities market capability and the creation of regional syndications with GCC banks playing the leading role”.

The clearest evidence of the size of the task facing Arab banks comes from the cost to income ratio – the traditional measure of banking efficiency. The Middle East has comfortably the lowest level with a 47% ratio. This compares with 85% in Japan, 67% in Latin America, 61% in the European Union, 60% in Asia and 58% in the United States.

“Within the Middle East, all countries have ratios below 60%, which is considered to be a healthy level,” says Azzam. “The leading banks in Saudi Arabia and Jordan have the highest ratios of nearly 60% due to their substantial investment in new technology, while those in Qatar, Kuwait and the UAE have the lowest levels, between 30-40%.”

Just as significantly domestic Arab banks are small compared to those in Europe and the US. National Commercial Bank (NCB) of Saudi Arabia, the largest Arab bank in terms of equity, ranks only 160th among the world’s banks. At the end of 1998, only two, NCB and the Bahrain- based Arab Banking Corporation (ABC) had assets of more than $20 billion, while the combined assets of all Arab banks – at just under $500 billion – was less than that of several of the world’s largest banks. Few can justify the need for the UAE to have 20 banks, most of which are solely focused on one small emirate while, in Kuwait, some banks have admitted privately to doing scarcely any conventional banking business at all.

But, until now, the restructuring has been painfully slow and the gap between Arab banks and the world’s largest has widened. Citigroup was the largest in the world in 1998 with $41.9 billion of tier one capital, a 3.84 times multiplier on a decade before when NatWest had $10.9 billion capital. The largest Arab bank NCB had $2.07 billion capital compared with Riyad Bank’s $1.15 billion a decade earlier, a growth multiplier of only 1.8 times.

There are no signs of a change in this trend. “The market has been effectively stagnant. Until banks and regulators feel a threat they will do nothing”, says one banker. Change has been held back by regulations which have made it difficult for banks to operate in more than one Gulf state and the attitude of regulatory authorities which have paid lip service to consolidation but done little to force it through.

Banks are turning in good profits – and are likely to do so again this year on the back of stronger oil prices – while directors have been reluctant to give up the prestige that comes from bank board membership. Says one banker: “The last couple of years have been a stress test for Middle East banks with the low oil prices. They seem to have come through it alright. The recent rises in oil prices have limited the damage to loan books and will, if anything, make banks even less prepared to consider mergers.” The result is that mergers and acquisitions have been few and far between. Most have only taken place when governments have forced through shot-gun weddings between banks either on the verge of or beyond the point of bankruptcy.

According to one Arab banker: “The banks need a big kick up the backside. It is the independence and prestige of being on the board of a bank which makes so many of them hold on to their positions. That attitude won’t change unless the regulatory authorities make a concerted effort to force through some consolidation through measures like raising capital adequacy ratios still higher.”

There has been some progress in the last year. “Mergers and acquisitions will happen in certain ways,” says Mamoun Tazi, equity research analyst for emerging Mediterranean rim banks at Salomon Smith Barney. “Countries will want a national banking giant to have a presence in the local market and they are unlikely to see these sold to outsiders. But these national giants will acquire other banks. There will also be foreign players from within and outside the region who will make cross border acquisitions.”

The proposed link-up between NBD and EBI was an example of domestic banks wishing to create a larger market share while that between Saudi American Bank (Samba) and the United Saudi Bank created the second largest institution in the country.

The market has been most active in Lebanon but that reflects the legacy of the civil war which left a large number of extremely small, technically undeveloped institutions. Even here, the mergers have tended to be absorptions of smaller banks by larger ones rather than real consolidation. “You need to create institutions with $10 billion assets, $1 billion equity and $2 billion market capitalization”, says Freddie Baz, adviser to the chairman at Bank Audi.

Another strategy has been to acquire all of, or a strategic stake in, banks in other countries in the region. ABC has bought Egypt Arab African Bank while EBI has taken a 10% stake in Bank of Beirut and Société Générale Libano-Europeanne de Banque owns 35% of Jordan’s Middle East Investment Bank.

One way ahead is through strategic alliances which will enable Arab banks to work jointly on specific projects, share products and risks and reduce costs. Among the pioneers in this strategy were the NBK and NCB. However the change of ownership at NCB has meant that the results have yet to meet expectations.

Part of the problem has been the determination of Gulf governments to preserve their domestic markets for their own institutions. As a result, very few banks have any significant presence outside their own state. In the UAE, only Mashreq Bank offers a service across the seven emirates. But there are signs of a change in attitude. GIB, which is owned by the six GCC states, has permission to operate in all Gulf states and has just opened its first branch in Saudi Arabia.

Indeed the dominant banks in the region stress the importance of establishing a regional presence. NBK, which has dominated the Kuwaiti banking market for a generation and was one of the first Arab banks to establish an international reputation, has been at forefront of the campaign to allow a wider regional presence.

The bank already has a presence in Lebanon and is looking to make an acquisition in Egypt. “We were the first to see the need to have a regional strategy. The problem is that local laws still do not allow us to open branches. However, eventually all Arab countries will have to open up”, says Dabdoub.

Dabdoub argues that size is important as it enables banks to underwrite big-ticket deals and because of the need to “spend on technology. You have to have deep pockets to invest in the systems needed for home banking, telebanking and automated teller and point of sale machines. Our strategy is and will remain consumer banking. We have reduced our branches from 65 to 38 since 1991 and our staff from 1,700 to 1,000, yet our profits have gone up from $100 million to $300 million”, he says. Some analysts believe that the lack of a branch-network culture among Arab customers gives Arab banks a major opportunity. According to Tazi, “banks in Europe and the US have traditionally expanded through their branch networks and their customers are reluctant to change their banking habits. Arab banks have the opportunity to jump several technical barriers and generations in one leap. They can sidestep 10 years and avoid investing in bricks and mortar because the younger generation is receptive to electronic and telebanking and will be happy to go into wireless technology for banking over the mobile phone as well”.

However, if they do not seize the opportunity, the gap between Arab banks and their western competitors will widen still further. “They will find it ever harder to compete in terms of technology, efficiency and cost control, the size of capital commitments and delivering return on equity to shareholders”, says Finigan.

Azzam warns that “foreign banks will then have the opportunity to skim off the more profitable top-tier customers, providing them with a comprehensive range of financial services at more competitive rates than what is available locally”.

If the Arab banks do not consolidate and attain critical mass, there is a real risk that they will be unable to invest in the technology needed to survive and will fall into a downward spiral of ever-declining investment and decreasing business.