NPLs on the rise

Having exhibited positive signs of recovery and growth following the financial crisis in 2008, the Gulf Cooperation Council (GCC) banking sector is currently facing serious macroeconomic challenges that are reshaping its loan market.

Borrowers are facing increasing liquidity challenges driven by a changing economy that has been significantly impacted by the reduction in oil prices since 2014. This has given rise to increasing non-performing loans (NPL) as borrowers struggle for cash and find it more difficult to service their bank debt.

If not addressed properly and proactively, NPLs can have a serious impact on the banking sector and the economy in general. They can adversely impact banks’ profitability, credit ratings and capital requirements, thus leading to restrained lending measures and worsening liquidity.

Changing dynamics

Macroeconomic factors

Since the significant decline in oil prices in 2014, the GCC economies have struggled for liquidity, given their high dependency on oil export revenues. They have reduced government spending, particularly in the oil and gas, real estate and construction sectors.

Corporates heavily invested in those sectors and highly dependent on government spending have subsequently faced declining profitability, suffering in turn from their own liquidity pressures.

It has become more challenging for companies to fully and timely service their existing project finance commitments and debt exposures, driving the increase in NPLs across the banking sector.

SMEs and skipped portfolios

In the absence of liquid bond markets, banks in the GCC are by far the main and largest source of funds for corporates, including small and medium-sized entities (SME) and start-ups.

SMEs and start-ups in the economy are usually the first to feel the impact of a decline in market liquidity and economic growth, and consequently become desperate to meet short-term financing needs to sustain or grow their businesses.

As banks started to impose restrictions on SME lending, largely due to tightening credit risk management, shareholders of SMEs and start-ups were left in fear of criminal charges, particularly in the case of bounced checks. When faced with the potential risk of prison, and in the absence of developed restructuring platforms to encourage borrowers to engage in constructive discussions with banks, some shareholders chose to abscond. This has left the GCC banks with large SME portfolios of skipped cases with limited recourse and recoverability. 

Rising NPLs—so what?

A decline in banks’ profitability

NPLs adversely impact the banks’ asset quality and profitability. They result in reduced interest income, increase in impairment costs, unrecoverable principal, lower credit ratings and increased cost of funding. If not managed properly and proactively, this could lead to a reduction in the banks’ cash flows and lending abilities. 

When faced with a higher NPL ratio, banks are required to recognize greater loan provisions, hence reducing their profitability. As a result, regulators will require more capital to be set aside by banks to improve their solvency and capital adequacy ratios. This could reduce the banks’ ability to provide lending and is generally exacerbated by the very measures taken by banks to address their NPL concerns, which often come in the form of tighter credit policies and further restrictions on lending.

Corporates face increasing liquidity struggles

Once corporates start to exhibit signs of financial distress, obtaining further credit becomes even more difficult. This would, in turn, worsen their liquidity struggles and make it more difficult to finance their projects and short-term working capital needs. Corporates should seek creative financing and restructuring solutions to mitigate default risk and engage in transformation initiatives to adapt to the changing dynamics of the market. In the absence of similar initiatives, corporates risk deepening challenges if they remain loyal to an outdated business model that might no longer be viable under the new macroeconomic and financial parameters.

Some causes for optimism

While the rise of NPLs is a serious risk not to be taken lightly, there are measures that can be undertaken to potentially restore economic growth and financial stability. Those measures might include:

Political and regulatory support to encourage banks to review, assess and remediate the quality of their assets, particularly their loan portfolios. Shareholders and management would need to establish and empower work-out units within the banks to oversee distressed loans and seek deleveraging solutions whether in the form of aggressive collection, debt restructuring, outsourcing services or sale of non-core assets.

Distressed loan sale market should be developed in terms of the infrastructure and regulatory environment necessary to attract investors and encourage banks to participate. An NPL market could offer banks an opportunity to raise liquidity, clean their balance sheet and enhance their capital structure. It could also offer new return opportunities for bullish investors willing to trade with distressed loans. To support such a market, portfolio sale advisers, loans servicers, lawyers and other professional advisory firms should be encouraged to participate.

Developing the legal framework to improve existing bankruptcy laws and align them with international resolution and restructuring standards. This move could restore confidence and drive efforts towards consensual solutions rather than encouraging shareholders to abscond.

Capital markets, in particular bond markets, could be further developed as an alternative source of funding that could fill the gaps left by the lack of liquidity in the banking sector, tightening credit policies and lending restrictions.

Most of these measures are already being considered by banks in the GCC, along with more aggressive provisioning and pursuit of absconders. Banks continue to look for new ways to restructure their balance sheets and dispose of non-core assets, which is driving further M&A (merger and acquisition) opportunities in the banking sector and generating interest in distressed loan sales both by potential sellers and investors.

On the other hand, regulators and banks are being more proactive in prioritizing new regulatory, capital adequacy and reporting standards (such as IFRS 9, IFRS 13 and Basel III) as well as considering the impact and potential implementation frameworks of these new standards.

A new bankruptcy law has been issued in the United Arab Emirates (UAE) and similar laws are being finalized in Saudi Arabia and other GCC countries. This law constitutes a major step forward towards encouraging the offering of alternative restructuring solutions and increasing creditors’ and investors’ confidence in the financial markets by developing a structured legal framework for restructuring discussions. 

In conclusion…

There is a serious risk of a rise in NPLs across the GCC banking sector that could have an adverse impact on market liquidity and economic growth. However, the risk can be mitigated by pursuing proactive measures as highlighted in this article.

While there are some serious macroeconomic and liquidity challenges to overcome, there is cause for optimism as stakeholders across the GCC have started to demonstrate a fair level of awareness to these challenges. Measures and reforms are being undertaken but there is still considerable room for improvement and efforts should continue as the journey to maintain stability and drive growth is a long one.

by David Stark, Partner, Restructuring Services and Karim Labban, Assistant Director, Restructuring Services, Financial Advisory, Deloitte, Middle East