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When Rates Rise: UAE Banks Will Benefit From Higher Interest Rates

We expect banks in the United Arab Emirates (UAE) to benefit from the planned increase in interest rates by the U.S. Federal Reserve, which the Central Bank of the UAE (CBUAE) will likely mirror because the UAE dirham is pegged to the U.S dollar. S&P Global economists expect the Fed to raise rates six times this year starting in March, and five more times in total in 2023 and 2024. These changes will be earnings-accretive for UAE banks because of the structure of their balance sheets. This is, however, predicated on the assumption that the shift in the yield curve is parallel, and that banks' balance sheets remain static. Second-round effects of the increase in interest rates could come from a higher cost of risk and cost of funding. A higher loan charge could push some mortgage- or personal-loan clients to the edge of default, while at the same time pressuring small and midsize enterprises (SMEs) that are still healing from the impact of the COVID-19 pandemic. However, stress tests applied by banks to mortgages at inception in relation to an increase in rates, the granularity of the exposure, and salary assignments for retail lending will act as mitigants.

For corporate exposures, we expect banks will adopt a pragmatic approach and would not reflect the full extent of the increase in rates whenever this could push their clients to non-performance. Overall, we project the banking sector's Stage 3 loans will reach 7.0% of systemwide loans by the end of 2022 compared with 6.1% at year-end 2021. We also expect cost of risk to increase slightly in 2022 to around 120-130 basis points (bps) compared with 116 bps in 2021 as support measures are lifted and companies in still vulnerable sectors are reclassified. Cost of funding will inevitably rise as some deposits migrate from no- or low-interest to interest-bearing products. However, with around two-thirds of total deposits bearing no or limited interest, UAE banks' funding will remain a strength. The net external asset position is also likely to shelter UAE banks against lower and more expensive global liquidity. We rate five banks in the UAE, the ratings on which all carry stable outlooks, reflecting our view that their strong capitalization and profitability will continue to protect their creditworthiness over the next 12-24 months.

UAE Banks Stand To Benefit From The Increase In Rates

As of Dec. 31, 2021, data from the top 10 banks in the UAE show that banks are likely to have an increase of 15% of their net income or an additional 1.4 percentage points of return on equity for every 100-bps increase in rates (see chart 1). While these numbers are on the stylized assumption that banks' balance sheets remain static and the shift in the yield curve is parallel, it is a broad indicator of the direction and magnitude of the impact of rising rates.

Chart 1


That UAE banks will on average benefit from the rising rate environment is not surprising. First, banks in the UAE continue to benefit from a large proportion of current account and saving deposits (CASA), which accounted for two-thirds of total deposits at system level as of Sept. 30, 2021. Over the past three years, the contribution of these to the total deposit base of UAE banks continued to increase (see chart 2). Second, banks' balance sheets have been positioned in a manner that makes them benefit from the increase in interest rates--with a higher amount of repricing assets than liabilities.

Chart 2


Two Risks To Profitability

However, an increase in interest rates can also have negative indirect effects on banks' profitability. We see two main potential channels for this.

Increase in cost of risk as some borrowers' experience difficulties

An increase in interest rates would imply a higher debt-service burden for retail and corporate clients. Depending on the pace and the overall amount of the increase, some clients may experience difficulty and restructure their debt. In the UAE context, we see two main sources of risk: retail loans (including mortgage and consumption loans) and exposure to SMEs. For corporate exposures, we expect banks will adopt a pragmatic approach and would not reflect the full extent of the increase in rates whenever this could push their clients to non-performance.

Retail loans for lending and consumption purposes accounted for 27.8% of total lending as of Sept. 30, 2021. We estimate the residential mortgage lending exposure of UAE banks was around AED150 billion as of Sept. 30, 2021 (almost one-third of total retail exposures), based on the data disclosed by CBUAE at year-end 2020 and assuming a similar growth rate for mortgage lending compared with other bank lending. Residential mortgage loans contributed around 20%-25% of the residential real estate demand in Dubai, according to data reported by the Dubai Land Department over the past four years (based on transactions of flats and villas). If commercial real estate is included, mortgage-financed transactions (including residential and commercial real estate) contributed between 50%-60% of transactions in Dubai (see chart 3).

Chart 3


Mortgage loans are generally granted with a variable rate in the UAE (or fixed for a few years and then floating), unlike in Saudi Arabia, where the bulk of mortgages are granted with fixed rates. While in 2020 the CBUAE increased the loan-to-value ratio applicable to mortgages for first-time buyers by five percentage points, the debt burden ratio (loan charge to total income) remained constant at a maximum of 50%. By regulation, banks are also obliged to stress-test their mortgage exposures to an increase in interest rates by 200-400 bps in the debt burden ratio (DBR) calculation. Banks are also limited in the total amount of lending to seven years of annual income for expatriates and eight years for nationals. With these parameters, we have simulated the impact of an incremental 100-bps increase on the mortgage charge of the client assuming a property value of AED2.5 million ($0.68 million), a 20 year-tenor, and lending of up to the maximum allowed to calculate the annual income (using the mortgage calculator of The value of the property and the tenor were calibrated based on the average reported by for 2020, with an increase in the value, as real estate prices have increased in 2021. The simulation indicates an increase in DBR by 6.9% with a 200-bps increase in rates (see chart 4). Such an increase could, in our view, stretch the repayment capacity of some clients. However, given the granularity of mortgage lending books and the stress-test applied at the inception of the loans, we expect the overall impact on banks' non-performing loan (NPL) ratios to be minimal. We also expect banks to reflect the increase in rates gradually. Given the significant contribution of real estate lending to total lending, we do not exclude a scenario in which the central bank implements some macroprudential measures to limit the impact on financial stability. For example, the central bank in 2021 implemented a new enhanced framework to supervise banks' exposure to the real estate sector with more extensive supervisory review of underwriting standards and risk management practices of banks for higher risk-weighted real estate exposures.

Chart 4


Other retail consumption loans may also be affected by an increase in interest rates, although here again we expect the granularity of the exposures and salary assignments to help. Banks are therefore rather more exposed to the swings in economic cycle and retail clients' loss of income than to rising interest rates. Against the backdrop of an economic recovery and higher oil prices, we expect these risks to remain in check. Another source of risk for the UAE banks when rates increase is the lending to SMEs, which account for around 5% of total system loans as of Sept. 30, 2021.

In order to quantify the exposures that could be potentially affected, we looked at Group 1 and Group 2 exposures published by the banks under the Targeted Economic Support Scheme (TESS) program. These are the exposures that have been affected by the pandemic (minimal impact for Group 1 and severe impact for Group 2). It is worth mentioning that the deferral program was officially concluded on Dec. 31, 2021. The recovery program is continuing until June 2022. Some banks have stopped providing Group 1 and Group 2 loans. Based on the disclosures of the top 10 banks in the UAE as of Dec. 31, 2021, Group 1 exposures contributed to 8.5% of total loans and Group 2 exposures contributed to 1.8% compared with 15.6% and 1.9% as of year-end 2020. We are of the view that some of these exposures could migrate to non-performance because of higher interest rates. We expect banks to reflect the increase in rates gradually in order to avoid putting further strain on these fragile clients. Overall, we project the banking sector's Stage 3 loans will reach 7.0% of systemwide loans by the end of 2022 compared with an expected 6.1% by the end of 2021. We also expect cost of risk to increase slightly in 2022 to around 120-130 bps as TESS measures are lifted and companies in still vulnerable sectors are reclassified.

Increase in cost of funding

Another channel of transmission of the increase in interest rates on UAE banks could be through the cost of local and foreign sources of funding. For local sources of funding, we think that some deposits might shift back from CASA to time deposits as interest rates increase. In 2019, for example, the contribution of CASA deposits dropped to 51% compared with 55% at year-end 2016, and part of that was driven by the increase in interest rates at that time. However, with CASA making up two-thirds of total deposits, UAE banks will enter the new interest-rate cycle from a position of strength. We also expect external funding will be scarcer and more expensive. We note that, on a net basis, banks' dependence on external funding in the UAE is limited, as banks are in a net external asset position.

Chart 5


On balance, we are of the view that the increase in interest rates will benefit the UAE banks through higher profitability. We believe that banks will be more than capable of absorbing our projected increase in cost of risk. Banks are also very efficient, with a cost-to-income ratio of around 36% for the top 10 banks at year-end 2021. While we expect a slight increase in costs for some rated banks, efficiency will continue to support their profitability. Finally, with an average Tier 1 ratio of 16%, banks in the UAE continue to benefit from strong capitalization, which will provide them with an effective cushion against unexpected credit risks. From a rating perspective, our outlooks on all UAE-rated banks are stable, reflecting our view that their capitalization and profitability will continue to protect their creditworthiness over the next 12-24 months.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Mohamed Damak, Dubai + 97143727153;
Secondary Contact:Puneet Tuli, Dubai + 97143727157;

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