Tuesday, August 10, 2010
UAE Banking Stress Tests brought to you by the shadow central bank: Shuaa Capital
When I first saw an article calling for stress tests of the Gulf Banks I laughed. My opinion was that the Western Governments that had enacted them largely to try to counter the market suspicion that despite the massively unpopular but massively necessary injections of capital that the banks were still in serious trouble. Knowing that they would struggle to muster the political will to rescue the banks again they decided to try to show the world that no more injections would be necessary and then market confidence might build on itself. It seems to me that this is totally unnecessary in the Emirates.
Given that the Emirates were unwilling let Dubai World fold, what are the odds that they’ll let the banks collapse? Zero. More to the point, since the banks will ultimately rely neither on the markets nor the voters for their rescues what is the point of reassuring either as to their health? At the end of the day the largesse which rescues the banking system will come from the Al Nahyan who answer to neither and indeed answer to no one. Thus rather than a statistical shock to the values of the assets on the balance sheets of the banks what a would-be stress tester would have to determine was the odds of the various banks winning the coin toss of Al Nahyan support. Given the fact that they allowed Dubai to pour $15 billion into the Nakheel black hole my guess is the coin they’ll use for banks has heads on both sides.
Apparently the UAE central bank agrees with my conclusion if not my reasoning and has decided not to conduct these stress tests. So it has fallen on the shadow central bank of the UAE, Shuaa Capital, to conduct them. I should say that I have a lot of respect for Shuaa. When I first got to the Gulf I tried to work out partnerships with a lot of local institutions whereby my firm would provide intellectual capital and they would provide the local connections. At the time intellectual capital was rarer than local connections so the deals I struck were generally pretty favourable. When I met with Shuaa they sent me packing. They had intellectual capital in spades which they showed me over the next two years as one of our stiffest local competitors for the equity market access business. They had a vastly more nuanced understanding of the legal and regulatory environment. They knew, in a way that my compliance department in Frankfurt could never know, that you can cross the lines but you can’t cross the men who draw the lines. They were a well led and effective firm.
They’re no fools with regard to how they played the stress tests either. The headlines in all the newspapers about it read in one form or another: “UAE Banks well capitalized.” I’m sure that the rulers and the regulators read that with pleasure which should serve the partners at Shuaa well indeed. Add to this the fact that the UAE Central Bank is now off the hook and it’s quite the coup indeed. Having read about them in the papers I was tempted to dismiss them but they’re pretty interesting and reward a good read. Despite my general scepticism of stress tests generally I think Shuaa did a good job. I could pick nits with their methodology. For example they limited themselves to loans made at the peak of the real estate bubble which is a de facto assumption that real estate prices which will not continue to decline, a precarious assumption in my view. I don’t want to go into the minutia of the tests but rather point out some features that I find salient.
The first thing I find interesting is that the headlines about bank solvency are a bit misleading. On the one hand they rightly make the point that the capital requirements of the UAE are more stringent than those of Basel II and that under none of their scenarios do the banks violate the Basel II capital requirements. They go on to say that under most scenarios the banks they survey are “on average” adequately capitalized but only “on average.” In every scenario at least one of the banks (ADCB) requires additional capital. Under their worst case scenario several do, up to $4.3 billion. They then say that this is well within the power of the authorities to commit to the recapitalization of the banks. Their confidence therefore is not necessarily in the banks themselves but rather in the governments’ willingness to supply that capital. I agree with this but it is not the same thing as saying the banks are well capitalized.
What I find more interesting than the report on whether the banks are adequately capitalized or not are the diagnosis of the problems which are affecting the UAE economy and the prescriptions for how the government can use the banking system to reverse them. First off they point out that the economic recovery in the Emirates has been sluggish and they lay the blame for this at the feet of the banks on account of the fact that their provision of credit to the private sector has fallen off a cliff. They point out that the banks have already been recapitalized once with an injection of cash from Abu Dhabi and a blanket guarantee on deposits. They then show that since the bailout the banks have focused on lending to the government or to government controlled entities. They then bravely assert that this is not evidence of risk aversion on the part of the banks but rather that the banks are owned by the government or allied families and they are consciously directing the flow of capital to themselves.
They then go on to describe two courses of action for the government to take to free up lending. The first is a more aggressive recapitalization of the banking system. They look at the Spanish and the Irish examples and strongly prefer the Irish case wherein the government swapped its own paper for the distressed assets held by the banks, effectively simultaneously recapitalizing and de-risking them. This is all well and good but it seems to me to not really go to the core of the problem. If the main issue is that the government and the merchant families are directing lending to their own enterprises then why would recapitalizing the banks change that?
I personally think that the main issue is neither that the banks lack sufficient capital nor that what capital is available is being directed to the government. Those two things may be true but the real problem is most likely that the excesses in the real economy and asset prices that had been built up in the system from 2005-2008 have still not yet been worked out. You can see this from the recent Aabar downgrades. Though I do not doubt the influence of the ruling and merchant families over the direction if credit flows I do actually think they are likely driven by risk aversion as much as by command.
To this end I think Shuaa makes a more effective recommendation when they suggest deep structural reform which would encourage private and foreign investment into the Emirates. Unfortunately all they do is use the favourite buzzwords for this “transparency” and “improved governance” without making any specific recommendations. I can understand why they keep it general rather than specific. This is because everyone knows what has to be done, but nobody wants to do it. This is because the only way to create a stable and predictable environment in which to deploy capital would require submitting the law of the ruler to the rule of law. No more arbitrary arrests of out of favor burecrats, no more turning a blind eye to local merchant families who rob investors blind. So far the powers that be have not connected the dots between these structural problems and the lack of access to capital but they are there.
Shuaa says some brave things in their report about the solvency of the system and the degree to which it actually responds to the market. They hint at what really needs to be done but don’t spell it out. Once again Shuaa crosses the line without crossing the men who draw the lines.