Data & Analytics,Islamic Banking,Markets Exchanges,

Data & Analytics,Islamic Banking,Markets Exchanges,

A slowdown in Islamic financing growth in the UAE will reveal a deterioration in banks' asset quality as portfolios season more quickly, Fitch Ratings says. This will start to become evident as banks report their 2016 results. Financing growth slowed in 2016 and we expect a continuing slowdown in 2017, leading to faster seasoning of banks' portfolios and higher impaired financing ratios.

Rapid growth in the sector in recent years has artificially improved asset quality metrics as impaired financing ratios are typically lower in the early years of financing arrangements. Demand for Islamic financing in the UAE has grown rapidly with increasing customer awareness and wider adoption of sharia products, especially among retail customers. Islamic banks tend to be newer than conventional banks, with smaller franchises, and are growing faster than conventional banks to gain market share. However, growth is now slowing, reflecting lower GDP growth and tighter liquidity - ultimately a consequence of lower oil prices.

We expect growth of Islamic bank financing in 2016 to have been significantly lower than in 2015, although still higher than that of conventional bank lending. UAE Islamic banks typically have higher impaired financing ratios and impairment charges than conventional banks as they have had looser underwriting standards and attracted riskier customers while building their market share. Their weaker asset quality historically also reflected their proportionally larger exposure to the 2008 fall in UAE real estate prices, and still also reflects their greater focus on retail financing, which carries higher impairment charges. Newer Islamic banks with smaller franchises are likely to be affected first by the slowdown.

Those that have been established for longer are likely to be affected later, and to a lesser degree, given their stronger franchises. Asset quality has improved for Islamic and conventional banks in the UAE since the financial crisis. The Islamic banks' average impaired financing ratio was 6% at end-1H16, significantly improved from 11.5% at end-2012. But deterioration due to portfolio seasoning has started in some corporate segments, particularly SMEs, and we expect this to filter down to other segments, including retail. The banks that suffered the most during the crisis are still benefiting from some recovery and this may offset any deterioration in asset quality metrics in the short term.

Since 1H15, liquidity conditions have tightened, reflected in a higher cost of funding and some government deposit withdrawals from Abu Dhabi banks. Although liquidity conditions have now stabilised, deposit growth has weakened, slightly pushing up average financing-to-deposit ratios for Islamic banks. We do not expect significant deterioration in profitability, despite pressure from lower GDP growth and costlier funding, as most banks have been successfully repricing their financing books.

Additionally, earnings should benefit from expected interest rate rises, given Islamic banks' high levels of non-remunerated deposits. Our rating Outlooks for UAE Islamic banks are therefore Stable but the sector is more vulnerable than conventional banks to a cyclical downturn, given the higher proportion of retail financing, including residential mortgages, and typically looser underwriting standards. The share of total bank gross financing held by the six largest Islamic banks and the Islamic windows of conventional banks was around 26% at end-1H16.

Re-disseminated by The Asian Banker from Reuters