Rohit Chawdhry, portfolio manager of BisB, Bahrain Islamic Bank, looks at the issue of overbanking in the Gulf region and the institutions anticipating mergers.

The Gulf Cooperation Council has ambitious plans. In the GCC states of Saudi Arabia, the UAE, Kuwait, Qatar, Oman and Bahrain, policy makers are looking to develop more-diversified and sustainable economies through a vast spending programme involving both public and private sources of financing. The Institute of International Finance estimates there are about $1.9 trillion worth of projects under way in the region, making the GCC one of the largest project finance markets in the world. While the majority of these are centered in the real estate/infrastructure sector, others such as transportation, heavy industry, petrochemicals, energy, oil and gas, all have massive spending targets as well. But analysts estimate that the present project finance, which includes bank lending, bond and equity issuance, has a funding shortfall of at least $900bn, if not more. Explains Nikhil Phutane, fund manager at Qatar National Bank: “Funding constraints have meant cancellation of certain key projects, particularly related to the downstream petrochemical sector such as refineries, which require significant project finance from banks compared to upstream projects (related to oil exploration), where most of the funding is through equity.” Traditionally, such project finance is available in a reasonable proportion through debt markets and bank finance. However, a vastly under-developed regional debt market puts the burden squarely on bank finance. It should be noted that it is the size of the debt capital markets in the Middle East as a whole that remains insignificant at $124bn, or 8% of GDP. This compares very poorly with 60% for Asia and Latin America. Even African debt capital markets have a size equal to 15% of GDP. Therefore, the regional policy markers are now being confronted with a challenge which is seemingly straightforward: Create banks which are able to shoulder a greater proportion of the financing needs of projects under construction, by state and private investors.

Despite anticipated growth of GCC banks and sky high current account surpluses, the average regional bank remains small relative to its global peer group. This has been the root cause of shortfalls in funding for infrastructural projects requiring scale of operations. The largest bank in the region, Emirates-NBD of the UAE, has assets just under $80bn, paling in comparison with global players such as HSBC with more than $2 trillion. Until June 2008, conditions were conducive to an environment where smaller banks could evolve and survive. However, transmission of the global credit crunch to the region via channels such as trade and financial markets has resulted in funding shortages, especially when oil prices are trading close to $40 per barrel, a level which remains close to the breakeven point for the budget balances of regional governments. In essence, there are quite a few banks that are small in size yet large in number relative to the population of the region, suggesting the GCC is overbanked. It has also been argued for that an overbanked structure in the region’s financial sector has meant overcrowding of markets resulting in reduced lending margins, for which there is ample supporting evidence since mid-2007. Critically speaking, mergers tend to occur when the margin for growth is extremely tight, thus forcing participants to seek out external acquisitions instead.

However, examination of the overbanked theme for the Gulf states is not uniform. There is reasonable dispersion within the GCC on this issue. While there is unambiguous evidence that the UAE and Qatar are overbanked, the banking sector in Saudi Arabia stands relatively under-banked considering the size of the population and credit penetration rates. With the exception of the UAE, where credit to GDP ratio is around 103%, the rest of the GCC region has a credit to GDP ratio in the range of 55–65%, with Saudi Arabia being an outlier at 41%. Overbanking usually leads to phases of consolidation/mergers/acquisitions. Is the present situation suggestive of the same?