Banks in the United Arab Emirates are facing lower profits due to a recent interest rate cut, expected lower credit demand, and higher cost of risk with a deterioration in asset quality due to the impact of the new coronavirus.

At the same, policy measures from the country's central bank have boosted bank capital and should reduce insolvencies among borrowers.

The pandemic will likely generate "a broad-based shock to the economy," hurting tourism, transportation, trade and real estate, Moody's said in a research note. The economy was already slowing due to factors including slower population growth, regional geopolitical tensions, low oil prices and the strength of the United Arab Emirates dirham affecting tourism.

Authorities in the UAE have announced strict stay at-home orders, ceased issuances of new tourist visas, closed down most international air travel and shuttered nonessential retailers. Organizers of Dubai Expo 2020, a major trade event that had been expected to contribute to an economic uplift this year, have requested a one-year delay.

"Banks here in the UAE and [Gulf Cooperation Council] have begun this process of trying to work with clients who they know are under pressure, especially sectors like aviation, travel, tourism [and] retail," said Trevor McFarlane, CEO at Dubai consultancy Emerging Markets Intelligence & Research. "To what extent — the devil will be in the detail."

The blow to the UAE's nonoil economy comes as oil prices have sunk to historic lows, far below the breakeven fiscal oil price for the country, which the IMF estimates is around $70.

Nevertheless, the UAE is in a strong financial position and will be able to "ride this out and manage [the coronavirus] crisis without flashy spending now," said Scott Livermore, chief economist at Oxford Economics Middle East.

"What that means for 2021 and 2022, clearly the implications can be quite severe and pronounced depending on how the situation in the oil market evolves over the next 12 months," he said.

Preventing insolvencies

Analysts welcomed the Central Bank of the United Arab Emirates' coronavirus policy package, worth more than 100 billion dirhams. It will offer "temporary relief from the payments of principal and interest on outstanding loans for all affected private-sector companies and retail customers in the UAE" for up to six months, said the regulator.

The package contained 50 billion dirhams in zero-interest loans to participating banks, and will allow banks to draw down their countercyclical capital buffers and systemically important banks — including First Abu Dhabi Bank PJSC, Emirates NBD Bank PJSC and Dubai Islamic Bank (PJSC) — will be able to draw down those buffers, freeing up an additional 50 billion dirhams in liquidity.

The overall scheme equates to 6.4% of UAE banks' domestic credit as of January 2020, and will "mitigate the extent of the deterioration by keeping some borrowers' liquidity issues from becoming solvency issues," said Moody's.

Some prudential requirements, including the cap on real estate exposures and the increase in loan to value limits, were also relaxed, said S&P Global Ratings, which revised the outlook on five UAE banks to negative from stable on March 26.

McFarlane said the relief packages announced in the UAE to date "will only be the beginning," with the timing of subsequent measures depending first and foremost on how the pandemic is managed within the UAE and by key external trading partners, including in Europe, he said.

Lower rates, lower profits

UAE banks will also see a hit to profits due to an interest rate cut in March, when rates on one-week certificates of deposit were slashed by 75 basis points.

This will reduce UAE banks' net interest margins as yields on loans will decline more than funding costs, said Moody's in a March report.

Lenders are already paying zero or negligible interest on retail deposits, while around 81% of systemwide loans are corporate, government or public sector, which typically have floating rates that reset at intervals of around three to six months, when they will be repriced to a lower rate, said Mik Kabeya, an analyst at Moody's.

Banks were already operating in a weak environment: At year-end 2019 the top 15 banks' average return on assets was 1.5%, compared with 1.7% at year-end 2018, according to S&P Global Ratings.

Reduced visibility on asset quality

Full details on loan categorization under the central bank relief scheme have not yet been made public, said Kabeya. "Banks will be providing funding to affected borrowers. How that will translate in terms of accounting and classification — at this point we have limited clarity. But the most important point is that there will be a weakening in asset quality."

Should the impact of the coronavirus prove protracted, "the measures may reduce the visibility on asset quality," he said.

S&P Global Ratings expects the volume of stage 3 loans to increase to 7%-8% of systemwide loans in 2020-2021, and problematic assets — stage 2 and stage 3 loans — to rise to around 20% of total loans from 15% at year-end 2019. The average ratio of stage 3 loans had already risen over 2019, to 6.3% from 5.8% for the 15 largest banks.

Nevertheless, the package underlines that banks are expected to receive support and are unlikely to face liquidity issues, even if UAE corporates draw heavily on revolving credit facilities.

"We don't expect liquidity to become an issue given the strong level from which banks are starting. If it was to become an issue we are confident that the central bank will step in and provide whatever liquidity is needed," said Kabeya.

As of April 1, US$1 was equivalent to 3.67 United Arab Emirates dirhams.