US interest rate cut will impact UAE bank margins

September 6, 2024, 11:21 AM

Federal Reserve chairman Jerome Powell. If the Fed cuts US interest rates, UAE banks will feel the effect because of the dollar peg

UAE bank profits have soared
NBD reports record AED13.8bn
Fed rate cuts will hit net profit

UAE banking sector profits have soared as higher-for-longer interest rates boosted margins and loan defaults remained low. Yet analysts predict that imminent US interest rate cuts will squeeze profitability, despite the likelihood of reduced borrowing costs bolstering loan growth.

Dubai’s Emirates NBD reported a record first-half profit of AED13.8 billion ($3.76 billion), while First Abu Dhabi’s rose 3.3 percent year on year to AED8.4 billion and those of Dubai Islamic Bank and Abu Dhabi Islamic Bank increased 7.2 and 30 percent respectively.

A central factor in the sector’s sustained earnings growth – combined annual profits more than trebled from 2020-23 according to S&P Global data – has been the swift increase in US interest rates to a 23-year high of around 5.3 percent, from near zero in early 2022.

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Banks adjust their lending to reflect interest rate rises more quickly than they increase the interest rates paid on deposits, so higher rates usually mean greater net interest margins.

UAE interest rates mirror those of the US because of the dirham’s dollar peg. Market expectations are for a 50-basis point rate reduction at the Federal Reserve’s September 17-18 meeting and for further cuts totalling 50 bps by year-end, Julius Baer wrote in a September 4 note.

“UAE banks have benefited generally from rising interest rates as their margins expanded, so as rates start to decline banks should be negatively impacted,” says Shabbir Malik, a bank analyst at EFG Hermes in Dubai.

“That being said, not all banks will be impacted equally. Emirates NBD and Abu Dhabi Islamic are likely to be more affected than Dubai Islamic because of the nature of their balance sheets and how they're positioned for rate cuts.”

To determine the likely impact of rate cuts one must consider the maturity of a bank’s loan book, says Sherif El Etr, a banking analyst at CI Capital in Cairo.

“The sooner these mature, the sooner a bank will have to reprice lower,” says El Etr. “Abu Dhabi Islamic and Dubai Islamic have the longest maturity on their assets."

Blazer, Clothing, CoatTo determine the likely impact of rate cuts one must consider the maturity of a bank’s loan book, says Sherif El Etr — The impact of rate cuts will be influenced by the maturity of a bank’s loan book, says Sherif El Etr

Banks rarely hedge their loan books against interest rate changes, Malik explains.

“Corporate loans typically reprice faster than retail loans,” says Malik. “Interest rates on retail loans such as personal and auto financing are usually fixed for the term of the loan, with the rates only changing if the customer borrows more or decides to refinance.”

Lower rates should boost loan growth, say both Malik and El Etr.

Emirates NBD’s net interest margin was 3.65 percent in the second quarter, below the 4.08 and 4.05 percent of the third and fourth quarters of 2023.

Margins tightened year on year “due to higher funding costs, increased cash reserve ratios, and competitive loan pricing”, Patrick Sullivan, ENBD’s chief financial officer told a July 18 analyst call.

Such has been the magnitude of interest rates rises that many UAE customers have switched money to so-called time or term deposits – where savers receive a higher rate of interest in return for not withdrawing their savings for a set period – from current account and savings accounts, which pay little or no interest.

A 25-basis-point rate cut would impact First Abu Dhabi’s “bottom line” – net profit – by AED200 million, Lars Kramer, FAB’s chief financial officer, told a July 25 analyst call, noting a same-sized rate cut a year earlier would have caused a AED350 million hit to the bank’s bottom line.

“Even if we do start seeing rate cuts … we are in a much healthier position to accommodate those,” Kramer said.

FAB’s net interest margin was 1.94 percent as of June 30, up 20 basis points versus a year earlier. Dubai Islamic’s net profit margin – essentially the same as a net interest margin – was 3 percent in the first half of 2024, down 10 basis points versus full-year 2023, while Abu Dhabi Islamic’s was 4.6 percent in the first half of 2024, up 19 basis points from a year ago.

Corporate tax could increase to 15 percent next year from 9 percent currently, Malik said; 2024 will be the first year that banks pay corporate tax.

“So, banks will prioritise growing their balance sheet to offset this greater tax burden and other headwinds,” he said. “Profitability will come under pressure, although banks have a few levers they can pull to support their earnings.”