Dr Gokhan Ozevin, Senior Principal in the Financial Institutions Practise of Kearneyby Nabilah Annuar
UAE—An attractive banking market with unique characteristics
Most banking markets around the world have seen limited growth and profitability improvement in recent years. In contrast, despite the recent economic slowdown, UAE has been an attractive market from a growth and profitability standpoint and remains so.
UAE banking income grew at a CAGR of five per cent between 2014 and 2018. Average annual RoE over the same period was 13 per cent. UAE banking is characterised by relatively higher risk costs and lower leverage which are offset by a high degree of cost efficiency and somewhat higher margins.
Share staff costs in total costs remains very high. Corporate and GREs account for an unusually high share (approximately 70 per cent) of deposits and loans in the system, in line with the structure of the economy and concentration of dominated by real estate and trade, with increasing yet limited diversification into manufacturing, transport and oil and gas.
Deposits generate the lion’s share of risk-adjusted net interest income due to high risk costs associated with lending; high competitive pressure, negatively impacting pricing, and high share of current account and savings account in the deposit mix.
Wining primary relationships in retail and transaction banking business in corporate are key for sustained profitability.
Competitive dynamics changing rapidly
Competitive dynamics is changing rapidly in the UAE market— top-end of the market has become much more concentrated after the major mergers over the past couple of years.
While First Abu Dhabi Bank, Emirates NBD, Abu Dhabi Commercial Bank and Dubai Islamic Bank, together account for more than 75 per cent of assets, rest of the market remains fragmented and overbanked—five banks with asset market shares between 2-7.5 per cent and 11 banks with less than two per cent.
Growing pressure on mid-and small-size banks Impact of scale on performance becomes very visible the market is separated into three tiers based on asset market shares (Tier 1: > 5 per cent, Tier 2: 2-5 per cent, and Tier 3: <2 per cent asset market share in 2013).
Although Tier-2 and Tier-3 banks managed to maintain their market shares so far, we observe a sizable profitability gap between Tier-1 banks and the rest. While Tier-1 banks delivered positive economic value added from 2013 to 2018, Tier-2 and Tier-3 banks struggled to pay back their cost of equity.
Scale clearly matters, and gaps in digital as well as foundational capabilities contribute further to this profitability gap. We observe lesser productivity with Tier-2’s, and lesser productivity and lower risk-adjusted margins with Tier-3 banks.
Gaps in scale, digital and foundational capabilities are likely to start a problematic competitive cycle for Tier-2 and Tier-3 banks. Investment pools required for customer innovation will be inadequate. Customer may accelerate defection to competitors with stronger balances sheets, more convenient and innovative offerings.
In the absence of competitive value propositions, acquisition and retention levers may default to aggressive pricing and additional risk taking.
Leading indicators and technology trends pointing towards tougher times
Despite the unsupportive macro environment, profitability of UAE banks has remained broadly intact so far thanks to rising interest rates, cost-cutting efforts and financial buffers.
Decelerating loan and deposit growth, tightening margins, accelerating NPL formation ratio are pointing towards tougher times. In addition to the bleak macro background, shifts in habits and preferences of customers, ongoing structural changes with the rise of fintech, open banking, and entrance of ‘platform’ businesses continue prompting a fundamental transformation of banks' operating models.
Cost optimisation is necessary, but not enough
Commitment to efficiency and productivity gains
Rigorous cost management, more selective definition of target segments and focusing business models accordingly are necessary for Tier-2 and Tier-3 banks.
In addition to traditional cost optimization techniques, cost savings can be also achieved through cross-industry multi-bank efforts such as shared infrastructure, industry-wide utilities, smart outsourcing and strategic distribution partnerships.
In many developed and emerging markets, non-strategic assets and activities such as ATM infrastructure and network management, call centres, KYC processes, payments processing etc. are being shared.
Large banks or bank coalitions can position themselves as service providers/utility centres, selling their services to smaller banks, increasing their economies of scale. Another common route to efficiency is partnerships with companies from other industries and large digital and e-commerce platforms.
Sharper customer segment and experience focus
Smaller players should focus on (sub-) segments which are most attractive and where they are most able to compete and reduce commitments to noncore businesses to reduce organisational complexity and costs.
There is a wide gap between leaders and laggards in UAE banking in terms of customer experience quality. Banks should aim to leverage this customer experience gap to their competitive advantage.
Not all the advocacy drivers have the same impact for each bank. Identifying a bank’s unique formula for superior client experience given its competitive positioning in the market is key.
Revenue and margin growth
Successful growth starts with reaching full potential in the core business and there are many levers to this end. When a bank has little competitive advantage and generating returns below the cost of capital, it would be more appropriate to focus on profit improvement with little growth or investment, shrinking the business to more attractive segments/products/channels.
The chosen strategic intent should be supported by action across four essential enablers: value-based digital transformation, better analytics, agile ways working, and right talent and HR strategies.
Regardless of their chosen strategy, firm foundational capabilities such as digital-ready IT, robust capital management and risk processes are key for UAE banks.
Four essential transformational enablers
Digitise intelligently or die
Digital has the potential to enable stronger growth and lower costs. Digital fuels growth by allowing banks to create new products and propositions and do this much faster.
It also improves customer acquisition and retention by enabling an integrated multichannel offering that deepens customer engagement, intelligent sales and service processes where RMs can take advantage of advanced analytics tools.
Banks can extend their customer reach and distribution capacity, either partnering with online/offline players or positioning themselves as the hub of an ecosystem. On the cost side, digital allows banks to decrease cost of their customer sales and service interactions without sacrificing their richness.
Furthermore, through digitising and automating many time-consuming manual, non-STP processes they can reduce their reliance on branches, radically transform their CX, and take out a lot of cost.
Using data and analytics to boost performance
With the demand for faster information and decision making higher than ever, a progressive data strategy that effectively collects, integrates and manages data across the large numbers of customer touchpoints so that it can be acted on; adopting advanced analytics (big data analytics, AI/ML algorithms) and embedding them into operational workflows is both a key imperative and a low hanging fruit.
Agile ways of working
Leading banks in the UAE are adopting agile ways of working to tear down functional silos and cut down time to market of new products and services. Many have established digital factories, with the aim of accelerating transformation and eventually spreading the factory’s agile culture back to the larger organisation.
Scaling agile to projects with dozens of teams working on complex products over multi-year horizons presents a serious challenge to incumbents and require a careful redesign of the operating model.
Talent strategy for digital shift
To manage the transition to digital and data driven era, banks need to align recruiting and digital strategy, adapt performance management and recognition processes, rethink career tracks and flatten organisational models. They need to reinvent their talent strategies to attract, train and keep quality digital talent.
Strong foundational capabilities: Digital-ready it, robust capital and risk management
Banks that are serious about digital transformation will need to enhance their enterprise IT landscape along three critical dimensions.
Firstly, banks need to simplify their application and infrastructure architectures and decouple their application landscapes. Second, banks need to revamp their data management practises and provide a digital-ready data infrastructure.
Third, banks need to adopt continuous delivery and DevOps to automate their delivery processes to reduce time to market and increase development quality. Overall bank value metrics— EVA, RWA, etc.— must be consistently broken down across divisions and value creation targets should be integrated into target agreements for all business unit heads and must be regularly monitored.
UAE banks must continue enhancing their ability to manage risk, considering new opportunities emanating from data, analytics and digital tools as well as emerging new risk types. There is ample room in the market to further automate credit underwriting processes and workflows and use advanced analytics techniques (e.g. ML/AI, ensemble models) to improve the accuracy and consistency of risk models.
Where does all this leave banks?
Further consolidation may be only part of the answer. Banks need to think in terms of transformation rather tactical measures, have a comprehensive strategy and executive alignment to deal with the issues in front of them and meet the future of the industry.
This means seeking a sustainable business model, embracing a stronger customer focus, and intelligently investing in digital. UAE banks need to find ways to collaborate within the industry, firstly, to achieve a more efficient operating models, but more importantly, to effectively compete against nonbanks that are making inroads into financial services.
At this inflection point for the industry, those willing to be make bold decisions and take decisive action are likely to emerge as winners. It is important to remember that 'in the middle of difficulty lies opportunity’.