Moody’s views the outlook for the direction of credit conditions in the Egyptian banking system as stable, albeit with risks on the downside. This view is primarily underpinned by the considerable progress achieved on the banking sector reform programme being implemented by the Central Bank of Egypt (CBE) – including sector consolidation, upgrading the CBE’s supervisory and monitoring capabilities, the financial and managerial restructuring of the state-owned banks, and addressing the problem of their high non-performing loans (NPLs).
As a result, the banking system is now more resilient and better positioned to withstand pressures. The economy is also benefiting from strong economic growth (estimated at over 7 per cent in 2008), which has a positive impact on banks’ loan growth and business generation.
These positive factors are, however, counterbalanced by a challenging operating environment, characterised by low per-capita GDP, high unemployment, soaring consumer price inflation (despite slowing slightly) and the effects that the global economic slowdown may have on the Egyptian economy. The latter may also delay the completion of certain aspects of the banking sector reform programme, including the repayment of all public sector NPLs and the recapitalisation of the state-owned banks with core (Tier 1) capital.
National Bank of Egypt STA (m) Baa1/P-2 Ba2/NP D;
Banque Misr STA (m) Baa2/P-2 Ba2/NP D;
Banque du Caire STA (m) Baa2/P-2 Ba2/NP D;
Bank of Alexandria STA (m) Baa2/P-2 Ba2/NP D;
Commercial International Bank (Egypt) SAE STA (m) Baa1/P-2 Ba2/NP C.
The Moody’s-rated Egyptian banks comprise entities representing both parts of the two-geared system: the state-owned and privately owned banks. The state-owned banks have high market shares and solid funding franchises, but still generally display weak financial fundamentals, primarily because of the high NPLs, which drives down their profitability and capital adequacy. Implementation of their financial and operational restructuring is improving financials, risk management, processes and systems, but the shedding of their bureaucratic habits will take some time.
On the other hand, the leading private sector banks are smaller in size, but still have good franchises with good management and better systems/procedures than the state-owned banks; these factors translate to stronger financial fundamentals, although excessive loan concentrations are a key weakness for most rated banks. Based on the above, we expect the differentiation in ratings between private and state-owned banks to remain.
The recent global financial crisis and credit crunch has had a limited direct impact on the Egyptian rated banks: exposure to structure products was minimal, while none of the rated banks are dependent on market funding or are unduly leveraged (loans-to-deposits ratio of 55 per cent), although the cost of funding has obviously increased.
Since the introduction of Moody’s Joint Default Analysis and Bank Financial Strength Rating (BFSR) methodologies in April 2007, Moody’s has taken rating actions involving Egyptian banks on two occasions. The first was in June 2008, when the outlook on the Ba2 long-term foreign currency deposit ratings of the five rated Egyptian banks was changed to negative from stable. This rating action followed an earlier similar rating action on Egypt’s foreign currency deposit ceiling. The second rating action took place in August 2008, when the outlook on the D- bank financial strength rating (BFSR) of Bank of Alexandria was changed to positive from stable.
Positive rating factors
• Implementation of the Egyptian banking sector reform programme is leading to stronger, more efficient banks that are better positioned to withstand pressures;
• An under-banked market with significant medium-term potential;
• The underdeveloped retail, mortgage and SME sectors offer opportunities for growth – but this could be more of a medium-term proposition;
• Egyptian banks rated by Moody’s, especially those in the public sector, have a solid and broad funding Base;
• Hidden value in equity participations (mainly) in the state-owned banks: these are included in the financial statements at the lower of cost and fair value; trading gains from the sale of these investments are used to cover the loan-loss provision shortfall;
• Strong systemic support is factored into the banks’ deposit ratings.
Negative rating factors
• The high level of NPLs is a major issue facing the Egyptian banking system, particularly at the state-owned banks; however, this issue is being addressed as part of the banking sector reform programme. Connected to this is their weak profitability and capital levels;
• Industry consolidation is making the banking sector more competitive;
• High credit concentrations compromise banks’ risk positioning;
• A challenging operating environment characterised by low per-capita GDP, and high unemployment and inflation; but increased foreign investments and the government’s apparent commitment to the reform process also provide opportunities;
• An improving regulatory and supervisory framework, but in need of ongoing development.
Franchise value
In 2004, the CBE took over the responsibility for restructuring and reforming Egypt’s banking sector, and established a dedicated Banking Reform Unit (BRU) responsible for implementing its banking sector reform programme. The programme was based on four pillars:
(1) Consolidation and privatisation of the banking sector;
(2) Financial and managerial restructuring of the state-owned banks;
(3) Solving the problem of the high non-performing loans – specifically at the state-owned banks; and
(4) Upgrading the supervisory and monitoring capabilities of the CBE.
Implementation of the second and third pillars is having a major positive impact on the three state-owned banks (NBE, BM and BdC), which have in the past faced problems that compromised their overall competitiveness and financial agility. These included material asset quality problems in relation to their low capitalisation, weak recurring earnings, entrenched bureaucracy and challenges in raising staff calibre and modernising operations. The public sector banks have also been burdened by an inefficient corporate customer base, which mainly comprised public sector entities and companies with longstanding financial problems.
The situation as described above has been in the process of being fundamentally changed over the past three years. Under the auspices of the CBE and in collaboration with external consultants, restructuring is under way in the areas of (i) risk management, (ii) human resources and (iii) IT/MIS.
Significant progress has been noted on all three fronts; experienced bankers were recruited in key positions, early retirement schemes were offered to reduce employee numbers, new policies were introduced for selection, recruitment and appraisal, and numerous training programmes have been taken; new IT/MIS/banking systems have either been implemented or specifications delineated and vendors selected; new risk management policies and procedures were introduced.
At the same time, the banks’ medium-term strategic initiatives have been re-defined, and this has included a ‘front-office’ restructuring aimed at redefining processes, focus on client service, and expanding their product base and expertise to include SME and retail banking.
The operational restructuring of the state-owned banks, combined with their financial restructuring – specifically addressing the asset quality issues and low capitalisation – and their significant market share which exceeds 40 per cent, should allow these banks to strengthen their franchises, which already benefit from a strong retail funding base, extensive branch network, and high single-obligor limits that allow them to serve Egypt’s largest corporates.
However, in our view, implementation of the whole restructuring programme will take longer than management envisages. On the one hand, changing the “public sector mentality” and shaking off bureaucratic habits remains one of the state-owned banks’ most challenging tasks, while their levels of IT automation, operational re-organisation and risk management capabilities still lag behind those of the leading private sector banks. The global credit crunch and deteriorating macro/market conditions may also delay their financial restructuring.
A more competitive banking sector
The recent industry consolidation – triggered by the authorities’ decision to raise the banks’ paid-up capital requirements, the sale by state-owned banks of their stakes in joint-venture banks, and privatisations – has led to the number of banks operating in Egypt falling from 57 in 2004 to 40 currently. We believe this process is making the sector more competitive. Sector consolidation has also led to the entry/strengthening of foreign banks (including Intesa Sanpaolo, Societe Generale, Calyon and Barclays), bringing expertise, capital and an extended product range to the Egyptian banking system, while the concentration of population in Cairo and Alexandria makes it relatively inexpensive to develop a branch network with decent demographic coverage.
Nonetheless, the sector may still be considered under-banked given that only 10 per cent of the 75 million population have a bank account, and the loans-to-GDP ratio of 45 per cent in June 2008 indicates that there is significant growth potential available to local banks.
The underdeveloped retail, mortgage and SME sectors
Most Egyptian banks are now focused on growing their retail banking and SME businesses, which offer better profit margins than other lending. Expanding their retail base will also enable banks to diversify their operations, risks and revenue streams. Exposure to the retail sector is still low, and banks have good opportunities for selective growth: household debt as a percentage of GDP is estimated at under 9 per cent – well below the levels of developed markets.
Retail sector loans currently make up 20 per cent of total loans and just 7 per cent of total assets but nonetheless represent a significant area of growth. This is specifically so for mortgages, credit cards and personal loans, while the establishment of a credit bureau in July 2007 should enhance banks’ information set in consumer lending.
Mortgage-related finance constitutes less than 1 per cent of the sector’s total loans but the potential is much higher given the demands of a rapidly growing population. According to some estimates, more than 300,000 housing units will be required annually, and demand over the longer term is likely to soar when housing finance becomes more accessible. New foreclosure regulations, the establishment of a regulatory framework for securitisation, the availability of funding from development institutions, the easing of property registration rules and lower fees capped at EGP2,000, as well as the establishment of a Mortgage Guarantee and Subsidy Fund for low-income earners, should facilitate growth in the sector.
In general, banks appear to be following prudent guidelines in lending to individuals – a policy viewed positively by Moody’s. We believe that, despite all the steps taken by the banks to reduce credit risk, retail lending remains a new and developing area and it will take time to educate borrowers, enhance credit policies, controls and follow-up, and develop a delinquency track record. In addition, there are weaknesses in Egypt’s commercial code and legislation: in case of a dispute, legal proceedings are time-consuming and tend to favour the borrower rather than the lender, while any collateral held by the bank can take considerable time to liquidate.
With the above in mind, we believe that the critical factors for successfully penetrating the retail sector will be the quality of systems, expertise and credit knowledge. The state-owned banks can also use their extensive branch network to develop their retail business and lending, since their proximity to the customer would be an advantage in marketing new retail products and services.
Limited geographical diversification
None of the rated Egyptian banks have any material operations outside Egypt, and these are usually limited to a small number of branches or subsidiaries in some of the regional/global financial centres. We do not expect this to change over the medium term, as state-owned banks remain focused on their restructuring, and the leading private sector banks aim to capitalise on the potential offered within the country. Occasionally, some banks may test the waters in a foreign market, but at this point in time we do not foresee that this would contribute a significant proportion to their earnings. Although Egyptian banks’ franchise value is constrained by their lack of geographical diversification, we consider this a prudent strategy for most of them.
Risk positioning
Overall, Egyptian banks maintain a weak risk positioning constrained by high credit concentrations – their top 20 group exposures typically exceed 200 per cent of their Tier 1 capital, even before taking into account their sovereign exposures (currently rated Ba1 with a negative outlook by Moody’s).
With the exception of a small number of private sector banks, Egyptian banks’ risk management systems and corporate governance culture have historically been weak (especially for the state-owned banks), and this is still reflected in the high level of non-performing loans and significant related-party transactions to state-owned enterprises, whose ability to honour their commitments has proven questionable.
Visibility of these issues was also hindered by the fact that the financial statements of state-owned banks are prepared in accordance with the Egyptian Accounting Standards and audited by the Egyptian Central Auditing Organisation, while some important information (including level of non-performing loans, risk-weighted assets and capitalisation) is not publicly disclosed.
We do acknowledge, however, that as part of the banking sector reform programme, there is evidence of substantial improvements in both the risk management systems and corporate governance culture of the state-owned banks. In the areas of related-party exposures, no major new loans to weakly positioned public sector enterprises were noted, while the capabilities and expertise of the management team and the board have substantially improved following some high-calibre additions (especially at NBE).
The banks are also redefining their credit risk management processes by strengthening their origination, underwriting and monitoring procedures, introducing internal rating systems, centralising credit procedures and establishing a credit committee to review and approve loan requests. These new processes and systems should improve the banks’ risk management capabilities but a successful track record needs to be built before their positive impact can be confirmed.
Good liquidity management capabilities
Liquidity management capabilities at Egyptian banks are good, in our view, which is partly due to the CBE’s high reserve requirements. The CBE requires banks to maintain with it cash reserves equal to 14 per cent of local currency deposits (excluding deposits with a maturity exceeding three years) and 10 per cent of foreign currency deposits. In addition, the banks are required to maintain liquid reserves of no less than 20 per cent of their liquid liabilities (25 per cent for foreign currency), and also have the ability to raise additional funds through repo facilities offered by the CBE.
Egyptian banks have a moderate market risk appetite, primarily confined to interest and exchange rate risks, but – given relatively strict internal and regulatory limits – these are usually not excessive. The rated Egyptian banks have no material exposures to structured products, but the state-owned banks in particular are exposed to substantial equity/valuation risks given their sizeable equity investment portfolios. Such risks are not ‘visible’ when analysing financial statements (as the majority of these investments are carried at cost); however, the impact on the economic/fair value of a correction in the stock market could be substantial.
Profitability and efficiency
The profitability of the state-owned Egyptian banks remains weak, with a 2007 return on average equity of 4.1 per cent and return on average assets of 0.16 per cent. The banks’ low profitability levels are mainly the result of low net interest margins – of under 1 per cent partly because the banks have stopped accruing interest on non-performing loans – and high provision charges that absorbed more than 75 per cent of pre-provision income despite significant (EGP6 billion plus) one-off investment-related gains.
The bottom-line profitability trends are not expected to fully providing for NPLs. Efficiency indicators at the state owned banks also have potential to improve given their still low levels of automation and centralisation, public sector mentality, and over-staffing (although salary levels remain low).
According to the CBE’s annual report, private sector banks have continued to record a much stronger performance, with return on average equity at 16.5 per cent and return on average assets of 1.1 per cent even though these were lower than in the previous year (22.1 per cent and 1.5 per cent respectively). We should note, however, that the rated private sector banks (CIB and BoA) have both recorded strong earnings growth, as they focus on better-quality customers and are more efficient.
Hidden value in equity participations are being used to cover the provision shortfall
Public sector banks have equity holdings in numerous Egyptian corporations, including leading blue-chip companies. Most of these shareholdings are included under “Investments available for sale”, which are valued at the lower of cost and fair value, but with fair/market values estimated to be substantially higher than their book value.
As part of the CBE’s initiative for the banks to cover the provision shortfall, managements are disposing of many of these shareholdings – a move that helps release this hidden value in the form of one-off investment gains. The hidden value in the three state-owned banks as of June 2007 was estimated at above EGP10 billion ($1.8 billion), including shares in Sidi Kerir Petrochemicals, Alexandria National Iron & Steel Company, Alexandria Mineral Oils Company, Misr Beni Suef Cement, Abu Kir Co. for Fertilizers and Chemical Industries, and Ezz El-Dekhila for Steel – Alexandria.
Liquidity
Rated Egyptian banks maintain strong liquidity reserves and funding bases, comfortably meeting the minimum reserve requirements for local and foreign currency. Liquid assets account for more than 50 per cent of total assets, while government exposures (i.e. balances with the central bank and government bonds) are estimated to exceed 25 per cent of total assets. Egyptian banks rely almost exclusively on customer deposits to fund their activities, as these account for approximately 70 per cent of total assets, while the banks’ aggregate loans-to deposits ratio stood at under 55 per cent.
The state-owned banks in particular have solid funding bases, supported by their broad networks of branches and strong franchises. The three state-owned banks mobilise large volumes of stable deposits, and have a combined distribution network in excess of 1,000 branches and a market share of approximately 42 per cent of total deposits in the system. Household deposits comprise the largest component of total customer deposits, while funding concentration is being reduced.
Egyptian banks do, however, run large mismatches in the maturity profile of their assets and liabilities, but the risks are partly mitigated by their sizeable liquidity reserves as well as the ‘stickiness’ of customer deposits and lack of investment alternatives for the retail depositors (e.g. pension, money market funds). The ‘credit crunch’ has also increased the cost of funding – and in the case of Egyptian banks this is specifically so for dollar-denominated funding.
Capitalisation
According to CBE data, the sector’s capital adequacy ratio for 2007 stood at 14.8 per cent (against the 10 per cent minimum), with core capital representing approximately 10.8 per cent and supplementary capital approximately 4 per cent. More recent data show the ratio of shareholders’ equity to total assets at 6.2 per cent, but according to our estimates this ratio is substantially lower (at 3.9 per cent) for the state-owned banks.
Although the ratios appear adequate, we consider that – at least for the public sector banks – capitalisation levels are low. This is based on the high level of non-performing loans and the potential provisioning gap that exists – but this is partly mitigated by the substantial hidden reserves in their equity participations – and the fact that government exposures are zero risk-weighted even though Egyptian government bonds for both local and foreign currency are rated Ba1 with a negative outlook by Moody’s.
We believe that both managements and the government are aware of this issue, and have refrained from paying/receiving a dividend, while they are committed to re-capitalising them. BM has already received a EGP5.7 billion ($1 billion) subordinated – Tier 2 capital – loan from the proceeds of a policy loan from the World Bank and the African Development Bank, while a $500 million capital injection is earmarked for NBE from the proceeds of a loan from the World Bank. However, the capital adequacy of the state-owned banks will be partly dependent on whether these amounts are eventually incorporated in core/Tier 1 capital.
With regard to the private sector banks, following sector consolidation and the entry of stronger regional and international banks, many of these banks are now better placed to raise additional capital if and when required.
Egyptian banks have not yet implemented Basel II. The CBE is, however, in negotiations for the signing of a new three-year protocol with the European Central Bank to assist with Basel II implementation; the project is due to be launched at the beginning of next year. We believe that Basel II implementation will help strengthen Egyptian banks’ risk management processes by recruiting specialised risk professionals, acquiring new systems to measure and monitor risk, and improve their public disclosures on risk issues.
Asset quality
Asset quality issues have been a major concern for state-owned Egyptian banks for many years, but limited information has in the past prevented us from accurately quantifying this problem. NPL balances are not disclosed in financial statements, which are prepared under Egyptian accounting standards and audited by the Egyptian Central Auditing Organisation. However, owing to restructuring efforts by the CBE, the banks have in recent years been more forward in discussing – and more importantly addressing – the asset quality issue, while the flow of information has also improved.
Based on discussions held with the banks’ managements, we estimate the level of NPLs at state-owned banks at above 20-25 per cent of gross loans, also incorporating the fact that non-performing government/public enterprise-related loans are not classified while a number of recently rescheduled loans are now classified as performing.
With this in mind, we consider the current provision reserves of approximately 16 per cent of gross loans as insufficient, although we should note that asset quality was also adversely affected by the acquisitions of weak/problematic banks (such as NBE’s acquisition of Mohandes Bank and Al Tegareyoon Bank, and BM’s acquisition of Misr Exterior Bank).
The government is committed to resolving the issue of the high NPL balances that relate to state-owned banks’ exposure to public sector enterprises. This commitment was manifested by its move to settle Bank of Alexandria’s public enterprise loans (EGP6.9 billion/ $1.2 billion) ahead of its privatisation, while a final agreement was reached with the Ministry of Investment regarding the amount of NPLs (EGP19 billion/ $3.4 billion) owed by public business enterprises to the remaining state-owned banks.
Approximately half this amount has already been paid in January 2007 from privatisation proceeds: NBE received EGP2.3 billion ($418,190), BM received EGP5.55 billion ($1 billion) and BdC received EGP1.3 billion ($236,421). However, as a result of the current more challenging operating environment conditions, final settlement of the outstanding amount may take longer than anticipated.
To address the private sector NPLs, the CBE has established an ‘NPL Management Unit’ with public and private sector banks also instructed to establish similar units. The purpose of these units is to reschedule and/or settle non-performing accounts, primarily via moral suasion. A Secretariat for Conciliation and Arbitration was also established to undertake the management of the settlement mechanism and to offer banks an alternative to lengthy court proceedings. According to CBE officials, 92 per cent of private sector NPLs have already been rescheduled and 43 per cent of NPLs settled as a result of these initiatives.
The CBE, together with the state-owned banks, has also completed a programme to resolve small NPLs in the manufacturing, trade and services sectors, resulting in the resolution of 7,600 or 63 per cent of the total cases addressed by the programme.
Although such actions are considered basic for more developed banks, they are nonetheless an important step forward for the state-owned Egyptian banks. We believe that all state-owned banks and the CBE are committed to addressing the asset quality issue, by settling/rescheduling existing problematic exposures, building up the provisioning reserves and strengthening their credit policies and risk management systems. Nonetheless, we believe it will take at least another two to three years before the provisioning gap in the state-owned banks can be substantially covered.
Private sector banks display better asset quality than state-owned banks
The top-tier private sector banks typically display better credit vetting and controls than their public sector counterparts; in many cases, these were introduced by their foreign shareholder banks. They have mainly been involved in lending to good-quality public sector institutions and leading private sector companies. Generally, the leading private sector banks suffer from fewer problem loans, while provision reserves are broadly in line with NPLs. A review of the banks’ latest financial statements does not reveal any significant deterioration in asset quality, although we are mindful of the global economic turmoil and will monitor this closely in the coming months.
Deposit rating drivers
Moody’s uses its joint default analysis (JDA) methodology to incorporate the potential for external support into a bank’s local currency deposit rating. The potential for external support – systemic or other external support – can improve the creditworthiness of a bank’s deposit and debt obligations; however, such support is often uncertain.
With regard to systemic support, Moody’s assesses Egypt as a ‘high’ support country. This guideline takes into consideration the history of support for banks, and the size, strength and degree of fragmentation of the Egyptian banking system. Although there is no deposit insurance scheme in place, the Egyptian authorities have historically demonstrated both their willingness and their ability to intervene and prevent a banking default by any of the Egyptian banks, irrespective of their size or relative importance to the system.
Moody’s therefore believes that the probability of systemic support is very high for the rated private sector Egyptian banks while full systemic support is assessed for the public sector banks, and hence their deposit ratings are also supported by the rating of their underlying support provider, i.e. Egypt’s A3 local currency deposit ceiling. As a result, we rate the public sector Egyptian banks’ deposits an average of four notches higher than their respective Baseline Credit Assessments, and the private sector banks’ deposits are rated one or two notches higher unless they also benefit from parental support (as is the case for Bank of Alexandria which benefits from a two-notch parental support).
The foreign currency deposit ratings of all rated Egyptian banks are currently constrained by the country’s foreign currency deposit ceiling of Ba2. The outlook on these ratings is negative, in line with the outlook on this ceiling.
Constantinos Kypreos is a Vice President and Senior Analyst for Moody’s in Cyprus; Mardig Haladjian is Managing Director for Moody’s in Cyprus and Antoine Yacoub is an Associate Analyst for Moody’s in Dubai.