UAE Banking: Storm Signals in ADCB's 3Q2016 Financials

AA Has the Full Range of Flags, If Needed

As promised earlier, further thoughts on ADCB’s 3Q16 financial report plus an added bonus--a typical AA “get off my lawn” rant on financial reporting and regulatory environment.  The latter in a separate section at the end.

Introductory Comments

If you know your nautical flags, you will immediately see that the “storm signals” warning is at a modest level. In other words, I am not predicting an imminent serious crisis for ADCB.

The bank has reasonably robust stand-alone financials, though note the reporting  “lapses” discussed below. 

If by some low probability event, the bank were to develop life-threatening problems, it would almost certainly receive official support as it and other UAE banks have in the past, e.g., after the Great Financial Crisis of 2008.    The Abu Dhabi Government owns more than 60% of ADCB’s equity and has a special “incentive” to step up and has the resources to do so.  ADCB is a systemically important bank. Thus, the Central Bank is also likely to provide support.

If there is no imminent danger of collapse, why this analysis and why the use of the term “storm signals”? 

Free float is generally low in GCC equities (ADCB somewhere around 30%) and generally this free float is primarily in the hands of retail and not institutional investors, the latter presumed to be less susceptible to market panic.  Note I said “less susceptible” not “not susceptible”.  

In such “markets”, the price impact of investor actions—sales or purchases--is outsized relative to other markets.  A change in market sentiment and one’s return on ADCB stock could decline.  A large enough market decline and one might lose some of the initial investment, depending on one’s entry price. 

These characteristics increase risk.  If risk is higher, then the utility of a warning is greater.  

In addition as is the case here, when an issuer’s financials are deliberately opaque, the utility of a warning increases.   

“Storm signals” like the picture of the flag above provide warnings about potential problems. 

If there is a gale force typhoon in progress, one hopefully doesn’t need to see a flag to decide to keep one’s boat in port.  But if the storm is not yet fully apparent, a warning flag can prevent the sailing of boat, a change in its planned course, or alert the crew to be on the watch for the storm if they decide to leave port on the original course. 

Financial storm signals serve the same function for investors.  Warnings can be used to trigger action to prevent losses or in some cases to gain profit. 

One final note:  warnings about potential problems are not infallible.  Sometimes no storm appears. Sometimes the storm is much different from that predicted. 

Some Technical “Notes”

I used NBAD and FGB to provide some comparisons to ADCB’s financial reporting.  NBAD’s business is different from ADCB’s in many respects so I acknowledge there are limitations to that comparison.  

Abbreviations:   3Q16 = Third Quarter 2016.  FYE15 = Fiscal Year End 31 December 2015.

Financials: 

1. ADCB:  3Q16, 2Q16, 1Q16, FYE15  
2. FGB Annual Financial Reports Access Page,  FGB Quarterly Financial Reports Access Page
3. NBAD Financial Reports Access Page

Summary

During my review of ADCB’s 3Q16 financials I noticed two significant developments which occurred primarily in a single quarter—3Q16— and which may be signs of distress in the loan portfolio. 

1. Accrued Interest Receivable (AIR) jumped some 50% from FYE15 (31 December 2015) with more than 70% of the increase during 3Q16. 
2. Overdrafts increased some 84% from FYE15 with all the change occurring in 3Q16.    

My concerns were exacerbated by a major deficiency in ADCB’s financials – a failure to report renegotiated loans.  The absence of this rather critical piece of information prevents a deeper analysis of the bank’s condition and raises questions why it isn’t provided.      

Are these 2016 “developments” and the reporting deficiency signs of problems in the loan portfolio?  Does the failure to disclose renegotiated loans indicate that the bank is “actively managing” (AA euphemism of the post) non-performing loans (NPLs)?   That is, hiding problems?  Or are there other more “innocent” explanations?  

There isn’t enough information to make a conclusive call.  On the one hand, it’s hard to build a case for a trend based on a single data point (3Q16 financials).  But the failure (which predates 2016) to disclose required information, the significant “divergence” from past financials, and the fact that these apparently occurred in a single quarter suggest that not everything is “right”.

We won’t get more financial information until FYE16 financials are released and more likely than not the same reporting or non-reporting standards will be used.  A lot can happen until then.

ADCB isn’t “going down” but its share price can.  That’s important for equity investors because by their nature share prices are more volatile than debt prices.  The limited free float and the composition of the investor base for ADCB stock exacerbate that natural characteristic for this stock.

Accrued Interest Receivable (AIR)

Problems in the loan portfolio often show up in increases in AIR before NPLs are formally acknowledged in the financials.  AIR on NPLs often turns out to be as substantial as the air we breathe.

ADCB’s AIR (included in Other Assets) was AED 1.6 billion at 3Q16, AED 1.2 billion at 2Q16, AED 1.3 billion at 1Q16, AED 1.1 billion at FYE15, and AED 1 billion at FYE14.

A couple of things jump out of those numbers.

1. The increase from FYE15 to 3Q16 was approximately 50%.  That’s larger than the 11% growth in loans. 
2. More than 70% the increase from FYE15 occurred in a single quarter--the third quarter. 

If ADCB is accruing interest on a time proportion basis, then it would seem that increase would be gradual unless loans ballooned between 2Q16 and 3Q16. 

That doesn’t appear to be the case. Net loan outstandings were AED 162 billion (3Q16), AED 155 billion (2Q16), AED 157 billion (1Q16) and AED 146 billion (FYE15).  An increase of only 11% since the beginning of the year.

If volume isn’t driving the increase, then it could be pricing.  A higher rate on newly extended loan(s) in 3Q16.  If we assume rates were higher just on the AED 7 billion increase in loans between 2Q16 and 3Q16, the rate would have to be around 23%.  That doesn’t seem likely.

It might also be an overall rate increase on the total portfolio or at least an increase on those loans that reprice quarterly. In such a case, it’s more likely that an increase of this sort would come from an increase in the base rate not an overall increase in credit margins. 

Assuming that were the case, an approximate 1% increase on the entire portfolio for three months would be required to boost AIR by AED 0.4 billion. Looking at FYE 15 Financials Note 44 “Interest Rate Risk, some 70% of ADCB’s loans are priced off base interest rates three months or less.  That would make the required base rate increase about 1.45%, assuming that the other 30% could not be repriced.   According to CBUAE data, EIBOR has not risen by that amount during this period. 

But we don’t have to look at external rates.  We can look at ADCB’s financials where an increase in the rate on loans would have to show up in gross interest revenue.  A back of the envelope analysis of quarterly interest revenue on loans to customers divided by the average of the total balance of customer loans and advances (computed using beginning and end of the period totals divided by two) shows an average 4.3% annualized yield on the loan portfolio for the three quarters of 2016 roughly consistent with full year 2015's annualized yield, though on an individual quarter basis the yield is declining:  4.44% (1Q16), 4.27% (2Q16) and 4.22% (3Q16).  2016 gross interest income on customer loans is roughly AED 1.9 billion a quarter which would put it AED 0.4 billion over 2015 but for the entire year.  However, if interest repayments are quarterly as argued above, AIR shouldn’t increase this much because clients should be paying roughly quarterly.   

A cursory inspection of other components of interest income doesn’t show any other asset types likely to be responsible for the increase –these are much more modest in amount and are fairly consistent across 2016 and comparable to the 2015 total performance (divided by four).   

So it seems an interest rate increase is unlikely for the AIR jump as well.

What are other explanations? 

1. A “catch-up” accrual – correcting a mistake(s) made earlier in 2016.  Would have been a whale of a mistake, though as we know “whales” are not that uncommon even in the Thames.  
2. A write back of previously “uncollectable” interest.  Both 1 and 2 should appear in the financials.  I didn’t see anything to indicate this. 
3. A failure by a borrower or borrowers to make an interest payment.  As noted above, Note 44 states that more than 70% of the bank’s loans were priced off interest rates three months or less at FYE15.  This probably hasn’t changed much in 2016, though we won’t know until FYE16 financials are released and then we’ll only have end of period information. Standard banking convention would be that interest is due at each repricing.  So it is possible (but not conclusively proven) that non-payment could explain a spike in the AIR.  If you’re wondering, details like those in Note 44 are not mandatory for interim financials.

Overdrafts

Increases in overdrafts are often a sign of problems. 

[AA side comment:  Another reason for looking here is historical not necessarily analytical.  Those who know their UAE banking history know that the UAE banking system floundered on “perpetual” overdrafts with capitalization of interest (to add insult to injury). ADCB was formed from the wreckage of Emirates Commercial, Federal Commercial, and Khalij Commercial Banks back some 30 or so years ago.]

At 3Q16 OD’s stood at AED 8.3 billion compared to AED 4.5 billion (FYE15) and AED 3.7 billion (FYE14), roughly an 84% increase since FYE15 and 124% since FYE14.  Note that even with the increase ODs are roughly 5% of the loan portfolio, not a large amount unless you compare them to total equity at 30 September 2016.  In that case the figure is 28%. 

OD’s increased rather dramatically in 3Q.  ODs were AED 8.3 billion (3Q16), AED 4.5 billion (2Q16), and AED 5.0 billion (1Q16).  Like AIR, the increase was concentrated in 3Q16.  Unlike AIR, the entire increase took place in the third quarter.   

By contrast NBAD’s comparative figures are AED 10 billion (3Q16), AED 12 billion (FYE15), and AED 14 billion (FYE14).   A 17% decrease since FYE15 and 29% since FYE14.   

FGB doesn’t provide this information, probably based on “materiality” compared to the aggregate amount of the loan portfolio.  ODs at both NBAD and ADCB were about 5% of total loans well under the traditional 10% materiality standard.  A similar level is likely at FGB.

So why is AA making a “federal” case (pun intended) on this issue? 

ODs are one of the trickier forms of credit for banks to manage. 

When extending loans with a defined drawdown period and defined repayments (triggered off the end of that drawdown period and specified by date and amount), banks perform a detailed analysis or should. Monitoring of the status of the loan has well defined milestones in the form of amount and date certain contractual repayments. 

Overdrafts don’t have the same clearly defined signposts as these other loans do.  Typically, the test for non-performance of an OD is an absence of adequate turnover (drawdown and repayment transactions) which has led to a persistent level of debt.  This test is based on the concept that ODs are revolving facilities that should track the borrower’s business/cashflow cycle, increasing when expenditures exceed cash collections and then reversing as collections exceed expenditures. 

This test makes monitoring more difficult and allows more discretion in the timing of classifying a loan as non-performing.  What is an adequate “turnover” of transactions in the account?  What time period should be used to determine that a persistent level of debt has been reached? Does a slowdown in economic activity justify new norms and how should these be calibrated?  Beyond conceptual issues like these, there is also the practical matter of conducting effective monitoring, keeping one’s eye on the ball.

Non-Disclosure of Renegotiated Loans

ADCB does NOT disclose data on renegotiated loans.

AA understands that IFRS #7 (I believe paras 36 and 44, though I am not a hafiz of IFRS) require that this information be disclosed.  Both FGB and NBAD disclose this information. NBAD takes the prize for disclosure.  Let’s hope the merged entity follows NBAD reporting standards. 

NBAD’s FYE 2015 Annual Report Note 4a provides aggregate totals and a reconciliation of the movement in renegotiated loans.  As per that information, during 2015 NBAD’s renegotiated loans doubled to AED 2.6 billion.

By contrast ADCB has a “bland”  “philosophical rumination” defining renegotiated loans but no numbers.  Not really of much analytic utility.  

But it could be worse, here’s a quote from ENBD’s 2015 Annual Report.

Loans with renegotiated terms are loans, the repayment plan of which have been revised as part of ongoing customer relationship to align with the changed cash flows of the borrower with no other concessions by way of reduction in the amount or interest, but in some instances with improved security. These loans are treated as standard loans and continue to be reported as normal loans.

ADCB almost certainly has renegotiated loans.  See the Fitch quote below. 

The bank also has a concentrated portfolio with large individual and aggregate exposures to government related enterprises (GREs) and “private” companies connected to the shaykhly but hopefully not shaky elite.  By some estimates (see Fitch report linked to below) the latter is twice the GRE related exposure.  Ample “opportunities” for problem loans.   

Failure to disclose renegotiated loan data--amounts and other IFRS required information--indicate to AA  that the bank thinks it needs to hide this information.  Why?  Presumably not because it has so few but rather because it has so many.  IFRS-required disclosures would enable a reader to determine when renegotiation took place –giving an indication of whether NPL problems were increasing or decreasing.  That is precisely one of the reasons that IFRS #7 imposes this requirement.

What could be another reason for not reporting this information?

Renegotiating loans typically gives the borrower less onerous terms – lower interest rates, a revised repayment schedule, a longer average life of the loan.  In some cases payments can be reprofiled to push substantial amounts of principal payments well into the future – “ballooning” as one banker I know calls it. 

Take an extreme example: a loan maturity is extended from 5 to 20 years with 80% of principal due during the last three years.  For the first 17 years of the renegotiated loan period, maintaining a “performing” status is much easier than if the loan were extended for a shorter tenor with equal semi-annual principal installments.    

If a bank takes pre-emptive action (before a loan has missed a payment) it can avoid declaring the loan non-performing, thus, “hiding” NPLs and making the bank’s loan portfolio look more robust than it actually is.   If it doesn’t report renegotiated loan data, pre-emptive NPL management might not be noticed by the market.

However, there is no evidence in ADCB’s financials of a massive increase in loan maturity as per Note 45 “Liquidity Risk” in FYE15 financials.  The relative percentages in less than one year and the other two maturity “buckets” for 2015 are almost spot on with 2014. 

But the bank’s reporting is also opaque here as well.  

ADCB uses a maximum maturity “bucket” of “over three years”.  FGB and NBAD use maximum maturity “buckets” of periods of “over five years”.    ADCB therefore has more room to maneuver. If a loan with a three year maturity were extended two years, this would not show up in the Maturity Risk note at ADCB.  It would at FGB or NBAD.    

Dramatically lengthening maturities is one but not the only way to avoid NPL status.  One could back end principal payments (making later repayments higher than nearer repayments) with much shorter extensions of maturity.  If a bank were pro-actively managing problem loans to prevent the appearance of NPLs and did not disclose renegotiations, it could use future renegotiations to manage the problem on a rolling basis. 

But we can’t tell from ADCB’s financials what , if anything, might be going on.

With no evidence in the financials, let’s turn to a quote from Fitch’s August 2016 ratings report (which by the way confirmed an A+ rating for the bank).  Boldface courtesy of AA.

ADCB does not disclose the volume of renegotiated loans, but Fitch understands that it has done a lot of corporate loan renegotiations since the crisis and has reclassified most of these exposures back to performing over this time as they demonstrated normal performance.  ADCB renegotiated some of its 20 largest exposures during 2015.  Fitch understands that these loans would be overdue if they had not been renegotiated.

We don’t know for certain if ADCB is pre-emptively renegotiating troubled loans to avoid having to declare them non-performing, but that’s clearly one way to read the Fitch quote.  Non-disclosure of renegotiated loan information certainly provides cover for such activities, if they are occurring.  AA can’t think of a single “benign” reason why ADCB would withhold this information. One final comment on the Fitch quote: if the terms of the renegotiated loan are generous enough, the bar for “normal performance” may be set low indeed.

AA was also troubled by ADCB’s new external auditor signing off on the financials as being in compliance with IFRS.   As AA understands it, IFRS compliance is all or nothing.  One can’t be partially compliant.

Troubled as well by the CBUAE’s apparent acquiescence.  That being said, though there is both historic precedent elsewhere in the GCC, what wags refer to as IRS (Investcorp Reporting Standards), and closer to home and time, CBUAE “Dubai Inc” renegotiated loan treatment rules.   

Another Warning But This Time About Something That Definitely Will Happen

Accounting and Regulatory “Rant”

Cashflow Statements: 

Accrued but uncollected interest is not a “use of funds” that “increases” Other Assets as seems to be common reporting practice for ADCB, FGB, and NBAD.  Until interest is paid by the borrower, it is uncollected revenue and not cash. 

There are two consequences. 

1. Since it wasn't collected, it is properly a deduction from net income on the cashflow statement. 
2. Since it isn't cash, it can't be used to fund an increase in Other Assets. 

If one insists on treating AIR as a “use” of funds, then the statement issuer and its auditor have the duty to disclose the components of Other Assets so that financial statement users can determine what is happening with collection of AIR.  Financial statement users should not have to wait for annual reports to get this information.

Investors/Creditors: 

When issuers shy away from disclosure, it’s usually because they have or think they have something to hide. 

1. Lack of disclosure limits an investor’s ability to monitor and thus protect its investment. 
2. More importantly it offers an important insight into the business ethics of an issuer. 

Should you invest with an issuer that withholds basic information from you? And may be withholding that information so it can “manage” its financials?  

Standard financial theory holds that when risk is higher, investors should demand a higher risk premium.  But a key wrinkle to the successful implementation of this theory is that realized returns are often much lower than earlier anticipated or promised returns.  A problem more acute with equity than debt because with equity there are no contractual “promises” and equity prices are more volatile.