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Even as Gulf banks struggle to find funds to offset a severe liquidity shortage triggered by the global financial crisis, they also suffer from a decline in their assets.
The combined assets of the banks in the six-nation Gulf Co-operation Council (GCC) recorded a drop despite measures by monetary authorities in some members to support the banking sector with cash injections and relaxation of reserve requirements.
Bahrain, which has the largest offshore banking sector in the region, suffered from a sharp decline in its bank assets, which plunged to nearly $244.5 billion at the end of January from $252.3 billion at the end of December, according to the Central Bank of Bahrain.
The largest decline was in their foreign assets, which slumped to around $197.9 billion from $203.6 billion in the same period.
In the UAE, which has the largest banking sector in the Arab region, the combined assets of its 24 national banks and 28 foreign units declined to around 1,466.5 billion dirhams at the end of January from 1,480.5 billion dirhams at the end of December after recording a steady increase in the past months.
Figures by the Central Bank show their loans and advances recorded one of their slowest growth rates in two years as they edged up by only around 0.4 per cent to 1,022 billion dirhams from 1,018 billion dirhams during the time.
But deposits suffered from their first fall in more than a year, dipping to around 905.7 billion dirhams from 922.5 billion dirhams after growing from 906 billion dirhams at the end of November and 883 billion dirhams at the end of October.
After slipping by around three billion dirhams in December, the banks' capital and reserves recovered to nearly 177 billion dirhams at the end of January from around 153.6 billion dirhams at the end of December, the Central Bank says.
Despite the decline, the UAE banking sector retained its position as the largest in the Arab world in terms of assets after overtaking Saudi Arabia in 2007.
Meanwhile, Saudi banks still have sufficient liquidity to meet domestic demand for credit but they are adopting a tight lending policy following a sharp growth over the past year.
As the kingdom is plunging slowly into a recession because of the sharp fall in oil prices and its production, private sector demand for credit is also slackening.
"We think that the debate about banks' liquidity should be refocused. Liquidity in the strict sense for a bank is its ability to meet its financial obligations as they come due," the Saudi British Bank says in a study.
"We think that banks are liquid in that sense and far more liquid than many regional banking systems. While banks can't lend ad infinitum, we believe that there are three interrelated trends unfolding in the banking system."
How will central banks cope with the situation? What would be done to ensure proper liquidity in the system?
UAE's Central Bank governor Sultan Nasser Al Suwaidi says: "There will be a trend towards creating banking systems that depend 100 per cent on local finance, which will give traditional commercial banks an advantage over investment banks."
Al Suwaidi says the UAE's banking and monetary policy would from now on concentrate on guaranteeing a reasonable expansion of credit with low interest rates and restricted expansion of the banking sector.
"The level of liquidity in the banks currently seems stable as no bank is currently drawing an amount exceeding its obligatory reserves from its current account at the Central Bank.
"In addition, the interest rates on deposits among the banks have decreased, though they are still higher than those in some GCC countries."
The Manama-based Gulf Finance House (GFH) says it expected GCC banks this year to suffer from their first negative growth in their profitability in eight years as a result of credit tightness, the collapse in crude prices and lower business activity in the region.
"In our opinion, these dynamics will affect GCC banks in some ways.
"Firstly, most GCC banks will witness profit contraction during 2009, as a result of slower growth in business volumes. Lower net interest income will compound the impact of losses on investment portfolios and lower fee income on bottom lines. Some banks will need to recapitalise or merge, and, in the process, cut back on credit expansion to improve capital adequacy metrics," GFH says.
"Secondly, in order to ensure adequate capitalisation, banks will take one of three routes - either recapitalise earnings and cut back on dividends, seek private shareholders' money via rights issues, and/or sell stakes to strategic investors, government or quasi-government bodies, as has been the case in Qatar."
With the Gulf downturn expected to last until 2011, what strategy should financial institutions adopt?
That no GCC financial institution has yet reported huge losses illustrates that the region's tight regulation has largely worked.
But, policymakers and experts across the board feel that financial institutions should kickstart lending to long-term projects.
Governments need to increase their participation in the banking sector by increasing deposits in banks. Such a move would also provide greater room for banks to increase their exposure to risky assets.
