For almost a decade, retail banking has expanded briskly in the countries of the Gulf Cooperation Council—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. Favorable oil prices, sustained GDP growth, high lending margins, and a young and growing population ready for consumer loans and credit cards have persuaded many institutions to go beyond corporate banking. That move has earned them solid profits (Exhibit 1). Indeed, by growing with the local lending markets and holding a considerable number of deposits from Islamic customers, who forgo interest because of religious considerations, many Gulf banks can boast higher levels of profitability than most retail banks in Western Europe.¹

But the growth of the simpler lending products has now slowed down, and with interest rates in decline the advantage of sitting on deposits that bear no interest shrinks day by day. As a result, Gulf banks now realize that continued revenue growth will come only from deeper market penetration, which means developing and selling more sophisticated products. Competition is already heating up. Top-performing local banks that entered the consumer market early, such as National Bank of Kuwait (NBK), are busy building their marketing, sales, and distribution skills. International institutions such as Citibank and HSBC are expanding in the region in force, bringing best practices in marketing and distribution.

Superior skills in product development, sales, and distribution will be vital if Gulf banks are to confront a challenge familiar to banks in Eastern Europe and other emerging markets: customers whose income and wealth vary a good deal (Exhibit 2). Banks in the Gulf States could once limit their attention to affluent people—individuals with financial assets of more than $25,000—who contribute more than 70 percent of bank profits. But these banks must now deal with the mass-market customers brought into the banking system by the recent shift away from salaries paid in cash and toward electronic deposits. Although banks can achieve handsome profits from consumer lending to upper-mass-market customers, the low-paid expatriate workers from North Africa, Southeast Asia, and the Indian subcontinent, who constitute the lower mass market, will continue to be unprofitable as customers unless radically cheaper ways can be found to serve them. Banks must therefore tailor their products (and the way they market, sell, and distribute those products) to the needs of each customer segment—and satisfy themselves that value is to be had by doing so.

New products and the Islamic factor

A vast part of the Gulf States’ population opened bank accounts for the first time during the past ten years. These newcomers to the banking system then received their first loans and credit cards, so the market for simple products expanded quickly—typical of banks in emerging markets. Now such growth has slowed down as the penetration of consumer loans has reached, for example, 6 percent of GDP in Saudi Arabia, a level similar to Southern Europe’s. This development leaves open more complicated opportunities: long-term savings and investment products, for instance, must be marketed to an affluent population that traditionally invests in local real estate and otherwise prefers to hold its savings in liquid assets. Saudi institutions such as National Commercial Bank (NCB) and Riyad Bank are marketing expanded offerings of mutual funds, while Saudi Fransi has introduced pension and educational-savings plans to a broader base of customers.

Gulf banks also confront, in the form of Islamic banking, a segmentation challenge that transcends categories of income and wealth. The conviction underpinning Islamic banking is that investments should be put to productive rather than speculative use and that a lender, instead of charging interest, should be compensated with a share of the profits. In providing a consumer loan, for instance, the bank would in practice buy the desired item—for example, a car or a television set—and resell it at a margin to the consumer, in essence transforming a conventional loan into a marked-up installment purchase or the equivalent of a leasing contract.

Islamic banking currently poses a real if somewhat unpredictable challenge to conventional banks

Islamic banking has come of age since its beginnings in the 1980s and now poses a serious if somewhat unpredictable challenge to conventional banks; it has already expanded to control 20 percent of banking assets in some Gulf countries, and Islamic assets are poised to grow more rapidly than conventional ones over the next half decade. In Saudi Arabia, for instance, Islamic mutual funds have grown at an annual rate of more than 15 percent during the past few years and now command 60 percent of the total mutual-fund market.

Specialized products are coming not only from Islamic institutions, such as Saudi Arabia’s Al-Rajhi and the Kuwait Finance House, but also from the Islamic-finance divisions of banks such as NCB and Riyad Bank. NCB, which is leading the way by adapting mutual funds, savings instruments, and consumer loans to Islamic rules, is Saudi Arabia’s largest mutual-fund provider, with a market share of more than 40 percent. It is now joining with Deutsche Bank to create globally marketed structured financial products (such as index certificates) that comply with Islamic rules.

International banks such as Citibank have long been active in Islamic finance; others must expand their range of banking products in this area to compete with the Islamic financial institutions. Some international banks are now developing Islam-compliant credit cards that offer customers a credit facility but charge the financing cost in the form of a service surcharge. Certain institutions continue to enter the sector at every level: in Bahrain, for instance, Union Bank of Switzerland recently established a subsidiary called Noriba focusing on wealth management for the Gulf’s Islamic sector.

Because Islamic banking often grows at the expense of conventional products, local banks should evaluate the overall economics of the different approaches before expanding their product and service range to Islamic clients. For some banks, an alternative to the expense of establishing a separate network of Islamic branches (as NCB did) might be to distribute Islamic products in a "window"—as a separate product family, possibly with specialized customer-service representatives. Perhaps 15 to 20 percent of all consumers have a strong preference for a purely Islamic provider, but most consumers seem happy to obtain Islamic products from conventional banks. This option is a top priority for banks in Kuwait as they look to the country’s parliament to pass, this year, long-awaited legislation that would open up Islamic banking to all institutions in the country.

Overhauling marketing and sales

As the products and customer segments of banks become more complicated, banks must persuade their frontline staff to think beyond transactions and develop a strong sales culture. That transformation will entail comprehensive changes in the way sales are organized, staff trained and rewarded, and products designed—which in turn will require explicit managerial involvement. Because the sales function is central to the way a business works and performs, its reorganization is essential for a real cultural change.

Few institutions now have a full overview of their relations with each customer, and cross-selling rates in the region are mostly quite low. Some of the Gulf banks have invested more than $20 million in customer-relationship-management (CRM) software but, burdened by a lack of knowledge about their customers and by weak sales organizations, have little to show for their money. Banks must now redesign the business processes of their branches and call centers to take advantage of IT systems.

In addition, many banks will need specialized sales forces for products beyond the scope of the branch. Citibank is leading the trend with a door-to-door sales force, which has helped the bank’s Saudi subsidiary, Saudi American Bank, to achieve uncontested leadership in credit cards. Only a few local players are really pushing mobile sales. One of them, Kuwait’s Gulf Bank, has used this approach to boost its growth in profitable retail products.

Designs for distribution

The next big battle will be to win over the affluent. To do so, a bank must first categorize all its customers and then tailor the way it serves them. Saudi American Bank, for example, has identified four basic segments, ranging from high-net-worth individuals to mass-market, mainly expatriate, workers. Its branches have a general service and sales area for all customers as well as exclusive zones for each of the two wealthiest segments; efforts are made to divert mass-market customers to self-service facilities. Other banks too are moving toward segmented distribution models. NBK has even introduced into many of its branches private-banking representatives who offer access to the bank’s top-end wealth-management services.

Most banks, though, retain traditional branch designs, with large teller transaction zones that divide staff from customers. To gain a more competitive edge in sales, branches could be redesigned to make them more open and retail friendly, with specific spaces for certain types of customers. It would be necessary to reduce the largely transactional functions of branch offices by diverting to alternative channels activities such as withdrawals, ATMs, and bill payments. Emirates Bank International, for instance, took a step in this direction by setting up the new meBank, which provides sophisticated self-service machines for bills and other payments.

Tougher competition confronts the retail banks of the Persian Gulf region. But as long as oil prices continue to support the area’s economy, banks that can master the new product, sales, and distribution challenges should find that strong revenue growth will outweigh any decline in margins.