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Middle EastApril 1 2016

Saudi Arabia's banks braced for a slowdown

Well capitalised, with low non-performing loan ratios and strategically diverse business lines, Saudi Arabia's banks have weathered the country's economic slowdown well. Now, with the economic backdrop unlikely to change in their favour, these lenders are looking at ways to remain profitable in the long term.
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Saudi banks braced for slowdown

The good news for Saudi Arabia’s banks is that despite the fall in oil prices their growth story looks set to continue. With strong capitalisation and liquidity levels, as well as a supportive government budget for 2016, the country’s lenders are in a good position to maintain their positive momentum.

But the cooling economic climate means that this growth will be slower than in previous years. Indeed, according to most system-wide indicators, the past 12 months have illuminated some of the challenges facing the country’s lenders in this new environment. Corporate credit growth for 2015 slowed to 10.8% from 12.8% in 2014, while consumer credit growth fell to 4.5% from 8.8% over the same period, according to local investment firm Jadwa Investment.

Meanwhile, deposit growth in 2015 slowed to 1% from 12% in 2014, according to ratings agency Moody’s. And in January 2016, the banking sector as a whole posted its first year-on-year decline in profit growth since April 2013, as it fell by 3.7%, according to research from Jadwa Investment.

Start of a slowdown 

The mixed fourth-quarter 2015 results of Saudi banks highlight some of these difficulties. Though most banks performed well in the first half of the year, given that supportive liquidity conditions were still in place, by the final two quarters economic conditions had deteriorated, leading to a noticeable decline in performance.

Though a few lenders bucked the trend, most registered either a fall in net profits or flat performance for the three months ending in December. National Commercial Bank, Alinma Bank and Banque Saudi Fransi were among the stronger performers, with year-on-year fourth-quarter net profit growth of 16.6%, 16.3% and 11.6%, respectively.

Beyond this, Saudi Hollandi Bank, the Saudi British Bank (SABB), Riyad Bank and Arab Bank all recorded declines in fourth-quarter net profit, while Samba Financial Group remained flat for the period. This more challenging outlook was accompanied by a marked reduction in system-wide liquidity. According to research from Oxford Economics, the ratio of liquid to total assets had fallen from 22.3% at the end of 2014 to 15.6% by the close of 2015.

“By the fourth quarter of 2015 we clearly saw evidence of a slowdown in the overall market. In a slowing market with increasing pressure on liquidity and the expectation that oil prices will remain subdued, most banks will be looking closely at their risk appetite,” says David Dew, managing director of SABB.

Gaps in the debt market

Across the Gulf Co-operation Council (GCC) region, falling oil prices have led to a tightening of liquidity conditions in respective financial systems. In the case of Saudi Arabia, as the government and government-related entities have drawn down their deposits, which account for about 22% of total system deposits, banks’ liquidity positions have suffered.

“We expect 2016 to have the same mix of challenges and opportunities as last year, although the growing liquidity crunch will present a number of new difficulties,” says Usman Sikander, co-head of investment banking at Saudi Fransi Capital.

Just as public sector deposits are falling, the government commenced a domestic debt issuance programme midway through 2015. As a result, Saudi lenders have been using their cash and deposits held with the Saudi Arabian Monetary Agency (SAMA) to buy longer term government securities.

“The banking sector is quite crucial to the fiscal financing outlook because [banks] are going to be buying a lot of the government’s debt,” says James Reeve, deputy chief economist at local financial services firm Samba Financial Group.

Ratings agency Standard & Poor’s believes that the banking sector is ready to support ongoing government issuance and can ‘comfortably’ fund $75bn to $100bn of sovereign debt by the end of 2016.  

Meanwhile, the country’s largest pension funds and government-related entities have also been withdrawing their deposits with the banks to support the debt issuance programme, compounding the liquidity challenge. This trend has also had unintended consequences for the growth of Saudi Arabia’s corporate debt market.

“Traditionally, the biggest investors [in the corporate debt market] have been the banks and the pension funds. Now that the government is borrowing from them, their liquidity levels are down and their ability to participate in corporate debt issuance is constrained,” says Mr Sikander.

Room for manoeuvre 

In response to this tightening liquidity environment, SAMA temporarily relaxed the loan-to-deposit (LTD) ratio from 85% to 90% in late 2015, in an effort to free up liquidity and permit the banks greater room to lend. This move has been widely welcomed by Saudi lenders, given that it not only provides the sector with much-needed flexibility but that it retains SAMA’s hallmark prudence when it comes to oversight: most regional markets have LTDs at 100% or more, with the exception of Bahrain, according to Fitch Ratings.

“I think the liquidity situation is challenging but manageable. The measure taken by SAMA will surely help. And there are many other things that can and will be done to ease the pressure,” says Bernd van Linder, managing director of Saudi Hollandi Bank.

Nevertheless, a spike in the three-month Saudi Interbank Offered Rate is expected to be maintained despite these efforts. In February 2016, the rate hit 1.73%, up from about 0.8% in the earlier months of 2015. “I don’t see the interbank rate going down because that’s a reflection of a more challenging liquidity situation,” says Mr van Linder.

Strong position

Beyond the liquidity challenge, SAMA also intervened in early 2015 with the introduction of its single obligator regulation. Under a four-year timeframe, the country’s banks must reduce their exposure to a sole counterparty from the current maximum level of 25% of their capital and reserves to 15%. The intention is to limit the maximum loss a bank can face in the event of a default, while promoting greater loanbook diversification.

“Saudi banks’ loanbooks remain concentrated, with the 20 largest lending exposures making up 25% of most banks’ loanbooks,” says Suha Urgan, primary credit analyst with Standard & Poor’s.

This situation is particularly true for the contracting sector, which is now subject to stricter government approval requirements. “We expect some delinquencies to come from this sector in 2016, which for Saudi banks we rate represents 7% to 10% of gross loans and 26% to 40% of equity as of year end 2014,” says Mr Urgan.

NPL growth?

Indeed, Saudi banks’ non-performing loans (NPLs) are expected to grow in the coming years. In some respects this is inevitable given that they currently sit at historic lows; as of September 2015, the ratio of NPLs to total assets was about 1.2%, according to data from SAMA. But projections from Standard & Poor’s indicate that aggregate NPLs could reach between 2% to 3% over the next 12 to 24 months.

“Although I can only speak for Alinma Bank, I am very confident that the country’s financial institutions are well supervised [when it comes to NPLs]. We are diligent in our assessment of credit-worthiness, which is what you would expect to enhance the quality of assets,” says Abdulmohsen Al-Fares, managing director and chief executive of Alinma Bank.

Beyond these longer term challenges, most players in the country’s banking sector remain upbeat about their prospects. While the years of double-digit growth in deposits, assets and net profits are on hold, most bankers are expecting a medium-term outlook characterised by solid single-digit growth. Indeed, the country’s banks are gearing up for the new opportunities that are expected to emerge in this environment.

“A changing environment means new opportunities. This cooling economic climate will give us the opportunity to reinforce our position in the markets thanks to the strong foundation that we have built for ourselves since 2011. I see good opportunities moving forward,” says Mr Couvegnes.

New avenues 

For many of the country’s corporate-oriented lenders, specific opportunities are opening up in the retail sector. This serves a dual purpose of diversifying their loanbooks while tapping into the country’s booming demographic growth story, characterised by a highly urban and young population. Given that some of these banks are starting from a relatively low base, their retail growth is likely to accelerate quickly in the coming years, despite lower-than-usual consumer credit growth.

“We’re no longer a corporate-only focused bank. As part of our strategy that we put in place three years ago, to be a bank of choice for mass affluent and premium retail segments, we have seen some very good traction in our retail banking. By the end of 2015 more than 20% of our loanbook was retail oriented, up from 12% in 2012,” says Mr van Linder at Saudi Hollandi Bank.

For Banque Saudi Fransi, the outlook is similar. With a long history of catering to corporate clients and with a strong market share in serving the country’s largest corporate groups, the bank is now preparing to grow its presence in the retail sector.

“When it comes to retail banking the foundations are there and now it’s about producing some differentiating products. So that means new saving plans, home financing options and e-channels, among other offerings. It’s a matter of finding the right niche and the right products in this space,” says Mr Couvegnes.

Digital future 

Here, digital banking offerings are on the rise in the country and most lenders have invested heavily to generate online and mobile solutions for both their retail and corporate customers. Yet, most of this effort has only been applied relatively recently, with smartphone apps mostly launched since about 2011. 

In global consultancy EY’s '2015 GCC digital banking' report, it is noted that Saudi Arabia still has some way to go in this area, with just 15% of all customers in the country using mobile banking. For the country’s lenders, this space offers a sizeable opportunity.

“Our focus on the retail sector is very much on SABB’s digital capabilities and offerings. Saudi Arabia has a young population that is increasingly moving online and the trends here are very clear. For us, the future of retail banking is a digital future,” says Mr Dew. “Every year, the growth in digital banking outpaces branch banking. As a result, we see the number of manual transactions in branches decrease every year even though our business is growing. And that’s what we want – to put our customers in charge of their business."

It is a similar story for Saudi Arabia’s dominant fully sharia-compliant banks. Like most of their conventional counterparts, these banks have no legacy systems in place to slow the implementation of new digital systems and offerings. Here, Alinma Bank launched its first mobile app in 2013.

“The population dynamics of Saudi Arabia’s major cities, especially population density, mandate that the digital space become ever more reliable, secure and convenient. There isn’t much that the app doesn’t do and it obviates the need to visit bank branches on a regular basis,” says Mr Al-Fares.

Promising prospects

Looking to the future, most Saudi lenders are aware of the difficulties that will emerge in the coming years. But the system as a whole is approaching this new economic reality from a position of strength. Prudent oversight from SAMA has seen Saudi banks generate an aggregate Tier 1 capital ratio of 15.8%, while loan loss reserves to NPLs are at about 160%, according to data from Standard & Poor’s.

“Despite the challenges ahead, we expect banks' healthy capital positions will remain one of the core strengths of the Saudi banking system. [In addition] we believe Saudi banks have adequate cushions to cope with asset-quality deterioration, since their NPL ratios are fairly low and are backed by sufficient loan loss reserves,” says Mr Urgan.

The banking sector’s clean bill of health means that most lenders now have an optimistic eye on the country’s privatisation drive, as well as its new emphasis on foreign investment. For international banks, in particular, this is a promising prospect. SABB, which operates in both China and South Korea and has a desk for customers dealing with Asia, sees scope for growth with the country’s burgeoning ties with the Asia-Pacific region.

“Trade with Asia continues to grow and China is now Saudi Arabia’s largest single trading partner. This is in line with the general direction in which the country is heading from an economic perspective with increasing ties to Asia. The more that Saudi Arabia engages with the international economy, including trade and investment flows, then we are well positioned to capitalise on that and play our part in developing the Saudi economy,” says Mr Dew. 

Though the environment in which Saudi Arabia’s banks operate is beginning to normalise, few banking sectors in the world are as well positioned to handle the change. Though their growth is slowing, most Saudi lenders can expect a positive end to 2016. 

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