Close reading of the banks' income statements and balance sheets suggests the rapid profit hikes posted since 1999 might start to slow - or possibly be reversed - in the second half of the year. Just how sharp the slowdown will be, and how long it will last, remain complex questions. Equally, the impact on individual banks will be determined to a great extent by the skill of senior executives and, just possibly, a little luck.

Key macro factors - the price of oil, interest rates, woeful global markets and the strength and pattern of regional credit demand - are tugging in diverse and often contradictory directions. The result is a complex paradigm for strategic planners and, given the comparatively small size of most regional banks, one that they cannot afford to misunderstand.

Defying most forecasts made at the start of the year, oil prices have stayed high, averaging $24 a barrel in the eight months to August. As for most businesses in the region's petro-economies, strong oil is normally good for the banks. As usual, regional export earnings have trickled and leaked on to bank balance sheets. Of the 17 banks covered, 14 have seen their total assets inflate. Taken across the board - although there are some interesting exceptions, most significantly in the long-tenor range - regional liquidity remains high.

Traditionally, high oil prices have also had the complementary benefit of driving up credit demand. Bankers say the cycle has become more complex since the last oil price crash of 1998, which was a severe, but comparatively short, shock. In the past three years, most regional governments have been cautious in their budgetary planning and the bust and boom model has been modified. The windfalls of recent years have been used less to launch fresh grandiose projects and more to hack back government liabilities and re-establish finances on a more sustainable footing. The result for the banks has been a delay in the long-expected surge in credit demand.

But, as the interim results clearly show, loan appetite is coming back. Loan:deposit ratios have risen at 11 of the banks surveyed and, notably, five of the other six were already the most aggressively lent (see table 1). Perhaps those that reduced their ratios were doing so more for balance sheet restructuring reasons than a lack of opportunity. Of course, there are also regional variations. Starting from a low base, the surge in credit appetite is clearly most pronounced in Saudi Arabia and considerably less strong in Kuwait and the UAE.

There are also sectoral differences. Corporate loan demand might be returning in some markets after a prolonged period of weakness, but consumer credit appetite never went away, and continues to offer the most dynamic and high-yielding opportunities. It is no coincidence that those banks focusing on the retail market over the past five years or more - such as National Bank of Kuwait and Al-Rajhi Banking & Investment Corporation - have consistently generated strong earnings growth.

However, broader balance sheets and bigger loan books do not alone translate into booming profits. The quality of the assets and the spreads obtained are the underlying determinants of performance. Increases in credit demand should afford the well-run banks the opportunity to build high-quality loan books and lay the foundations for strong earnings in future.

However, in the near term, the Gulf is going to feel the weakening of the US economy, despite the attempts by Alan Greenspan at the US Federal Reserve to shore it up with a string of interest rate cuts last year. The linking of most regional currencies to the dollar has led to regional interest rates following US rates downwards (see table 2). While rates are moving, banks are able to widen spreads by lowering their cost of funding faster than they lower the yields from their loan portfolio. As table 3 shows, the cost of deposits for Kuwaiti banks has fallen sharply over the past 12 months, with the proportion of private-sector deposits receiving interest of less than 3 per cent almost doubling from 32 per cent to 61 per cent. Hence the surge in profits at 71 per cent of GCC banks last year (see Banking, MEED Special Report 14:6:02, pages 21-38).

But when rates go low and stay low the pain begins. Successful hedging on fixed-interest portfolios can be used to delay the hit, but in an environment in which non-interest bearing deposits account for an uncharacteristically high proportion of funds - an average of 30 per cent of deposits in Saudi Arabia, for example - it is unavoidable.

The half-year results suggest a growing number of banks might be getting close to the lean period. Net interest income declined year-on-year at a third of the banks surveyed and there is no reason to think that they will not be in the majority in the second half of the year. And the hit will go straight to the bottom line.

Of course, the more imaginative strategic planners will use this to their advantage and argue the case for revenue stream diversification. More than enough lip service has been paid to the need to develop non-interest income - it is a more predictable and less risky line of revenue than interest income. Until now, the chatter has not been matched by action. It is significant that, at half the banks surveyed, net interest income as a proportion of total operating revenues declined in the first half of the year (see chart 4). One interpretation might be that this is simply the result of contracting spreads, but the flip side of the coin is that fee income is beginning to rise.

However, patience might be needed. As chart 5 shows, there is as yet no clear correlation between the best performing banks and those with the most diversified revenue streams. The four banks with the highest annualised returns on period-end equity (ROE) - Saudi Hollandi Bank, Saudi British Bank, Al-Bank Al-Saudi Al-Fransi and Saudi American Bank - all had net interest income making up more than 75 per cent of operating revenues. In contrast, many of the more diversified banks - Mashreqbank, GIB, and Ahli United Bank - had less exciting ROEs. Of course, it is no coincidence that the four top performers are all Saudi banks and, as such, are operating in one of the most protected markets in the GCC.

For now, bank chief executives will be pondering their sales pitches. Over the past three years, shareholders have grown accustomed to rapid profit growth. But the low interest rate environment will make the trend increasingly hard to extend into the second half of the year. The bankers will stress the silver lining: putting variables such as ongoing high oil prices and firming credit demand in the context of low interest rates, the medium term prospects look excellent. Now is a good time to lay the foundations for the next profit spurt, shareholders will be told. Building strong loan books, developing new products, improving customer relationship management (CRM) systems, diversifying revenue streams and keeping a weather eye open for acquisition targets will generate rich rewards further down the path. The cigars can still be enjoyed - but perhaps not in public for a while.