In April 2011, Financial Transaction House, a local corporate finance business, asked Riyadh’s Capital Market Authority (CMA) to cancel its licence for capital market arranging and advisory work. It had been one of the first firms in Saudi Arabia allowed to do such work under the new CMA licencing regime that was rolled out in 2005.

It’s a commercial bank monopoly here. They do the lending and then they get the mandates

Saudi head of international bank

Since then, the volume of work foreign firms had hoped for has failed to materialise, leaving many to either cancel their licences, or focus on smaller niche areas away from the competitive areas that local banks are involved in. “There are too many banks chasing not much work,” says the head of investment banking at one local lender.

When it was created in 2004, the CMA was expected to bring about a revolution in Saudi Arabia’s financial sector. Its mandate was to develop the local capital markets, including opening them up to foreign investment and allowing international banks to set up in the country.

Licencing regime for international banks

Progress on the first of those has been slow. Despite the rumours that the CMA has for years been on the cusp of allowing in foreign investment, it still has yet to happen.

In contrast, the CMA was quick to set up a licencing regime for international banks to enter Saudi Arabia. More than 100 banks were licenced by the CMA at the end of 2008. But instead of rising that number now seems to be falling as volatile capital markets mean that investment banking deal flow has been disappointing. New entrants find it increasingly difficult to compete with established local banks. In 2009, as many licences were cancelled at the licence holders request, as were granted.

One of the CMA’s first moves was to ask local banks to spin off their asset management, brokerage and investment banking units into separate licensed entities.

That served one practical purpose and one progressive one. First, it made the CMA’s job as regulator easier by putting activities it was responsible for into distinct legal entities, avoiding a rather cumbersome mix of regulatory responsibilities between the CMA and the Saudi Arabian Monetary Agency, which regulates banking activities.

Branches of international banks in Saudi Arabia face a significant conundrum

David Dew, SABB

The extent of the separation between the capital market activities of domestic banks and the rest of their operations had to go right down to their physical presence. Banks were encouraged to move investment banking teams into new offices or, if they were in the same building, they had to have separate entrances and signage.

At the same time, foreign banks were invited into the kingdom under a CMA licence. That broke the Saudi banks’ monopoly on equities trading and created competition between them and international lenders. It was also hoped that foreign banks would bring in their expertise in investment banking.

In the beginning, there was a flood of interest from international banks, eager to get access to the region’s largest and most liquid stock market. The CMA has shown few signs of reluctance to grant licences. At the end of 2005, there were just eight licenced entities. A year later, it had jumped to 45. By the end of 2008, the number had risen to 110.

It now seems that the number of licences is falling. In 2009, 12 licences were granted and 12 cancelled. Currently, there are about 92 licenced firms and that number seems likely to fall further.

The timing of the CMA move to open up the market is to partly blame for the decline in licenced firms. In 2005, the Saudi Stock Exchange (Tadawul) crashed. A modest recovery was scotched in 2009 as the global financial crisis rocked capital markets. Only now is the local sukuk market beginning to pick up. A recovery in the equity markets since the beginning of the year will boost confidence and should lead to some more initial public offerings (IPOs) taking place later this year, if the momentum continues.

International banks priced out

With liquidity in the local banks so high, international banks have been largely priced out of lending to Saudi businesses. That enables local banks to position themselves for the big, high-profile investment banking advisory work on IPOs and sukuk (Islamic bond) issues because they already have a strong relationship with local corporates. “It’s a commercial bank monopoly here,” says the Saudi head of one international bank. “They do the lending and then they get the mandates.”

“Branches of international banks in Saudi Arabia face a significant conundrum,” says David Dew, managing director at the local Sabb. “Yield compression makes it unattractive for them to lend into Saudi Arabia and if they try and concentrate on generating fee income from advisory work, then the local banks are making it harder and harder for them to do that as well.”

Local bank tie-ups

Sabb benefits from its links with the UK’s HSBC, which has a significant stake in the firm and also its investment banking operation, HSBC Saudi Arabia. Through this it is able to get the best of both worlds. Deposits from Sabb’s retail network help to drive the lending business, which in turn helps it win investment banking mandates.

Banque Saudi Fransi benefits from a similar relationship with France’s Calyon. These opportunities are limited though. The only other joint venture bank, Saudi Hollandi, is part owned by the UK’s Royal Bank of Scotland (RBS). Although several regional and international banks have expressed interest in buying the RBS stake as a way to develop their Saudi presence, it appears that a sale is not imminent.

Banks lacking that local presence can find it more difficult to develop the relationships needed to start winning capital markets work. The UK’s Barclays says it has focused on wealth management since setting up in 2010.

“In wealth management, we have done excellently,” says Ayman Sejiny, chief executive officer of Barclays Saudi Arabia. “Developing the investment banking business has been slower as it takes time to develop the clients and competition with the local banks is intense.”

International banks in Saudi Arabia are waiting for the opening of the market to foreign investment. That will allow them to start selling Saudi equities to their clients in Europe or the US, something they will be in a much better position to do than most of the local banks.

“The real advantage that we will have is in steering foreign investment into the kingdom, rather than trying to do local deals,” says the Riyadh-based international bank head.

“That will be true whether it is international bond issues or selling Saudi equities to foreign investors.”

Hanging on until cross-border links with the Saudi capital markets are generating a steady pipeline of work may not be easy though. The CMA is expected to increase the minimum capital requirements at investment banks, forcing businesses to decide if they want to put more resources into Saudi Arabia or consolidate.

If bond market activity and IPOs do pick up, many will want to remain on the ground to ensure they are close to clients.

“If markets remain buoyant, then seven to eight IPOs and a couple of rights issues are expected in the remainder of 2012,” says Hany Ahmed al-Shuwaier, head of securities at the local NCB Capital.

Secondary listing on the Tadawul

There is also the potential for foreign companies to seek a secondary listing on the Tadawul, enabling them to capitalise on liquidity in the region’s most active exchange.

“There could be potential demand from regional banks, blue-chips and established corporates from GCC and neighbouring countries for a cross listing,” says Al-Shuwaier. That could be another potential source of deal flow for investment banks in Saudi Arabia.

Until steps are taken to open the capital markets to foreign investment, many of the larger international banks in Saudi Arabia will remain on the sidelines. When the market does finally open, they should find their business expands rapidly.

After several years of waiting for that to happen and faced with intense competition in the meantime, some international banks are expected to cancel their licences and maybe come back later.

Once Riyadh opens the market, it will require much more sophisticated investment banking activities.

Foreign banks would be well advised to ensure they maintain a local presence even if current activity is disappointing as the market should become a lot more active over the next few years.