Banks are already facing an unhappy confluence of economic trends, mainly driven by low oil prices, which will make 2016 an even more difficult year.
In the UAE, there are AED5bn-7bn of problem loans involving small and medium-sized enterprises
Source: UAE Banking Federation
While oil prices were high, bank deposits from governments and the boost to regional businesses and households meant deposits growth was rapid. This gave banks a source of cheap funding, making them compete to lend cheaply.
Deposits are slowing or even falling, tightening liquidity in a number of GCC countries. Government borrowing, both as corporate loans and bond issuance, is also soaking up liquidity and threatening to crowd out the private sector.
At the same time, economic growth overall is slowing, causing some small and medium-sized enterprises (SMEs), and a few larger ones, to struggle. In the UAE, there are AED5bn-7bn ($1.4bn-1.9bn) of problem SME loans, according to the UAE Banking Federation, with many business owners absconding to escape harsh bankruptcy laws.
The effect of a weaker economic climate on asset quality will mean banks will be less willing to lend and more rigorous with potential borrowers. The weaker global economy will also reduce international banks willingness to lend within the region.
The seriousness of the liquidity issue depends on the national context, with Qatar likely to be highly affected and Kuwait barely at all.
Banks are being pushed into tapping bond markets for funding to continue lending, a more expensive option. The sector will pass this, as well as expected rises in US Federal Reserve interest rates, on to borrowers.
As yet, there is no consensus on whether there will be a dangerous liquidity crunch or not, but 2016 is set to be a challenging year, with oil prices expected to remain about $50 a barrel.
GCC banks have been lucky in the past to be able to use deposit bases as their main source of funding, while paying little or no interest. In Saudi Arabia, state deposits reached 22.5 per cent of the total in December 2014, but had dropped 2.7 per cent by mid-2015, according to US-based Moodys Investors Services, slowing the deposit growth rate to just 4 per cent.
Qatar shows a worrying trend, as deposits are flat while loan growth remains at 10.7 per cent year-on-year
In Oman, state deposits have held steady at about 35 per cent, while in Kuwait they are estimated to be a third of deposits, including state-owned companies.
Qatar shows a particularly worrying trend, as deposits are flat while loan growth remains at 10.7 per cent year-on-year. As the investment for the 2022 World Cup picks up, these deposits could be drawn down even faster, creating a liquidity crunch.
Private sector deposits have also begun to slow, although not as sharply. In Kuwait, they slowed to 5.4 per cent growth year-on-year, and in the UAE to 6.6 per cent year-on-year by the third quarter.
As oil revenues and deposits shrink, liquidity gets tighter and the lending environment will become more discriminating, says Khalid Howladar, vice-president senior credit officer at Moodys in Dubai. Deposit pricing is already rising as banks compete to attract funds and adjustments in the pricing on credit will feed through also.
This will slow loan growth, especially as some central banks are imposing loan-to-deposit ratio limits. US Federal Reserve interest rate rises will also have to be mirrored to maintain the currency peg.
Non-performing loans ratio
Overall, this has already begun to push up the cost of lending for all, by about 50 basis points so far. However, the largest, most-creditworthy borrowers will still have access to attractive terms.
There are growing concerns over the level of problem loans for banks as economic growth slows.
Banks tended to be loose on lending when liquidity soared over the past few years, and agreed to some loans for political rather than commercial reasons. Smaller banks have also been more aggressive with their lending strategies, especially with SMEs.
Banks will be much more rigorous and cautious with creditors, and will tighten their lending conditions
Many GCC banks have also concentrated lending in the contracting, construction and real estate sector. This makes up 21.5 per cent of Qatari lending, 16.4 per cent of UAE lending and 18.2 per cent of Bahraini lending. The UAE market has already begun to correct, so non-performing loans (NPLs) there could begin to rise. However, the situation will not be nearly as bad as in 2009.
Lessons were learned in the last cycle on concentrated GRE [government-related entities] and real estate exposures, says Howladar. Banks were more conservative this time as they are not so far out of the last cycle that they had forgotten the stresses of the past. Many banks have since reduced the risk concentrations and Central Banks also have passed regulations in this regard.
Moodys expects NPLs to creep up in Saudi Arabia to 2.5 per cent, and in Bahrain to 6 or 6.5 per cent. This will increase provisioning requirements, affecting liquidity.
Banks will also be much more rigorous and cautious with creditors, and will tighten their lending conditions.
On the other hand, public sector lending represents a major proportion of loanbooks, reaching 11.2 per cent of the total in the UAE, and 31.6 per cent in Qatar. It will remain high quality due to the good fiscal positions of sovereigns.
Banks will be pushed towards market funding through bond or sukuk issuance. This will also help them comply with Basel III tier 1 capital requirements, which are being implemented gradually.
It has already picked up with recent issuances, including $300m by the National Bank of Oman, $500m by the International Bank of Qatar, $400m by the Commercial Bank of Dubai and $750m by the National Bank of Abu Dhabi. The return of GCC governments to bond markets will underpin this trend by deepening yield curves.
However, there are concerns about the liquidity of regional bond markets, and their capacity to absorb an increased level of banking sector issuance. Abu Dhabi Commercial Bank has already had to cancel a benchmark dollar issuance over the poor response.
Credit and deposit growth
Local demand is a key part of a successful placement, but when local banks are less liquid there is less to invest, says Howladar.
Money is getting more expensive and spreads are widening, so banks need to adjust to paying more.
Sukuk markets may have more liquidity, but are still relatively small. Conventional banks could increasingly target the liquidity contained in this segment.
Banks may find this borrowing expensive as 2016 continues, and will protect their margins by passing the costs on to borrowers.
As government clients increasingly delay payments and find alternative ways to fund projects, banks are being asked to plug the gap. International banks are facing a difficult year as the global economy weakens, so regional banks will continue to play an important role.
Liquidity will continue to tighten, but the important question is how it will affect contractor and project finance. Difficulty in securing the financing to begin work could delay projects.
Some contractors are already being hit by cash flow issues and are unable to raise more finance. Their existing debt service could also become a problem.
Banks should be able to survive the difficult conditions, and increase efficiency to maintain profit ratios, even if profit and asset growth slows. But customers may suffer from the rising cost of lending and more cautious approach.
Outlook for Middle East and North Africa banks
The UAE is the most leveraged market in the GCC, and is therefore more at risk from a liquidity squeeze. The credit-to-deposit ratio has slipped past 100 per cent in the last few months, as deposit growth dropped to just 1.6 per cent year-on-year.
Aside from the expected AED5-7bn of SME defaults about 1 per cent of balance sheets the biggest risk to UAE banks is overexposure to real estate. Banks have lent a total of AED224bn, or 16.4 per cent of total lending, to real estate and construction companies.
As real estate markets continue to slow, some of these assets could deteriorate in quality.
As one of the smaller systems, with lower fiscal buffers, Oman will be more affected by falling liquidity than other GCC countries.
The credit-to-deposit ratio has crept above 100 per cent, and loan growth has slowed to 6 per cent year-on-year.
The government is also continuing to borrow from the domestic market, soaking up remaining liquidity. This is despite stated plans for international sovereign bond issuance in 2015.
As Oman continues its high capital spending, international banks will have to take on major debt tranches on projects such as Liwa Plastics and independent power and water schemes.
Saudi Arabias banking system is seeing liquidity tighten from an extremely high base. Loan to deposit ratios are still well below the 85 per cent upper limit at 78.1 per cent. The biggest concern is that increased government borrowing through bond issuance could begin to crowd out private sector lending.
Saudi banks have more than SR460bn in excess liquidity to buy government bonds, according to Riyadh-based Jadwa Investments. Nevertheless, reduced spending and a number of cancellations and delays on megaprojects could slow the economy and reduce lending opportunities.
As Qatar embarks on a massive investment programme in readiness to host the 2022 Fifa World Cup, banks will need to play an important supporting role.
Public sector deposits have fallen 13.9 per cent. At the same time, loan growth has slowed from breakneck rates of more than 20 per cent before 2013 to a steadier 10.7 per cent in the last year. It remains the highest growth rate in the GCC.
Liquidity concerns are growing but not yet serious, and the risk of a crunch may be exaggerated, as capital buffers were still above 15 per cent at the end of 2014, according to Moodys.
Kuwaiti banks will buck the GCC trend in 2016, due to low government spending in previous years. This allowed lenders to build up a huge amount of liquidity. Credit-to-deposit ratios stand at just 78.6 per cent, with low government borrowing. NPL levels have recovered from the 2009 crisis, reaching a healthy 2.8 per cent.
The Kuwaiti economy is set to heat up from the stagnation of the last two years as the government finally moves forward on multibillion-dollar spending programmes. While some tightening is expected due to lower oil prices, Kuwaiti banks are eagerly anticipating the upcoming downstream oil and public-private partnerships projects. The Kuwaiti dinar tranches will prompt increased loan growth and profits at domestic banks.
Egyptian banks enjoy strong liquidity, but interest rates above 12 per cent inhibit the demand for loans, especially long-tenor project finance. Deposits continue to grow at 13.5 per cent, providing a cheap source of funding, and credit at 17.1 per cent.
Bank performance in 2016 depends on public infrastructure projects going ahead, and stimulating higher economic growth. This would bring NPLs down from the current 8.6 per cent and provide opportunities for loan growth.
Egypts hard currency shortages continue to hamper banks operations and hold back an economic revival. With local banks only able to lend in Egyptian pounds, this will have to be resolved before international lenders supplement their relatively small capacity.
In the rest of the Middle East and North Africa, the banking outlook is equally cloudy. Jordanian and Lebanese banks are struggling to maintain profits as the refugee crisis creates a drag on their domestic economies.
The Moroccan banking system is an exception, performing well due to domestic economic growth
NPLs remain a significant obstacle, for example in Tunisia, where they are still at 15.8 per cent, according to the Washington-based IMF.
High domestic government borrowing and undercapitalisation also limits private sector lending.
The Moroccan banking system is an exception, performing well due to domestic economic growth.