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.

Problem loans

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.

State deposits

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 Moody’s 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 Moody’s 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.

Lending costs

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.”

Moody’s 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.

Stricter terms

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.

Wider spreads

“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.

Cash flow

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.