Optimism belies the challenges ahead for Saudi banking

19 May 2010

Despite government spending bouying the Saudi economy, the banking sector will struggle to rebuild profits this year as low interest rates and provisions eat into margins

There has been a dramatic turnaround in the Saudi Arabian economy in recent months. A year ago projects were being put on hold or restructured, and the government was being forced to ditch private finance schemes and fund projects itself.

Now Riyadh is buzzing with activity. Projects such as the Princess Noura university scheme and the King Abdullah Financial District are under way, and bankers are preparing for a flurry of renewed interest in listing companies and financing projects.

“The concerns of last year are fading away,” says Robert Eid, chief executive officer of local Arab National Bank.

State stimulus

This optimism stems from the huge government stimulus packages announced in the 2009 and 2010 budgets. In 2009, Riyadh announced it would expand the state budget from SR520bn ($139bn) to SR550bn. This was followed by a further increase in 2010 to SR620bn.

“There would have been a deep recession in Saudi Arabia without the government spending package,” says John Sfakianakis, chief economist at the local Banque Saudi Fransi. Many of the projects that have recently moved into the construction phase have benefited from these government measures, which have also included giving contractors mobilisation payments to help them finance the commencement of work on new projects.

“The economic benefits from the multiplier effect of government spending are already being felt in the economy,” adds Eid.

But these signs of economic activity belie the challenges that still lie ahead for the banking sector. Analysis of the financial results of the kingdom’s local banks shows that although profitability was mixed across the sector, the combined profit in the Saudi banking sector was flat at about $7bn in both 2008 and 2009. But in the first quarter of 2010, the 12 banks reported total profit of nearly $1.9bn, representing a fall of 24 per cent compared with the first quarter of 2009, when combined profits amounted to $2.5bn.

[Bad debts from name-lending] have triggered a change in the ‘trust me’ type of transactions that used to occur

Phillipe Touchard, Banque Saudi Fransi

Boardrooms have also reflected the difficulties faced by the kingdom’s banking sector, with SABB, Samba, and Saudi Hollandi all making changes to their top management teams as the impact of the financial crisis played out.

Only two banks managed to post an improved performance in the first quarter of this year: National Commercial Bank (NCB) and Riyad Bank, both of which are government-owned institutions. Each recorded a large drop in profits in 2008, while most of the rest of the sector was still reporting modest growth.

Faisal al-Sakkaf, chief financial officer at NCB, says: “We feel we have largely negotiated the financial crisis now, and tried to take the brunt of the expenses in 2008. So 2009 really was a year of significant recovery with earnings rebounding.”

Not everyone has been so lucky. The smaller Saudi banks suffered considerably in 2009 with lenders such as Saudi Hollandi, Bank al-Jazira and Bank al-Bilad reporting profit decreases of more than 50 per cent.

In addition to the slowing economy, banks have also had to endure a huge rise in provisioning against bad debt. In 2007, the combined provisions for the sector totalled about $600m. By the end of 2009, the figure had risen to $2.9bn.

“In 2009, there was a very sharp increase in non-performing loans,” says Al-Sakkaf. “In our view, the credit environment has now stabilised and we don’t see a continuation of the trend in rising non-performing loans during 2010.”

The main reason for the rise in provisions has been the defaults on more than $20bn of debt by two large local corporates, the Saad Group and AH al-Gosaibi & Brothers. While the origins of their debt problems is still mired in legal disputes, the adverse impact on the local banking sector has already made itself felt. Bankers say that full provisioning for their exposure to the two firms has already been taken; most local banks benefited from having assets linked with their loans, which they have taken possession of, sold, and settled their positions. International banks have not been so fortunate.

In numbers

  • SR620bn: Value of Saudi Arabia’s state budget in 2010
  • 24 per cent: Year-on-year fall in total banking sector profit in the first quarter of 2010
  • $2.9bn: Total provisions for bad debt across the Saudi banking sector at the end of 2009

Source: MEED

Lending rethink

The debacle has led banks to rethink the practise of ‘name-lending’, where loans are agreed based on the strength of reputation alone. Phillipe Touchard, chief financial officer at Banque Saudi Fransi, says: “Those events have triggered a change in the ‘trust me’ type of transactions that used to occur and family offices are now having to open their books.”

He adds: “We have some name-lending, but it is limited and with a lot of collateral.”

Despite these difficulties, so far none of the banks in Saudi Arabia have reported an annual loss or been forced into seeking government bailouts to keep them afloat. This is largely because the banking sector has been well capitalised and well regulated. Banks are forced to strictly adhere to a loan-to-deposit ratio of 85 per cent, which helped to prevent them becoming overleveraged as the financial crisis hit. Elsewhere, in the UAE for example, banks became hugely overextended, leading to a significant drying up of credit as regulators cracked down and tried to stop loans from exceeding deposit levels.

Saudi bank results total sector wide200720082009
Loans and advances128,212165,879161,977
Total assets276,882341,053352,442
Customer deposits201,640248,324263,258
Total operating income13,10011,54415,139
Salaries and employees benefits2,3742,1712,862
Total profit8,0707,0297,025
Source: Tadawul

At the end of 2009, in the Saudi banking sector as a whole had a loan to deposit ratio of just 61 per cent, well below the maximum level permitted.

As a result, the kingdom’s banking sector is among the most liquid in the region. But at the end of the first quarter of 2010, Saudi banks were putting SR120bn on deposit with the Saudi Arabaian Monetary Agency (Sama) rather than lending it out. That has fallen from its peak of SR149bn at the end of 2009, but is still significantly above the SR70bn at the end of the third quarter of 2008, when banks were much less troubled by the prospect of borrowers defaulting.

“The proof that things are improving is that margins on loans are going down because of the competition to lend”

Robert Eid, Arab National Bank

Sfakianakis says that both the private sector and the banks must share the blame for the risk aversion that has crept into the sector. “If you look at why banks were not lending money in 2009, both sides were responsible. The banks were risk averse, but also demand from the private sector dropped off,” he says.

In 2009, the total volume of loans and advances fell 2.35 per cent to $162bn, while deposits from customers rose by 6 per cent to $263bn, indicating that banks, like consumers, were switching their focus to saving rather than spending.

But as the fall in the size of bank deposits with Sama illustrates, lenders are now starting to loosen their purse strings. “Now the system is suffering from surplus liquidity,” says Eid. “Demand for loans is being met promptly by the banks. Obviously, banks take decisions on a case-by-case basis, but the proof that things are improving is that margins on loans are going down because of the competition to lend.”

Private sector floundering

Although there are signs that some appetite to start lending is returning, in truth the picture is more nuanced. Most of the lending being done is only to government or quasi-government entities. For example, the $3.9bn financing deal being arranged by Saudi Binladin Group to fund the development of the King Abdullah Financial District is mainly proving successful because banks consider it ultimately as a government loan. The developer of the project, Al-Rayadah, is government owned, so the bank loan to Binladin is just enabling them to spend money now while they wait for government receivables. In contrast, some of the more typical private-sector deals, such as plans by Saudi Telecom to tap the local banks for $600m to fund the development of its subsidiary in Indonesia, have floundered.

While lending opportunities will focus on the strongest credits, it will still be a tough year for the banking sector. Touchard says: “2009 and 2010 look like very difficult years from a banking perspective. In 2009, there was a reduction in the demand for loans, and now the low interest rate means that as demand picks up, there will still be a slowdown in revenue growth.”

Saudi banking first quarter net profits ($m)Q1 2009Q1 2010
Arab National Bank18579
Banque Saudi Fransi198190
National Commercial Bank279385
Riyad Bank118243
Saudi Hollandi7661
Saudi Investment Bank646
Source: Tadawul

The significant riyal liquidity is contrasted with a lack of dollar deposit sources. As a result there has been a major shift away from the local banks lending in the US currency, even though most of the larger corporate borrowers would prefer to borrow in the greenback. This factor, coupled with the growing interest in the Middle East from international debt investors, is leading more banks to look at aping Banque Saudi Fransi’s move to tap the bond market, after the bank raised $650m in a successful issue.

“The low interest rate means that as demand picks up, there will still be a slowdown in revenue growth”

Phillipe Touchard, Banque Saudi Fransi

NCB is also looking at options to raise a stable source of dollar funding, particularly to help it lend dollars to project sponsors seeking long-term dollar financing. Other banks in the kingdom are rumoured to be planning to follow suit.

As a result of the historically low interest rate environment cutting the margins banks make on lending, most bank executives say they will now focus on growing their retail business. Retail lending typically benefits from higher margins and the security of being backed by salary-assigned accounts.

But growth in the retail sector alone will not compensate for the drop in corporate and investment banking activity, though it may help banks protect their profitability from falling further.

The financial crisis has compounded a long period of falling revenues over the past few years. The combined profit across the Saudi banking sector has fallen from $9.4bn in 2006 to $7bn in 2009 as the impact of the stock market crash in late 2006 wiped out brokerage revenues, and now provisioning and slower lending weighs on profit.

A turnaround in the fortunes of the stock market, and the gradual development of a local Islamic bond (sukuk) market offer the opportunity to grow investment banking revenues. But attracting the largely retail investor base back to the equity markets will be tough.

“In many ways the financial crisis of 2008 is not new to people. For most investors it started two years ago with the 2006 stock market crash,” says Mohammed el-Kuwaiz, managing director of the local investment house Derayah Financial. “Two unrelated but successive crashes have really scarred investors.”

That will challenge the ability of banks to run successful equity raisings for companies. Already one flotation, for travel agency Al-Tayyer, was cancelled in February because of weak demand. But investment bankers point to a growing pipeline of initial public offerings, including several that will be offered at a par value of SR10 because they benefit from some form of government subsidy. These deals have attracted huge interest in the past and should help kickstart the equity markets.

Year of disappointment

But this is unlikely to be enough to prevent 2010 from being another disappointing year for the local banks. Instead, the focus this year will be on capturing market share and hoping that as provisioning levels drop profitability will be protected.

But unless the risk aversion ends, banks will struggle to make 2010 a more profitable year than 2009. Sfakianakis says he sees more liquidity going into the private sector from the second half of the year as banks realise that they need to raise their profitability levels. But a strong return of lending appetite is not expected until 2011. By the end of the first quarter of 2010, total lending was only just back up the levels of a year ago, while total investments by the banking sector had fallen considerably.

Undoubtedly, though, the Saudi banking system has proven itself to be one of the most robust in the region, and Sama has shown itself to be a confident regulator, with all banks surviving both the global financial crisis and two huge corporate defaults without any major aftershocks. However, it is too early to say the impact of the crisis is over, and it could be a long time before the sector regains the profitability levels seen in the past few years.

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