The beginning of 2011 has not brought the rebound that banks in Saudi Arabia had been hoping for.

Despite a sense of optimism that the kingdom was recovering from the financial crisis in 2010, profit growth in the banking sector is still constrained. In the first quarter of 2011, the combined profits of the 12 local banks were up by just 1 per cent on the same period last year. Most bankers do not expect to see the pace of growth accelerate much over the rest of the year.

“The first quarter of 2011 is really an indicator of what the rest of this year will be like,” says Suliman al-Gwaiz, deputy chief executive officer at the local Riyad Bank.

John Sfakianakis, chief economist at Riyadh-headquartered Banque Saudi Fransi, says: “Bank profits have been better in the last year, but it has not been a significant improvement by any means.”

Market constraints in Saudi Arabia

In 2010, the combined profits of the kingdom’s 12 banks rose by just 1.7 per cent, from $7bn to $7.1bn. That is despite the kingdom’s economy expanding by 3.7 per cent last year, a significant recovery from the 0.6 per cent growth in 2009.

Growth in the economy is predicted to hit 7.5 per cent in 2011, according to the Washington-based International Monetary Fund. Profit growth in the banks is expected to be much weaker. The local banks are in a market awash with liquidity, with low interest rates, little foreign opportunities and slow loan growth, making it difficult to find ways of boosting income.

Bank profits have been better in the last year, but it has not been a significant improvement by any means

John Sfakianakis, Banque Saudi Fransi

The positive news is that provisioning is thought to have peaked, which should mean profits can grow a bit faster without the overhang of bad loans. “Profit growth has been muted because the banks are taking a lot of provisions and have become quite conservative, but the perception is definitely that a lot of those provisions are behind them now,” says Khalid Howladar, banking analyst at Moody’s Investor’s Services, a US ratings agency.

Figures indicate that provisioning peaked in 2009 and is now starting to decline. Provisioning reached $2.9bn in 2009, falling to $2.6bn in 2010. In the first quarter of this year, provisions amounted to $330m, about half the amount the same time last year. Bank executives say provisioning will be much more benign in 2011 and the Saudi Arabian Monetary Authority (Sama), the kingdom’s central bank, is also less worried about bad loans than it was last year.

However, profits are still a long way off 2006 levels, when a stock market boom inflated bank revenues through frenzied share trading on the Saudi Stock Exchange (Tadawul). In 2006, profit across the sector hit $9.4bn as a result of the income banks were making from the capital markets. Although banks now make more money in terms of operating income – $13.7bn in 2006 compared with $15.1bn in 2010 – provisions and rising expenses have eaten into that making them less profitable.

Low issuance

Recent weakness in the capital markets has also been felt. A lack of initial public offerings (IPOs) has deprived banks of a lucrative income stream, and a flood of issuances does not appear to be waiting in the wings. “The Capital Market Authority has been vigilant about what deals it lets through to the market because they don’t want to let an IPO through that eventually fails,” says Rajiv Shukla, head of global capital financing at HSBC in Saudi Arabia. “So while there is a backlog, it is not huge.”

Banks are taking a lot of provisions … but the perception is that a lot of those provisions are behind them now

Khalid Howladar, Moody’s Investor’s Services

Attention has shifted to new areas of potential growth. Most banks have been trying to expand their retail operations, which tend to charge much higher interest rates than corporate banking. Interest rates on credit cards can be more than 20 per cent, while corporate loans can pay less than 1 per cent.

Competition in the retail space has been intense, however, and growth has been disappointing. “Everyone has been looking at retail banking for growth and that has made it very competitive, and also means it has not been as lucrative as we had hoped,” says one banking executive.

Another senior banker in the kingdom adds: “Banks that are focusing on retail are finding at the moment that their costs are growing, but their assets are not growing as quickly as they would like.” Total operating expenses in the banking sector were relatively flat in 2010, but rose 63 per cent in 2009. Part of that is down to the additional expense that retail networks require.

Mixed performance for Saudi Arabian banks

Some banks have been able to achieve a better profit from the market, but their performance remains mixed. Many of the kingdom’s smaller banks posted a significant turnaround in performance in the first quarter of 2011, largely due to lower provisioning. Saudi Investment Bank saw profits jump nearly tenfold, from $5.6m in the first quarter of 2010 to $55m in the first three months of 2011. Bank al-Jazira recorded a nearly 400 per cent profit increase in the first quarter of this year.

In contrast, the larger banks have struggled to grow in 2011. The most profitable bank in the kingdom is still Al-Rajhi Bank, but its profits were flat in 2010 and the first quarter of 2011. Banque Saudi Fransi also failed to grow in the first quarter, while Riyad Bank posted a more than 80 per cent decline in profits for the quarter. Al-Rajhi and National Commercial Bank (NCB) remain the dominant players, both in terms of profits and assets. Looking back over the past few years shows that NCB has been one of the most successful in grabbing market share in terms of profits. In 2008, it had a market share of just 8 per cent, this rose to 18 per cent in 2010.

This is partly due to the reversal of provisioning at NCB, but it is also because of the bank’s aggressive pursuit of new business over the past 12-18 months, which at times has been to the detriment of other banks.

Overall asset growth in the Saudi banking sector has shown some signs of strengthening, with total assets up 4 per cent in 2010. At the same time, deposits have been accelerating faster, rising 11 per cent in 2010. This is adding to the liquidity in the banking sector, weighing on profitability as banks have vast pools of cash that are not being used.

At the end of the first quarter, the overall loan-to-deposit ratio had fallen to just 74.8 per cent, well below the regulatory limit of 85 per cent.

The banks are keeping the money in the vaults, viewing the interest rate environment as too low to warrant putting the cash to work. “An increase in loans will not have much impact on profits,” says Sfakianakis. “The impact on profits won’t really start to be felt until there is a shift in interest rates.”

Hindering economic growth

This is worrying the government, as it is eager to see the private sector take on a more active role in the economy, especially in job creation. While credit growth is lacklustre – especially to the private sector – it will dampen the prospects for economic growth.

The Saudi riyal’s peg to the US dollar means local rates are unlikely to move until the Federal Reserve moves first. With US growth still fragile, rate increases are not expected until next year, meaning that Saudi rates will also stay low for the time being.

As a result, the Saudi banking sector faces at least another year of low growth. Even when rates do start to rise, profits will be slow to catch up because the rates that banks pay to customers on deposits typically reprice faster than loan rates. So when rates do rise, initially at least, profits will come under further pressure. That worry is already starting to weigh on banks. As are concerns that government spending is reducing the need for bank finance.

For the next year, the Saudi banking sector is expected to face continued slow growth. Most banks are optimistic, however, that the situation is improving, now that all the serious challenges have been overcome.

Operating income figures show that the banking sector is making much more money than it was in 2007; it has just been wiped out by provisions. The end of the provisioning cycle means that profit figures should continue to increase in the months ahead, but sluggish loan growth will make growth steady, rather than spectacular.