After a lacklustre performance in 2009 and 2010, the Saudi banking sector has started to turn a corner. In total, the kingdom’s 12 banks made 15 per cent more profit in 2011 than in 2010, the first significant increase across the sector since 2006.

With provisions declining, high government spending and strong demand for loans from both corporate and retail clients, the sector is expected to pick up further throughout 2012. Overall, however, the banking sector is still not as profitable as it was before the financial crisis and the local equity market bubble burst in 2006. Concerns about managing the glut of liquidity in the system are also rising and attempts to grab market share from competitors seem to be largely failing.

Debt writedowns

Two main factors have contributed to the large jump in profitability. Firstly, provisioning is steadily falling after peaking in 2009. That year, banks put aside a total of about $2.9bn as provisions against bad debts, largely due to the defaults of two family groups, Ahmad Hamad al-Gosaibi & Brothers and Saad Group.

The two are thought to hold about $5bn of loans that have had to be written off by local banks. The case has since become embroiled in legal disputes in various jurisdictions so that several bank managers in Riyadh say they no longer keep track of it, despite losing hundreds of millions dollars.

With the write-offs now behind them and robust economic expansion in Saudi Arabia ahead, banks are eager to start growing again. Shareholders too have been keen to see profitability improve, putting the banks in an uncomfortable position. Lenders are now sitting on huge stockpiles of cash, but are struggling to find a use for it.

“Eventually banks will find places for their funds, government expenditure is at record levels and with the infrastructure investment will come lending opportunities,” says one government source in the kingdom.

After a relatively slow period of growth, there are also signs that banks are starting to issue more loans. After the Saad/Gosaibi defaults, credit growth was flat in 2009. The influence of risk managers rose as it was realised that loans were being made without proper due diligence. Bankers now say it is getting easier to get new deals approved internally.

Credit growth in 2011 was nearly 11 per cent. In 2012, it is expected to pick up further. Much of that will depend on whether large government-linked schemes go ahead this year or are not financed until 2013. Saudi Aramco, for example, had been hoping to finance the $20bn Sadara petrochemicals project this year. That looks increasingly unlikely.

The UK’s HSBC estimates that there are about $60bn of credit facilities that need to be signed this year. Some of these will inevitably have to be pushed back to 2013, but many are expected to start seeking commitments from banks in the third quarter.

Bank deposits have been boosted by high oil revenues and large salary bonuses from the government and many private sector firms. At the end of March, the loan-to-deposit ratio was 78.2 per cent, giving banks plenty of room for more deals before they run up against regulator guidelines to keep that ratio below 85 per cent.

Low pricing

With ample liquidity in the banking system and lenders hungry to book assets, there is little doubt that all these deals will get done. The question will be at what price. Over the past 18 months or so, loan margins have dropped as bank lending appetite returned and they fought over the best deals.

“For some customers, it almost seems like they are doing us a favour if they allocate a loan to us,” says a local banker.

Government-related borrowers in Saudi Arabia are now often getting rates less than 100 basis points above the Saudi interbank offered rate. Bankers say that pricing is unlikely to fall much further. “There might be some further decline in pricing, but it will not be as stark as the decline over the past 12 months,” says Irfan Said, head of structured finance at Samba.

There are indications that banks are already starting to walk away from deals where pricing is seen as too low. “We are increasingly saying no to deals on the basis of pricing,” says a financier at one of the kingdom’s mid-tier banks. So far, that attitude has not yet filtered through to some of the largest banks, particularly National Commercial Bank (NCB), Banque Saudi Fransi and Samba, which are commonly seen as having led the downward trend on pricing.

It may do later this year if a glut of loans hits the market. “There is a lot of liquidity at the moment and it may take until the end of the year, when the picture starts to become clearer in terms of demand, that we start to see banks pushing back on pricing,” says the local banker.

Market share for loans and assets

That may be wishful thinking. Lenders in Saudi Arabia say they are under intense pressure from management to start using their balance sheet. They will also be cautious about stepping back from deals if their peers are still actively trying to gain market share. Analysts are predicting that lending margins will shrink further as competition picks up.

Attempts at grabbing market share over the past year have so far not yielded much reward. Market share for loans and for assets across all banks shows little change over the past few years. “As you look at the size of the economy, you couldn’t argue that Saudi Arabia is overbanked, but at the same time competition is very tough,” says David Dew, managing director of the local SABB. “Banks do a very good job of defending their market share and that is why we have seen some margin compression.”

Despite banks saying a year ago that they hoped to increase market share, there has been little real movement. The market remains dominated by NCB and Al-Rajhi in terms of assets, loans and profits. Both are helped by a funding base that consists of large retail deposits, much of which is in Islamic accounts that pay no return to customers.

Lending rates are also being pushed down by large government-related loans. Lending to government-owned entities is often unattractive as well as slow to arrive.

State-owned borrowers such as Saudi Aramco and Saudi Basic Industries Corporation (Sabic) can use the huge deposits they control as leverage to force banks to lend at wafer-thin margins. “We all know we’re here to support the kingdom, but if we are lending to Aramco for 15 years at under 100 basis points, that capital could be used to earn 2.5 per cent on a three-year real estate deal and serve our shareholders much better,” says one banker. So far, no one has had the courage to walk away from one of these deals, but as the pipeline develops some banks may do so.

Bank profit margins

It is not just increased lending that is improving the profitability of banks. Total income has also been broadly rising. The banks now have a higher income than during the stock market boom of 2004-06, but still make much less profit. That is due to the change in the types of income they are generating. When the Saudi Stock Exchange (Tadawul) was in the middle of a buying frenzy, banks were making easy money from their brokerage arms. Now, they are deriving more income from lending activities, but with interest rates at historic lows the margin is not that high.

A stock market rally in 2012 is doing wonders for income from brokerage activities as trading ramps up. How sustainable this will be is unclear. Already some analysts are starting to worry the Tadawul is looking a little overheated, although it is nothing like the equities bubble in 2005. Moves towards opening the Tadawul to foreign investment are also afoot. If realised, it should support banks’ brokerage income.

A long delayed mortgage legislation offers the potential for developing new income sources, but even without the law banks are offering home loans. The law will also do nothing to allay fears about a funding mismatch between long-term home loans and short-term, deposit-based funding. The central bank is unconcerned about the issue, saying deposits are historically stable sources of funding, but banks already face pressure over the disparity between their deposits and long-term loans.

In a strong economic environment, awash with local currency liquidity, the challenge for Saudi banks during 2012 will be managing growth rather than finding it.

Several investment bankers say their biggest issue is finding enough people to handle all the loan requests they are receiving. In that environment, the possibility of making mistakes is climbing. “It will all end in tears, we are booking assets at silly prices now,” says the banker from a mid-tier institution.

With activity set to continue rising and competition increasing, banks in Saudi Arabia will continue to grow over the coming 12 months, but they will find it increasingly difficult to maintain their margins.

Click here for 2011 banking results