In a recent roadshow to promote inter-national investment in Saudi Arabia, Khalil Ghalayini, head of private banking at Audi Saudi Arabia, was asked which was the best Saudi bank in which to invest. “If you close your eyes and pick one, you will do well,” he answered.

This renewed optimism contrasts significantly with the events of last year, when retail investors were dropping banking stocks because of contracting revenues and institutions were underperforming the overall economic growth rate.

In 2007, the Saudi economy grew by 3.5 per cent, with a budget surplus of $47bn. Since then, the oil price has risen above $120 a barrel and the kingdom has raised more than $8bn through initial public offerings (IPOs) in the first five months of 2008. This is already more than the total raised in 2004, 2005, 2006 or 2007, indicating that sentiment towards the long-slumped Saudi stock market (Tadawul) is improving.

“It is a great market for banks,” says the manager of one local financial institution. “There is masses going on and a lot of opportunity.”

Slow recovery

In the first quarter of this year, the banking sector as a whole grew by only 2.4 per cent. While the rest of the GCC banks have already recovered from the regional stock market crashes of 2005 and 2006, Saudi banks are still failing to match up to the income they made during the boom years.

Over the past three years, banking stocks on the Tadawul All-Share index (Tasi) have largely underperformed the index.

In 2007, profit for the banking sector fell by 14.5 per cent to $8.1bn, driven by the decline in brokerage and asset management fees, which accounted for 19 per cent of the income achieved in 2006. The shift in the income base is demonstrated by the change in the proportion of total income that is made up of non-interest income, which dropped from 55.6 per cent in 2006 to 47.3 per cent in 2007.

Despite growing by only 2.4 per cent, the banks’ performance in the first few months of 2008 was a marked improvement on the first quarter of 2007, when most Saudi banks posted a significant downturn in profits from the previous year of between 8 per cent and 75 per cent. The only exception was Arab National Bank (ANB), which managed to book a modest 3 per cent increase in profits.

Robert Eid, chief executive officer (CEO) of ANB, says this was because of the bank’s conservative approach to stock market business. It continued to grow its profits in the first quarter of 2008, with an increase of 5 per cent on the previous year.

The performance of other banks, such as Al-Rajhi, Samba and Riyad Bank, was broadly flat in the first quarter of 2008, with only Saudi Hollandi and Sabb posting significant growth on the previous year. Riyad Bank was the only bank to report an increase in profit in 2007, albeit a modest rise of 3.5 per cent to $803m.

In the remaining three quarters of 2008, profits are expected to continue on an upward trend. “What we have seen in the first quarter of 2008 is banks getting beyond lower personal loans, lower asset management income, and other market-related income,” says Tim Gray, CEO of HSBC Saudi Arabia. “Now we will see a more normalised growth pattern, consistent with a broader base of business. This won’t be 40 or 50 per cent growth, but it will be good double-digit earnings growth.”

New restraints

Old challenges such as the lack of human capital are now combining with new restraints on dollar capital, which will make the recovery a more muted affair compared with the stellar growth rates achieved when the stock market was peaking in 2006.

“There will be growth, but it will not be as spectacular or as exuberant as in 2005-06,” says Eid. “It will probably take the full year to go back to the level of income banks had two years ago.”

The broadly positive economic environment is clouded by the huge increase in the cost of dollar funding and inflation eating into the bottom line. The cost of dollar funding has risen substantially over the past 12 months. Given the strength of the economy and strong government support, banks were not expecting to have such difficulties in getting hold of
dollars from international investors.

Just 12 months ago, most banks were busy plotting out medium-term note (MTN) programmes to help them diversify their income sources, as the majority of dollar deposits in the Saudi banking system are short-term corporate deposits. These MTN programmes are now on hold because of the sharp uplift in pricing that occurred because investors became nervous about the unforeseen effects of the sub-prime crisis.

Jean Marion, managing director of Banque Saudi Fransi, says the cost of borrowing has increased by more than 100 basis points since the credit crunch began to take effect last year.

“Everything is on ice because the bond market just does not exist in the region any more, except maybe for sukuk,” he says. “There is no real pricing in the market for dollar-denominated bonds. Syndicated loans can be done but they are costly and time consuming.”

“Banks in the kingdom may have to learn the hard way that raising dollars in this market is not as easy as it used to be,” says Mohammad al-Tuwaijri, managing director of JP Morgan Saudi Arabia. “Previously, banks used to just pick up the phone and call the Saudi Arabian Monetary Agency [Sama] if they wanted dollars. They are becoming very expensive this way now.”

This has again led banks in the kingdom to turn to their shareholders for additional funds. “With the return on equity that investors have been getting, shareholders have also been willing to invest more capital into banks,” says Marion.

This is also a signal that banks have still got plenty of business and need the additional capital to allow them to lend more to individual borrowers.

The dearth of dollar funding is in sharp contrast to the abundant riyal liquidity, which has led to a shift towards pricing more deals in local currencies. This trend is expected to continue throughout 2008.

Bankers say the result of this is that where liquidity is available, it will be allocated only to the highest-credit-quality and highest-yielding transactions.

If the turnaround in the cost of dollars was a surprise for the banking sector, the huge increase in inflation has been even more dramatic. Inflation has jumped from less than 3 per cent in 2006 to nearly 10 per cent in March 2008.

This will hit the banking sector in conflicting ways. The cuts in interest rate by Sama may have matched those in the US, but so far there has been little sign of passing these cuts on to customers.

This should help to push up margins on retail lending as it is more closely linked to the interest rate than corporate lending, which is generally priced from the London interbank lending rate (Libor).

Conversely, it causes problems for the Saudi economy and the banking system. Cutting the interest rate at a time of already rising inflation is a major policy concern for the Saudi government, says Said al-Sheikh, chief economist at National Commercial Bank.

“Sama has introduced some new instruments to help drain some of the liquidity in the economy, such as increasing the reserve requirements for banks, which it has done three times from 7 per cent to 13 per cent,” he says.

“This has implications for the Saudi banking sector, as it is effectively a tax on banks that cannot be passed on to depositors or borrowers, so banks will have to carry that cost.”

Inflation will also take its toll on expenses, with employees demanding larger salaries and bigger bonuses. This will start to eat into profitability.

Other restraints are also a problem. Eid says the two biggest factors hitting profitability in the banking sector in 2007 were “the stock market and the stagnation of consumer lending”. Banks are finding that expanding their exposure to retail lending is becoming more difficult.

“Consumers are no longer that willing or able to borrow,” says Eid. “Their capacity to take on more debt has been constrained by psychology following the stock market downturn, and a spate of regulatory measures affecting things like debt service ratios and maximum maturity of debt.”

“Although there is apparently masses of liquidity in the banking system, there is not the liquidity for individuals and individual companies – at least, not the levels they would like,” says the director of one Saudi bank.

This is why some Saudi companies are turning to other markets for sukuk issues, to sidestep domestic constraints on borrowing. “My view is that everybody is overstretched, it just does not all show up in the banking system,” says the director.

The director predicts this will force banks to become more sophisticated and specialised in targeting specific markets or customer bases.

John Sfakianakis, chief economist at Sabb, agrees that banks will be unable to increase their income at the rates that have been achieved in the past. “Lending will reach a limit on the corporate side, the cost of funding for banks will increase, and consumer credit is not growing very fast,” he says.

Slow response

How corporates react to this remains to be seen. Businesses in the Gulf have become accustomed to having easy access to cheap credit, and there are signs that they are getting frustrated at the slow response from banks wanting to push up the price.

Saudi International Petrochemical Company (Sipchem) is rumoured to be considering dropping its relationship with some banks after they missed two deadlines to respond to financing requests.

Marion says that despite a lot of talk about the introduction of complex structured products, such as securitisation, being used in the Saudi banking sector to help banks deleverage their balance sheets and reopen credit lines to individual borrowers, it is still not occurring in Saudi Arabia. At the moment, most banks are going to shareholders for new injections of capital.

In 2007, several new investment banking operations were started up by international firms such as JP Morgan and Morgan Stanley, competing with the subsidiaries owned by local banks.

The new competition in this area has pushed down fees, and means that despite the huge volume of IPO work available, not all of it will be particularly lucrative.

Al-Tuwaijri says this is damaging issuers’ perceptions of value in investment banking. “Issuers are finding that too many people are approaching them all offering the same services,” he says. “But in the end, quality will prevail.”

One local investment banker says margins on some deals have become so low that they no longer reflect the risks. The banker says this could also be a reflection that most Saudi bankers have only known good times, and have yet to really learn the value of properly pricing risk.

Although the Saudi banking sector is one of the kingdom’s most successful at hitting targets to hire and train Saudis, there remains a massive shortage of skilled staff, which is affecting every bank. How much this could affect their ability to grow is unclear.

What is clear, though, is that anyone expecting a return to the years of huge profit growth will be disappointed.

Over the past 12 months, the UAE has overtaken the Saudi banking market as the region’s largest by assets, while Emirates NBD, created through the merger of Emirates Bank and National Bank of Dubai last year, has overtaken National Commercial Bank to become the biggest bank in the region by assets.

“Growth in the Saudi banking sector will be slower than in some other GCC markets, but that is a function of more regulatory constraints, and banks there are generally more conservative, and probably better run because of it,” says Robert Thursfield, financial institutions analyst at ratings agency Fitch Ratings.

Despite years of being the largest banking market in the region, Saudi Arabia is now in the unusual position of coming second. It is a position perhaps more suited to the country, though, plotting a slower and more stable and considered growth path while its neighbours follow a more liberal approach with greater risks.

Table: Saudi bank net income profits ($m)

2005 2006 2007
Arab National Bank 488 668 656
National Commerce Bank 1,338 1,673 1,610
Samba 1,073 1,389 1,286
Sabb 669 811 695
Saudi Fransi Bank 592 802 723
Saudi Hollandi Bank 281 254 117
Bank al-Jazira 234 526 215
SIB2006 284 535 219
Al-Rajhi 1,504 1,947 1,720
Riyad Bank 758 776 803
Belad na 47 19
Total 7,221 9,428 8,064

na=not available

Source: Sama

Table: Banking sector performance

2006 2007
Number of employees 34,363 36,676
Return on equity (%) 30.5 22.3
Return on assets (%) 4.2 2.82
Net interest income/ total operating income (%) 44.4 52.7
Non interest income/ total operating income (%) 55.6 47.3
Total operating income ($bn) 14.0 13.4
Total operating expenses ($bn) 4.4 5.2
Net income ($bn) 9.6 8.2
Total assets ($bn) 229.5 292.5
Customer deposits ($bn) 171.0 207.7
Loans and advances ($bn) 124.9 152.2

Source: Sama