The past 18 months has been a brutal period for banks the world over. Yet despite experiencing two of the largest corporate defaults in the region, Saudi Arabia’s banks have managed to stay profitable throughout the financial crisis and the drop in economic growth in 2009.

Nevertheless, in the first quarter of 2010, only two banks in the kingdom reported an increase in profit from the same period in 2009: National Commercial Bank and Riyad Bank. Riyad Bank is the third-largest bank in the kingdom by assets, behind National Commercial Bank and Samba, and is fourth largest in terms of profits.

Deputy chief executive of Riyad Bank, Suliman al-Gwaiz, says the robust performance of the Saudi banking sector shows that after the initial headlines, the financial crisis was not as bad as feared.

Portfolio recovery

“There was a lot of panic and fear about the financial crisis, but what transpired, although problematic and painful, was much better than what people expected,” he says. “The local market has been in good shape and hasn’t come under any severe pressures.”

He attributes the change in fortunes at Riyad Bank, which suffered a 14 per cent fall in profit in 2008, before posting a 14 per cent recovery in 2009, to the performance of its investment portfolio.

“We reported a higher income in 2009 that was due to our investment portfolio,” says Al-Gwaiz. “In the first half of 2008 and the first quarter of 2009 it took a beating, but has since recovered.” He says the quality of the bank’s investment portfolio meant it could ride out the financial crisis without having to sell off any assets and wait for market valuations to recover.

Riyad Bank’s investments totalled SR27.7bn ($7.4bn) at the end of 2007, rising to SR40.3bn by the end of 2008. This figure fell sharply in 2009 to SR32.3bn, although it has since stabilised in the first quarter of 2010.

The recovery has not led Al-Gwaiz to become complacent, though. He still expects the rest of 2010, and early next year to be a difficult time. “We are emerging from the challenges of last year, but a new challenge is emerging,” he says.

The steep drop in interest rates is temporarily a good thing for the banking sector. As interest rates fall, banks benefit in the short term because the amount they pay out to depositors quickly mirrors that fall, while the rate they receive from existing loans continues at the previous levels. But once market rates stabilise, low interest rates erode the margin banks earn.

Next year will see the carry-over effects of interest rates in 2010, so I don’t foresee a very stellar performance

Suliman al-Gwaiz, Riyad Bank

“When interest rates drop more than 4 per cent to about 50 basis points, that is a significant margin when you are lending several billion riyals,” says Al-Gwaiz. “It is very difficult to fix that hole in earnings.” Already Riyad Bank has experienced some tightening in its margin, shrinking from 3.3 per cent in 2008 to 3 per cent in 2009, according to analysts at the UAE’s Al-Mal Capital. Net interest income has also fallen slightly, from SR1.061bn in the last quarter of 2009, to SR1.012bn in the first quarter of 2010.

“When rates start to climb, that is also bad for the Saudi banks,” says Al-Gwaiz. Interest rates are expected to start to pick up in 2011, and as they do, so the lag between re-pricing cheap loan rates with more expensive rates paid to depositors will again eat into margins.

“Next year will see the carry-over effects of interest rates in 2010, so I don’t foresee a very stellar performance in the banking sector. The first quarter will be indicative of the broad earnings trend, though there may be some pick-up on lower provisioning,” he adds.

Despite this, he says Riyad Bank is on track to make more money in each of the remaining three quarters of the year than it did in the first, which means the bank should end the year ahead of the $808m profit it made in 2009.

In part it aims to achieve this by focusing on higher-yielding retail banking – in common with several other banks in the kingdom. Al-Gwaiz concedes that the retail banking sector is becoming increasingly competitive and that is driving down margins, but insists it is still an attractive business.

The defaults at Saad Group and AH al-Gosaibi & Brothers have also been a major source of angst for the local banks. Al-Gwaiz will not comment on the full extent of Riyad Bank’s exposure, but says the bank has “one of the lowest exposures to these groups that is not very substantial at all”. But the impact of these defaults is still being felt in other ways. Although the extent to which Saudi banks were involved in ‘name-lending’, where banks lend on the strength of reputation alone, has been overplayed, he does say that lending practices are tightening as a result.

“Demand for credit is there,” he says. “But there is now a more rigorous assessment of operations and banks are more inquisitive. Also, large conglomerates are realising that the more they share information with banks, the more likely we are to help them with requests. The old ways of misusing confidentiality privileges and getting leverage have really changed.”

There was no growth in bank lending in Saudi Arabia in 2009, and Al-Gwaiz says “in the first half of 2009, some banks were just not in the market at all”. He adds that the bank’s clients frequently complained of the difficulty in getting new credit lines in early 2009.

Loan growth

But now Al-Gwaiz sees an appetite for lending returning as banks seek to book new assets. “Demand is there, expect to see it continue to grow,” he says. “It picked up late last year and we managed to increase our total loans in 2009. The only dip has been in the three months since December.”

In the first quarter of 2010, Riyad bank reported total loans fell slightly from SR106.5bn to SR106.3bn, while total assets fell from SR176.4bn to SR174.3bn. Al-Gwaiz puts this down to fewer transactions closing than the bank had hoped.

During 2009, the bank also experienced a brief fall in the level of deposits, which dropped SR122bn in the second quarter to SR119bn in the third quarter. They have since recovered strongly, though, indicating that it was just a temporary phenomenon.

But loan growth will also have to recover strongly though to compensate for the fact that lending is now less profitable than it used to be. “We are a big player in the project finance market and those skills are very useful in other areas of corporate finance, which is good as we need to grow our business volumes to offset the drop in net interest income,” Al-Gwaiz says.

Riyad Bank is on course to play a major role in the projects sector over the next 12 months: Taking a large role in lending on two refinery projects for state oil giant Saudi Aramco; acting as financial adviser for Saudi Arabian Mining Company’s aluminium smelter project; and acting as a large lender on several of the contractor financing loans for developers of government-funded projects. These large loans will help boost loan growth, although the pressure on lending margins will keep income from these operations tight.

Despite Al-Gwaiz’s optimism that loan growth is returning to the Saudi banking system, he does pick out an anaemic loan market as one of the key challenges to the banking sector in 2010. “The lack of loan growth was partly the cause of the lack of economic growth in 2009,” he says. The omens for both loan growth and economic growth in 2010 are much better.

A key driver of this growth will be lending to small, medium-size enterprises (SMEs), which are benefiting from government initiatives and more data on their credit quality. “Government investment and accommodative lending schemes where they partner with banks to share risks is helping to improve sentiment,” Al-Gwaiz says. “In addition the availability of good credit reporting data is beginning to improve. That is helping the wheel start to turn and more investment start to go into SMEs.”

Cautious outlook

Al-Gwaiz insists the local banks have largly put the problem of Saad and AH al-Gosaibi defaults behind them, and besides, “corporate defaults are a fact of life”, he says. “As a banker, they never stop. We even saw them in 2007 and 2008 when things were booming. The sheer size of the problems with these two corporates tends to overshadow everything.”

Despite the eagerness with which bankers in the rest of the region are jetting into Saudi Arabia hunting for business, Al-Gwaiz says he remains cautious about the outlook. “It would be naive to say the financial crisis is over,” he adds. “You can always have surprises.”