Saudi banks are proud of their conservative reputations. Cautious lending strategies have enabled them to ride out financial peaks and troughs, as well as helping them maintain a good track record of profitability.

The kingdom’s central bank, the Saudi Arabian Monetary Agency (Sama), has developed a reputation as a tough regulator, keeping a close watch on the banking sector and ensuring strong capitalisation and risk mitigation.

Yet that hard-won reputation has been challenged over the past couple of years. The massive expansion in credit that accompanied the 2004-08 Saudi economic boom caused banks to drop their guard and loan loss provision levels slid back from their traditional 150 per cent coverage ratios.

Loan coverage in Saudi Arabia

Provisioning levels were relaxed as banks courted a rapidly expanding private sector. Between 2004 and 2005, Saudi bank provisioning levels actually decreased, declining from $635m to $539m.

The emergence of large Saudi corporate defaults, associated with the Saad Group and AH al-Gosaibi & Brothers – two prominent family-owned conglomerates that revealed significant debts in mid-2009 – exposed local, regional and international banks, alike.

Although many Saudi banks were adequately provisioned, they were still forced to spend the next 18 months ramping up their non-performing loans (NPLs) coverage to account for their exposure to impaired loans. Local banks witnessed an increase in both the level of NPLs and in provisions needed to cover these exposures.

According to a September 2010 assessment of Riyadh’s banking sector by Moody’s Investors Service, the NPL ratios of rated Saudi banks increased to 3.4 per cent at the end of 2009 from 1.5 per cent at the end of 2008. The ratio of provision charges as a percentage of gross loans increased to 1.4 per cent – the highest level since 1999. 

The deterioration of NPLs was due to SR12.7bn ($3.4bn) increase in NPL balances, primarily attributable to the two troubled family conglomerates, said Moody’s.

Even before the Saad and AH al-Gosaibi defaults sent shock waves through the region, Saudi banks were having to crank up provisioning levels. Absolute provisioning increased from $864m in 2007 to $1.39bn in 2008.

Loan loss provision expenses trebled from SR3.2bn in 2008 to SR10.1bn in 2009.

Individual banks’ income statements reveal the detail of hiked provisioning levels. Net provisions for credit losses at Sabb Bank rose to SR1bn for the first nine months of 2010, from SR782.2m in the same period a year earlier. 

Banque Saudi Fransi’s provisions to total NPLs rose from 111 per cent at the end of 2008 to 126.6 per cent at the end of 2009. By the third quarter of 2010, this had risen to 142 per cent – just short of the 150 per cent level now stipulated by Sama.

Arab National Bank (ANB) has shown one of the steepest increases in provisioning of Saudi banks. Its net provision for the third quarter of 2010 rose to SR377.3m from SR51.2m in the same period in 2009 – this represents a seven-fold increase. Sharia-compliant lender Al-Rajhi Bank says its provisions cover 122 per cent of bad loans.

Despite these efforts, Sama is increasing the pressure on banks to make further provisions. The central bank is insisting that Saudi banks commit to provisioning levels of 150 per cent, even if this eats into bank profits in the meantime.

Sama’s tough and prudential stance is nothing new. According to Banque Saudi Fransi chief economist John Sfakianakis, the central bank is merely reverting to the historical trend.

“In 2005, Saudi banks were provisioned at levels of more than 115 per cent,” says Sfakianakis. “After that, the level of provisioning that banks were prepared to take declined. We had exuberance from banks in terms of credit expansion from 2004-08. What’s happening now is that Sama would like banks to go back to the historical norm of more than 100 per cent. It has therefore indicated to the banks that this is what they have to do.”

Increased financial regulations in Saudi Arabia

Senior Saudi bankers appear relaxed about the increase. “I don’t think it will be a challenge,” says one bank executive in Riyadh. “Some feel it’s prudent, some feel it’s drastic. But overall, Saudi banks – with one exception – have enough recurrent income to absorb not just what’s been required, but much, much more.”

The pain of increased provisioning is not evenly shared across banks. For those institutions that have already provisioned at a faster rate, the impact will be less. Some banks, such as Banque Saudi Fransi, were already provisioned in excess of 100 per cent going into the crisis, but others who were at the 80-90 per cent level have had to substantially step up their efforts. This will erode profit margins.

Nonetheless, Sama’s tough stance on loan loss coverage is viewed as a positive for the health of the wider financial sector. Crucially, it does not foresee further corporate debt defaults in the pipeline.

“Sama is a hands-on and prudent regulator, so it is not a surprise to us that Saudi banks keep building up their loan loss provision reserves. Increased provisioning does not necessarily mean that there are more skeletons in the closet,” says Christos Theofilou, a Saudi bank analyst at Moody’s Investors Service.  

Positive impact

Analysts say the impact on earnings will be short term and one that will be comfortably absorbed. “We tend to see it as a positive rather than negative, even if it affects profitability in the short-term. Profitability isn’t something that worries us about Saudi banks,” says Theofilou.

The worst may already be over. Moody’s forecasts that a peak in provisioning charges should ensure slightly higher profitability for 2010 and this is expected to grow further in 2011.

This is not to minimise the impact of 150 per cent provisioning on bank profits. ANB reported a net profit of $429m for the first nine months of 2010, compared with $553m for the same period last year. Robert Eid, ANB chief executive officer, attributes the decrease on the bank’s conservative policy to create provisions in support of its financial position, as well as a substantial drop in commission prices.

“We think profitability will be affected by these one-offs, but all banks will be above 100 per cent coverage and next year banks will be able to grow their business,” says Eid. “The profit potential is there, but banks are progressing at a pace that is reflective of a very cautious mood.”

Some banks have managed to minimise the impact of greater loan loss coverage. As Banque Saudi Fransi’s chief financial officer Philippe Touchard said in a 25 October conference call, the bank is able to soften the impact of more provisioning if need be.

“We made a big effort in fourth quarter of last year preparing for enhancing this coverage ratio with a view to issuing a bond. Now that we are already at 142 per cent, the pain for us will be way less than other banks,” said Touchard.

Sama’s hard line on provisions suggests the central bank is not overly concerned about debt problems arising in future. 

“Sama is a regulator that closely monitors the banking system and they are doing a good job. The provisions reflect a particular set of circumstances where there has been a lot of media coverage about the collapse of corporate groups.  Sama thought it best to clear the air in one go, as banks can afford it,” says ANB’s Eid.

In Sama’s view, Saudi banks simply need to be better prepared for every eventuality. It will not countenance a return to the mid-2000s when conservative provisioning strategies were relaxed – leaving some banks vulnerable to corporate debt defaults.

Cautious lending by banks in Saudi Arabia

Even with only a slim chance of a double-dip recession hitting the kingdom’s economy, banks are under pressure to be more cautious.

After the past couple of years’ introspection, when management teams focused on reviewing loan books to ensure clients were free of financial stress, banks are now tentatively looking at increased lending to the private sector in 2011.  

Samba Financial Group expects overall Saudi bank lending growth to average just under 8 per cent this year, and to accelerate to more than 19 per cent in 2011 as the private sector recovery gains traction. 

Bank chiefs can feel private-sector appetite slowly returning, which will help profitability. “Saudi Arabia is doing much better than its neighbours and banks are benefiting, but its not double-digit growth we’re looking at,” says Eid. “The profit potential is there, but it’s progressing at a pace which is reflective of a very cautious mood. The government is spending a lot of projects, but there’s no euphoria – and maybe that’s a good thing.”

Conservative lending may be just what is needed, after the difficulties encountered over the past couple of years.

Sooner or later, though, banks will have start to lending again. In a low interest-rate environment, interest margins have come under pressure and banks will have to increase volumes to protect profitability. Saudi banks are liquid enough to boost their loans books – the key is finding the pick-up in private-sector demand to allow them to resume lending.

Profits may drop in the short term for those banks still facing a steep climb in provisioning levels, but the net impact from Sama’s stern oversight remains overwhelmingly positive for the sector.

Nonetheless, high provisioning is no guarantee that Saudi Arabia will not experience another Saad/AH al-Gosaibi-style debt crisis. But it does mean the local banks will be better prepared.