With three of its domestically licensed institutions in the regional top 10 in terms of net assets, Saudi Arabia’s banking sector is one of the largest and most vibrant in the Middle East. Historically it has thrived on the rise of high-value lending derived from the government’s infrastructure programmes, but recent years have also seen local lenders pursue a growing number of opportunities in the consumer and small and medium-sized enterprise (SME) segments.
More recently, low oil prices have raised questions regarding the ability of the domestic industry to maintain its healthy margins, and the sector will likely enter 2017 facing one of the most difficult operating environments in recent times. However, a history of prudent regulation means that the industry has sufficient buffers to ride out this part of the cycle, albeit with a modest softening of performance indicators.
The Saudi banking sector entered this challenging period from a position of strength, much of which was derived from the fact that it has taken lessons from times of financial turbulence. The sector had its genesis in the oil boom that followed the Second World War, when the nation underwent an economic transformation that propelled it to new prominence. By 1952 the level of capital flowing through the country’s financial institutions reached a point at which a central bank was deemed necessary. In that year the Saudi Arabian Monetary Agency (SAMA) was established by two royal decrees and continues to oversee the banking industry.
After a period of rapid expansion for the sector, which saw the arrival of key players such as National Commercial Bank (NCB) and Riyad Bank, a series of bad loans made by Al Watany Bank in the early 1960s resulted in the first failure of a SAMA-regulated major bank. In response, the regulator oversaw the incorporation of the troubled lender within Riyad Bank and set to work on a new regulatory backbone – the 1966 Banking Control Law, which still governs the industry.
The new legislation introduced robust liquidity, capital adequacy and reserve ratios, and granted SAMA a broad array of licensing and supervisory powers. From this regulatory platform the industry surged again during the 1970s, driven by rising oil revenues and a maturing economy.
By 1980 the Kingdom was home to 12 banks, 10 of which were partially foreign-owned. The decline in oil prices that took place during the 1980s exerted pressure on the industry, with non-performing loans (NPLs) rising to 20% of all extended credit at one point, yet the sector continued to expand, boosted by the arrival of important players such as The Saudi Investment Bank in 1984 and the Al Rajhi Banking and Investment Corporation in 1988.
The next two decades saw less turbulent hydrocarbons markets, and the growth of the non-oil economy in the 1990s and 2000s meant that credit expansion in this period was achieved with lower levels of systemic risk. By the early 2000s an increasingly confident SAMA began to open the market to majority foreign-owned investment banks, overturning a 1975 requirement that all banks should be majority owned by a local partner. Licensing for these international institutions began in 2004, resulting in global brands like Deutsche Bank, BNP Paribas and JP Morgan becoming established in the Kingdom.
Throughout these phases of new arrivals, sector growth and contraction, and global economic shocks, the regulator’s focus has been on the maintenance of a sustainable, financially sound system. This stance underpins the current stability of the sector. “We are seeing more of a conservative approach from lending institutions, but this is more driven by the need to stay in compliance with conservative regulations rather than negative market sentiment,” Bader Al Shammari, CEO at Islamic finance firm Al Yusr, told OBG.
As of mid-2016 the banking sector is made up of 12 locally licensed institutions. The largest by total assets is NCB, with SR449.8bn ($119.1bn) as of April 2016, according to the bank’s financial statements. NCB is followed by Al Rahji Bank, with assets of SR323.3bn ($86.2bn); Samba with SR235.2bn ($62.7bn); Riyad Bank with SR227bn ($60.5bn); and The Saudi British Bank with SR191.8bn ($51.1bn). Other prominent domestic players include Banque Saudi Fransi with SR184bn ($49.1bn) in total assets, Arab National Bank with SR166.6bn ($44.4bn) and Saudi Hollandi with SR108.6bn ($29bn).
Locally licensed banks have widened their focus from their initial concentration on the corporate and institutional segments to seek revenue from retail and SME customers, which are increasingly important segments of the market. But in competing for deposits and lending opportunities they are not alone. Foreign institutions have for many decades played an important role as well, to the extent that Saudi Hollandi, while a subsidiary of the Netherlands’ Trading Society, spent its early years in the Kingdom acting as a de facto central bank. Its transition to an ordinary private player with the creation of SAMA in 1952 provided a useful model for the increasing foreign participation that was to follow.
Bahrain-incorporated Gulf International Bank was an early arrival, entering the Kingdom in 2000. At first, foreign entrants were required to incorporate with Saudi partners to obtain a licence from the regulator to operate, but since 2004 international lenders have been able to open branches in the country. BNP Paribas and JP Morgan were the first to gain a foothold in the newly liberalised market, and as of 2016 they have been joined by a further 11 regional and global institutions, including National Bank of Kuwait, Emirates Bank and Deutsche Bank.
Recent years have seen the sector further deepened by the arrival of large numbers of investment banks, particularly after the 2005 liberalisation of regulations governing capital markets in the Kingdom. These institutions, which number more than 80 as of 2016, are licensed separately from foreign commercial banks, and their activities are overseen by the Capital Market Authority rather than SAMA. As well as regional institutions, several major global players have established a presence in the country to serve the investment community, including UBS, Goldman Sachs and the most recent significant arrival, Ashmore Group – a specialist emerging markets investment manager (see Capital Markets chapter).
The arrival of foreign players has diversified the industry both in terms of capital base and service provision, and has helped to establish a relatively well-balanced market. This characteristic is present even when taking the locally licensed lenders solely into account: net loans and advances data published by Saudi Arabia’s 12 local banks shows that the top five commanded 62.9% of the market in 2015, with no single lender claiming a share of more than 20%.
The challenges brought on by the declining oil price are readily discernible in the performance of Saudi Arabia’s banks over 2015 and into 2016. FY 2015 financial statements show the sector’s aggregate assets expanded by 3.4% to reach nearly SR2.2bn ($586.5m), a slower rate of growth than the 12% of the previous year, but still a robust response to the altered economic landscape. Al Bilad Bank led the field in terms of asset growth, posting a 13.2% rise, followed by Saudi Hollandi (11.9%) and Alimna Bank (9.7%). Deposits also continued to grow over the year, although the 1.58% expansion was the smallest since 2009, according to SAMA.
Some of the deposit slowdown can be attributed to government entities withdrawing demand deposits to purchase newly issued government bonds, resulting in demand deposits seeing negative growth of 1.3% over the year. The regulator points out that the SR1.6trn ($426.6bn) aggregate asset base means that this trend may not have a significant impact on liquidity, although it has moderately increased the cost of borrowing between banks, and SAMA has moved to take regulatory action to ensure sufficient liquidity in the market. “Debt issuances, of course, introduce investment opportunities for banks,” Abdulmohsen Al Fares, CEO of Alinma Bank, told OBG. “However, the liquidity in the market should be closely monitored.”
Bank Al Jazira showed the highest rise in net profit in 2015, at 124.8% for the year, followed by Alinma Bank (16.3%) and Banque Saudi Fransi (14.8%). The first quarter of 2016 saw the sector’s net profit continue along its upward trajectory, recording a 5.1% expansion, although four banks saw negative growth on a year-on-year (y-o-y) basis.
While the banking sector has performed relatively well within the context of low hydrocarbons prices and a subdued global economy, the size and duration of the oil price dip has resulted in an even greater focus on financial stability.
Clarity has been brought to this issue in recent years by a series of reviews of the nation’s financial system, including the Financial Sector Assessment Programme conducted by a joint IMF-World Bank Team in 2011, the Basel Committee’s Regulatory Consistency Assessment Programme on Capital Adequacy and Liquidity Coverage Ratios in 2015, and a peer review by the Financial Stability Board, which was also conducted in 2015.
All of these reviews found that Saudi Arabia had either fully or largely implemented international standards. Moreover, SAMA’s warning indicators revealed no sign of asset bubbles or excessive leveraging in 2015 – the first full year during which banks were operating in a low-oil-price environment. While the share of credit to GDP rose to 56.2% over the period, this was a result of slower GDP growth rather than a fall in energy revenues.
Revealingly, the credit-to-non-oil-GDP ratio remained almost static at 78.6%, suggesting that lending activity is consistent with the economic expansion of the private sector. The quality of banks’ loan portfolios also remains reassuringly high: the NPL ratio for consumer and credit card loans stood at just 0.7% in the fourth quarter of 2015, according to SAMA, and has steadily declined from the recent high of just over 1% in late 2014.
Much of the sector’s resilience derives from the straightforward relationship between its deposit base and its aggregate loan book. The vast bulk of deposits in the system come from Saudi households, businesses and government entities, while most bank lending is also directed to Saudi households, corporates and semi-government entities.
As a result financial institutions in the Kingdom have little need to expose themselves to foreign banks for funding purposes, a built-in protection that is enhanced by a fixed exchange rate system that has for decades significantly reduced foreign exchange transaction risk. Moreover, during periods of economic stress, sizeable capital buffers further protect this relatively self-sufficient system.
The traditionally prudent stance taken by the regulator provides more protection to banking sector players. SAMA’s conservative regulatory framework requires banks to maintain a capital level well in excess of the Basel Committee’s 6% Tier-1 capital requirement: in 2015 the Tier-1 ratio for the Kingdom’s banking sector stood at 16.2%.
While both the banking sector and the wider economy have been slowly opening up to foreign investment since the nation’s accession to the World Trade Organisation in 2005, most markedly with the opening of the Saudi Stock Exchange to foreign investors in 2015, SAMA has sought to reduce the potential for external shocks and speculative interest by limiting foreign ownership of locally licensed commercial banks to 40%. Foreign commercial banks operating within its jurisdiction are caped at a 60% foreign share, and the degree of domestic liquidity that can be invested overseas is restricted by the requirement for 20% of a bank’s liabilities to be held in liquid assets.
The regulator oversees the sector according to the provisions of the 1966 Banking Control Law, which lays out the statutory requirements on banks and establishes which financial activities may be carried out in the Kingdom. However, because the law is relatively new, much of the sector’s day-to-day operations are addressed by a great number of rules and instructions that are distributed to banks in circulars. This framework applies to all banks in the country, with SAMA making no distinction between Islamic and conventional institutions. While the creation of a Banking Dispute and Settlement Committee has put the task of ascertaining what activities are permissible within SAMA’s jurisdiction, the regulator prefers not to involve itself in questions of sharia compliance.
Thanks to prudent regulation, the assets of the domestic banking sector are generally of the high-quality and liquid variety, such as Saudi government bonds, SAMA bills and reserves held with SAMA. From a defensive perspective, then, a period of low oil prices poses little risk to the system. However, the possibility of a long-term reduction in oil prices does pose a performance challenge to the banking industry, which has traditionally thrived on the large projects that the government has been able to undertake as a result of generous oil revenues.
The question of liquidity in the system has therefore risen to the fore over the past year, and SAMA’s most significant regulatory change in 2016 reflected its concern in this regard. In January 2016 the regulator raised the loan-to-deposit ratio (LDR) requirement from 85%, where it had stood for some years, to 90%, which allows banks to continue to lend even in a low deposit growth environment. While the move has been described as “credit negative” by rating agency Moody’s due to what it sees as a relaxation of a prudent credit framework, the liquidity position of the Saudi banking sector remains strong (see analysis).
Another recent regulatory move, also in January 2016, was similarly intended to shore up confidence and minimise contagion and liquidity risk in the sector. When the new Saudi Arabian Deposit Protection Fund came into effect, it was announced that all eligible deposits are now to be covered for up to SR200,000 ($53,300) of the deposited amount. The scheme is financed by a special fund established particularly for this purpose by the banks, which pay quarterly premiums on eligible deposits.
Meanwhile, the performance of domestic banks in 2015 showed that a previous tranche of reform has not had a negative impact on margins. In late 2014 the regulator introduced new consumer lending regulations aimed at ensuring that the extension of credit to the retail segment does not reach a growth rate that might threaten the sector’s stability. The revised framework grants SAMA the power to cap the level of retail lending at individual banks and limit the fees banks can charge. All fees, costs and administrative charges collected by banks must not exceed either 1% of the financing amount or SR5000 ($1330), whichever is lower. In addition, the regulations reduce costs for early repayment, require banks to provide borrowers with a month’s notice of any change in fees and establish a requirement to give clear, annual interest rate schedules rather than show flat rates.
Looking to the other end of the lending spectrum, in February 2015 the regulator issued its long-anticipated single obligor regulation, the Rule on Large Exposures for Banks. This established a four-year schedule by which banks must reduce their exposures to single counter-parties from the current maximum of 25% of their capital bases to 15%.
Branches of foreign banks operating in the Kingdom face a less onerous regime under the new regulation, simply being required to establish policies to ensure a reasonable diversification of their exposures, and to report their 50 largest exposures to SAMA. The goal of the new rules is to limit the losses faced by a financial institution in the event of a default by managing credit concentration risk, thereby increasing the stability of the entire financial system. A corollary to this is the potential for greater bond issuance, as large entities will be encouraged to seek funding from the capital markets if the revised framework constricts bank credit.
One of SAMA’s principal objectives as an institution is to maintain a regulatory environment in which banks are able to play their proper economic role in a sustainable manner. Their ability to lend across the customer spectrum is a key measure of the success of this effort, and therefore the credit portfolios of Saudi Arabia’s banks have come under particular scrutiny in the period following the oil price decline that began in mid-2014.
Net loans and advances at the nation’s commercial banks grew by 8.2% in 2015, which represents the slowest expansion of credit since 2011. Lending to the corporate sector has traditionally been the preferred route to margin for the Kingdom’s financial institutions, and in 2015 this part of the loan book continued to provide the basis for credit expansion across the sector. According to SAMA, the corporate sector accounted for 57.7% of total bank credit in 2015, a slight increase on the previous year, while credit to the corporate sector recorded robust 11.6% growth. The bulk of this expansion came from strong demand from the commerce sector, although credit demand from the building and construction industries was also higher in 2015 than it was in 2014.
Consumer lending has been of increasing interest to banks over recent years, thanks to a rapidly expanding bankable population, better risk assessment and new technologies that have allowed lenders to interact more efficiently with potential customers. In 2015 consumer loans accounted for 24.8% of total bank credit, a slight decline on the previous year. The overall slowdown in economic activity since 2014 has affected this part of the aggregate loan book more significantly than corporate lending, and in 2015 consumer loans expanded by a relatively modest 4.5%.
According to SAMA, slower consumer credit growth is an indication of changes in consumer spending behaviour, wherein consumers are presently less willing to spend on items such as cars, major appliances or equipment and consumption-related activities, concentrating instead on essential areas including, for example, home renovation. Real estate lending also saw lower growth in 2015 relative to the previous year, falling from over 30% to 17.2%.
Banking sectors across the world exhibit similar tendencies in periods of economic slowdown: limiting credit extension, concentrating on big-ticket lending to key clients, and showing caution where more challenging consumer and SME opportunities are concerned. While the Saudi sector behaves in a broadly similar fashion to the global norm, some areas of the consumer segment are likely to retain the attention of market observers over the medium term.
The recently reformed mortgage sector is one such point of interest. The regulator sought to stabilise the mortgage market in late 2014 with the introduction of its Real Estate Mortgage and Financing Laws. This comprised a set of five separate pieces of legislation dealing with regulatory issues such as mortgage creation, oversight and default. While the move was welcomed from a financial stability viewpoint, a conservative loan-to-value ratio introduced by the new regulations saw a slowdown in home loans, as many potential buyers were compelled to rent property instead. This in turn had the effect of pushing up 2015 rents in locations like Riyadh and Jeddah by 13% and 9%, respectively, according to mortgage lenders.
In 2016 SAMA revisited the issue, this time allowing the finance companies that compete with banks in this segment to provide loans for 85% of a property’s value. Commercial banks will also be permitted to offer 85% mortgages to the approximately 450,000 nationals registered on a Ministry of Housing waiting list, with the extra 15% of the total being guaranteed by the Ministry. The continued evolution of the Kingdom’s mortgage market is likely to remain a key theme within the banking sector as new regulations and processes open up more growth opportunities. “The home mortgage industry has been traditionally associated with long waiting periods and paperwork. Digitisation will play an important role in driving change in the market landscape,” Mazin bin Ahmed Al Ghunaim, CEO of Bidaya, told OBG.
Auto leasing is another competitive segment in retail banking. The large number of banks that operate dedicated auto-leasing programmes means customers have become accustomed to shopping around for the best rates, and therefore pricing remains the front line in the battle for market share.
NCB’s auto leasing operation is typical of larger institutions: customers can select their vehicle at a dealer’s showroom and then obtain a pre-approval from an NCB sales representative at the showroom or the nearest NCB sales centre. The bank undertakes to contact the client with a final approval via SMS within two business days, and then after coordinating with the car dealership and the traffic department, deliver the vehicle to the customer within 10 business days.
Competition in the auto-leasing business is further increased by a number of non-bank leasing companies such as Abdul Latif Jameel and Al Yusr Leasing and Financing. While higher funding costs makes competing with the banks on pricing a challenge, these independent leasing companies have built their businesses on the back of quick approvals, high service levels and promotional efforts, such as special prices with dealerships. As with the mortgage financing segment, a young and growing population and rising levels of disposable income underpin the future prospects of auto leasing.
While data on vehicle sales in the Kingdom is scarce, the US Department of Commerce estimates that total unit sales, including passenger cars, commercial vehicles and trucks, reached 900,000 in 2015 – a two-fold rise over the 2006 level. However, while the potential for future growth in this segment remains high, the change in consumer behaviour noted by SAMA in 2015 and the prospect of a prolonged period of low oil prices means that a question mark hangs over expanded auto leasing in the short term. “The new SAMA regulation on vehicle financing has benefitted consumers, who now have a choice of lower rates to choose from,” Omar Mohammed Hindi, managing director at Taajeer, a financial services company for automobiles and real estate, told OBG.
The nation’s SMEs account for around 90% of registered businesses and 60% of total employment, according to a report by Aljazira Capital, and as a result occupy a central position in the Kingdom’s recently formulated development strategy (see Economy chapter). In line with the government’s Vision 2030 economic development plan, the Public Authority for Small and Medium Enterprises was formed in 2015 to support the sector. The General Authority for Statistics (GaStat) defines small enterprises as those with between five and 19 employees and an annual turnover of $1.3m-6.7m. Companies with more than 20 employees and a turnover of $6.7m-33.3m are considered to be larger enterprises.
Extending credit to the large number of businesses in this stratum of the economy is a challenge for Saudi banks. Many lenders have only recently established dedicated SME departments, and finding and retaining personnel with the specialised knowledge required for effective SME lending is a challenge. This problem is mirrored within the SMEs themselves, where cash management and accounting skills often fall short of the requirements posed by the banks that are assessing them as potential clients.
These factors help to explain the SME funding gap that has remained a feature of the local banking landscape for decades. For many lenders there has historically been little incentive to invest capital and manpower in pursuit of the relatively modest returns offered by SME facilities, when big-ticket deals with corporates have provided easy and consistent revenue. Therefore the Kingdom’s banks have adopted a conservative stance on SME lending which the tightening of liquidity in the sector in 2016 is likely to reinforce. In essence this means that in the short to medium term the Kingdom’s lenders will be reluctant to extend SME credit beyond those subcontractors that are considered low risk due to linkages with the large contractors already financed by the bank.
Loan Guarantee Programme
However, the government has a useful tool by which it can offset some of the effects of this trend. The SME Loan Guarantee Programme managed by Saudi Industrial Development Fund (SIDF), better known as the Kafalah programme, was established by the Ministry of Finance in 2006. Its principal mandate is to work with local banks to enable SMEs to better participate in the growth of the economy and provide employment opportunities for the Kingdom’s workforce.
The performance of the scheme to date has been positive. According to the SIDF’s most recent annual report, by the end of the FY 2014 a total 10,892 guarantees had been issued by the programme since its establishment worth SR5.3bn ($1.4bn). These were issued against cumulative financing of SR10.6bn ($2.8bn) by banks, which went to 5579 SMEs. There are 10 locally licensed lenders that have made use of the Kafalah guarantee in their extension of credit to SMEs, with National Commercial Bank, Riyad Bank, Arab National Bank and Al Rajhi Bank accounting for around 80% of the total. “The SME market is very promising,” Ahmed Rashed Al Ameer, CEO of Kirnaf Finance, told OBG, “It is very large and underserved, so there is a gap for those willing to fill it.”
Visa and MasterCard are the two largest credit card brands in Saudi Arabia, according to HSBC, followed by American Express. Most domestic banks also offer the Saudi Payments Network (SPAN) debit card, which takes its name from the SPAN routing switch for all cross-bank ATM transactions and point-of-sale (POS) transactions in the nation. It was first implemented for ATMs in 1990, with the rapidly growing number of POS units added to the system in 1993. The volume of transactions processed over the network has grown exponentially, from 16.9m in 1993 to 754.6m in 2015.
The acceleration of ATM numbers and increasing complexity of their operations has also helped foster the expansion of the service companies which work with domestic banks in the technology arena. Abana, for example, has developed an ATM management programme which provides complete ATM outsourcing services, including site finding and construction, civil and telecoms works, and cash replenishments.
As banks amplify their attempts to gain market share, their technology offerings continue to evolve. Services are increasingly cross-sold with technology products, such as by bundling a credit card with a consumer loan or insurance. “Bundling products and services like this is increasingly common,” Abdullah Alkhalifa, CFO at Al Rahji Bank, told OBG. “We look at it on a segmental basis, middle income, affluent and so on. Our ultimate aim is to push up our cross-selling ratio.”
This process may become easier thanks to a new development which has the potential to radically alter the way customers interact with their banks: glassless branches are currently being trialled by National Commercial Bank and Riyad Bank. By sitting down with customers rather than staying behind a screen, staff are better positioned to cross-sell products. The idea has worked well in other markets, albeit in branches with a concentration of high-net-worth individuals.
The Kingdom’s prudentially regulated, highly capitalised banks are well positioned to weather today’s economic challenges from a financial stability viewpoint. However, questions remain as to how they will perform in an increasingly challenging operating environment, which is expected to dampen funding, asset quality and profitability. After nearly two years of subdued oil prices, these concerns prompted major credit ratings agencies to downgrade a number of Saudi banks in the first half of 2016. Justifying its decision, Standard & Poor’s stated that it expected the Kingdom’s banks to experience a correction cycle, which may result in an increase in NPLs and credit losses, and a decline in profitability. The move followed a downgrade of the sovereign in late 2015, which saw Saudi Arabia’s rating slip from “AA-” to “A+” with a negative outlook – a decision which the Ministry of Finance described as “reactionary” and inconsistent with the idea of ratings being a medium-term tool meant to look through the cycle while assessing creditworthiness.
With or without downgrades, however, both the ratings agencies and the sector foresee a challenging year or two ahead. In March 2016 Moody’s stated that it expected the operating environment to weaken over the following 12-18 months, with loan growth likely to slow to between 3% and 5% for the year. Local banks concur with this assessment, although they have also been quicker than the ratings agencies to recognise the potential upsides to Saudi Arabia’s altered economic landscape.
However, other opportunities may present themselves, as the government has indicated its interest in divesting itself of some of its biggest assets, such as its airports. The potential sale of state-operated entities forms part of a wider process of economic reform, which is likely to open up many more opportunities for banks wishing to grow their loan portfolios in the coming years. While the possibility of shrinking margins and tightening liquidity is likely to capture the attention of the sector in the short term, the ability of the Kingdom’s banking sector to continue its growth trajectory in the long term is very much tied to the government effectively implementing Vision 2030, which is widely seen as the most ambitious economic development plan in the Gulf (see Economy chapter).
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