The decline in oil prices since the second half of 2014 has focused attention on the liquidity position of the kingdom’s banking sector, and its consequent ability to achieve lending growth. The issue is a regional rather than a purely local one. The prominence of hydrocarbons revenues on the balance sheets of GCC governments means that they are particularly vulnerable to the movements of oil and gas spot prices and futures contracts.
The high energy prices of the last decade have been a boon to government planners, allowing them to divert revenues to large infrastructure spending programmes and generous social support frameworks, but the downside of this phenomenon is that when hydrocarbons revenues are eroded by low energy prices, the public sector-dominated project pipeline has a tendency to slow, and the chain of contractors and suppliers — from large multinationals and domestic players to the myriad small businesses who provide goods and services to them — experience a drop-off in business.
For the financial institutions that secure their annual net profits by servicing these sectors, one clear challenge is a significant reduction in lending opportunities. In the short term, banks are compelled to seek new efficiencies as they look to avoid a reduction in profitability.
LIQUIDITY ISSUES: In the longer term, a sustained reduction in oil prices raises the prospect of a liquidity crunch, as the slowing project pipeline reduces bank deposits from companies and individuals, which in turn nudges lenders towards the loan-to-deposit ratio (LDR) set by regulators, which tends to be set at a conservative level in the GCC.
This effect is compounded by the need for governments to draw down deposits held in domestic banks in order to meet the fiscal gap brought about by falling oil revenues. This scenario has played out across the GCC region since 2015, as finance ministries have sought to meet their spending commitments through a mixture of deficit financing, tapping into foreign reserves and calling upon pre-existing domestically held balances.
EARLY SIGNS: In 2015, the first full year of the new low oil price environment, there were some early signs that this phenomenon was beginning to occur in Bahrain. According to data from the Central Bank of Bahrain (CBB), the outstanding loans and facilities of the kingdom’s retail banks increased by 9.9% over the year to reach BD7.8bn ($20.7bn), while domestic deposits grew at the more modest rate of 2.7% to reach BD11.1bn ($29.4bn). Government deposits actually decreased over the year, in line with other regional Gulf markets, and the small aggregate rise was primarily made possible through the growth of private sector accounts.
The trend of domestic assets – principally credit extension – growing at a faster rate than domestic liabilities – principally deposits – was repeated in the wholesale segment, which focuses more on the regional market than the domestic one. By the outset of 2016 it was clear that Bahrain’s banks, like others in the region, were faced with a liquidity management challenge, due largely to the reduction of government deposits in the system. The effects of tightening liquidity began to show themselves in the interbank rate, which stood at around 1.5% in January 2015, had risen to just over 1.6% by January 2016 and by October 2016 had surpassed 1.8%, a level that it had not breached since 2010.
RAMIFICATIONS: The uptick in retail deposits in 2015 helped to offset the government drawdown of deposits held with domestic banks, allowing the Bahraini banking sector to maintain a solid liquidity position over the year. However, the liquidity question will remain a prominent one within the industry over the medium term, as the CBB sets about implementing the liquidity coverage ratio and net stable funding ratio requirements required by Basel III regulations. Moreover, while years of prudential regulation mean that Bahrain’s banks are well defended against the effects of a low oil price environment, the resulting slowdown or reversal of low-cost government and government-related entity deposits means that banks will be compelled to secure funds through more expensive channels in order to maintain lending growth, which in turn will place pressure on margins.
RATINGS AGENCIES: The possibility of banks keeping their funding costs down has not been helped by the actions of the major ratings agencies. In February 2016 Standard & Poor’s removed the kingdom’s investment grade credit rating and placed Bahrain’s sovereign rating in the speculative category, citing concerns regarding the country’s fiscal vulnerability due to oil price fluctuations. In May 2016 Moody’s followed suit, downgrading Bahrain’s long-term issuer rating to “Ba2” from “Ba1”, and in June 2016 Fitch downgraded the kingdom’s sovereign rating from “BBB” to “BB+”, meaning that all three major ratings place the kingdom outside the investment grades. The sovereign downgrades have also begun to affect the ratings of individual banks due to their exposure to government debt and the apparently reduced capacity of Bahrain to support its domestic banks in the event of a significant economic shock.
In July 2016 Fitch downgraded two of Bahrain’s domestic lenders, citing these concerns while acknowledging their strong domestic franchises and resilient financial performances in the face of strong economic headwinds. “Retail banking has been unaffected by the downgrade, with no stop or even an interest rate change seen by consumers, due in part to the CBB regulations in place that holds all banks to high standards,” Ali Moosa, managing director for JP Morgan Chase Bank, told OBG.
The prospect of increased funding costs due to a rising interbank rate and ratings downgrades has impelled some Bahraini financial institutions to adopt a more creative approach to loan structuring. For example, some lenders in the Bahraini domestic market are expending an increasing amount of energy and resources on developing their relationships with export credit agencies (ECAs) in Europe and Asia as a means to assemble more efficient loan structures. “We are seeing an increased focus on ECA financing as liquidity has become more expensive. You can attract a larger pool of interest and better pricing by cooperating with an ECA, as well as longer-term financing. We have seen ECA funding as a central component of most recent large deals,” Abdulla Bukhowa, head of corporate and institutional clients and financial markets at Standard Chartered Bank, told OBG.
LOOKING AHEAD: The low oil price environment, a continued slowdown in government deposits and the need to invest in high-quality liquid assets to comply with the requirements of Basel III all combine to challenge the Bahraini banking sector’s ability to maintain lending growth over the medium term.
However, while increased funding costs are an unwelcome reality for Bahraini banks, it is easy to overstate the acuteness of the situation. The interbank rate of around 1.8% in late 2016, while a substantial increase on the average of just over 1% seen since 2010, represents only a modest rise in comparison to the peaks of 2007, when, in the midst of an overheating economy, the interbank rate ran at a level in excess of 5%.
ROOM TO MOVE: By the close of 2016 the CBB had not moved to raise the LDR in order to allow for continued lending expansion, unlike markets such as Saudi Arabia and Oman. Should it need to act at a later stage, the regulator has considerable room for manoeuvre. At the end of 2015 Bahrain’s lenders exhibited relatively modest LDRs, ranging from National Bank of Bahrain’s 46.8% to Ahli United Bank’s 80.3%, according to KMPG. The CBB could allow these to rise without engendering a risk to financial stability: to put these figures in perspective, numerous banks in Oman, Kuwait, Qatar and the UAE exhibit LDRs in excess of 100%.
Capital adequacy also remains robust across the domestic banking sector, standing at an aggregate rate of 18.2% at the outset of 2016 – well above the CBB’s regulatory requirement of 12.5%, which is in turn more conservative than the minimum recommended by Basel. Aside from the issue of slowly rising lending costs, the key concern from the perspective of the banks is the supply of lending opportunities, and here too there is ample cause for optimism. Bahrain’s economy is one of the most diversified in the region, with non-oil activity accounting for almost 80% of nominal GDP on average since 2010, according to Moody’s.
While the sovereign and bank downgrades which took place in 2016 represent a challenge in terms of cost, the kingdom’s high per-capita incomes — estimated by the IMF at $50,100 in terms of purchasing power parity in 2015 — are considerably higher than the average of $15,000 seen in other similarly-rated markets, and do much to support retail lending opportunities during challenging economic periods. On the corporate side, Bahrain’s access to a funding pool worth $10bn under the Gulf Development Fund (see Economy chapter) enables the government to maintain a programme of spending on infrastructure, despite its fiscal difficulties.
Therefore, the focus for the kingdom’s lenders over the next year will be on seeking efficiencies wherever possible in a bid to help maintain margins during this period of economic turbulence. “Government spending in Bahrain is only $10-11bn, so it is e small for the GCC in terms of size. However, it is a very stable and well-structured market, not overly dependent on any single sector or highly exposed to exotic assets,” Mohamed Asem Abdelhalek, country manager for the Jordan-based Arab Bank, told OBG.