Islamic Banks’ Growth in Saudi Arabia to Continue Unabated

JEDDAH — S&P Global Ratings forecast oil prices will stabilize at $50 per barrel in 2017 and 2018, with unweighted average GDP growth in the six GCC countries at 1.9% in 2017 and 2.4% in 2018, after 2.3% in 2016. S&P expects the slowdown in growth at both conventional and Islamic banks in the region will persist. Asset growth stabilized at 6.4% in 2016 for Islamic and conventional banks in our sample, compared with 6.6% and 6.9% respectively in 2015. The rating agency said asset growth will drop to about 5% as governments› spending cuts and revenue-boosting initiatives, such as tax introductions, reduce opportunities in the corporate and retail sectors.
“We see banks becoming more cautious and selective in chasing high-quality lending opportunities, triggering stiffer competition.”

The story is not the same for all GCC countries, though, it said.

Although the economic slowdown was and will remain more pronounced in Saudi Arabia, Islamic banks› growth accelerated there in 2016, thanks to their strategy to increase their foray into the corporate and small and midsize (SME) sectors. By contrast, the slowdown was deeper in Qatar, where a mix of lower liquidity and government spending cuts prompted banks to curtail their pace of expansion. Asset growth was about nil in Kuwait over the past year, hit by the depreciation of some foreign currencies and the ensuing impact on the financials of some leading Kuwaiti Islamic banks. Lastly, despite the tepid economy and the drop in real estate prices in the UAE, Islamic banks continued to expand at high single digit figure.

The asset quality indicators of GCC Islamic banks remain on a par with those of their conventional counterparts. Both Islamic and conventional banks are well entrenched in their local real economies in the GCC. As the economic cycle turns, “we think that asset quality indicators will continue to deteriorate in 2017-2018. The weakening that has already occurred was not noticeable in 2016 because – as is typical – banks started to restructure their exposures to adapt to the shift in the economic environment. Therefore, we saw an increase in restructured loans in the GCC in 2016, but we didn›t observe a marked increase in nonperforming loans (NPLs) or cost of risk. We think the deterioration will be more visible in 2017-2018. Although some market participants maintain that Islamic banks will fare much better than their conventional counterparts due to the asset backing principle inherent to Islamic finance, we think they will be on equal footing.”

Overall, S&P believes  that subcontractors, SMEs, and expatriate retail exposures will bear the brunt of the turning economic cycle and prominently contribute to the formation of new NPLs in 2017 and 2018.

“We see as positive the buffers that GCC Islamic banks have built in previous years, when the cycle was more supportive. The ratio of NPLs to total loans was 3.1% on average for our sample at year-end 2016, with an average coverage ratio of 133.9%. Under our base-case scenario, we think NPLs could increase to 4%-5% over the next two years: Credit losses could climb by more than 50% over the same period.”

Moreover, growth in customer deposits slowed to 6% in 2016, compared with 9% in 2015 for the Islamic banks in our sample.

“We expect this trend will continue in 2017 and 2018, as governments and their related entities, whose deposits largely depend on oil prices, contribute between 20% and 40% of the total deposits in GCC banking systems. This is somewhat counterbalanced by Islamic banks› natural tendency to attract retail depositors because of their Shariah-compliant nature. In addition, we consider that the funding profiles of GCC Islamic banks remain strong by international standards. Core customer deposits mostly dominate in funding profiles, and banks› use of wholesale funding sources remains limited. The use of sukuk as a funding source is limited, and we don›t think this will change dramatically anytime soon. Most recent sukuk issues by GCC banks were capital-boosting sukuk (primarily in the form of Tier 1 sukuk) as their pricing was attractive compared with banks› cost of common equity. We don›t anticipate many sukuk issues from GCC Islamic banks in 2017-2018.

GCC Islamic banks› liquidity also remains strong by international standards. Banks tend to keep sizable amounts of cash and money market instruments (about 19% of total assets at year-end 2016,  owing to the lack of high-quality liquid assets. Moreover, most of the GCC governments› issues (except in Oman and Bahrain) were conventional. Still, we think that some GCC governments might start to look at tapping the liquidity buffers of GCC Islamic banks through sukuk issuance in 2017-2018. The relatively lengthy and complex process related to sukuk issuance has so far dampened this trend, though, while also bringing sukuk standardization to the forefront of policymakers› and market participants› agendas.”

Growth opportunities are becoming scarcer because of government spending cuts and lower disposable income for retail clients. S&P said banks will become selective and prioritize quality and risk profiles over quantity. This, in turn, will fuel competition and pressure on asset yields. Cost of funding has increased, squeezing the intermediation margins of GCC Islamic banks in 2016.

The pressure eased a bit after some governments issued international bonds and unlocked payments to contractors.

That said, “we think that GCC Islamic banks are on an equal footing with their conventional counterparts as far as cost of funding is concerned. We foresee increased credit losses in the coming two years due to the currently less supportive economic environment. Exposure to subcontractors, SMEs, and retail customers, especially expatriates, should lead the uptrend. We therefore expect banks› revenue growth will decelerate, and we think banks will focus on their cost base (by pruning branches, for instance) to mitigate the impact.”

As for their conventional counterparts, GCC Islamic banks, through their relatively low cost base, should protect their profitability somewhat in 2017 and 2018.

Although consolidation might be a way forward in some GCC markets, S&P expects mergers will remain the exception in 2017-2018, rather than the new norm. — SG

Originally published on www.saudigazette.com.sa