Despite muted lending growth and deposit acquisition, Saudi Arabia's banking fundamentals remain sound as profits continue to rise

As one of the biggest banking sectors by assets in the MENA region, Saudi Arabia has been something of a sleeping giant in recent years. Economic uncertainty and the effects of low international oil prices have seen both muted lending growth and deposit acquisition. The Kingdom’s lenders have, however, remained profitable throughout this period, and are well positioned to take advantage of opportunities arising from an anticipated acceleration of economic growth. In the meantime, an industry that has seen little structural change in recent decades is about to be transformed by new market entrants and mergers of some of its biggest institutions.

History

Saudi Arabia’s modern banking sector was formed during the era of rapid economic growth that followed the Second World War. The petrodollar-driven boom caused lenders to call for greater market supervision in the wake of a rapidly expanding money supply. In 1952 the Saudi Arabian Monetary Authority (SAMA) was established as the country’s central bank to supervise a rapidly expanding roster of financial institutions. This period marked the arrival of some of today’s key players including National Commercial Bank (NCB) and Riyad Bank. The central bank was soon faced with its first serious regulatory challenge when a number of large, non-performing loans (NPLs) made by Al Watany Bank in the 1960s resulted in the first collapse of a major domestic financial institution. SAMA’s response was to formulate the 1966 Banking Control Law, the precepts of which still govern the industry.

The central bank was endowed with a wide range of licensing and supervisory powers by the new framework, which it used to tighten control of the sector through the introduction of new liquidity, capital adequacy and reserve ratios. The stable regulatory platform produced by these actions allowed the industry to expand once again during the 1970s, driven by expanding oil revenues and an increasingly diverse economy. A watershed moment came in 1977, when rules were changed to allow up to 40% ownership of Saudi banks by foreign entities. Saudi Hollandi Bank was the first joint-venture to form in 1977, and was 40% owned by ABN Amro. The Saudi British Bank (SABB) followed in 1978, 40% owned by HSBC. By 1980 there were 12 locally licensed institutions in Saudi Arabia’s banking sector, according to the Bank for International Settlements, 10 of which were partially foreign owned.

The following decade saw the arrival of a number of major players, including the Saudi Investment Bank (SIB), established in 1984, and the Al Rajhi Banking and Investment Corporation in 1988. While regulations required that all banks be majority-owned by a local partner prior to 1975, the early 2000s saw SAMA begin opening the market to majority foreign-owned investment banks. The first licences for these international institutions were issued in 2004, and over succeeding years brands such as Germany’s Deutsche Bank, France’s BNP Paribas and the US’ JP Morgan entered the Saudi market for the first time.

Local Giants

The banking sector was made up of 12 locally licensed institutions in 2018. Of these, four domestic firms accounted for around 56% of total sector assets at the outset of 2018, according to local investment firm AlJazira Capital. NCB was the largest bank in the Kingdom by assets, accounting for 20% of the market share, followed by Al Rajhi Bank (16.1%), Samba Bank (10.1%) and Riyad Bank (10.1%).

At the end of 2018 combined assets at NCB stood at SR453.4bn ($120.9bn), up from SR444.8bn ($118.6bn) at end-2017. NCB was the first bank to gain a licence in Saudi Arabia in 1953, although other banks had operated in the Kingdom before that, and since then it has acted as a catalyst for its economic development. Its position as a facilitator of growth was further cemented in 1999, when the government acquired a majority holding in the institution through the Public Investment Fund (PIF), the Kingdom’s sovereign wealth fund. The second largest bank, Al Rajhi Bank, is one of the largest Islamic banks in the world by capital base. At the end of 2018 it claimed assets of SR365bn ($97.3bn), an increase on SR343.1bn ($91.5bn) at end-2017. Established in 1957 as a money exchange business, it became a bank in 1988. It has since been at the forefront of the sharia-compliant segment, building up the largest customer base in the domestic market. The four banks that are fully sharia-compliant (as opposed to offering Islamic banking windows) – Al Rajhi Bank, Alinma Bank, Bank Al Bilad and Bank AlJazira – together account for 27.9% of total national banking sector assets. Established in 1955, Samba Bank is the third-largest player, with assets of SR229.94bn ($61.3bn) at end-2018, up from SR227.6bn ($60.7bn) one year prior. It was the first domestic bank to introduce ATMs and charge cards, as well as the first to expand into foreign markets such as Pakistan, the UK, Qatar and Dubai. The fourth-largest player, Riyad Bank, was founded in 1957. Its combined assets stood at SR229.9bn ($61.29bn) at end-2018, up from SR216.3bn ($57.7bn) at the end of 2017. Other institutions with sizeable claims on the market include Banque Saudi Fransi (8.4%), Arab National Bank (7.9%) and SABB, with 7.7% of total sector assets.

Foreign Interest

The prominence of foreign institutions in the developmental stages of the banking sector has a left a legacy in the modern industry. Alawaal Bank, until recently known as Saudi Hollandi, was formerly a subsidiary of the Netherlands’ Trading Society, and spent its early years in the Kingdom acting as a de facto central bank. Until 2004 foreign entrants were required to incorporate with Saudi partners in order to obtain a licence to operate from the regulator. Samba Financial Group (in which Norway’s Norges Bank, the UK’s Ashmore Group and US-based T Rowe Price have small interests), Banque Saudi Fransi (14.9% owned by France’s Crédit Agricole) and SABB (40% owned by British multinational HSBC) are all examples of such joint ventures. Following the removal of the local partner requirement, foreign financial institutions were quick to engage the local market. BNP Paribas and JP Morgan were the first entrants under the new framework, and as of the first quarter of 2019, they have been joined by 16 regional and global institutions, including First Abu Dhabi Bank and the Industrial and Commercial Bank of China. A further phase of market liberalisation in 2005 allowed for the rapid expansion of investment banks and financial houses. Such institutions receive their licences from the Capital Market Authority (CMA) rather than the central bank.

Some of the world’s biggest investment houses have a presence in the Kingdom, including Goldman Sachs, Swiss multinational UBS and Ashmore Group. These institutions, of which there were nearly 100 at the outset of 2019, carry out a broad range of activities, from investment fund management, to custody arrangements and deal arranging and underwriting, with the CMA issuing activity-focused licences as appropriate.

Changing Landscape

A high degree of sector stability and consistent returns on assets have meant that there has been little mergers and acquisitions activity in the domestic sector. The static nature of Saudi banking, however, is widely expected to undergo a shift, with mergers and new market entrants set to shake up market structure and increase competition.

In October 2018 SABB and Alawwal Bank agreed to terms for a merger, marking the first major tie-up in the Kingdom for two decades. SABB is 40% owned by HSBC Holdings, while Alawwal is 40% percent owned by the UK’s RBS Holdings, which has been trying to reduce its stake in the Saudi lender for some time. The new entity will have total assets of $68.4bn, making it the third-largest bank on the domestic market. The boards of both banks unanimously approved the agreement in October 2018; however, both institutions will remain independent, continuing to operate as usual until the deal is finalised. Meanwhile, in December 2018 it was revealed that NCB was in preliminary talks to merge with Riyad Bank. If successful, the deal will create the third-largest lender in the GCC and the largest lender in Saudi Arabia with $182bn in assets. The joining of the two institutions may be facilitated by the fact that they have a common shareholder in the PIF, which owns 44% of NCB and 22% of Riyad Bank. Elsewhere in the sector, JP Morgan International Finance sold its minority stake in SIB in June 2018 for $203m, as part of a winding down of its non-core global holdings. The shares were sold back to SIB, which is majority owned by the governmental agency.

New Competition

In terms of new market entrants, a number of Gulf institutions have recently applied for licences to operate in the Kingdom, including First Abu Dhabi Bank and Mashreq Bank. A number of global players have also expressed an interest in either entering the market or expanding from an investment operation to a full banking platform. In 2018 Citigroup re-entered the market after nearly 15 years of absence by acquiring an investment licence from the CMA. The bank is reportedly considering an application to SAMA for a full banking licence. Swiss multinational Credit Suisse also confirmed in 2018 that it had applied for a banking licence, with the CEO of the company travelling to Riyadh personally to meet the head of SAMA. The bank currently holds a licence from the CMA to offer investment services, but is still working with a local custodian bank for its local operations.

More Swiss interest came in 2018 from the Geneva-based Bank Lombard Odier. In June the institution revealed that it was in talks with a Saudi bank to establish a partnership that would allow it to book money locally and manage assets internationally. Bank Lombard Odier, which managed $257bn of assets as of the end of 2018, already operates a representative office in Dubai and is currently seeking out partnership arrangements across the region.

Performance

Banks have faced a challenging economic environment over recent years. The decline in oil prices which began in late 2014 led to concerns regarding reduced government spending and muted private sector demand. A process of economic reform, while welcomed as a necessary undertaking for long-term growth and stability, has led to more market uncertainty. The last year the sector showed double-digit growth was in 2014, when total assets expanded by 12%, according to an OBG analysis of financial results. The effects of lower oil prices began having an impact in 2015, with aggregate assets expanding by a more modest 3.42% to reach SR2.2trn ($586.5bn). In 2016 assets expanded by 2.1%, and by 2017 asset growth had slowed to 0.4%, while net loans and deposits showed modest contractions of 1.1% and 0.7%, respectively.

Banks reported lower lending opportunities in 2018, as firms adopted a wait-and-see stance with regard to expansion plans. Cuts in government energy subsidies also placed downward pressure on consumer spending, negatively affecting the retail banking segment. In September 2018 loan growth was largely flat, showing a modest 0.2% rise year-on-year (y-o-y), while sector deposits showed a decline of 2%, according to figures included in a report by Al Rajhi Capital.

Profitability

Throughout this challenging period, however, the profitability level of the Kingdom’s banks has shown a high degree of resilience, supported by rising interest rates, strong franchises and a relatively advantageous market structure – with only 12 local banks serving a population of over 30m people. Consolidated profits grew by 8.7% to reach SR45bn ($1.2bn) in 2017, with all but one bank showing an increase in profits for the year. In September 2018 sector income had expanded by 10% y-o-y, driven by higher operating incomes and a decline in provisions.

A dispute between banks and the General Authority of Zakat and Tax (GAZT) regarding retroactive tax liabilities threatened banks’ profitability in early 2018, but by the end of the year it had been largely resolved. The 12 listed banks involved reached a SR17.9bn ($4.8bn) settlement with the GAZT regarding the payment of religious tax that had been due for a number of years, including fiscal year 2018. Egyptian investment company EFG Hermes predicted that any weakness caused by the payments would be “short-lived”. Al Rajhi Bank will pay the largest share amounting to SR5.4bn ($1.4bn), followed by Riyad Bank (SR3bn, $799.8m) and Samba Bank (SR2.3bn, $613.2m).

Lending Slowdown

Following a modest increase of 2% in 2016, aggregate loan growth in 2017 shrank by 1%, marking the first contraction in 11 years, according to SABB. As with sector growth in general, the knock-on effects of the oil price decline and subsequent economic uncertainty were responsible for the slow recovery in credit extension, although beginning in April 2018 lending growth made modest gains and by January 2019 the value of loans had increased by 2.4% y-o-y, according to SAMA. “The year 2018 was not easy, we didn’t grow as much as we wanted. While the supply was available, the demand wasn’t there,” Tareq Al Sadhan, CEO of Riyad Bank, told OBG. According to global ratings agency Fitch, demand for credit is being weakened by fiscal tightening, low confidence levels and geopolitical risk. Banks have also shown a more cautious approach to the corporate sector, where some contractors continue to face difficulties in securing payment from the government. In terms of lending market share, NCB and Al Rajhi Bank together claimed 35% of net sector loans in 2017, with market shares of 18.1% and 16.9%, respectively. The next five banks by size – Riyad Bank, Banque Saudi Fransi, Samba Bank, SABB and ANB – together claimed 44.3%, with each holding between 8% to 10%. The five smallest banks, meanwhile, accounted for the remaining 20.1% of net lending over the course of the year.

Limiting Risk

As well as the economic backdrop, regulatory changes are also playing a part in the muted lending environment. The introduction of the International Financial Reporting Standards (IFRS) 9 at the beginning of 2018 established stricter rules about how much banks must provision for problem loans, while SAMA introduced tighter corporate lending rules designed to limit a bank’s exposure to a single customer. Under the new large exposures framework introduced by SAMA in 2015, which is coming into effect in a transitional manner, by 2019 no bank will be permitted to have exposure to any one customer of more than 15% of their Tier-1 capital. This represents a significant reduction from the previous limit of 25%.

Lending to the corporate sector has traditionally been the preferred route to margin for the Kingdom’s financial institutions, but an expansion of the bankable population, advances in risk assessment practices and the advent of new technologies have allowed Saudi banks to make greater inroads into the retail and commercial segment. Business loans still dominate, however, accounting for 60% of total lending in 2017, with consumer lending (24%) and real estate loans (16%) accounting for the remainder.

Credit Bureaus

The credit bureau industry has registered exponential growth in terms of the variety of economic sectors covered and credit information included. The Saudi Credit Bureau was established in 2003 to collect, analyse and provide detailed credit information on both individuals and local institutions. In 2015 a second credit bureau, Bayan, was established. Its main focus is on providing a platform for business-to-business data. Advances in this segment have seen number of citizens covered by a private credit bureau increase from 14.1% in 2008 to 63.2% in 2018, according to the World Bank. This is compared with the OECD average of 64.4% and the MENA average of 18.1%. This is especially important as boosting financial inclusion for small and medium-sized enterprises (SMEs) is seen as a cornerstone of the Kingdom’s economic diversification strategy. Ayman Sejiny, CEO of the Islamic Corporation for the Development of the Private Sector (ICD), the private sector arm of the Islamic Development Bank Group, told OBG that ICD is helping the government reach its objective of quadrupling the contribution of SMEs to the Kingdom’s GDP. In 2014 the ICD set up the first SME investment fund in Saudi Arabia, an SR1bn ($267m) quasi-equity and debt, sharia-compliant fund to invest in SMEs with high growth potential. In addition, in 2018 ICD organised various events to support start-ups.

An improved credit reporting system should facilitate lending to SMEs, which often lack physical collateral or are otherwise unable to prove their creditworthiness. “The primary use of credit information services is to reduce the country’s rate of defaults and ultimately extend financing to local SMEs,” Hesham H Almadbl, acting CEO of Bayan Credit Bureau, told OBG.

Sector Stability

While NPLs have grown as a result of the introduction of the new IFRS 9 accountancy standards, with most banks showing rises in NPLs at the beginning of 2018, banks were protected against any deterioration in asset quality by high levels of loan loss provisions and sizeable capital buffers. In 2018 Saudi Arabia’s average weighted core capital ratio of 17.8% was one of the highest globally. The sector also exhibits high levels of liquidity, which helps to mitigate risk arising from funding contractions. At the outset of 2018 the average weighted liquidity coverage ratio for banks rated by Fitch stood at 208%, supported by large stocks of liquid assets, representing 20% of total assets.

Regulation

The stability of the Kingdom’s banking sector is to a large extent due to the prudence of its regulator. The 1966 Banking Control Law set out the statutory requirements on banks and established which activities could or could not be carried out in the Kingdom. This framework applies to all banks nationwide, both Islamic and conventional, and SAMA makes no licensing distinction on grounds of sharia compliance. SAMA has sought to reduce the potential for external shocks and speculative interest by limiting the foreign ownership of locally licensed commercial banks to 40%, and requesting that 20% of a bank’s liabilities be held in liquid assets – a demand which limits the amount of capital that can be invested overseas. As well as ensuring the stability of the industry, SAMA is also charged with supporting the wider financial sector, including the insurance industry, and ensuring that it plays its proper role in the economic development of the country. In terms of strategy, SAMA’s Banking Vision 2020, now in implementation phase, aims to bolster the economic role of the financial sector by addressing issues such as financial inclusion, technological advances and increasing the skill set of the local labour force.

The most significant regulatory change experienced by Saudi banks since 2017, however, was the introduction of the IFRS 9 regulations. The new framework significantly alters the way banking institutions calculate their potential impairments, or bad loans, changing the process from an historical one – whereby banks reviewed past performance in determining their provisions against impairments – to a forward-looking one, in which the losses from an impaired asset are projected over the next 12 months. If there is a significant increase in credit risk, the credit losses are projected over the instrument’s full lifetime.

In practice, IFRS 9 makes it harder for banks to delay recognition of their impaired assets, and in a number of Middle Eastern markets – where some banks do not charge interest on late payments and provide loans to related parties with low or no interest charges – its implementation is challenging. In Saudi Arabia, the main effect of the new standard has been an increase in provisions, which in turn impacts banks’ solvency positions and shareholders’ equity.

Digital Finance

Despite the challenging environment, financial technology (fintech) products and services are expanding rapidly in Saudi Arabia. The SAMA sandbox is currently testing seven fintech solutions. The sandbox guidelines are considered to be highly inclusive, and are supported by banks. Further, related regulations are set to be issued that will support more fintech enterprises in the market in the process of obtaining licences. A second application round for the sandbox will provide opportunities to other fintech companies in the lending landscape.

In the Kingdom the rate of smartphone ownership is close to 90%. According to a 2017 survey published by YouGov, a UK-based market research firm, mobile apps are the preferred channel of communication for banking activity for a quarter of Saudi consumers, while 40% consider it a priority to have banking services available on their mobile phone. Fintech solutions also offer banks a relatively low-cost way of streamlining services and boosting banking inclusion.

In October 2018 Saudi Telecom Company (STC) launched the beta version of its mobile wallet STC Pay. The app allows customers to access basic financial services through their phone, including paying at participating stores, settling utility bills, and transferring money directly to other STC Pay users and bank accounts. It was also revealed in late 2018 that global payments service Western Union was in negotiations with STC Pay to add cross-border technology, allowing users to send money to friends and family in most countries without the need for an account at a formal financial institution. STC Pay has also joined forces with ANB and Saudi Post to establish a framework for its remittance business and product distribution.

The regulator has shown itself to be positively disposed to fintech. In February 2018 it signed a deal with the US-based blockchain company Ripple to create a pilot programme for the Kingdom’s banks to test cross-border transfer settlement processes. Following the decision, four banks signed up to global payment system RippleNet, thereby opening up new remittance payment corridors between Saudi Arabia and other markets. In December 2018 SAMA announced that it was also working with the UAE on the establishment of a digital currency that would be used in transferring funds between the two countries.

Outlook

While 2018 was a quiet year in terms of lending activity, the longer-term potential of the market is evidenced by the interest shown in it by a raft of international institutions – although it remains to be seen how readily SAMA will welcome an influx of new banking brands. The capital spending commitment in the government’s 2019 budget has been welcomed by the sector (see Economy chapter), and holds the prospect of increased lending opportunities.

Mortgages represent another possible avenue to loan growth for some Saudi institutions. A new housing project announced in February 2018 includes an SR18bn ($4.8bn) loan-guarantee programme and a SR12.5bn ($3.3bn) funding pool to support down payments on properties, all of which is to be disbursed by 2030. In August 2018 Al Rajhi Bank reported a 6% y-o-y increase in real estate loans, which it hoped would help to return its overall lending growth to a “low single-digit” level for the full year.

Other sectors, meanwhile, have become more promising as a result of an ongoing process of liberalisation and efforts to boost tourism levels. Entertainment is one such area of interest to the Kingdom’s banks. OBG understands from discussions with leading institutions that, with the capital requirement for a new cinema standing at around SR25m ($6.7m), or SR3m ($799,800) per screen, significant potential exists for credit extension to the industry over the long term.