Oman's economic rebound set to spur growth among banking sector's lenders

Oman’s banking sector has weathered the economic downturn resulting from the 2014-15 hydrocarbons price crash without a significant erosion in asset quality and returned to its long-term trend of deposit and loan growth. As a result of firmer oil prices and a broadly positive outlook for the sultanate’s economy, the industry is preparing for a new phase of credit expansion. However, challenges remain. Recent years have seen banks struggle to meet previous levels of profitability, and an ongoing process of regulatory reform is placing a strain on the bottom line of some institutions.

Sector History

Oman was relatively late to join the regional banking explosion triggered by the large-scale production of oil in the GCC. Until the late 1960s the British Bank of the Middle East was the only lender in the domestic market. By 1972, the second year of His Majesty Sultan Qaboos bin Said Al Said’s reign, a total of three banks were in operation and the majority of the population remained unbanked.

However, the era of economic reform ushered in by Sultan Qaboos led to rapid development of the industry. In 1973 the country’s first domestic bank, the National Bank of Oman, entered the market and was followed three years later by a second local lender, the Commercial Bank of Oman. The 1970s also saw the emergence of a regulatory framework and key supervisory body the Muscat Currency Authority, which was later renamed the Oman Currency Board. In 1974, in accordance with the Banking Law of that year, the Central Bank of Oman (CBO) was established, allowing for even greater sector expansion. Significant market entrants over the following decade included three specialised development banks focusing on housing, agriculture and fisheries, and the first wholly owned Omani bank, Oman International Bank.

The last decade of the 20th century was a time of increasing competition, and the resulting mergers and acquisitions produced some of today’s market leaders. A more crowded market also prompted the uptake of new technologies, with face-to-face banking gradually ceding ground to phone and, later, internet channels. This trend has continued to the present, as developments in financial technology (fintech) provide increasing linkages between Omani banks and their customers, and offer potential solutions for lenders faced with narrowing margins.

Today’s Market

At the beginning of 2018 a total of 16 conventional commercial banks were operating in the Omani market. Of this number, seven were locally incorporated and nine were branches of international institutions. The locally incorporated banks were Bank Muscat, National Bank of Oman, HSBC Bank Oman, Oman Arab Bank, Bank Dhofar, Bank Sohar and Ahli Bank, while the international banks were Standard Chartered Bank, Habib Bank, Bank Melli Iran, Bank Saderat Iran, Bank of Baroda, State Bank of India, First Abu Dhabi Bank, Bank of Beirut and Qatar National Bank.

In total, the conventional banks operate a network of 436 branches, 1288 ATMs – of which around 620 are off-site – and 225 cash deposit machines. All the conventional banks are privately owned, although the government maintains minority stakes in a small number of them. Ownership in locally incorporated banks is limited by law to a maximum of 70% of total equity, with a number of further prudential sub-limits on the shareholding structure.

Two government-owned specialised banks also operate in the market. The first is Oman Housing Bank, which provides low-interest loans to mainly low- and middle-income nationals to build or purchase residential property, and the second is Oman Development Bank, which provides similar assistance to private sector investors for the financing of small-scale projects. Together, these specialised banks maintain a network of approximately 23 branches.

Islamic Banks

While the conventional component dominates banking sector activity, the market also includes an increasingly vibrant sharia-compliant segment. Following its introduction in 2012 sharia-compliant banking has gained momentum: in the first nine months of 2017 it expanded by 29%, which was the fastest rate in the global market, and by March 2018 the segment accounted for approximately 12.4% of total banking assets. There are currently two Islamic banks operating in the sultanate – Bank Nizwa and Alizz Islamic Bank – as well as six Islamic windows operated by conventional institutions. At the start of 2018 these banks maintained a total of 76 branches, 79 ATMs and 41 cash deposit machines.

The continued expansion of the industry is being supported by the government’s sovereign sukuk (Islamic bond) issuance programme, which began in May 2017. The sultanate’s inaugural sukuk offering was open to sophisticated investors such as fund managers, banks and other institutions, and raised $2bn. The issue gave domestic sharia-compliant institutions a much-needed instrument to manage their liquidity more effectively, a development that participants in the industry had long been calling for.

In the early stages of 2018 the sultanate was reported to be in talks with banks regarding the issuance of a second dollar-denominated sukuk. The continued development of the sovereign sukuk yield curve would provide a useful benchmark for private Omani companies to issue corporate bonds, and would also contribute to adding momentum to the development of Islamic financial services in Oman.

Non-bank Finance

All of the sultanate’s banks face further competition from outside the sector, in the form of non-bank lending institutions. At the beginning of 2018 there were a total of six finance and leasing companies (FLCs) operating under the supervision of the CBO. These institutions are permitted to accept deposits from corporate clients but not retail clients. In practice, however, their largest source of funding is banks and other financial institutions, with bond issuances a comparative rarity.

Despite the relatively high cost of their funding model, FLCs have succeeded in claiming market share thanks to their higher risk appetite and willingness to offer enhanced service levels and provide faster turnarounds on loan applications.

Traditionally, FLCs have performed well in retail financing, which is mainly for the purchase of electrical goods and vehicles, equipment leasing for small and medium-sized enterprises (SMEs), as well as factoring and working capital financing to SMEs for domestic and cross-border trade. Together, they operate 40 branches, all of them within Oman.

Market Consolidation

The sultanate has a higher banking density than the region’s larger markets, with 16.4 branches per 100,000 inhabitants as of 2016, compared to 8.8 for Saudi Arabia and 12.4 for the UAE, according to World Bank data. The market exhibits a top-heavy market concentration, with the largest player, Bank Muscat (including its Islamic window), at 35% of total banking sector assets as of June 2018, and the next three largest institutions contributing around 33.4% between them. Lower down the order the banking sector is highly fragmented, resulting in competition for deposits and lending opportunities.

Since the period of consolidation in the 1990s, there has only been a modest trend of mergers and acquisitions in the market. The most recently completed deal occurred in 2012, when HSBC combined its Omani operations with Oman International Bank. The topic of consolidation has recently returned to the agenda, with the announcement by Oman Arab Bank in May 2018 that it was seeking a merger with Alizz Islamic Bank. The joining of the two institutions would create a new lender with approximately $7.7bn worth of assets. In August 2018, the National Bank of Oman and Bank Dhofar announced they were exploring the possibility of a merger, creating an entity with $20bn in assets.

As profitability levels come under pressure and regulatory demands increase, there is growing potential for more mergers and acquisitions over the medium term.

Performance

Oman’s banks have faced considerable challenges over recent years, including a struggling global economy and a decline in oil prices, which has undermined the sultanate’s fiscal position and slowed growth. Nevertheless, the industry’s performance since the oil price decline of 2014 has been solid. Between December 2014 and March 2018 aggregate deposits increased at a compound annual growth rate (CAGR) of 6.9% to reach around $57.9bn.

This steady rate of increase has supported the banks’ lending activities, with aggregate loans over the same period expanding from $46.7bn to $62.6bn, representing a CAGR of 9.5%, according to data from Bank Muscat. The only year since 2014 in which both deposits and lending activity contracted was 2016, as the effects of lower oil prices travelled through the system. During this period the CBO took remedial action in the form of an adjustment to its capital adequacy requirements. The regulator has expressed its satisfaction with sector liquidity but also signalled that the matter would remain under review until further notice.

Looking to the current scenario, while muted economic activity depressed credit demand in 2017, rising oil prices have since supported demand for personal credit, which accounts for a significant proportion of lending. Accordingly, Fitch’s BMI Research forecast a total asset growth of 7% for 2018, up from 5.1% the previous year. Where banks have struggled most in recent times, however, is profitability. At the close of 2017 Oman’s largest banks reported a broadly flat result year-on-year. Bank Muscat’s annual net profit was only 0.1% higher than the previous year, Ahlibank reported a similar level and the National Bank of Oman saw a slight decline in profits for the period.

As the CBO follows the lead of the US Federal Reserve in setting interest rates, rising funding costs over 2018 and 2019 are likely to maintain downward pressure on profits by increasing the cost of banks’ local currency deposits. In October 2018 Moody’s forecast that the net interest margins of Omani banks would decrease throughout 2019 and early 2020 to reach around 2.2%, down from 2.3% in the second quarter of 2018, and 2.4% in 2016.

Financial Stability

Like its regional peers, Oman’s banking sector faces a number of downside risks, ranging from geopolitical disturbances to an unexpected decline in oil prices. In terms of loan book structure, the chief downside risk is the significant exposure of domestic lenders to the real estate sector. This exists both directly, in the form of financing for residential and commercial real estate, and indirectly, such as financing secured against real estate. Around one third of the sector’s total lending portfolio is exposed to real estate assets, according to the CBO, and therefore any significant downturn in the real estate market represents a threat to the sector’s stability. In December 2017 Fitch downgraded five Omani banks, citing a combination of concerns over the ability of the government to support the banking system as a result of deterioration in public finances, an erosion of the domestic operating environment and the significant links between the banks and the sovereign.

Nevertheless, the sector is well protected against economic shocks. Throughout the 2014-18 period Omani banks succeeded in growing their lending portfolios without a significant increase in gross non-performing loans (NPLs), which in 2018 stood at a modest 2.8% of total sector lending. This compares favourably with the NPL levels of regional peers such as the UAE (6.4%), Bahrain (5.9%) and Kuwait (2.2%).

A strong capitalisation level of approximately 16.4% as of June 2018 means that Oman’s banking system holds considerable reserves against any economic shock and is well positioned for future growth, according to data from Bank of Muscat. The sector is further defended by its deposit-based funding model, which lowers its reliance on wholesale funding, and a sizeable government infrastructure programme, which continues to support credit expansion.

Robust Regulation

The soundness of the domestic sector is largely due to the conservative stance taken by the CBO in recent years. The regulator has been quick to introduce international prudential standards to the market, first bringing Basel III requirements into effect in January 2014.

Banks have had considerable time to adjust their operations to meet the new capital and liquidity requirements of the Basel programme, but more recently they have been presented with a new regulatory hurdle. The ninth International Financial Reporting Standards (IFRS 9) protocol, introduced in January 2018, is part of the global response to the weaknesses in the financial system exposed by the global financial crisis of 2007-08, but its implementation in Oman has proved challenging for some lenders. Under the new framework, banks are compelled to adjust the way in which they address credit risk, most significantly by assessing risk during the entire loan’s credit life cycle, rather than at the point of default. Banks are also required to take into account varieties of credit which were previously ignored in their risk assessments, such as credit and overdraft limits, letters of credit, performance and financial guarantees. Lenders must therefore retain defined longer-term liabilities, be it in the form of deposits or long-term borrowings.

For customers, meanwhile, the most significant change applies to the way their commitments are analysed: a protocol of cross-product default means that, rather than being assessed in isolation, a customer’s personal, credit card, mortgage and other commitments will be considered together. A default on one facility will result in lenders impairing the other products held by the customer. Mindful of the potential negative effects of these changes, in April 2018 the CBO issued a number of directives aimed at increasing the ability of banks to provide credit to projects undertaken in the country. The capital adequacy ratio was lowered from 12% to 11%, boosting banks’ lending capacity and providing a useful fillip to overall loan credit growth. According to the CBO, the change resulted in an increase in available credit within the sector from OR5.2bn ($13.5bn) to OR7.8bn ($20.3bn).

The regulator also sought to ease liquidity and stimulate the interbank market by allowing lenders to include deposits from domestic banks in calculating their loan-to-deposit ratio limit, which currently stands at 87.5%. As the sector average loan-to-deposit ratio was approximately 80% at the close of 2017, banks already had room to increase their leverage, and the new amendment grants them even more.

Other liquidity-boosting measures that were introduced in April 2018 by the CBO include the removal of the 100% risk weighting that had previously been placed on non-Omani sovereign exposures, and a loosening of the restrictions on credit exposure to non-Omanis and the placement of banks’ funds abroad. “Banks need to focus on asset quality and develop standardised approaches to maintain strong positions on liquidity. Although this will limit profitability, it will bring about a balance in banking operations,” Khalid Al Kayed, CEO of Islamic lender Bank Nizwa, told OBG.

Digital Trend

The regulator is also playing a leading role in the digitalisation trend that is sweeping the banking industry. Digitalisation is seen as an essential tool in the effort to increase profitability; the technical innovations adopted by local lenders include payment gateways, cards, merchant services, alternate channels of ATMs, cash deposit machines, as well as connectivity with utilities providers. “Digitalisation is the way forward, technology is widely available and companies in Oman must align themselves with global offerings and standards,” Sunil Pherwani, general manager of National Finance, a local FLC, told OBG.

Tahir Salim Al Amri, the CBO’s executive president after 25 years, was the chief guest at the 2018 New Age Banking Summit in Muscat, where the importance of technology in banking was highlighted. Online banking is now a standard feature offered by all the major players, and mobile banking is rapidly emerging as a useful channel – although it is one that is being contested by non-banking companies as fintech start-ups move into the market. For example, in May 2018 local start-up Thawani rolled out a smartphone app that enables consumers to make in-store purchases by scanning a retailer’s QR code at the store or using their registered mobile number to pay regardless of where they may be located.

With card payments accounting for around one quarter of global banking revenue, the stakes in the struggle between banks and non-banking companies for ownership of the payments business are high, and over the coming years domestic banks will be compelled to respond by either forging partnerships with new mobile payment systems, or developing advanced mobile offerings of their own.

Outlook

In the short term, challenges to sector growth remain. Banks highly exposed to the construction and real estate sectors are likely to face the most pressure over the coming period, and therefore Islamic banks with their large real estate portfolios will be disproportionally affected by the prevailing market conditions. Looking to the medium term, a rebound in the national economy on the back of rising international oil prices is likely to result in stronger deposit and asset growth for lenders.

The sector is well positioned to take advantage of opportunities arising from an increased rate of economic growth, with GDP at constant prices projected to expand by 5% in 2019 compared to an estimated 1.9% in 2018 and a contraction of 0.9% in 2017, according to the IMF. At the same time, regulatory changes are expected to remain a challenge for some institutions.

Having adjusted to the requirements of IFRS 9 during 2018, banks are now tasked with the implementation of IFRS 16. The leasing arrangements of a large number of local lenders will be affected by the new standard, which comes into effect on January 1, 2019. The assessment of bank branches, ATMs, IT infrastructure and outsourcing arrangements to evaluate their impact on financial statements, operations and capital requirements will also be a considerable burden on banking institutions’ time and resources in the coming year.