Oman's central bank takes measures to increase liquidity

It is nearly a decade since banking sector liquidity was last a significant concern in the GCC, but the precipitous decline of crude oil prices that began in the summer of 2014 has brought the issue to the fore once again. The major role played by the hydrocarbons industry in regional economies means that large alterations to spot prices and futures have the potential to significantly affect the liquidity position, and therefore the lending ability, of banks.

Drying Up

Generous oil revenues over recent years have fuelled government infrastructure spending programmes from Kuwait to Oman, but the flipside of this phenomenon is that when hydrocarbons revenues decline, the project pipeline has a tendency to slow, and the chain of contractors and suppliers – from large multinationals and domestic giants to the myriad small businesses that provide goods and services to them – experience a drop-off in business.

For the banks, which secure their yearly margins by lending to these stakeholders, the obvious consequence is a reduction in net profit. Should the decline in oil price be sufficiently large, or the duration of the subdued price levels be sufficiently long, not only are profits dented, but liquidity ultimately begins to disappear from the system.

Slowing project pipelines mean smaller deposits in banks from institutions and individuals, which in turn means that banks are liable to find themselves hitting the loan-to-deposit ratios established by regulators, which in the GCC tend to be set at a conservative level. This effect is amplified when governments, attempting to meet the fiscal shortfall caused by falling oil revenues, are compelled to draw down their deposits with domestic banks.

In an oil price environment such as the one seen since mid-2014, the ability of banks to extend credit to their customers and thereby perform their proper function as agents of economic growth is one of the most important concerns for the Omani government.

Early Indications

As with most regulators in the region, the Central Bank of Oman (CBO) has historically adopted a conservative regulatory stance, thanks to which the sultanate’s banks are generally well capitalised and adequately liquid. Nevertheless, the domestic system is not completely immune to the effects of depressed oil prices, and by the second half of 2015 signs of a potential liquidity issue were clearly visible in the market.

One of the most obvious early warning indicators where liquidity is concerned is the relationship between deposits and lending. In 2015 credit growth in Oman outstripped deposit accumulation by about four percentage points, according to the CBO, which represented a reversal of a trend that had existed since the economy began its recovery from the economic crisis of 2008. As with other markets in the region, a reduction in government deposits caused by the need to meet a widening fiscal gap played a sizeable role in this development. In the last quarter of 2015 government deposits decreased by OR468m ($1.2bn), and remained relatively stable throughout the first half of 2016, exposing the state’s limited capacity to provide liquidity to the banking sector.

With deposits not keeping pace with lending activity, the aggregate lending ratio (loans to eligible deposits plus capital) of the sector began to creep upwards, reaching 80.8% by May 2016, compared to 76.1% just 12 months earlier. Oman’s banking industry was, therefore, displaying the classic characteristics of a tightening liquidity scenario.

Over the past two years this squeeze on liquidity has been clearly visible in the interbank rates the level of interest charged on short-term loans between banks. Throughout 2015 the Omani rial overnight domestic interbank lending rate ranged from 0.125% to 0.14%, broadly tracking a horizontal channel that had been established in 2010. By April 2015, however, the effects of the falling oil price were beginning to show in the rate, which hit 0.197% that month before reaching a new high of 0.217% in September. In 2016 concerns regarding a liquidity crunch grew further, with the rate hitting 0.578% in March and remaining above the 0.3% level for the summer.

Fast Response

By early 2016 the sector’s liquidity position had caught the eye of international observers. In February international ratings agency Standard & Poor’s announced that it expected low oil prices to act as a drag on liquidity in Oman’s banking system, given that government deposits account for more than one-third of the total deposit base. Moody’s, meanwhile, lowered the industry’s macro profile from moderate plus to moderate in March 2016. On changing the outlook for Al Omaniya Financial Services from stable to negative, for example, Moody’s noted that the new outlook reflected “the potential negative impact from tightening liquidity conditions and softening economic growth on the company’s liquidity and solvency profile”.

The regulatory response was swift: within a month the CBO had signalled its willingness to do what was within its power to improve the liquidity situation in the sector. One of the most powerful tools by which the regulator can manage liquidity in the banking system is the reserve requirement, the amount of cash banks must hold with the central bank against deposits made by customers. The most straightforward usage of this tool in times of low liquidity is a simple lowering of the reserve ratio, which frees up banks’ capital and allows them to increase the amount of credit they can extend to customers.

The CBO, however, adopted a more subtle approach as it set about boosting liquidity in the system. Rather than alter the 5% reserve requirement, it added a range of instruments to the list of eligible reserves. As a result, from April 1, 2016 Omani banks have been permitted to include Treasury bills, Omani government development bonds and Omani sovereign sukuk (Islamic bonds) as part of their reserves, up to a maximum of 2%. According to the CBO, the rule has made approximately OR400m ($1bn) in liquid funds available to lenders, a significant increase in the aggregate lendable resources of the sector.

Some banks will benefit from this more than others, depending on their level of deposits. Muscat-based Gulf Baader Capital Markets estimates that Bank Muscat will be able to liberate OR147m ($380.6m) from its existing cash reserves thanks to the new rules, while Bank Sohar stands to liberate an additional OR29.3m ($75.9m). Banks also benefit from the wider range of instruments at their disposal should they need to obtain liquidity from the central bank through discounting or repos.

Looking Ahead

While the recent uptick in the interbank rate is a matter of concern, and was sufficient to prompt the CBO into remedial action, in a wider context it is relatively modest. Between 2006 and 2008, in the run up to the global financial crisis, the three-month interbank rate exceeded 4% at times, significantly higher than current levels. Moreover, the liquidity squeeze that was becoming obvious by the beginning of 2016 did not immediately threaten to place the sultanate’s banks outside the conservative regulatory limits established by the CBO.

The sector’s aggregate lending ratio of 79% at the close of 2015 was comfortably within the prescribed 87.5%, meaning that banks have considerable room for manoeuvre before hitting the regulatory ceiling. As such, the liquidity challenge in 2016 was best described as one of growing costs, as demonstrated by the rising interbank rate, rather than a business-damaging liquidity crunch. Nonetheless, the central bank’s reference to liquidity in its “Financial Stability Report for 2016” suggests that it is continuing to track the issue closely.

While expressing its satisfaction that banks in the sultanate are adequately liquid, the regulator pointed to the budgetary requirements of the government as a potential cause of further liquidity tightening, stating that, “Banks comfortably maintained cash reserve requirements without significant signs of strains… However, given the budgetary needs of the government, the liquidity conditions in Oman may tighten in the future and funding costs may increase.” Should it feel the need to use them, the CBO has an array tools at its disposal. However, not many of them can be deployed without cost.

Facing similar liquidity concerns in 2016 as a result of a slowdown in deposits, Saudi Arabia’s regulator opted to raise the lending ratio requirement from 85%, where it had stood for some years, to 90%. While this allowed those banks that were nearing the old limit to continue to extend credit, the move was described by Moody’s as credit negative as it relaxed a safeguard of the conservative prudential framework that has historically gained its approval. The CBO is keen to maintain its prudent approach to the lending ratio requirement, but lacking of an oil price recovery this stance may come under pressure in the year ahead.