Growth continues as Saudi Arabia's banks diversify their revenues and banking sector shifts towards increased use of technology

Having posted another year of positive results, Saudi Arabia’s banking sector is positioning itself to take advantage of the government’s expansionist fiscal policy and the large number of projects this has created. In the meantime, opportunities in other areas of the lending landscape are being explored, most notably among the nation’s smaller businesses. An ongoing process of regulatory reform and intense competition continue to present challenges to the Kingdom’s banks, but underlying stability means that they can be tackled from a position of strength.

Lessons Learned

Saudi Arabia’s robust economy is the principal factor enabling the resilience of the banking sector. Another source of strength is its eventful history, which has included periods of significant challenge from which the sector has returned with renewed vigour. The modern sector evolved from the simple banking industry which existed in the first half of the 20th century, composed of a network of local money exchangers and a handful of foreign banks that catered to a relatively small business community. The rapid expansion of oil production in the years following the Second World War set in process the economic transformation which has established the nation as the regional economic powerhouse that it is today.

As business boomed in the Kingdom’s urban centres it was decided that the increased flows of capital into the country warranted the creation of a central bank. In 1952 the Saudi Arabian Monetary Agency (SAMA) was established by two royal decrees to fill this role, and continues to oversee the banking industry to this day. In the intervening years it has guided the sector through numerous phases of growth, the first of which spanned the years immediately following its creation when it set about licensing a host of local and foreign institutions which brought new services and products to both retail and commercial customers. Among their number were institutions that are still key players in the sector today, such as National Commercial Bank (also known as Al Ahli Bank) and Riyad Bank. The regulator has also been compelled in the past to address significant challenges to sector development. The first was presented in the 1960s, when a series of bad loans issued by Al Watany Bank resulted in its dissolution and incorporation within Riyad Bank.

The systemic fault lines exposed during this episode were addressed by SAMA in its development of the 1966 Banking Control Law, which still acts as the regulatory backbone of the banking sector. Much of the sector’s current solidity is a consequence of this far-reaching legislation, which required banks to maintain rigorous liquidity, capital adequacy and reserve ratios, and granted SAMA a broad array of licensing and supervisory powers. “Historically, the Saudi banking sector has been sound, sane and profitable thanks to conservative regulations,” Abdulaziz Al Helaissi, deputy governor for banking supervision at SAMA, told OBG. “We are one of the few countries that has never had a bank default.”

Strong Comeback

From this regulatory platform the industry surged again during the 1970s, driven by increasing oil revenues and a maturing economy. By 1980 the Kingdom was home to 12 banks, 10 of which were partially foreign-owned, according to the Bank for International Settlements. Challenging years lay ahead – declining oil prices during the 1980s saw non-performing loans rise to 20% of all extended credit, for example – but the sector continued to grow. A number of important players entered the market at this stage, including the Saudi Investment Bank in 1984 and the Al Rajhi Banking and Investment Corporation in 1988.

The oil industry entered a more sustained period of growth during the 1990s and 2000s, and the banking sector enjoyed a similar era of steady expansion. Non-oil activity, too, began to emerge as a potential route to revenue for the nation’s lenders, greatly reducing systemic risk. By the early 2000s an increasingly confident SAMA began to open the market to majority foreign-owned investment banks, a decision which overturned a 1975 requirement that all banks should be majority owned by a local partner. Licensing for international institutions resulted in global brands such as Deutsche Bank, BNP Paribas and JP Morgan setting up shop in the Kingdom.

The Modern Sector

After decades of sector growth and consolidation, today’s banking sector is made up of 12 locally licensed institutions. The largest of these in terms of assets is National Commercial Bank, which had total assets of SR434.9bn ($115.9bn) as of December 31, 2014, according to the bank’s financial statements. The remainder of Saudi Arabia’s “big five” banks include Al Rajhi Bank, with total assets of SR307.7bn ($82bn) at the close of 2014; Samba, with SR217.4bn ($57.9bn); Riyad Bank, with SR214.6bn ($57.2bn); and Banque Saudi Fransi, with SR188.7bn ($50.3bn).

Other prominent participants in the sector are SABB (formerly Saudi British Bank), with assets of SR187.6bn ($50bn), and Saudi Hollandi (SR96.6bn, $25.7bn), both of which maintain extensive branch networks across the Kingdom. Additionally, Saudi Arabia’s locally licensed banks have widened their focus from their initial concentration on the corporate and institutional segments to seek revenue in the increasingly important retail and small and medium-sized enterprise (SME) arenas.

In competing for deposits and lending opportunities they are not alone – foreign banks have been important market participants since its earliest stages: Saudi Hollandi, a subsidiary of the Netherlands Trading Society, acted as the nation’s de facto central bank prior to SAMA’s establishment, and when in 1952 it handed over responsibilities to become an ordinary private sector player it established a model for foreign participation in the banking sector. At first, foreign entrants were required to incorporate with Saudi partners to obtain a licence to operate from the regulator, but since 2004 international lenders have been able to open branches in the country. BNP Paribas and JP Morgan were the first to gain a market foothold under the new regime, and as of 2015 they have been joined by a further 10 regional and global institutions, including the National Bank of Kuwait and Deutsche Bank.

A liberalisation of the regulations governing capital markets and the establishment of the Capital Market Authority in the Kingdom has brought about an influx of investment companies to the sector since 2005. These institutions, which numbered around 100 in 2014, are licensed separately from foreign commercial banks, and their activities are overseen by the Capital Market Authority rather than SAMA. As well as regional institutions, a number of global giants have established a presence to serve the investment community, including UBS, Goldman Sachs and specialist emerging markets investment manager Ashmore (see Capital Markets chapter).

The arrival of foreign players to the sector has diversified the industry both in terms of capital base and service provision, and has helped to establish a relatively well-balanced market. This characteristic is present even when solely taking the locally licensed lenders into account: an OBG analysis of net loans and advances data published by the sector’s 12 local banks shows that the top five commanded 63.3% of the market in 2014, with no single institution claiming a market share of more than 20%.

Performance

All of these institutions have succeeded in displaying solid growth in recent years, and 2014 was no exception. An OBG analysis of fiscal year 2014 financial statements shows that the sector’s aggregate assets increased by 12.4% to reach nearly SR2.1trn ($559.7bn), a more robust expansion rate than the previous year’s 9.2% growth. Banque Saudi Fransi led the field in terms of asset growth rate, posting a 28.4% rise, followed by Bank Al Bilad (24.5%) and Saudi Hollandi (20%). In absolute terms, National Commercial Bank’s 15.3% rise from SR377.3bn ($100.6bn) to SR434.9bn ($115.9bn) represented the largest asset gain for the sector.

Looking to deposits, the Kingdom’s lenders have been successful in accumulating funds throughout the credit crunch and into the present year, posting a compound annual growth rate (CAGR) of 12% between 2007 and 2012, according to Aljazira Capital. In 2014 the aggregate deposit book grew by 12.4% to reach SR1.575trn ($419.7bn). The low interest rates that have persisted since 2008 have, however, altered the structure of the sector’s deposit base: the time deposits that made up 51.6% of the total in 2006 now account for 36%, as customers have abandoned bank deposits as a source of interest accrual and shifted capital towards demand deposits.

In terms of profitability, Saudi banks have enjoyed sustained growth in recent years, with aggregate expansion in 2014 of 10.2%, according to published financial results. Banque Saudi Fransi showed the highest growth rate, at 46% for the year, followed by Alinma (25.8%) and Saudi Hollandi (21.3%). In absolute terms, the most profitable bank in 2014 was National Commercial Bank, which saw net income rise from SR7.85bn ($2.1bn) to SR8.66bn ($2.3bn).

The Regulator

A history of prudent regulation has played a significant role in this development. Regulatory affairs are simplified in Saudi Arabia in that no distinction is made by either the regulator or licensed banks between Islamic and conventional institutions. No local bank is identified as an Islamic operator, and there is no formal test of sharia compliance in terms of banks’ services and products. The regulator prefers not to involve itself in questions of sharia and, contrary to rumours in the local press, has no plans to establish a centralised sharia committee to rule on such matters.

Instead, the focus of SAMA over the past decade has been on creating a sector that is regulated according to international best practice, and overseeing its opening up to institutions from outside the country. This undertaking echoes a more general opening of the economy that was set in motion by the Kingdom’s accession to the World Trade Organisation in 2005 and has reached another milestone in 2015 with the opening up of the stock exchange to foreign investors (see Capital Markets chapter).

In liberalising the sector, SAMA has followed a cautious line that has earned it a reputation as one of the most prudent regulators in the region. Keen to mitigate the risks of speculative investment and external shocks without dampening investor interest, SAMA raised the cap on foreign ownership of commercial banks from 40% to 60% in line with its WTO agreement in 2005. Moreover, the degree of domestic liquidity that can be invested overseas is restricted by the requirement for 20% of a bank’s liabilities to be held in liquid assets.

The regulator oversees the sector according to the provisions of the 1966 Banking Control Law, the 26 articles of which lay out the statutory requirements on banks and establish which activities may or may not be carried out in the Kingdom. However, the age of the law and its relative brevity mean that much of the day-to-day operations of the modern sector are addressed by a large number of rules and instructions distributed to banks in the form of circulars.

Regulatory Change

Through the regular issuance of circulars SAMA has brought incremental change to the market in areas as widely dispersed as money laundering, outsourcing and stress testing. A common theme in all of SAMA’s instructions is its desire to ensure that expansion takes place at a sustainable rate, and this ambition is readily discerned in the two pieces of regulation that are claiming much of the industry’s attention.

In late 2014 the regulator revised consumer lending rules of 2005 to give SAMA the power to limit the fees that banks can charge. As a result, all fees, costs and administrative charges collected by banks must not exceed either 1% of the financing amount or SR5000 ($1333), whichever is the lower. The new regulations also reduce costs for early repayment and compel banks to provide borrowers with a month’s notice should there be any change in fees. The thorny issue of interest rates was also tackled, with a new requirement to give clear, annual interest rate schedules rather than the sometimes-misleading flat rates that do not represent the true rate being paid.

While there have been some concerns that the new regulations could curb housing demand by limiting credit, many industry players have welcomed the changes. “SAMA finance regulations should not be viewed as a constraint to the growth of the housing market,” Naif Al Baz, CEO of Deutsche Gulf Finance, told OBG. “Given the huge existing demand, the responsibility to grow the market and come up with the right affordable housing mix should come from the supply side, such as the Ministry of Housing and private real estate developers.”

As well as the prudential aspects of the new regulation, SAMA’s action on consumer lending is also an element of a wider consumer protection drive that has seen the creation of a dedicated department for consumer affairs, a new call centre through which customers can air their grievances with the regulator and the publication in late 2013 of a new consumer protection framework which is now binding on all banks licensed by SAMA (see analysis).

Second Intervention

SAMA’s second significant market intervention in the past year concerns the other end of the lending spectrum. In February 2015 the regulator issued its long-anticipated single obligator regulation, the rule on large exposures for banks. The new regulation establishes a four-year schedule by which banks must reduce their exposures to single counterparties from the current maximum level of 25% of their capital bases to 15%. Branches of foreign banks operating in the Kingdom face a less onerous regime under the new regulation, simply being required to establish policies to ensure a reasonable diversification of their exposures, and to report their 50 largest exposures to SAMA.

The stated aims of the new rules are to contain the maximum loss a bank can face in the event of a default, to manage credit concentration risk from concentrated exposures to single parties or groups of connected counterparties, to put in place a large exposures framework which complements and serves as a backstop to the risk-based capital requirements, to deal effectively with large exposures so as to “contribute to the stability of the financial system”, and to aid the economic development of the Kingdom by ensuring a broader access to credit. On the latter point, the new rule may do more than liberate liquidity to be directed to borrowers that might otherwise not have been granted access to it: OBG understands from its discussions with the regulator that a secondary objective of the new rule is to assist the development of bond issuance in the country, as large entities will be encouraged to go to the capital markets to seek funding if bank credit to them is constricted by the revised regime.

Basel Rules

The regulator’s work to reduce large-exposure risk in the domestic system also forms part of its implementation of the Basel rules. SAMA differs from its regional peers in that it is a member of the Basel Committee, and therefore has a duty to implement the Basel III protocol according to the established timetable. With just 12 locally licensed lenders, the relatively small size of the domestic market gives SAMA an advantage over the rest of the G20 nations in terms of implementation, a competitive edge which is further sharpened by the fact that the Banking Control Law allows the regulator to formulate legislation on its own account rather than having it first approved by a parliament, as is the case with European countries.

SAMA implemented Basel III’s new capital regime in 2013, which has applied new capital buffers to Saudi Arabia’s already well-capitalised banks. In January 2015 the regulator introduced Basel’s leverage ratio, which introduces a non-risk weighted capital test as supplementary to the existing capital requirements, by which banks must hold Tier 1 equity to 3% of the value of its total assets – a constraint that is intended to prevent excess leverage in the system.

Further Safeguards

The same month saw the introduction of an important component of Basel’s liquidity regime, the liquidity coverage ratio (LCR). Designed to boost banks’ short-term resilience to liquidity shocks, the LCR requires banks to hold a stock of high-quality liquid assets, such as cash or assets which can be easily sold in private markets with little loss of value, which must at least equal the value of the likely net cash outflows which the bank might experience during a 30-day period of stress. Another Basel milestone approaches in January 2016, when the rules for local systemically important banks (D-SIBs) will be fully implemented by the regulator. Six Saudi lenders are set to be included in this list of institutions which will face higher loss absorbency requirements than the rest of the industry.

As an emerging market, SAMA is applying the Basel rules in a manner which it judges appropriate for domestic conditions, which is sometimes at variance with the approach taken in advanced markets. For example, although all locally licensed banks have adopted a regime of internal risk assessment for creditors, none have deployed internal risk assessment for capital purposes as yet. However, in areas such as implementation of the LCR and rules for DSIBS, the regulator’s ability to move swiftly has placed the local sector ahead of many of those in other G20 countries in terms of the Basel process.

Lending

The changing regulatory landscape will affect banking processes over the coming years, most obviously lending activity. In extending credit to the nation’s corporates, businesses and individuals, Saudi Arabia’s banks have shown a high degree of resilience to extraneous shocks, posting robust loan growth data even after the global economic crisis and during the subsequent era of regional unrest. A number of factors have combined to bring about this trend: a reduction in concerns regarding asset quality in the wake of the global economic crisis, a rebound in GDP growth from 1.8% in 2009 to nearly 8% over the period between 2010 and 2012, a high rate of government spending and renewed private sector appetite – all have played a part in boosting the sector’s aggregate loan book. Retail lending, which according to Aljazira Capital increased its share of total loans from around 21% in 2008 to 29.3% in 2014, has played a significant part in this growth, driven by higher disposable incomes and continuing efforts by the government to place more Saudi nationals in the workforce. However, the regulator’s move in 2014 to limit the fees charged has already been reflected in sector data: while retail lending continued to grow year-on-year (y-o-y), the market share of retail loans fell by 150 basis points from the 2013 high of 30.4% to 28.9%. Given the important role retail facilities play in banks’ net interest margins, any stagnation in their growth is an unwelcome challenge to profitability.

On the corporate side, the slowdown in credit extension in 2009 which took place against a backdrop of cancelled projects and economic uncertainty has given way to an improved lending environment. The single obligator regulation recently introduced by SAMA has yet to become apparent in market data, as banks effectively have a four-year grace period to implement it and very few loans breach the 15% threshold. Despite the increased interest in retail credit in recent years, corporate lending still accounts for around 70% of the sector’s loan book, and was the principal driver in the increase in aggregate loans and advances seen in 2014: according to the published results of the 12 locally licensed banks, net loans and advances rose by 12% to reach SR1.27trn ($337.1bn) by the close of the year.

Growth Prospects

Despite potential regulatory hurdles, Saudi Arabia’s dynamic economy and large, youthful population mean that the banking industry is well placed for further expansion. The retail sector remains a central focus for banks, which have been encouraged to diversify their loan books in the wake of the global economic crisis, and new areas of business such as mortgage finance promise to underpin growth. Within the retail sector real estate lending had been a growing component of consumer credit for some years, increasing from SR70bn ($18.7bn) in 2013 to SR94bn ($25.1bn) in 2014, according to figures from SAMA.

Long-Term Effects

The promulgation of a new mortgage law in 2013 was welcomed by many as an essential element of the segment’s future growth prospects, but any positive effect on credit extension is more likely to be felt in the longer term due to the implementation of a conservative loan-to-value (LTV) ratio of 70%. While this limit is widely considered to be an appropriate precaution against the possibility of unsustainable home loan growth and may be revised in the future to suit market conditions, the relatively low LTV level, which requires potential borrowers to provide a 30% deposit, has reduced interest in home purchases and driven rental rates upwards in some segments. The nation’s SMEs are another area for expansion for Saudi Arabia’s banks, given the growth potential for lending in the sector. “SME lending is lower than other segments, but we are seeing a clear trend that this is increasing,” SAMA’s Al Helaissi told OBG.

Around 90% of Saudi businesses are thought to fall into the SME category, and yet according to the International Finance Corporation, only 2% of the aggregate Saudi loan book is derived from SME lending. Recognising the importance of SMEs to the future economic growth of the nation, the government has sought to encourage lending to SMEs through the creation of a loan guarantee initiative.

SME Lending

The Kafalah programme has been running since 2006, and since its establishment has become the primary means by which Saudi banks have connected with this segment of the market. Continued investment in the programme by the government had enabled it to grant more than 10,000 loan guarantees by the close of 2014, which it has distributed in the market via locally licensed banks.

Lending to this segment has always been challenging. Many SMEs lack the accounting expertise to provide the banks with the level of data they need to properly manage risk, and this shortcoming is further compounded by a lack of collateral across the SME spectrum. As a result, banks have traditionally adopted a conservative stance to credit extension, lending only to the smaller firms that supply the main contractors financed by the bank, lending on a collateral-only basis, or only lending on a cash-flow basis to a limited pool of firms servicing major developments. However, the battle for revenue in an increasingly competitive market has heightened interest in SMEs, and all of the local banks have established dedicated SME departments in a bid to boost revenue. More importantly, some have moved beyond the Kafalah programme to develop their own risk-assessment criteria by which to seek out further lending opportunities (see analysis).

The SME sector is also a key market for other financial services providers, such as leasing and financing companies. “Demand for leasing services from SMEs is very strong and expanding rapidly thanks to solid growth in this segment and government support,” Bader Al Shammari, president and CEO of leasing firm Al Yusr, told OBG. “These SMEs will drive the Kingdom’s future economic growth.”

Trade Finance

At the corporate level, trade finance continues to present opportunities for the sector, as both imports and exports figures rise on the back of the economy’s recovered momentum. SAMA data show that the value of letters of credit settled and bills received has been steadily growing and, just as with other markets, banks are starting to invest in cost-saving, service-enhancing, automated trade finance platforms.

Meanwhile, the project pipeline that has traditionally driven corporate banking growth has returned to its previous healthy flow. Some surveys have it that over 80 mega-projects, many valued at $1bn or more, are currently taking shape on the ground or are planned for completion by 2030.

These include the $27bn King Abdullah Economic City being constructed north of Jeddah; the King Abdullah bin Abdulaziz Security Forces Medical Complexes; the $7bn Knowledge and Economic City in Medina; King Abdullah Medical City; King Abdulaziz International Airport; the $7bn Saudi Landbrige, a rail project that will extend from the Red Sea to the Gulf; an $80bn, 22-year expansion of the Jubail industrial area; the $22bn Riyadh Metro (the construction of which is now well under way); and the Kingdom Tower, which is to be built in Jeddah and is expected to be the world’s tallest building when completed in 2019, at over a kilometre high.

The range and scale of Saudi Arabia’s project pipeline clearly offers the banking industry an opportunity to expand its activity on the back of the financing needs of large developments. It also brings many challenges, not least the question of the capacity of individual lenders to meet the larger funding demand. The response to this is likely to come in the form of increased syndication – a trend which is already well established in the Saudi market: according to Aljazira Capital, syndicated loans stood at SR237.3bn ($63.2bn) in 2013, representing a jump of 35.3% yo-y and a 2007-13 CAGR of 45%.

Developing Infrastructure

The efforts by banks to diversify revenue and gain market share are underpinned by an increasingly sophisticated infrastructure. E-banking legislation introduced in 2011 has greatly enhanced the ability of banks to interact with their customers, with online services now ubiquitous and mobile applications rapidly emerging as a significant channel. This shift towards increased usage of technology is being driven not just by the cost saving benefits it offers to financial institutions, but also by the demand arising from a growing population that is increasingly tech-savvy.

The number of Saudi residents connected to high-speed internet is expanding thanks to continued investment in infrastructure and the widespread adoption of smartphones (see Telecoms & IT chapter). According to the latest data from the Communications and Information Technology Commission, the fixed broadband penetration rate stood at around 48% of households in the second quarter of 2014, while the mobile penetration rate reached 169%.

Banks are also investing in a new breed of ATMs, which offer advanced, non-traditional self-service options and, in some cases, the ability to communicate directly with a live agent. The anticipated expenditure on new ATM technology has attracted other international infrastructure providers to the Saudi market. Some of them, such as global tech company NCR, have entered directly, while in other instances they have sought business in partnership with a local firm, such as the partnership formed by Germany’s Wincor Nixdorf and Riyadh-based firm ABANA. As well as advanced ATM units, many of which will be located in dedicated e-branches, these firms are also helping banks enhance other aspects of their customer interface, such as with new queuing solutions that are able to actively manage flow distribution, monitor branch performance in terms of time productivity and link with human resource departments to provide actionable feedback.

New Models

The creation of glassless branches is also emerging as a theme in the industry, and promises to alter the way some customers interact with their bank. “It’s a new concept in Saudi Arabia, and has a number of advantages. Staff sitting down with customers are better able to cross-sell products, for example. It’s not suitable for all branches, just those with a high concentration of high-networth individuals. However, it’s a major cultural change for the industry,” Talha Iqbal, assistant general manager of ABANA Enterprises Group, told OBG.

Business banking is benefitting from a recent amendment in regulations that has opened up cashin-transit operations to new players. The daily cash collection from corporate clients is a considerable logistical operation, and therefore the provision of safe deposit machines is a growth area for the sector’s technology providers. ABANA Technology, for example, has brought a useful innovation to the cash management arena with its multi-bank cash centre, for which it recently received approval from SAMA. A combined cash collection and cash management mechanism, the new facility is a test case and may be replicated by other operators if successful.

“The Saudi banking industry is an early adopter of cutting-edge technologies, which makes it a world leader in this area. We are not only adopting new international technologies, but are also creating our own innovations and initiatives,” Abdulmohsen Al Fares, CEO of Alinma Bank, told OBG.

Outlook

With the government’s determination to maintain fiscal expenditures (see Economy chapter), the outlook for Saudi Arabia’s banking sector is a positive one. Market fundamentals suggest that there is room for a further expansion of lending by the industry, even within the relatively conservative regulatory regime established by SAMA. The loans-to-deposit ratio (LDR) decreased slightly from 76.8% to 75.9% between December 2013 and December 2014, and remains below the regulatory requirement and the regional average of around 86%.

Risks do exist though. Any cut in fiscal spending is likely to result in a slowdown of credit growth, and the low LDR has compelled banks to lower lending rates to attract business – a move that is likely to depress net interest margins in the coming year. However, the sector has the benefit of facing these challenges from a position of considerable strength. The industry’s capital adequacy ratio runs at an average of 17.8%, comfortably above the 8% required by SAMA and Basel, and the non-performing loan ratio stood at a modest 1.3% in the third quarter of 2014 with a coverage ratio of 169%.

Looking to the regulatory side, SAMA issued new credit card rules in April 2015, which upgrade the existing framework and further its consumer protection drive. The regulator is also writing its first financial stability report (FSB), which will assess the whole financial system on an annual basis and provide an overview of macroeconomic risk. The adoption of FSB standards is now becoming commonplace across the region, and they are likely to play a useful role in policy decisions regarding the banking sector in the future. The Kingdom’s banks are setting their sights on continued growth, but both banks and their regulator are adequately prepared for any interruptions to their planned trajectory. On the back of another year of positive results, the local banking sector is well-positioned to continue growth, as the government’s expansionary fiscal policy and investment drive creates new opportunities. Despite challenges such as new competition, the sector’s stability will allow it to lead from a strong position.