Strong retail loans and stability ratios in Saudi Arabia banking sector

Despite the effects of lower international oil prices placing downward pressure on sector profitability, Saudi Arabia’s banks have succeeded in expanding their assets over the past year. While the trend of lower profits is likely to prevail over the medium term, the Kingdom’s banks are well positioned to capitalise on the growth opportunities encompassed in the country’s new economic development strategy.

The modern banking landscape emerged from the oil boom that followed the Second World War, a period of economic transformation driven by strong revenue flows from growing hydrocarbons exports. A rapidly expanding money supply and an increasing number of banking institutions called for greater supervision of the market, and in 1952 the Saudi Arabian Monetary Authority (SAMA) was established and tasked with regulating the banking industry.

Decade Of Growth

The following years saw the arrival of some of today’s key players, such as National Commercial Bank (NCB) and Riyad Bank. It was a decade of rapid growth, and with this expansion came SAMA’s first major regulatory challenge: in the early 1960s a series of large, non-performing loans (NPLs) issued by Al Watany Bank resulted in the first failure of a major financial institution regulated by the young central bank. SAMA’s response was to merge the troubled lender with Riyad Bank before setting to work on a new supervisory framework for the sector – the 1966 Banking Control Law, the precepts of which still govern the industry. The new legislation granted SAMA a range of licensing and regulatory powers, which the central bank used to introduce tighter control of the sector through new requirements for liquidity, capital adequacy and reserve ratios. This marked the starting point of a conservative prudential stance that has contributed to the stability of the Kingdom’s banking sector ever since. On this new base, the industry experienced a second surge during the 1970s, driven by increasing oil revenues as well as a maturing economy.

By 1980 there were 12 locally licensed institutions in the banking sector, according to the Bank for International Settlements, 10 of which were partially foreign owned. Declining oil prices during this decade placed significant pressure on the industry, with NPLs rising to 20% of total extended credit. Yet the industry continued to expand. The 1980s saw the arrival of important players such as Saudi Investment Bank, established in 1984, and the 1988 market entry of the Al Rajhi Banking and Investment Corporation.

During the 1990s and 2000s, oil prices experienced a less turbulent trajectory, and the steady growth of credit during these decades was achieved with lower levels of systemic risk. Legislation promulgated in 1975 made it a legal requirement that all banks be majority-owned by a local partner, but in the early 2000s an increasingly confident SAMA began to open the market to majority foreign-owned investment banks.

The first licences for these international institutions were issued in 2004 and resulted in market entries by companies such as Deutsche Bank, BNP Paribas and JP Morgan – an important step in an ongoing process of economic liberalisation.

Today’s Market

In May 2017 a new local banking licence was issued to Gulf International Bank, bringing the number of local banks to 13. There are also 14 branches of foreign banks. The number of local banks licensed to operate in Saudi Arabia is low in regional terms. By comparison, 23 locally incorporated banks served the much smaller population of the UAE in 2016.

Three banks claim double-digit market shares. NCB, the largest player, accounted for 19.5% of total sector assets in the second quarter of 2017, according to SAMA. NCB was licensed in the Kingdom in 1953, and as such it has played a central role in the economic development of the country.

The bank’s position was further cemented in 1999 when the government acquired a majority stake in the institution through its Public Investment Fund. With total assets of SR449.8bn ($119.9bn) as of June 2017, it is one of the largest banks in the Arab world.

The Kingdom’s second-biggest bank, Al Rajhi, is one of the largest Islamic banks in the global market, with assets of SR345.6bn ($92.1bn) in June 2017 and a 15% market share as of the second quarter of the year. 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 and has built up the largest customer base in the domestic market. Samba Bank, the third-largest player, held 10% of the market and assets of SR231.1bn ($61.6bn) in June 2017. Another early market entrant, established in 1980, Samba Bank is most notable for its innovation in the domestic market – being the first to introduce ATMs and charge cards – and its expansion into foreign markets, such as Pakistan, the UK, Qatar and Dubai.

Between them, these three institutions account for around 44.4% of total sector assets. Other institutions with sizeable claims on the market include Riyad Bank (with 9.5% of total assets in the second quarter of 2017), Banque Saudi Fransi (8.9%), Saudi British Bank (7.9%) and Arab National Bank (7.4%).

Foreign Input

Foreign capital has played an important role in the sector for decades. Saudi Hollandi (now rebranded as Alawwal) was the Kingdom’s first bank, opening its doors in 1926 as a subsidiary of the Netherlands Trading Society. It spent its early years in the Kingdom acting as a de facto central bank. The institution’s transition to an ordinary private sector player with the creation of SAMA in 1952 provided a useful model for the increasing amount of foreign participation that followed. Today, the lender is 40% owned by Royal Bank of Scotland.

In the beginning, foreign entrants were required to incorporate with Saudi partners in order to obtain an operating licence in the Kingdom. Samba Financial Group (in which Norges Bank, Ashmore Investment, JP Morgan and T Rowe Price have small interests), Banque Saudi Fransi (14.9% owned by Credit Agricole) and Saudi British Bank (40% owned by HSBC) are all examples of such joint venture institutions.

Since SAMA opened the market to foreign institutions in 2004, the number of international participants has risen further, increasing competition and helping to drive innovation. BNP Paribas and JP Morgan were the first to enter the newly liberalised market, and as of 2017 they have been joined by 12 other regional and global institutions, including the National Bank of Kuwait, Emirates Bank and Deutsche Bank.

Another phase of market liberalisation in 2005 allowed for the rapid expansion of investment companies and financial houses in the Kingdom. These institutions, which numbered over 85 in 2017, are licensed separately from foreign commercial banks, and their activities are overseen by the Capital Markets Authority (CMA) rather than SAMA. Their activities range from investment fund management to custody arrangements, deal arranging and underwriting, with the CMA issuing activity-focused licences as appropriate. As well as local and regional institutions, several global giants have established a presence in Saudi Arabia to serve the investment community, including UBS, Goldman Sachs and the most significant recent arrival, emerging markets investment manager Ashmore.

Performance

The lower oil price environment that emerged in mid-2014 has challenged banking sector growth. Indeed, 2014 was the last year in which the sector showed double-digit growth: that year total assets expanded by 13%, according to SAMA. In 2015, as lower oil prices began to take effect, aggregate assets for the sector expanded by a more modest 3% to reach SR2.24trn ($597.2bn). This trend continued in 2016 when the sector’s assets grew by just over 1.6% to record SR2.28trn ($607.8bn).

Loan growth during 2016 was the lowest in five years, rising by 1.6% over 2015 levels. Deposits, meanwhile, increased by 0.1%, with a decline in demand deposits being mitigated by a modest rise in time deposits. Despite the slowdown, positive growth of loans and deposits demonstrate the sector’s ability to expand even during a period of lower government spending, reduced corporate revenues and an ongoing process of economic reform.

Profitability, however, has suffered as a result of these challenges. Saudi banks’ profits decreased by 5.8% in 2016, with net income declining from SR43.7bn ($11.7bn) to SR41.1bn ($11bn). Part of this contraction is attributable to the rising competition between banks to secure a greater supply of dwindling sector deposits.

Negative profitability was led by the corporate segment, where aggregate profits declined by 21% in 2016. In contrast, the retail segment showed a 15% expansion in profits. These were primarily derived from high demand for consumer credit.

Lending Mix

The relatively strong performance of the retail segment over the past year is interesting in the context of the sector’s lending mix. Lending to the corporate sector has traditionally been the preferred method for building profit margins among the Kingdom’s financial institutions, a legacy of Saudi Arabia’s early economic development based on government oil revenues and large infrastructure projects.

However, extending credit to retail customers has been of increasing interest to the Kingdom’s banks, thanks to a rapidly expanding bankable population, advances in risk-assessment capabilities and the advent of new technologies that have allowed lenders to interact with potential customers with much greater efficiency. In 2016 retail loans stood at 25% of the total, compared to 59% for corporate loans, according to figures by Albilad Capital.

At the individual bank level, lending portfolios are very diverse. Al Rajhi Bank’s loan book is the most retail-dominated by some distance, with 73% of its lending directed to retail clients and 27% to corporate customers in the first quarter of 2017. The corporate loan books of the other 11 banks are all larger than their retail books, with Aljazira Bank (43% retail), NCB (35%) and Albilad (33%) showing the greatest proportions of consumer-directed lending. The trend, however, is clear: in 2016 the share of corporate loans declined by about 1.5% on the previous year, while retail loans expanded by 5%. Credit card lending showed particularly strong growth, rising 7% to reach nearly SR10bn ($2.7bn) by the close of 2016.

Significantly, Saudi Arabia’s banks are gaining an increasing amount of total income from their retail assets. For example, while NCB’s commercial loan book is larger than its retail book, in 2016 it derived a greater share of its net income from retail assets – 33% compared to the 28% it earned from corporate assets. The profitability of the retail segment has encouraged banks to perform a strategic pivot towards consumers. For example, the recently rebranded Alawwal, a primarily corporate-facing institution, now has a strong focus on expanding its retail business, forming a partnership with Costa Coffee to establish one of the most innovative branches in the market (see analysis).

Sector Stability

This recalibration of banks’ loan books is taking place against a challenging economic backdrop: although Brent crude prices had climbed to above $60 per barrel by mid-December, 2017 was the third year of a low oil price environment, which has resulted in pauses in some government spending and undermined corporate growth. While banks have focused on maintaining profitability during this period, there has also been a greater effort than usual put on the question of financial stability.

Still, a history of prudent regulation means that the Kingdom’s banking sector is well defended against economic shocks. The Basel Committee’s Regulatory Consistency Assessment Programme and a peer review conducted by the Financial Stability Board both confirmed in 2015 that Saudi Arabia had fully or largely implemented international standards.

Nevertheless, as a state debt issuance programme put pressure on banks’ deposits in 2016, concerns regarding system liquidity began to arise. The most obvious effect of a nascent liquidity squeeze was a rising interbank rate, as well as higher market rates resulting from banks competing with each other to attract deposits. However, SAMA took a number of mitigating steps throughout the year, including a change to the loans-to-deposit ratio requirement, which caused market rates to trend down by the end of 2016, thereby reducing the cost of funding in the interbank market (see analysis).

Loans

On the issue of asset quality, although there was a slight uptick in the NPL rate in late 2016, the overall level is low. In the fourth quarter of 2016 the NPL rate rose to 1.4%, up from 1.2% in the same period of 2015, according to SAMA. This compares to an OECD average of 2.7% and 4.4% in the eurozone.

SAMA maintains a robust provisioning framework to protect the industry against the possibility of loan write-offs. This includes a general provisioning requirement of 1% of a bank’s credit portfolio, as well as a rising scale of specific provisions for vulnerable loans: 25% of an exposure that is deemed “substandard”, 50% of an exposure that is classified as “doubtful” and 100% of an exposure that is considered a “loss”.

The SR7.8bn ($2.1bn) of loan write-offs in 2016 represented an increase of SR1.2bn ($319.9m) over the previous year, and was largely concentrated in the construction and consumer segments.

However, write-offs remain at a low level relative to total credit extended: consumer write-offs make up 1.35% of total consumer credit, and corporate write-offs were just 0.38% of total corporate credit, according to SAMA’s Financial Stability Report 2017.

The banking sector is also defended by the relatively straightforward relationship between its deposits and loans. Most deposits in the system are derived from Saudi households, businesses and government entities, while most lending is directed to domestic households, corporations and government-owned firms. Saudi Arabian banks, thus, are not significantly dependent on foreign banks for funding, a built-in protection that is further enhanced by a fixed exchange-rate system that has reduced foreign-exchange transaction risk for decades. During periods of economic stress, this largely self-sufficient system is protected by sizeable capital buffers. In 2016 banks’ Tier-1 capital adequacy ratio (CAR) grew to reach 16.9% – comfortably above the Basel III requirement of 6% – while the Tier-1 + Tier-2 CAR was 19.5%, according to SAMA.

Supervisory Function

The sector’s healthy financial stability ratios are testament to SAMA’s history of practical regulation. In carrying out its supervisory function, the regulator applies the precepts of the 1966 Banking Control Law, the 26 articles of which lay out the statutory requirements for banks and establish which activities may or may not be conducted in the Kingdom. Many of the daily operations of banks are further addressed by the large number of rules and instructions distributed to institutions in the form of circulars. This framework applies to all banks in the country, both sharia-compliant and conventional.

The majority of Saudi Arabia’s commercial banks offer sharia-compliant banking products through Islamic windows, and four operate as fully fledged sharia-compliant institutions.

However, SAMA makes no licensing distinction on these grounds. No local bank is formally identified as an Islamic operator, and there is no central test of sharia compliance in terms of banks’ services and products. While the creation of a Banking Dispute and Settlement Committee has made the task of ascertaining which activities are permissible within SAMA’s jurisdiction more straightforward, the regulator prefers not to involve itself in questions of sharia interpretation.

The conservative stance SAMA has applied to financial stability ratios also extends to the most fundamental elements of the industry, including bank ownership. While the economy and the banks that serve it have been gradually opened to foreign investment, the regulator has sought to reduce the potential for external shocks and speculative interest by capping the foreign ownership of locally licensed commercial banks at 40%. Foreign commercial banks operating within the authority’s jurisdiction, meanwhile, are limited to a maximum 60% foreign share. Furthermore, 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.

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.

SAMA’s Banking Vision 2020, now in the implementation phase, aims to bolster the economic role of the financial sector by addressing issues such as financial inclusion, technological advances and increasing the skillset of the local labour force.

Regulatory Change

The most significant regulatory changes in recent years have come as a result of the central bank’s response to tightening liquidity. The January 2016 raising of the loan-to-deposit ratio requirement from 85% to 90% was intended to allow the Kingdom’s banks to continue to lend even in an environment of low deposit growth.

Another defensive measure taken at the same time was the creation of the new Saudi Arabian Deposit Protection Fund, which aims to increase confidence by guaranteeing eligible deposits of up to SR200,000 ($53,300). The scheme is financed by a fund established particularly for this purpose by the banks, which pay quarterly premiums on eligible deposits.

On the issue of lending regulations, SAMA has completed the changes required to ensure the long-term stability of the sector and align the industry with international best practices. New consumer regulations were introduced in 2014, granting SAMA the power to cap the level of retail lending at individual banks and 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 ($1330), whichever is lower. The new framework also reduced penalties for early repayments, required banks to provide notice of any changes in fees and compelled lenders to give clear, annual interest rate schedules rather than the sometimes misleading flat rates.

For commercial lending, meanwhile, the most significant recent change came in 2015 with the issuance of a single obligator regulation, the Rule on Large Exposures for Banks. The regulation established a four-year schedule by which banks must reduce their exposures to single counterparties, starting at 25% of their capital bases and finishing at a rate of 15% in 2019. Branches of foreign banks operating in the Kingdom lie outside this framework; however, they are required to establish policies to ensure a reasonable diversification of their exposures and to report their 50 largest exposures to SAMA.

As a member of the Basel Committee on Banking Supervision, SAMA is committed to introducing its regulatory obligations according to schedule. It has therefore applied Basel’s capital and liquidity requirements to the domestic sector, the most recent of these being the implementation of the liquidity ratio in 2015. This measure requires banks to hold a stock of high-quality liquid assets – such as cash or assets that can be easily sold in private markets – which must at least equal the value of the estimated net cash needs during a 30-day period of stress. In 2016 SAMA turned its attention to Basel’s guidance regarding domestic systemically important banks (D-SIBs).

The regulator has identified the D-SIB institutions and the additional loss absorbency requirements over and above the Basel III requirements that are to be applied to them. A total of six banks have been defined as D-SIBs, with one required to hold a 1% capital buffer and five required to hold a 0.5% capital buffer.

Cybersecurity

The question of cybersecurity and how it applies to the nation’s complex payments system has also occupied the regulator recently. The 2016 data breaches suffered by leading banks in Qatar and the UAE’s Sharjah emirate, which included the theft of thousands of files containing passwords, PINs and payment data, have drawn the region’s attention to the risks associated with evolving technologies and increasing interconnectivity. Financial technology (fintech) products and services are expanding rapidly in the GCC, and customers are taking advantage of e-payment capabilities across all bank channels, as well as those provided by other service providers, such as telecoms operators, utility firms and transportation companies. Providing attractive fintech solutions is a central component of the effort to tap into the lucrative retail segment, but the advantages that new platforms and digital features bring to both banks and their clients come with an increased security risk.

Given the fast-moving nature of this area of the market, cybersecurity presents a significant regulatory challenge. Consequently, SAMA has been working with banks and other stakeholders to establish an array of payment options to meet consumer needs in a secure manner, as the country’s Integrated Payment Strategy aims to increase electronic transactions to 30% of all transactions by 2021. The strategy establishes a number of objectives, including building an automated clearing house to enable retail payment transactions to move at the speed of the internet; developing new online and mobile payment applications; and promoting product development through an innovation centre, concept hubs and fintech labs.

In addition, SAMA has also developed a cybersecurity strategy for the banking sector. The key elements of this plan include protecting information assets, detection of cybersecurity incidents and recovery, fostering a cybersecurity culture and understanding and managing the interdependencies on national and international levels. Part of the strategy involves the implementation of a new cybersecurity framework, which will establish a common approach that the financial sector can take to address cyber risks. Both of these initiatives are being implemented in coordination with the Banking Committee for Information Security.

Growth Potential

The increased availability of secure digital payment channels will be a helpful boost to the sector during a time of slowing credit expansion, and despite the macroeconomic headwinds, a number of other growth opportunities exist. Corporate lending units stand to benefit from the government’s drive to increase private sector participation across a broad range of economic activities. While the sale of close to 5% of Saudi Aramco has garnered headlines worldwide over the past year, the privatisation drive is much broader in scope, and includes the postal service, football clubs, health and education services, desalination plants and chemical companies.

In 2017 the attention of the banking sector was already turning to health care, where the government is “corporatising” the state-owned health care system by transferring responsibility to a number of public companies. While these institutions remain in state ownership, they will be operated with a corporate model, competing against each other and the private sector while the government steps back into a supervisory role (see Economy chapter).

Lending to these public bodies will add another route to asset growth for some banks. “The National Transformation Programme is essentially about the ministries revamping the way they do business to reach the targets established in Saudi Vision 2030,” Nizar Tuwaijri, general manager at Arab National Bank, told OBG. “Corporatisation is part of this process. These new public entities will be modelled on the private sector – each will have its own CEO and so on – and in this way they are being prepared for later privatisation.”

The aggregate retail book, meanwhile, is likely to feel the benefits of recent state wage decisions. The government removed certain financial allowances, privileges and incentives for civil servants and military personnel in September 2016 as part of its cost-cutting drive. However, facing pushback and better-than-expected budget figures, the decision was reversed in April 2017, re-implementing a number of the perks. The effect of the policy change is likely to be significant over the medium term: around 70% of Saudi nationals are employed by the state, and hundreds of thousands of them had been facing salary cuts of up to 40%. How the Kingdom’s increasingly retail-focused banks compete for this newly available capital will be an interesting industry issue in 2018.

The adoption of new technologies is already emerging as a key growth driver in this segment, with the introduction of self-service kiosks, glassless branches and interactive teller technology for ATMs. Another growth driver is the rapid uptake of card usage. Concerns over sharia compliance meant that for many years the debit card was the most popular form of card payment in the Kingdom, and according to a 2015 report by HSBC, these accounted for around 90% of the payment cards in circulation. However, advances in sharia interpretation have underpinned a significant expansion of credit card usage, with sharia-compliant banks employing a number of models to provide their customers with credit card services (see analysis).

Mortgages

Real estate lending is also expected to expand following the introduction of new regulations. The Kingdom is undertaking measures to help provide homes to its citizens as part of the National Transformation Programme 2020, approved in 2016, which aims to increase the percentage of Saudi families owning homes from 47% to 52%, and raise the ratio of real estate finance to non-oil GDP from 8% to 15%.

In September 2017 the central bank announced steps to help cut home financing costs. According to SAMA, mortgage holders will be exempt from paying administrative fees when they switch from a floating loan rate to a fixed loan rate. Mortgage holders will also be able switch from one mortgage lender to another at no extra cost. In January 2017 SAMA also said it was raising the maximum loan-to-value ratio for home financing from 70% to 85% for first homes. The bank licensed a national home finance company, Bidaya, and introduced an affordable mortgage programme in conjunction with the Ministry of Finance.

“Starting in 2017 we have seen high growth in the mortgage industry, with 20-35% increases year-on-year,” Khalid M Alamoudi, general director of the Real Estate Development Fund, told OBG. “The government is seeking to identify opportunities for partners and financial institutions and enable their risk appetite. This will appear even clearer after the introduction of the mortgage guarantee programme.”

Outlook

The publication of the National Transformation Programme has helped explicate regarding Saudi Arabia’s medium-term economic direction. Although low oil prices continue to challenge sector growth, both corporate and retail opportunities are present in the market. Less certain is the industry’s willingness to shift to extending credit to the important and growing small and medium-sized enterprise (SME) class, which accounts for around 90% of registered businesses and 60% of total employment. Higher risk and lower returns have made these businesses a challenging proposition for banks, and during periods of tightened liquidity their interest in lending to less-established businesses is further reduced. Historically, much bank credit to SMEs has been supported by the SME Loan Guarantee Programme managed by Saudi Industrial Development Fund, better known as the Kafalah programme, which was established by the Ministry of Finance in 2006. A broader move into the SME segment would be welcome from a macroeconomic point of view, but it largely remains unchartered territory for the Kingdom’s lenders.

In terms of sector stability, lower oil prices have had a limited impact on the NPL rate across the retail and corporate segments to date. However, SAMA acknowledges a possible medium- to long-term risk due to a prolonged period of slower economic growth. During 2017, therefore, banks have sought to prioritise quality risk profiles over quantity in their lending, and this cautious approach is likely to extend throughout 2018.