Oman's banking sector records rises in assets, lending and deposits

A number of challenges have confronted Oman’s banking sector over recent years: a structural shake-up in the form of a new Islamic segment has increased competition levels; declining oil prices have constricted lending opportunities in some segments and compelled the regulator to encourage greater credit extension to others; and uncertainty surrounding the growth of regional economies adds a further question mark to the sector’s growth prospects in the short term. Nevertheless, the sector has continued to produce robust results, and is well positioned to weather the current economic turbulence.

Rapid Development

The well-populated banking industry that exists in the sultanate today is a relatively recent phenomenon. In the two decades after the Second World War, a single institution, the British Bank of the Middle East, monopolised the market. By 1972, the second year of Sultan Qaboos bin Said Al Said’s reign, just three banks with as many branches offered their services to a largely unbanked population, marking the sector as one of the least developed in the region. The new sultan, however, facilitated a new era of economic growth, and the following decades were to see the rapid advancement of the sector. In 1973 the National Bank of Oman (NBO) was established as the first local bank in the country, and was followed just three years later by the second domestic institution, Commercial Bank of Oman. This era also saw the development of a regulatory framework and the supervisory agencies that would implement it, starting with the Muscat Currency Authority in 1970. Two years later this body was transformed into the Oman Currency Board, which added the 1-, 5- and 10-rial notes to the denominations established by its predecessor in 1970.

A more significant change to the regulatory framework came in 1974, when the Central Bank of Oman (CBO) was established and charged with implementing the new Banking Law, a development that paved the way for the creation of the modern sector. The subsequent growth of the industry was rapid; the remaining years of the 1970s saw the emergence of three specialised development banks, focusing on housing, agriculture and fisheries. The first wholly owned Omani bank, Oman International Bank, was established in the 1980s, as was the Omani subsidiary of Hong Kong’s Overseas Trust Bank, which some years later was bought out by Omani merchants and rebranded as Bank Muscat.

In 1991 the CBO was granted more regulatory reach when it was given the authority to withdraw the licences or suspend the activities of banks under its jurisdiction, a power it used to take over the branches of the Luxembourg-based Bank of Credit and Commerce International (BCCI) when it was liquidated that year. The last decade of the 20th century was a time of sector consolidation; and the mergers and acquisitions that took place during this period produced some of today’s market leaders. Oman’s banks also began to reach out to their client bases with new technologies, as branch banking gradually gave way to mobile, and later, internet channels. This process has continued to the present, with technological offerings representing a key route to client acquisition in a crowded market.

The Modern Sector

With total assets of around $73bn in 2015, the Omani banking sector is the smallest in the GCC, according to Standard & Poor’s, more modest in scale than those of the neighbouring UAE ($630bn) and Saudi Arabia ($580bn). Nevertheless, the sultanate’s retail, business and corporate customers are served by both local and international lenders. At the start of 2016 the sector consisted of 16 conventional commercial banks, of which seven were locally incorporated and nine were branches of foreign institutions, according to the CBO’s annual report for 2015. Between them they operated a network of 468 branches, 1088 ATMs, 259 cash deposit machines and 13 on-site banking facilities. Given Oman’s relatively small population of around 4.5m, this infrastructure presents Oman with a higher banking density than the region’s larger markets. According to the World Bank, the sultanate had 16 branches per 100,000 inhabitants in 2014, compared to 9.2 for Saudi Arabia and 11.9 for the UAE.

Top Three

While the fractured nature of the market makes for elevated levels of competition, there is a high degree of market concentration among the larger players, with the top-three banks accounting for around 64% of total sector assets. The largest of these is Bank Muscat, which, with total assets of OR13bn ($33.7bn) in June 2016, claims a 42% market share by asset base. Established in 1982, it is three times larger than its closest competitor and operates the largest branch network in the country, with 154 locations. It also enjoys the highest level of government ownership in the industry; the Royal Court Affairs governmental arm owns 23.6% of the institution, and stakes by other government or quasi-government entities brings total state ownership to around 37%.

Bank Dhofar, with total assets of OR3.8bn ($9.8bn) in June 2016, is the second-largest lender in the sultanate. Incorporated in 1990, it currently operates a network of 68 branches and is one of the fastest-growing institutions in the sector. Much of its expansion has been derived from acquisition. In 1990 it purchased the assets and liabilities of the failed BCCI from the CBO, and in 2000 it boosted its network by buying 16 branches from Commercial Bank of Oman. Then, in 2002 it merged with Majan International Bank, expanding its balance sheet in the process. In October 2016 Bank Dhofar announced it had ended negotiations with Bank Sohar after exploring a merger for more than three years. The bank said the two sides had been unable to reach agreement on certain issues.

The largest shareholder in the bank, with a stake of 27.5%, is Dhofar International Development and Investment Holding Company, a Salalah-headquartered entity primarily engaged in investment activities in businesses, marketable securities and the promotion of new projects. The state’s interest in the bank comes primarily through a 10% stake held by the Civil Service Employees Pension Fund, a government unit that has administrative and financial independence.

NBO rounds out the big three, with total assets of OR3.6bn ($9.3bn) in June 2016. Established in 1973, the bank currently has a network of more than 60 branches in the country. The largest shareholder in the institution is the Commercial Bank of Qatar (34.9%), which is described by NBO as its strategic partner, with which it is working to develop its products and services. Further private sector interest in NBO comes in the form of a 14.7% stake held by Suhail Bahwan Group, while the government’s interest includes holdings by the Civil Service Employees Pension Fund (10.73%) and the Public Authority for Social Insurance (6.47%).

Foreign Interest

One characteristic shared by Omani banks is their focus on the domestic sector, with international assets generally accounting for single-figure percentages of their respective balance sheets. Foreign institutions, however, have shown significant interest in the Omani market, and have played a role in the country’s banking industry since its inception.

Standard Chartered, a well-established foreign player, began operating in Oman in 1968, since which time it has been joined in the market by eight other international institutions: Habib Bank, Bank Melli Iran, Bank Saderat Iran, State Bank of India, National Bank of Abu Dhabi, Bank of Baroda, Bank of Beirut and Qatar National Bank. These foreign players maintain a relatively small physical presence, with most operating no more than a handful of branches.

The largest branch network operated by a foreign bank is that of National Bank of Abu Dhabi, which entered the market in the 1970s and has subsequently established nine operating offices in the sultanate. Foreign banks, therefore, do not have the reach for engaging in significant retail business, which is left to domestic lenders and their more extensive infrastructure. Instead, they focus primarily on corporate business niches, such as trade finance.

One way for foreign institutions to quickly expand is through acquisition. In 2012 HSBC merged with Oman International Bank, which at that time operated the second-largest branch network in the country. HSBC holds 51% of the new entity, renamed HSBC Bank Oman, and has effectively become an Omani institution.

Islamic Innovation

Until recently Oman’s banking sector was populated entirely by conventional operators, with the sultanate choosing not to follow its GCC neighbours in establishing a distinct Islamic finance sector. In 2011, however, a royal directive radically altered the regulatory landscape by defining and authorising sharia-compliant services in the country, and the result of this decision has been one of the largest shakeups in the domestic industry in decades. The new framework allows for both standalone Islamic banks as well as sharia-compliant windows to be operated by conventional institutions, and both models have been enthusiastically adopted. In May 2012 the initial public offering of Bank Nizwa, one of the first sharia-compliant institutions to be granted a licence in the sultanate, was 11.3 times oversubscribed during a time of low appetite for listings, reflecting the perceived potential of Islamic financial services. The standalone Islamic institution began operations in 2013 and has since been joined in the market by Alizz Islamic Bank, a second standalone, sharia-compliant institution. Additionally, six out of the seven locally incorporated conventional banks have opened dedicated windows through which they offer Islamic banking services and products, with NBO being the first to enter the segment in this fashion. Among them, two Islamic banks and the larger number of windows operated 60 locations in the country by the end of 2015, a rise from 45 the previous year.

Experienced Rules

In establishing its Islamic finance sector, Oman’s latecomer status has been a benefit to it in a regulatory sense. The accumulated experience of other jurisdictions in the region and beyond, which have reacted to regulatory challenges in diverse ways, has allowed the CBO to deploy an advanced regulatory structure from the outset. The Islamic finance framework introduced in 2012 is more detailed than many of its regional counterparts, although it shares the fundamental pillars that are starting to provide a cohesive system for the global industry, based on guidance from the Islamic Financial Services Board of Malaysia and the accounting standards of Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions.

This strong regulatory platform has enabled the segment to grow rapidly since its first year of operation in 2013. According to the CBO, the sharia-compliant banks and windows had OR1.78bn ($4.6bn) worth of outstanding financing by the end of 2015, up from OR1.05bn ($2.7bn) at the close of the previous year. Customer deposits held by the segment also registered a significant rise over the year to OR1.54bn ($4bn) from OR688.9m ($1.8bn). The combined assets of Islamic banks and windows amounted to OR2.3bn ($6bn) as of the end of December 2015, which constituted about 7.5% of banking system assets. The trends in 2015 continued into June 2016, with sharia-compliant banks holding OR2.1bn ($5.5bn) of outstanding finance, customer deposits rising to OR1.8bn ($4.7bn); and combined assets of Islamic banks and windows reaching OR2.7bn ($7bn), making up 8.4% of banking system assets in the first half of 2016.

The prospects for the future growth of the sector are good and are greatly boosted by the emergence of a wider Islamic finance sector in Oman. In March 2016 a royal decree established long-anticipated guidelines for the sultanate’s new takaful (Islamic insurance), operators. The framework lays out the fundamental conditions under which takaful operations may be carried out in the sultanate, starting with the simple precept that only dedicated takaful providers may offer sharia-compliant insurance products. This means that, unlike their equivalents in the banking sector, conventional insurers cannot tap into the takaful market through Islamic windows, a decision that demonstrates the regulator’s desire to nurture its fledgling Islamic insurance segment (see Insurance chapter).

Like their conventional counterparts, takaful providers are expected to be publicly listed on the Muscat Securities Market by 2017, with minimum capital of OR10m ($25.9m). The regulations also address crucial areas such as the maintenance of solvency margins, fund set-up and management, and the transfer of takaful business between companies – all of which establish a new level of operational clarity for the segment. These developments help to raise the profile of Islamic finance in the country, as well as provide useful cross-selling opportunities for sharia-compliant banks and insurance companies willing to engage with each other in bancassurance activity.

Non-Bank Competition

The emergence of the Islamic banking sector in Oman has resulted in an increasingly competitive environment. Both conventional and sharia-compliant institutions, are also facing increased competition from non-bank lending activity. At the outset of 2016 there were six financing and leasing companies (FLCs) operating in the sultanate under the supervision of the CBO. The regulator views their presence in the market as an important component of broadening financial access and has sought to “create a conducive environment for them to carve a specific market niche for themselves”, according to the CBO’s annual report for 2015. Leasing companies are allowed to accept deposits from corporate but not retail clients, although in practice their largest source of funding is banks and other financial institutions, with bond issuances a comparative rarity. Despite the relatively higher cost of their funding model, they have succeeded in claiming market share thanks to a higher risk appetite and by offering enhanced service levels and fast turnarounds on loan applications. Traditionally, they have performed well in retail financing, mainly for the purchase of vehicles and electrical goods, equipment leasing for small and medium-sized enterprises (SMEs), and factoring and working capital financing to SMEs for domestic as well as cross-border trade. The segment has grown robustly in recent years; the total combined assets of FLCs increased by OR118.4m ($306.5m), or 12.9%, to stand at OR1bn ($2.6bn) as at the end of December 2015, compared to OR919m ($2.4bn) a year earlier. However, the significant reliance of FLCs on bank funding could constrain profitability should sector liquidity tighten again (see analysis).

Regulation

The task of supervising Oman’s increasingly dynamic and competitive banking sector falls to the CBO, which also acts as the custodian of payment and settlement systems in the country. The regulator implements a wide range of laws, regulations and decrees, the most relevant of which are an Islamic banking directive issued in 2011, the Commercial Companies Law and the Banking Law.

The CBO has a reputation for a prudent and sometimes conservative regulatory stance, with strict prudential ratios, as well as a number of price caps and lending ratios in place. For example, the interest rate on loans to individuals is capped at 6%, while a debt burden limit also restricts the amount banks can take as repayments from a customer’s salary. The result is a solvent and stable system. At the close of 2016, all banks operating in Oman were able to meet the regulator’s requirement of a 12.63% capital adequacy ratio, and 15 of 18 institutions had a ratio of 14% or higher.

Much of the regulator’s attention in recent years has been directed towards the implementation of the Basel II and Basel III standards. In 2013 the CBO issued its roadmap for the introduction of Basel III norms to the industry, covering the key regulatory issues, including the definition of capital, higher minimum core capital requirements, new capital buffers, the leverage ratio and liquidity measures. With regard to the implementation of Basel III’s capital guidelines, in May 2015 the CBO revealed the details of its capital conservation and counter-cyclical buffers. The rationale behind the move stems from the Bank for International Settlements (BIS) idea that outside of periods of stress banks should hold buffers of capital above the regulatory minimum. The capital conservation buffer is being introduced in 0.625% increments until 2019, when it will reach the desired level of 2.5%. The BIS noted that at the onset of the 2008 financial crisis a number of banks continued to make large payouts in the form of dividends, share buybacks and generous compensation payments even though their individual financial condition and the outlook of the sector was deteriorating. The CBO has revealed its determination that Oman’s banking industry does not make the same mistake. In its December 2015 concept paper on capital buffer requirements it stated that it would intervene in bank dividend payments in order to help lenders to meet the minimum requirement. Any such intervention is not without precedent: in 2014 two banks and a non-banking financial firm were told by the central bank to revise their dividend payments.

The regulator has also introduced a framework aimed at moderating senior-level staff compensation policies, most notably by requiring bonuses to be staggered over a three-year period in order to discourage risk-taking and short-termism and in decision-making.

Notably, Islamic banks have been excluded from the new buffer requirements and will be asked to comply with a separate framework. The regulatory divergence of the sultanate’s sharia-compliant and conventional institutions will be another point of interest for the industry over the coming years. As with other jurisdictions, Oman’s Islamic banks each operate their own sharia board, which oversees product development and banking operations. A supreme sharia board envisioned by the new Islamic banking regulations has only recently convened and has yet to make its presence felt in areas such as product approval or standard-setting, restricting itself to a discourse of general market conditions.

Performance

Despite increasing competition in the domestic market, a struggling global economy, the challenges associated with the sultanate’s fiscal and current account deficits, and the oil price decline that began in the second half of 2014, the banking industry has put in a solid performance over the past two years. The total assets of conventional banks increased by 13.6% to OR28.2bn ($73bn) in December 2015, up from OR24.8bn ($64.2bn) the previous year.

Much of this growth derived from the success of the industry in securing lending opportunities in a difficult economic environment. Credit extended accounted for 65% of assets and increased by 8.4% over the year to reach OR18.3bn ($47.4bn). Banks also succeeded in growing their deposit base, with aggregate deposits rising by 3.4% in 2015. Private sector deposits underpinned this expansion, jumping by 6.1% and accounting for 66.4% of the total sector deposit base by the end of the year. Government deposits, however, marginally declined as a result of the drawdowns necessary to tackle a growing fiscal deficit, a trend that was exhibited across the GCC in 2015 and 2016.

As with other jurisdictions, the relatively slow growth of deposits compared to the expansion of credit has led to concerns regarding liquidity. In 2016 the CBO took action in the form of an adjustment to its cash reserve requirements, expressing its satisfaction with sector liquidity but signalling that the matter will remain under review (see analysis). In terms of profitability, the banking sector received a significant boost in 2015 from recoveries on previous loan loss provisions, an increase in non-interest income and the successful containment of interest expenses.

The aggregate net profit of the industry rose from OR362.9m ($846.3m) in 2014 to OR393.4m ($1bn) in 2015, an increase of 8.4% over the year. Oman’s nascent Islamic banking segment grew at an even faster pace, posting a 69.7% rise in financing (the equivalent of credit extension in the conventional segment) and boosting its deposit base by 123.5%.

The upward trends of 2015 were broadly sustained in the first half of 2016. The three largest banks, which account for around two-thirds of sector assets, grew their aggregate assets by 10% in the first six months of 2016. Lending was up 11% and customer deposits increased by a more modest 3%, following the same pattern as the previous year. Profit for the period showed 4% year-on-year (y-o-y) growth, with Bank Dhofar posting the biggest rise in percentage terms, at 16%, and Bank Muscat recording the largest profit in absolute terms, at OR90.5m ($234.3m).

However, results from the third quarter in 2016 suggest the banking sector may be cooling off. The three largest banks saw only slight growth in net profit from the previous year, with aggregate assets and deposits remaining relatively stable. Meanwhile, lending was at 9.7% y-o-y, down OR1.3bn ($3.4bn). Combined banking sector results showed a modest downturn in net interest margins, and higher provisional charges are expected to slightly negatively impact profitability in the coming financial periods.

Despite the marginal decline in the sector, in October 2016 ratings agency Moody’s revised its outlook for Oman’s banking system from negative to stable based on positive projections of the country’s sector’s creditworthiness over the next year. The Omani government’s historic willingness to support banks financially signals the likelihood that profitability will remain high despite cooling off in growth, said Moody’s.

Lending

With liquidity under strain and a discouraging oil price outlook, the lending activity of Oman’s banks has been of particular interest to industry observers. The market is characterised by a high degree of personal lending, with personal loans accounting for 40.1% of total sector credit in 2015, by far the biggest component. In the first half of 2016 personal lending by conventional banks grew by 10.4% y-o-y, an acceleration that has been attributed by some as an attempt to secure credit before an anticipated interest rate hike.

However, the prudential limits applied to this segment mean that many banks will find it difficult to grow their balance sheets through further retail lending. The CBO caps retail lending at 50% of banks’ total credit portfolios and has introduced a debt burden limit defined as the portion of borrowers’ salary that is applied for loan repayments of 35% and 15% for personal and housing loans, respectively.

Those banks that have already hit the CBO’s personal lending limit can, of course, increase their corporate lending in order to gain more capacity to lend to the retail sector. The construction sector is the second-largest recipient of bank credit, and the government’s programme of economic diversification and investment in infrastructure projects has granted most contractors in the county robust order book positions throughout 2016 (see Construction chapter). However, should oil price volatility in 2017 result in the government further restricting spending, banks may be faced with reduced lending opportunities. Fewer tourists from oil-dependent economies in the region also threatens to subdue the project pipeline in infrastructure, hospitality, commercial and residential schemes.

Directing credit to the nation’s SMEs offers an alternative route to margin for lenders, although the higher risk and lower returns associated with the segment have acted as an impediment to credit extension in the past. The development of SMEs is considered a matter of national economic importance, and the CBO has taken steps to encourage banks to increase the amount of SME lending in their portfolios. In January 2016 the regulator instructed banks to adopt a new definition of SMEs established by the Public Authority for Small and Medium Enterprises and to ensure that 5% of their loan portfolios are devoted to the SME segment.

Outlook

The CBO’s response to the low oil price environment is likely to be a key industry theme in the short term. The coming year will reveal the efficacy of regulatory changes such as the new SME limit and the attempt to boost liquidity through an alteration in reserve requirements. While a prudent regulatory approach has left the industry well defended against adverse economic conditions, tighter liquidity conditions bring the downside risk of increased funding costs and lower margins. The direction of the oil price over the medium term, therefore, is the single most important factor governing the performance of the sector. Banks will be compelled to seek additional efficiencies if they are to maintain growth and expansion in the future.