[gallery td_select_gallery_slide="slide" ids="29182,29183"] JEDDAH — Despite the challenges ahead, Saudi banks are forecast to maintain healthy capital positions, highlighting it as one of the core strengths of the Saudi banking system, Standard & Poor's Ratings Services said Wednesday in its report titled "Saudi Banks: A Tough Year's Ahead, With Risks To Growth And Asset Quality". Banks typically operate with high capitalization levels, with reported Tier I ratios ranging from 14% to 19% for the banks we rate as of Sept. 30, 2015. Among the top three banking systems by assets in the Gulf Cooperation Council, Saudi Arabia's has posted fairly steady returns in recent years, which have been key to the banks' stable capital ratios. For the rated Saudi banks, the aggregate return on equity has stayed at about 15% for the past five years, thanks to a 40 basis-point improvement in credit losses that largely offset a 60 basis-point drop in the net interest margin. During the same period, Qatari banks, on the other hand, saw a decline in profitability, primarily due to a sharper decline in margins; while banks in the United Arab Emirates showed a steady rise in profitability, mainly due to much lower cost of risk. "In our view, Saudi banks will have very few avenues to improve their profitability over the next few years. We expect that net interest margins may stabilize in the coming quarters as assets are repriced faster than liabilities, with the exception of retail-focused banks." However, this will likely be offset by a gradual increase in credit losses and the cost of funding over the medium term. Consequently, we anticipate limited revenue growth and a drop in profitability for rated Saudi Banks in 2016, S&P said. Saudi Arabia's banking system has enjoyed a buoyant operating environment over the past four years, posting double-digit average growth of assets, loans, and deposits, alongside a decline in credit losses and a significant improvement in nonperforming loan coverage ratios. But with the drop in oil prices, several challenges emerged in the second half of 2015. While credit growth lost some momentum, local interest rates started increasing in response to tightening liquidity. Although banks' asset quality did not come under threat, potential risks emanate from certain sectors, such as construction, where contractors are reportedly facing payment delays. "In particular, we expect credit growth will contract to mid-single digits, given the strong correlation between oil prices, government spending, and credit growth," said Standard & Poor's credit analyst Suha Urgan. "We also anticipate that asset quality will deteriorate but remain tightly managed, owing to countercyclical buffers the regulator has imposed in recent years, and we expect further tightening of overall liquidity conditions, leading to higher funding costs." Urgan said "in our view, the sharp drop in oil prices and the resulting impact on Saudi Arabia's fiscal balance will weaken operating conditions for the banking sector. We expect banks' profitability will decline in 2016, owing to lower credit growth combined with a rise in funding costs and credit losses." "Our negative outlooks on the eight Saudi banks we rate reflect that on Saudi Arabia, as well as our view of negative economic and industry risk trends. "Despite the challenges ahead, we expect banks' healthy capital positions will remain one of the core strengths of the Saudi banking system," added Urgan. Though pressure on asset quality will increase in 2016, the report said it expects credit conditions for Saudi banks to deteriorate in 2016, resulting in an increase in credit losses and NPLs. "However, we expect banks will be able to manage the decline in asset quality, thanks to the countercyclical buffers SAMA has enforced in recent years. If oil prices stay low for a prolonged period, we expect the debt-servicing capacity in the private sector to weaken. This is due to the close link between corporate profitability and oil prices, as demonstrated in 1998 and 2009, when oil prices dropped sharply. In addition, the government has recently increased fuel, electricity, and water tariffs, which will inflate companies' utility expenses and eat into their profits. We also expect that tighter market liquidity will weigh on corporate balance sheets." A key source of risk for Saudi banks lies in the contracting sector, which was tested in 2015 by reported delays in government payments and tighter approval requirements for project values above a certain threshold. "We expect some delinquencies to come from this sector in 2016, which for Saudi banks we rate represented 7%-10% of gross loans and 26%-40% of equity as of year-end 2014. We note that Saudi banks' loan books remain concentrated, with the 20 largest lending exposures making up more than 25% of most banks' loan books." Among the listed enterprises in Saudi Arabia, those in the petrochemicals and energy sectors issued about 60% of corporate debt as of year-end 2014, based on data from the International Monetary Fund. This poses substantial concentration risk for Saudi banks, S&P said. "Nevertheless, the data also suggest that short-term debt accounts for only 15% of total corporate debt and corporate entities generally have healthy debt-coverage ratios. We believe Saudi banks have adequate cushions to cope with asset-quality deterioration, since their NPL ratios are fairly low and are backed by sufficient loan loss reserves (see tables 1 and 2). For the banks we rate, the aggregate NPL ratio was 1.2% as of Sept. 30, 2015, well below the peak of 3.3% in 2009. However, we expect NPL formation to accelerate over the next few quarters and the ratio to climb to 2%-3% or higher over the next one to two years."
