Learning to survive the shocks

In theory, banking in Saudi Arabia should be a straightforward and immensely profitable business. The Saudi population is affluent, saves a lot and, because of Sharia (Islamic) law, does not expect interest on its bank deposits. And on the asset side of the balance sheet, Saudi banks are first in line to lend to the government of a country sitting on over a quarter of the world’s proven oil reserves.

In addition, Saudi Arabia’s banks have been protected in recent years not only from foreign competition but also from new domestic rivals. The central bank, the Saudi Arabian Monetary Agency (Sama), has not issued a new banking licence since 1988 – and even that was a one-off.

The downside to this easy existence is that Saudi banks are highly exposed to fluctuations in the Saudi economy, which, in turn, is extremely vulnerable to any fall in the price of oil – a commodity that still accounts for almost 40% of Saudi GDP. Over the past 15 years, the Saudi financial sector has been hit twice by sudden economic shocks. In the mid-1980s a sharp fall in oil prices led to cuts in public spending and a wave of bad debts. The 1990 Iraqi invasion of Kuwait led to a briefer crisis. Swift action by Sama put an end to a run on the banks, which had threatened the entire banking system.

Now Saudi banks are again under pressure from external events. This year, global overcapacity and weak demand from Asia have reduced the oil price to under $13 a barrel, down from over $20 two years ago. This has slashed government revenues and the budget deficit is likely to hit $7.5 billion in 1998, equivalent to more than 5% of GDP.

In the past, weak government finances have tended to hit the banks’ balance sheets. Much of the country’s industry is dependent on contracts with the government or state-owned oil company Aramco. In previous economic crises the government delayed paying its bills to Saudi companies, causing an economic downturn and defaults on loans made by the country’s commercial banks.

This time the government is taking care to limit the damage caused by the state of its finances. “The government is looking at ways of supporting the private sector,” says Andrew Beikos, senior bank analyst at Capital Intelligence, a bank rating agency based in Cyprus. “It is paying companies with special bonds – tradable IOUs. That may not be as good as cash, but it has kept liquidity in the system.” The government is also cutting spending by 10%. Some of the biggest reductions will be in military spending, which accounts for over one-third of the country’s budget. Foreign arms suppliers, rather than domestic industry, will be the hardest hit.

“The impact of low oil prices is not instantaneous,” points out Sandy Flockhart, managing director of the Saudi British Bank. “The government has tried to maintain spending levels as far as possible in the current climate. So far, the effect on cashflows and liquidity levels has been minimal. There is also evidence that the dependency of the private sector on government spending is much less strong than it used to be.”

Nevertheless, government spending remains high even in good years. “There is still a structural budget deficit that needs to be addressed,” says a local banker. “This is why the government has had to make use of instruments which finance the deficit indirectly.”

So far this year, Saudi Arabia’s banks have continued to report strong profits. Even so, last month, Moody’s Investors Service revised its financial strength ratings outlook on three banks, moving Saudi American Bank’s outlook on its C+ rating from stable to negative and turning a positive outlook on D+ ratings for National Commercial Bank and Saudi Dutch Bank into a stable outlook. The rating agency cited concerns about the impact of low oil prices on the asset quality of these banks.

Although admitting that banks are under pressure, Beikos is upbeat about the state of the banking sector. “In 1999, if oil prices remain low, there will be a lot of pressure on the banks’ asset quality, but for now we believe that the sector is performing well.”

This may have something to do with the fact that the country’s banks are well capitalized – many having been substantially recapitalized in the early 1990s. According to Capital Intelligence, Saudi Arabia’s banking sector as a whole had capital of more than 16% of assets, double the BIS minimum ratio, and is well provisioned.

Despite this, the sector highly exposed to the government and its actions. Lending to government and quasi government bodies rose as a proportion of Saudi banks’ assets from around 23% in 1996 to over 27% in 1997. With the rise in government borrowing, the figure is likely to be much higher this year. According to Saudi British Bank, commercial bank holdings of government debt reached over SR106 billion ($28 billion) in mid-1998. Some are more exposed than others. National Commercial Bank, the country’s biggest and oldest, has historically had a large proportion of its assets composed of government debt. For the moment this is not proving too great a strain. “The appetite for government risk is good,” says Beikos at Capital Intelligence. “But the banks will be expected to shoulder more of the burden and make facilities available to both public- and private-sector borrowers.” Flockhart at Saudi British Bank agrees that there is still a strong appetite for government debt. “We do expect to have to lend more to the Saudi government,” he says. “We do expect to be called upon by the private sector for greater financial support. But Saudi banks are generally willing and able to offer their assistance.”

At present, banking in Saudi Arabia is very much a local affair. The country has a tight-knit group of 11 big commercial banks. Three of them – National Commercial Bank, Riyad Bank and Al-Rahji Bank – are wholly owned by Saudi citizens and are the biggest retail banks. Then there are the five Saudi joint-venture banks. Saudi American Bank, Arab National Bank, Saudi French Bank, Saudi British Bank and Saudi Dutch Bank were once the Saudi subsidiaries of foreign banks but were “Saudi-ized” (part-nationalized) in the 1970s. Foreign banks now own stakes of between 30% and 40% in these banks, which do not have as strong a retail base as their wholly Saudi-owned counterparts.

The remaining banks are generally smaller institutions, which are almost entirely owned by domestic shareholders. Saudi Investment Bank and Bank al-Jazira remain the two smallest Saudi banks. But another two smaller banks, United Saudi Commercial Bank and Saudi Cairo Bank, merged in 1997 to form a middle-ranking bank, United Saudi Bank.

This merger may be a sign of things to come with outside competition increasing pressure for the Saudi banking sector to consolidate. In December 1997 finance ministers of the countries of the Gulf Cooperation Council – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates – agreed to a measure of increased banking competition. Banks from one GCC country will be allowed to open branches in another.

The bank that has expressed the strongest interest in taking advantage of this new openness is Gulf International Bank, based in Bahrain. There are rumours that it is seeking to form a partnership with a Saudi bank, or even to acquire one.

There is a growing feeling that the Gulf should have its own strong player in international banking. Given Saudi Arabia’s importance in the Gulf, any such regional champion seems likely to include a Saudi element.

A long, slow process

But Gulf-wide consolidation seems some way off. And most bankers in Saudi Arabia believe Gulf-wide banking integration will proceed slowly. “Harmonization and integration of banking in the GCC is laudable,” says Flockhart, “but it is also complex and slow. Commercial banking experience around the Gulf is varied – central banking rules and regulations, for example, are not yet standardized fully. That said, it’s clearly evident that banking practices have moved closer in the last two decades, particularly in areas like liquidity and reserve requirements, capital adequacy and so on. My own view is that Saudi Arabia has pushed for the establishment of sound banking practices in the GCC.”

For now, Saudi banks have little to fear from foreign competition. A Moody’s report describes local banks as “strong and well managed”. It continues: “We are not looking at a classic deregulation scenario in which protected banks are suddenly exposed to competitive pressure from a new group of players.” But in other ways the Saudi authorities are moving towards greater openness and increased responsiveness to market forces. In early 1998 Sama allowed Saudi banks to set up joint ventures with foreign insurance companies as a way to encourage the development of a local insurance market. Sama is also becoming more proactive in its management of money markets. It even intervened in the market on a Friday on one occasion this year – something that would once have been unheard-of in a country where little business is done on the Muslim day of prayer.

“The authorities have moved to a market repo system for setting interest rates,” says Misbah Shah, treasurer at Saudi American Bank. “It used to have a repo window with a mandatory rate of 5.7%. Now the rate is market defined and guided by Sama. That typifies its growing approach of using market tools as opposed to mandatory measures.”

New policies of this type have helped to keep interest rates in check in spite of the growing demand for debt. Even so, yields on government securities have risen. Whereas in the past interest rates closely tracked those of the dollar – to which the Saudi riyal is pegged – interest rates in Saudi Arabia are now around 1% higher than in the US.

Although Saudi banks face little immediate threat from Gulf neighbours, there is another source of competition for retail deposits, which still account for nearly 70% of banks’ assets. Islamic institutions such as Dallah Albaraka take substantial deposits in Saudi Arabia. Sama has resisted pressure for Islamic financial institutions to be given banking licences, perhaps for fear of the implication that Saudi Arabia’s existing banks are in some way un-Islamic. However, one of these Islamic institutions, the Al Rajhi Banking & Investment Corporation, gained a licence in 1988.

And there are other growing sources of competition for Saudi savings. Mutual funds remain relatively small but have grown in recent years. At the end of 1997 assets in local funds stood at some $5 billion. The growth of mutual funds has been one factor driving the growth of the country’s stock market. The market capitalization of shares listed on the stock exchange has grown from $40 billion in 1995 to over $60 billion this year.

But with banks and mutual funds working to attract funds currently invested offshore there is still considerable growth potential for Saudi Arabia’s banks in their domestic market. Most bankers are upbeat about the opportunities presented by regional integration, privatization and the diversification of the Saudi economy away from its dependence on oil. And the price of oil is by no means certain to continue its downward trajectory. “At this stage the impact of low oil prices is not significant,” says Flockhart at Saudi British Bank. “Business confidence remains high. And it might only take a further agreement on oil cutbacks or a bad winter in the western hemisphere for us to see oil prices swinging in the opposite direction.”