November 17, 2019:   Rated banks in Saudi Arabia should maintain stable financial risk profiles in 2020, barring any unexpected increase in geopolitical risk or a major fall in oil prices. S&P Global Ratings does not envisage these scenarios in our base case, however, we cannot exclude event risk--as demonstrated by the recent attack on Saudi oil infrastructure.

 

We believe the Saudi economy will recover from the 2019 recession, linked to the attack, next year. In our view, government spending should somewhat revitalize corporate lending, although mortgages are still likely to lead credit growth, which will stay at about 5%. Cost of risk should also stabilize at about 75 basis points (bps) on the back of buffers created thanks to International Financial Reporting Standards (IFRS) 9. In addition, we expect Saudi banks' profitability to decline slightly as global monetary policy softens and rates decline.

 

Lending Growth Will Remain Mortgage-Led

 

Our base-case expectation is that lending growth will pick-up in 2020 as public investments somewhat revitalize demand for corporate credit. We believe mortgages will remain the key spur for credit growth (see chart 1) as the government's Vision 2030 transformation plan strives for 60% home ownership among Saudi citizens and a 16% share of mortgages in bank financing by year-end 2020. This compares with about 11.2% of total private sector credit at mid-year 2019. As a result, we expect that mortgage lending will continue increasing about 30% per year, in line with 2019 levels or even slightly faster.

 

Asset Quality Will Stabilize

 

The long rebalancing of the Saudi economy surprisingly did not result in a material increase in nonperforming loans (NPLs). The NPL ratio has stabilized at 1.9% of gross loans in 2019, comparing favorably with 2.8% for Gulf Cooperation Council (GCC) banks, but up from 1.2% at year-end 2015. This relative stability was achieved through a combination of write-offs and restructuring of exposures to adapt to the new economic reality.

 

Similarly, problem loans (Stage 2 and Stage 3 loans under IFRS9) averaged about 11% of total loans at year-end 2018, somewhat better than the 15% average for GCC banks. Under our base-case scenario, we expect the Saudi economy to pick up, resulting in stable asset-quality metrics at banks. That being said, we do not rule out some transition of loans between IFRS9 stages over the remainder of 2019 and 2020, resulting in an average cost of risk of about 75 bps.

 

In our view, the remaining pockets of vulnerability in the market are predominantly associated with asset prices. According to the General Authority for Statistics, residential real estate prices decreased 18% from 2015 to third-quarter 2019, with commercial real estate down about 25% and a heavier decline in Riyadh. We expect that property prices will be supported by government-led initiatives and somewhat stronger economic growth. Nevertheless, the general market trend is of weakening prices and rents across various segments and we consider the sector vulnerable to unexpected changes in economic growth.

 

 

External Borrowing Will Likely Increase

 

The pick-up in lending, along with an expansionary government budget, has revitalized deposit creation. Private sector deposits increased by 3% year on year to June 30, 2019, and we envisage 5% growth by year-end 2020 on the back of accelerated lending growth.

We think lower interest rates from global central banks and pronounced domestic demand for credit could mean borrowing from abroad increases, after rising $14.4 billion in the first nine months of 2019--predominantly from foreign banks. Nevertheless, we expect the sector to retain its position as a net external lender.

 

Only a sharp oil price decline could change our view on the funding and liquidity profile of Saudi banks. This may come if we see the burning of client deposits due to lower oil export revenue, combined with lower foreign investor appetite for Saudi risk. However, it is not our base-case scenario.

 

Capitalization To Remain Sound

 

We consider Saudi banks' capitalization to be strong in an international context, with an unweighted-average S&P Global Ratings risk-adjusted capital (RAC) ratio of 12.8% at year-end 2018. We believe our RAC ratio will remain at 12.5-13.0% in 2020-2021, which is high in an international context. However, the metric has somewhat declined since year-end 2017 owing to the introduction of IFRS9 and a settlement with zakat (religious tax) authorities in late 2018.

 

Since then, Tier 1 ratios have improved to 18.3% at mid-year 2019 from 17.5% at year-end 2017.

 

This largely reflects low credit growth in the country and banks' shift toward government and

 

 

Saudi Arabian Monetary Authority (SAMA) exposures. We also note, however, that reduced capital charges on mortgage lending (50% since 2019, compared with 100% in 2017) have proven to be an important driver for capital preservation. According to our estimates, banks were already saving about Saudi riyal (SAR) 5.7 billion in regulatory capital ($1.5 billion or about 1.5% of the total) at mid-year 2019 from this initiative. We expect the divergence between our RAC ratio and regulatory metrics will increase alongside forecast mortgage portfolio growth in 2020.

 

On the regulatory side, Vision 2030 commits the country to full compliance with international financial stability standards by 2020. Although SAMA has been proactive in implementing Basel III regulations and enforcing tight credit standards for retail lending, progress on the resolution regime has stalled. It remains to be seen if there will be any further momentum in 2020.

 

Profitability Will Decline Slightly As Rates Soften

 

Saudi banks, like their GCC peers, have long dollar interest-rate positions. This is due to the sizeable share of noninterest bearing deposits in the funding structure and the long-standing peg of the Saudi riyal to the U.S. dollar. As a result, the shift in global monetary policy toward a more accommodative stance, with the U.S. Federal Reserve cutting rates three times since July 2019, will have negative consequences for Saudi banks' margins.

 

Based on banks' disclosures, we estimate that a 25 bps shift in the Federal Reserve's Funds rate, and a corresponding shift from Saudi authorities, means a decline in net special commission income of 1.7% (about $300 million for the banking sector as a whole). This translates to an 8 bps decline in net special commission (interest) margin (NIM), or a 5 bps decline in pre-provision return on assets. Therefore, average NIMs are likely to trend toward 3%, down from about 3.36% in second-quarter 2019. At this stage, it appears unlikely that demand for credit will offset global rate dynamics.

 

New Technologies And Mergers Are Unlikely To Affect The Landscape

 

Saudi Arabia is still only in the early stages of becoming a cashless society, with an instant payment system set for 2020. The country still lags Europe and the U.S. when measured by transactions per card and has a higher average check per transaction. Nevertheless the shift toward cashless payments has been pronounced. In 2015, point of sale (POS) transactions constituted only 18% of total of cash withdrawals from ATMs, with the figure reaching 28% in second-quarter 2019. The number of cleared checks has also been declining steadily. Data disclosed by banks varies significantly, but they have uniformly reported marked increases in the use of digital channels such as internet banking and mobile applications, alongside reduced utilization of branches. As a result, over 2018-2019 the number of branches in the country increased by only two. The global shift toward electronic payments, along with ongoing technological innovation, will be important for competition in the years ahead.

 

 

Disruption, however, is unlikely in the short term. At this stage, the Saudi banking sector seems more focused on efficiency and cost optimization than developing innovative business models and the population still relies significantly on cash for daily settlements. Even in the longer term, large Saudi banks are well positioned to withstand pressure from new technologies and challengers. With robust earnings and concentrated retail clientele, they have sufficient capacity to entrench their positions. Furthermore, they control most transactional data sought by fintech companies, with the top-three retail banks controlling 53% of all POS terminals in the country as of third-quarter 2019.

 

The competitive landscape is also becoming more concentrated and crowded. SAMA has granted licenses to six international banks since 2017, increasing competition for corporate clientele. Moreover, the merger between Saudi British Bank and Alawwal in June 2019 means the top-five banks now control about 67% of assets, up from about 64%. Should the discussed merger between National Commercial Bank and Riyad Bank take place, the five largest banks may well account for 75% of assets. This, along with still stagnant corporate business, may test smaller institutions in the long term.

 

Our Bank Ratings In Saudi Arabia

 

The average long-term rating on banks in Saudi Arabia stood at 'BBB+' at Sept. 30, 2019, the same level as last year. This was in line with the outlooks on the banks, which were stable. The average stand-alone credit profile was 'bbb+', one notch higher than the anchor level for a bank operating in the country. This is predominantly owing to the strong capitalization of Saudi banks. Although we consider Saudi Arabia to be highly supportive toward its banking sector at present, we do not add any additional notches to our ratings owing to the near-convergence of banks' and the sovereign's intrinsic creditworthiness.