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Industry Report Card: GCC Banks 2020 Industry Outlook: Stable Credit Fundamentals Clouded By Event Risks

Industry Report Card: GCC Banks 2020 Industry Outlook: Stable Credit Fundamentals Clouded By Event Risks

Rated banks in the Gulf Cooperation Council (GCC) should maintain stable financial profiles in 2020, barring any major increase in geopolitical risk or a sharp fall in oil prices. Our base-case scenario continues to exclude a full-scale military intervention in the region or a disruption in oil production or supply. However, we cannot completely exclude event risk related to geopolitical developments, as demonstrated by the recent attack on Saudi Aramco facilities.

In our view, GCC banks will successfully navigate a less-than-favorable macroeconomic environment in 2020 supported by their solid financial profiles. Banks took the opportunity of the transition to International Financial Reporting Standards (IFRS) 9 in 2018 to recognize the effect of the softer economic cycle on their asset quality indicators in a relatively conservative manner. Therefore, we believe that the amount of problematic assets, which we define as IFRS 9 Stage 2 and 3 loans, will likely remain stable, but we do not exclude transition between the two categories.

We expect GCC economies to show modestly stronger economic growth in 2020 after a dip in 2019 primarily explained by the effect of the aforementioned event on Saudi Arabian growth. However, GCC countries' growth will remain below that seen during the era of triple-digit oil prices. Growth will also likely be constrained against the backdrop of a broader global slowdown. We therefore expect net lending expansion to remain flat, in the mid-single digits on average. At the same time, we expect cost of risk will stabilize at about 1.0% of total loans, due in part to the stronger buffer of provisions that GCC banks accumulated over the past few years and linked to IFRS 9.

Furthermore, we expect that GCC banks' profitability will deteriorate slightly or stabilize at best. Profits will likely be negatively affected by the shift in global monetary policy toward lower interest rates for longer. We think this is already triggering a closer look from banks' management toward operating costs, including through higher digitalization and collaboration with fintech firms. We still believe that Gulf banks' core business activities (lending to corporates and retail clients) will be protected from fintech disruption. In the absence of credible alternatives for the financing of their economies, authorities in the GCC will continue to protect their banking systems, while at the same time supporting fintech companies through accelerators and sandboxes.

Banks in the GCC continue to display strong capitalization by global standards. Over the past year, we have affirmed most of our ratings on banks in the GCC. We have taken a couple of positive actions because of upcoming mergers or our view of higher systemic importance. We have also taken a few negative rating actions, primarily because of a deterioration in the operating environment (local or international). In addition, we have highlighted risks posed by the faster accumulation of external debt by the Qatari banking system, especially in a volatile geopolitical context. However, strong government capacity, willingness, and track record of support are mitigating factors.

Lending Growth Will Remain In The Mid-Single Digits

Compared with our initial expectations, the economic performance of the GCC countries in 2019 was negatively affected by the attack on Saudi Aramco facilities, which took a significant part of Saudi Arabia's oil production offline for a few days. We understand that lost production capacity was fully restored and therefore think that the dip in economic growth will be followed by a strong recovery in 2020. For other countries in the region, 2020 will also be marked by a slight improvement in their economic performance thanks to government spending and stable oil prices. We forecast that oil prices will stabilize at about $60 per barrel in 2020 and anticipate unweighted average economic growth for the six GCC countries of 2.5% in 2020, compared with 1.6% in 2019. This is still significantly below their performance during the era of triple-digit oil prices. GCC growth is constrained not only by a broader global slowdown but also specific factors. These include real estate supply/demand imbalances, weaker consumer confidence, the extended Qatar boycott, and policies that could be perceived as discouraging long-term immigration.

Growth in net lending recovered slightly, reaching an annualized 5.3% at mid-year 2019. We expect a slight acceleration in 2020 barring any unexpected shock. Higher government spending, supported by strategic government initiatives will support lending growth. In Saudi Arabia, we expect mortgage lending to be the primary component of loan growth. A surge in geopolitical risk, significant drop in oil prices--because of a higher-than-expected slowdown in the global economy--causing delays to some of these initiatives, and a drop in overall consumer confidence could severely affect our base-case scenario, however.

Chart 1


The Indicators Show A Stable Stock Of Problematic Assets

Paradoxically, the muted economic activity of the past four years did not result in a significant increase in nonperforming loans (NPLs). At June 30, 2019, NPLs to total loans for the rated GCC banks reached 2.8%, compared with 2.4% at year-end 2015. A combination of write-offs, restructuring of exposures to adapt to the new economic reality, and tighter underwriting standards explain this stability.

The amount of problematic loans (Stage 2 and Stage 3 loans under IFRS 9) averaged about 15% of total loans at year-end 2018 for banks that reported these numbers. However, several top-tier banks and a number banks with niche positions displayed stronger metrics. Kuwaiti banks did not disclose their numbers since the regulator is still finalizing the guidelines for adoption. Therefore, we have arrived at estimates for the banks that we rate and incorporated them in our calculated average. Under our base-case scenario, we believe that the amount of problematic loans will remain stable in 2020, barring any unexpected shock. We do not rule out some transition between Stage 2 and Stage 3 loans in both directions, which would keep the cost of risk at about 100 basis points (bps) of total loans.

On the vulnerability scale, we see Qatari banks, except Qatar National Bank, as the most vulnerable from an asset quality perspective. The continued boycott on Qatar and ensuing real estate price and hotel occupancy rate declines have resulted in significant pressure on some Qatari banks. We see an important correlation between any potential escalation or de-escalation of the boycott measures and deterioration or stabilization of Qatari banks' asset quality. Second-tier United Arab Emirates (UAE) and Saudi banks are also vulnerable. The significant decline in real estate prices in the UAE, due to the mismatch in supply and demand, and the declining health of the contracting sector and related supply chains in Saudi fueled Stage 2 loans in these countries. Top-tier Saudi and UAE banks fared relatively better than their smaller peers. Positively, we expect UAE real estate prices to stabilize and an improvement in Saudi economic performance in 2020. NPLs coverage increased mechanically, due to the adoption of IFRS 9, reaching 175.8% at June 30, 2019. Given the intrinsic vulnerabilities of the GCC region, we expect banks to continue increasing their provisioning levels.

The other source of latent risk is Gulf banks' international operations. Several banks have invested internationally over the past few years, with Turkey among the most popular destinations. Given Turkey's lackluster economic performance, exposed GCC banks will see some effect on their asset quality indicators. However, this risk remains confined to only a few players, some of which have the financial muscle to absorb it.

Chart 2


Funding Is Satisfactory And Liquidity Is Stable But Watch Out For External Debt

Growth in customer deposits continued to decline, reaching an annualized 3.1% in 2019, compared with 7.1% in 2018. This drop is explained by lower government deposits, particularly in Qatar, Oman, and Saudi Arabia. In Qatar, the reversal of foreign funding outflows led to a drop in government deposits. In Saudi, the government used some of its excess funds to pay contractors, carry its investment projects, and more generally inject liquidity into the local economy. In Oman, the trend was led by the movements of some large government-related entity (GRE) deposits.

We view GCC banks' funding profiles as satisfactory. Funding is dominated by core customer deposits, and the use of wholesale funding remains limited except for a few large and sophisticated issuers. The GCC banking system's loan-to-deposit ratio averaged 93.6% at June 30, 2019, compared with 92.8% at year-end 2017. This ratio ranged from a high 117.7% in Qatar to a low 57.5% for Bahraini retail banks (see chart 3).

Chart 3


The ratio of cash and money market instruments to total assets remained stable over the past 18 months due to muted loan growth, still-increasing deposits, and the deployment of excess liquidity in government debt issuances. We think that government issuances will continue to attract local and regional banking systems' and international investors' attention given the shift in monetary policy in the U.S. and Europe. At June 30, 2019, the coverage of short-term (less than one year) wholesale funding by broad liquid assets (by S&P Global Ratings' definition) stood at about 4.8x on average for rated GCC banks, compared with 3.5x at year-end 2016. The slight decline compared with last year was due to higher recourse to wholesale funding sources.

Only a sharp decline in oil prices could change our view on the funding and liquidity profile of GCC banks. If governments start to burn their deposits at a more rapid pace, amid lower revenue and/or a declining appetite for their issuances from foreign investors, we might see liquidity decline at GCC banks. This is not our base-case scenario, however.

Chart 4


Three out of the six GCC banking systems remain in net external asset positions--Saudi Arabia, the UAE, and Bahrain. However, with the change in global monetary policy stance, some of these systems might be tempted to pursue cheaper global liquidity, chasing banking systems with a good credit story. We are specifically concerned about the speed and the extent of the buildup of Qatari Banks' external debt. Outflows, in the aftermath of the boycott have completely reversed and a significant portion of external debt is still made of potentially volatile interbank deposits. This increases Qatar's vulnerability to event risks. It also explains why, under our hypothetical stress scenarios of an increase in geopolitical risks in the GCC, the country stood out as the most vulnerable (see related research).

Chart 5


Profitability Will Decline Slightly, Or At Best Plateau

First-half 2019 saw a slight decline in rated GCC banks' profitability and we think this trend will continue (see chart 6). The drop is underpinned by the compression of margins in the aftermath of interest rates cuts by GCC central banks, which followed the U.S. Federal Reserve. Additional upcoming cuts will pressure banks' margins.

Chart 6


As cost of risk is not likely to decline because of IFRS 9 implementation and the still uncertain economic environment, banks are adopting a more-aggressive approach toward their cost management. They will also try to leverage technology and redeploy staff or close branches. In the UAE, the number of bank branches has been declining since December 2014 (see chart 7), suggesting that banks have managed to migrate some transactions to alternative channels. We think this trend will continue in the next 12-24 months, with a similar movement also starting to emerge in Saudi Arabia.

Chart 7


Overall, we think that GCC banks' profitability will decline slightly because:

  • Loan growth will remain in the mid-single digits. Banks will continue prioritizing quality over quantity and shy away from lucrative but higher-risk exposures, especially since IFRS 9 requires lifetime provisioning for exposures with deteriorating credit quality or repayment issues.
  • The shift in global monetary policy is reducing banks' pricing, with potential additional cuts in the next 12-18 months. Given the significant contribution of noninterest bearing deposits in GCC banks funding profiles, their bottom line is negatively affected by this trend.
  • The cost of risk will remain at higher levels of about 100 bps, compared with 80 bps in 2019 (annualized). Banks will have to continue building cushions to cover a relatively high amount of Stage 2 loans.
  • Cost control measures will help alleviate some of these pressures, but the transition toward higher automation will take time and core lending activities will continue to require heavy human involvement.

Consolidation is an avenue that some Gulf banks have decided to take. Although the first wave of mergers was driven by banks with common shareholders, the second wave could be due to lower financial performance. This would mean deals primarily spurred by banks' management teams rather than shareholders, in our view.

Capitalization Remains Strong

GCC banks continue to display strong capitalization by international standards, with an unweighted-average S&P Global Ratings risk-adjusted capital (RAC) ratio of 11.2% at year-end 2018. We note, however, that capitalization has dropped over the past four years, from an average of 12.4% at year-end 2014, due to higher risk weights applied. This came following the revision of our methodologies and a number of negative rating actions in the GCC and Turkey, primarily. The average Tier 1 ratio for GCC banks increased by almost 100 bps between 2015 and 2019 due to muted lending growth, the issuance of hybrids instruments, higher dividend payout ratios, and the adoption of IFRS 9 (see chart 8).

Most capital boosting initiatives have taken the form of hybrid issuances in the past few years and this trend is continuing. This is because shareholders and other investors are less willing to inject core capital into banks and more interested in a continuous and predefined income stream from hybrid instruments. It is also because of the global and local liquidity environments, where yields are low. We expect the quality of capital to continue weakening. However, this trend has yet to have a negative effect on our assessment of capital quality.

Chart 8


Additional loss-absorbing capacity (ALAC) instruments and resolution regimes are absent in the GCC (with the exception of Oman where a resolution framework is in place), but might develop in the future. For the time being, we continue to see the governments of four out of the six GCC countries as highly supportive of their banking systems, and we expect them to intervene to prevent problems at systemically important banks. We assess the likelihood of government support as uncertain in Bahrain and we view the authorities as supportive in Oman. In both countries, we think that the government's capacity to extend support to its banking system has diminished over time. Although in Oman the authorities have adopted a resolution regime, there were no requirements to build ALAC for domestic banks. We continue to believe that the preferred solution of the authorities in a distress scenario will be to bail out the banks rather than bail in some creditors. If and when resolution regimes are implemented in other GCC countries, we might revise our view on government support depending on the authorities' approach.

Our Bank Ratings In The GCC Countries

The average long-term rating on banks in the GCC stood at 'BBB+' at Sept. 30, 2019, the same level as last year. This is in keeping with our outlook distribution, where 88% of outlooks are stable. The average stand-alone credit profile (SACP) is 'bbb-' indicating that our expectation of sovereign support in case of need continues to be a significant factor underpinning our ratings in the region.

At Sept. 30, 2019, 8% of our rated GCC banks had negative outlooks. This group comprises banks whose creditworthiness is under pressure because of the local operating environment or their international operations. We have one rated bank under CreditWatch with positive implications due to the high likelihood of a merger with a more creditworthy entity. The recent announcement of the final agreement on the exchange ratio is an additional step toward the completion of this merger.

Chart 9


Chart 10


Chart 11


Related Research

  • Tech Disruption In Retail Banking: GCC Banks Are Catching Up As Clients Become More Demanding, Sept. 8, 2019
  • Credit FAQ: A Sharp Increase In Geopolitical Risk Could See GCC Banks Require Sovereign Support, July 8, 2019
  • Islamic Finance 2019-2020: One Industry, Three Accelerators, June 24, 2019
  • The Future Of Banking: Fintech's Prospects In The Middle East And Africa, June 10, 2019
  • The GCC’s Current Wave Of Bank Mergers Is Almost Over, May 27, 2019
  • GCC Islamic Banks Will Likely Stay Resilient In 2019-2020, May 6, 2019
  • IFRS 9 Data Gives Clearer View Of Asset Quality Trends At Gulf Banks, March 25, 2019
  • Dubai Real Estate Downturn To Continue: Projections And Ratings Impact, Feb. 18, 2019

This report does not constitute a rating action.

Primary Credit Analyst:Mohamed Damak, Dubai (971) 4-372-7153;
Secondary Contacts:Benjamin J Young, Dubai (971) 4-372-7191;
Puneet Tuli, Dubai +971 4 372 7157;
Zeina Nasreddine, Dubai + 971 4 372 7150;
Additional Contact:Financial Institutions Ratings Europe;

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