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Credit FAQ: Key Risks For Banks In Select EMEA Emerging Markets

This report does not constitute a rating action.

Many emerging market economies have been affected by the COVID-19 pandemic and the Russia-Ukraine conflict. Here, S&P Global Ratings responds to the main questions received from investors on banking sector vulnerabilities in Saudi Arabia, the United Arab Emirates (UAE), South Africa, Turkiye, and Central and Eastern Europe (CEE). Some banking systems face similar risks, for example, related to the effects of higher global interest rates or slowing local economies on their asset quality indicators. However, others face unique challenges related to high external debt positions and idiosyncratic fiscal and monetary policy decisions.

Frequently Asked Questions

Why is there less abundant banking system liquidity in Saudi Arabia?

We see a few reasons for the liquidity pressure:

  • The banking system experienced very rapid growth over the past few years, primarily driven by mortgages since increasing home ownership to 70% is a Vision 2030 objective. At the same time, deposit growth has not kept pace to fund this expansion, leading the system loan-to-deposit ratio to exceed 100% at year-end 2022 from about 86.4% at year-end 2019 (see chart 1).

Chart 1


  • Private sector deposit growth has averaged about 5% over the past five years, compared with 14% growth in deposits from the government and its related entities (see chart 2). We note that the government still held significant deposits with the Saudi Central Bank (SAMA) of Saudi riyal (SAR) 637.5 billion at year-end 2022. This means that it can, theoretically, ease liquidity constraints by placing more deposits with the banking system.

Chart 2


  • The government has created the infrastructure for banks to divest their mortgage portfolios and improve the structure of their balance sheets. However, banks are yet to sell large volumes of mortgages because a significant portion are low risk (primarily to civil servants and backed with salary assignments). Also, with the increase in interest rates, any divestment from fixed rate mortgages could result in some revaluation losses.
How did the Saudi authorities react to this liquidity stress and what are your expectations for the next 12-24 months?

SAMA intervened and injected SAR50 billion in 2022 and we expect it to continue providing banking system liquidity when required. We view the Saudi authorities as highly supportive toward their banking system and expect that systemically important banks will receive extraordinary support if needed. Given liquidity constraints and the progressive saturation of the mortgage market, we think that lending growth will slow and shift toward corporates as Vision 2030 contracts are awarded. In first-quarter 2023, growth already slowed to an annualized 10% compared with 14% in 2022.

In your view, can the Saudi banking system provide funding to Vision 2030 projects?

Not alone, given the reported value of these projects exceeds the size of the banking system. Therefore, it will require a combination of developing the local capital market and tapping the international capital markets. We expect the Saudi banking system will continue to play a key role, with high-single-digit percentage net loan growth in the next couple of years. Banks can achieve this by mobilizing additional resources in the form of deposits or local and international issuances--although in a context of higher-for-longer interest rates--or by divesting some mortgage lending to make space for corporate loans, at the risk of crystallizing some revaluation losses. From a risk perspective, it is unclear if lending to Vision 2030 projects will increase the concentration of Saudi banks' lending books. We understand that some projects will be fractionalized to make them easier to finance. Lending book concentration is already a source of risk for Saudi banks and in the wider Gulf Cooperation Council.

What are your expectations for UAE banks' asset quality indicators and could the implementation of corporate tax increase risks?

We expect the UAE's economic growth to slow in 2023, following a rapid post-COVID-19 recovery, due to agreed OPEC+ oil production cuts and deceleration in nonoil sectors amid higher interest rates. This will likely lead to slower lending growth, which we started to observe in second-half 2022. In our view, problem loans will increase slightly this year due to the economic slowdown and higher interest rates, with small and midsize enterprises (SMEs) in the trade and construction sectors as key contributors (see chart 3). We understand that banks are taking a pragmatic approach in passing higher interest rates on to their clients. If reflecting higher rates will make a client default, banks are likely to not pass on the full increase, or proactively restructure the exposure.

Chart 3


We don't expect corporate tax alone to lead to asset quality issues for banks, since it will be paid based on net income, after interest charges. The tax regime is still evolving but the 9% rate is low in a global context and companies need to meet certain revenue and net profit thresholds for it to apply, while there are also exceptions. Therefore, we don't expect significant pressure on companies' cash flows. Inflation and increasing costs are another important consideration that could pressure some corporates, although the official inflation rate is lower than what we observe in advanced economies.

How do you view the energy crisis in South Africa and its effects on banks?

South Africa's energy crisis and infrastructure gaps are clearly undermining the country's short- and medium-term growth prospects. We forecast slower GDP growth, as well as moderate growth in private sector credit to 5% in 2023, after a rebound in 2022. However, we think that the renewables sector could provide a growth opportunity for the banking system.

We think households' disposable income will be pressured by the additional costs of securing alternative power solutions, and higher interest rates. Prolonged electricity shortages will weigh more on SMEs than large corporates, which are likely to pass the costs on to customers. In terms of credit losses, we expect that the banking sector's cost of risk will remain slightly higher than the historical low of 0.75%, averaging 1.1% of total loans through 2024, and that nonperforming loans (NPLs) will remain at about 4.0% of systemwide loans. Positively, banks' earnings have improved since the 2020 pandemic shock, supported by higher interest rates. This has led to stronger capitalization, and they operate in a closed rand system with limited exposure to external refinancing.

In your view, what are the key risks for South African banks' operations on the continent and do you expect to see any rating impacts?

Operations in other African countries amount to about 10%-15% of the relevant banks' total exposures--spread over other countries in South, West, and East Africa. These groups primarily face traditional challenges such as exposure to economies that are riskier than their home market; external debt risk, mainly at the sovereign level; risks related to the political environment in some countries; and commodities price risk. However, to their credit, South African banks are prudently managed. Their operations in other African countries also benefit from this expertise transfer and help develop local banking sectors. Assets in Ghana, for example, averaged less than 1% of group assets and banks have impaired their exposure to the country's sovereign debt to average about 50%, which is above market expectations. Overall, we do not expect risks related to expansion outside of South Africa to weigh on our ratings on South African banks.

How do you perceive South African banks' capitalization and more generally the regulatory framework?

Banks have preserved capital though the cycle and maintain robust buffers against the minimum capital adequacy requirements; about 390 basis points (bps) on average for the common equity Tier 1 (CET1) ratio for top banks, for example. They also started adopting Basel III in 2013 and the South African Reserve Bank (SARB) recently updated its guidance on the rest of the Basel III reforms due by 2028. In particular, the SARB decided to phase out the 35% amount of stable funding (ASF) factor to 0% through 2028 for short-term wholesale funding of less than six months. Banks are expecting to replace this source of funding with customer deposits or capital market funds. The SARB will also adopt a resolution regime and we expect some clarity on the calibration of the additional loss-absorbing capacity (ALAC) instruments to be issued by domestic systemically important banks by year-end 2023. We also forecast the sector will maintain more than adequate risk-adjusted returns of 15%-16% on average, which will support banks' internal capital generation.

What is your view on the monetary policy in Turkiye and the lira (TRY) exchange rate?

Our outlook on interest rates and the lira is highly dependent on the policy setting after the second round of presidential elections later this month. Under our base-case scenario, we forecast a continued depreciation of the Lira. Turkiye's monetary policy combines low nominal policy rates and a patchwork of macroprudential regulations intended to sustain growth and suppress foreign currency (FC) demand by tightening domestic liquidity conditions. Since September 2021, the Central Bank of the Republic of Türkiye (CBRT) has lowered the policy rate (one-week repurchase rate) 1,050 bps, even with inflation hitting multiyear highs and nearly all major global central banks moving in the opposite direction.

A consequence has been a weak and volatile exchange rate, extremely high inflation, and increasing imbalances. Absent positive real interest rates or significant useable FC reserves, and amid recent weakening inflows of savings into FC-linked deposits, policymakers have resorted to other measures to contain lira depreciation. These include the use of financial and capital controls. Turkiye's monetary authority and financial regulator continue to impose FC surrender requirements on exporters, press banks to lend to the government and the corporate sector at steeply negative real interest rates, and curtail firms' preference to accumulate FC buffers against currency depreciation by restricting access to credit whenever their FC positions exceed regulatory ceilings, among other measures.

What are the key risks for Turkish banks?

We see two main vulnerabilities.

The first vulnerability is the risk of an unwinding of economic imbalances accumulated in previous years, including from a surge in real estate prices and highly accommodative monetary policy in a hyperinflationary environment. Additionally, credit growth in the country has been extremely high for the past few years. Although the rise in house prices has helped banks' asset quality by increasing the valuation of real estate assets held as collateral, we think the risk of a sharp correction is increasing. In our view, if house prices drop steeply, it could eventually result in substantial credit losses for the banking system. We expect the Turkish lira to further weaken amid higher interest rates in developed markets and local challenges. This is also eroding the creditworthiness of Turkiye's corporates, which are still highly indebted in FC. We currently expect banks' credit losses to increase to about 3.5% in 2023 compared with 3.2% in 2022, and NPLs to remain contained at 5%-6% of total loans in 2023 after a low 2.2% at year-end 2022. Our estimates also factor in a preliminary impact from the recent earthquake. That said, we acknowledge that NPL ratios in Turkiye are also influenced by many restructured loans not being recognized as delinquent, as well as rapid credit expansion inflating the ratio's denominator. We see significant risks to our projections, particularly in the event of a monetary policy reset, significant depreciation of the lira, or higher impacts from natural disasters.

The second vulnerability is the rollover of external debt. Under our base-case scenario, we still expect Turkish banks to be able to access external funding, and external debt to reduce gradually over the next few years if the government can contain balance-of-payment risks. However, banks remain highly vulnerable to negative market sentiment and risk aversion due to their still-high external debt ($132.5 billion if we use the international investment position data at year-end 2022 [see chart 4]). Therefore, we consider that lower, more expensive global liquidity heightens refinancing risks.

Chart 4


Although Turkish banks have sufficient FC liquidity to handle lower roll-over rates, most is either with the central bank or placed in government securities, which could reduce its availability in a highly stressed scenario. In addition, we see a risk that depositors might lose confidence in the banking system. We note that deposit dollarization dropped to about 40% at mid-May 2023 due to the prolongation of the protected local currency deposit scheme and to the regulator forcing banks to convert some of their deposits into local currency at the risk of incurring significant costs.

Do you expect CEE banks to comply with their minimum requirements for own funds and eligible liabilities (MREL) given high rates?

Like other European banks, CEE banks need to meet their MREL targets by Jan. 1, 2024. The largest and market leading banks in CEE countries are typically subsidiaries of European banking groups (except for Poland and Hungary). We understand that most CEE banks have already met their informative MREL targets for 2022 and 2023 thanks to high Tier 1 capital, which makes up a substantial part of MREL under EU law. Some banks still need to issue MREL-eligible debt during 2023 to meet their final targets.

Depending on the type of resolution strategy with their parent group--single or multiple point of entry--and whether there is a subordination requirement to meet MREL needs with subordinated debt instruments, banks will face different cost of funding for such instruments. These have increased significantly since interest rates picked up across the CEE countries. We expect banks to continue with their issuance plans, because not meeting MREL targets could hurt their reputations and lead to regulatory interventions.

The prevailing legal risk on Swiss franc (CHF) mortgages continues to complicate market access for some Polish banks. A few may be at risk of breaching their MREL in 2024 if the situation does not improve, although there could be better visibility on this following the European Court of Justice ruling on bank remuneration expected for June 15, 2023.

What is your view on deposit funding and costs for CEE banks?

CEE markets are roughly one year ahead in the interest rate cycle compared with the eurozone. Banks in these markets have already repriced deposits and the effect on margins is visible when looking at first-quarter 2023 results in Czechia or Poland, for example. Although deposit rates will clearly remain higher than before, some CEE banking markets are highly concentrated, which leads to pricing power for large players. This means that banks have somewhat more flexibility with their deposit pricing than in other more competitive markets, like Germany and Austria. We expect deposits to remain the most important part of CEE banks' funding compositions, but they are now costlier and can be moved faster than before given digital solutions that lower switching costs.

Where do you see CEE banks' asset quality in the next 12-24 months?

So far, there are no indications of asset quality deterioration. However, we expect a slight pickup of NPLs and loan loss provisions during 2023 for most markets except Hungary, where we expect the NPL ratio to double toward 5.5%.

Our views of the economic risk trends in some CEE banking markets have become negative, for example in Hungary and Czechia. This reflects that significant slowdowns or recessions in these economies could lead to defaults and rising credit losses. The high dependence of relevant industries (auto and manufacturing) in CEE countries on other European economies, like Germany, and tight integration of supply chains into overall EU trade flows, could hurt some regional companies. Moreover, sectors with high energy dependence are under pressure because of volatility in energy input prices to produce their goods.

However, fundamental indicators such as unemployment and GDP (growth and volatility) do not indicate severe risks ahead. In our view, elevated inflation and significantly higher funding costs will likely have a negative, yet manageable, effect given this is offset by wage growth in most CEE countries. We also do not expect housing market corrections in the countries we follow.

That said, Hungary and Poland are worth highlighting. In Hungary, risks related to the disbursement of EU funds may have wide-reaching implications for the economy and banking system, if they materialize. Meanwhile, in Poland, the open legal cases around FC-mortgage loans may be an additional burden on the system.

Primary Credit Analyst:Mohamed Damak, Dubai + 97143727153;
Secondary Contacts:Samira Mensah, Johannesburg + 27 11 214 4869;
Regina Argenio, Milan + 39 0272111208;
Anna Lozmann, Frankfurt + 49 693 399 9166;
Cihan Duran, CFA, Frankfurt + 49 69 3399 9177;

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