Kingdom's banking outlook stable; challenges ‘remain' JEDDAH – The outlook for the Saudi banking system is stable, underpinned by the sector's resilience and its ability so far to absorb the impact of the global financial crisis and deteriorating macroeconomic conditions. Moody's Investors Service said on its comment for June. Moody's believes that the banking sector will benefit from the Saudi government's continued commitment to supporting the economy with an expansionary budget and numerous infrastructure projects. Indeed, the Saudi government has prudently invested its oil revenue windfalls of recent years and has historically been the main driver of economic activity. The impact of the financial crisis has been contained, as Saudi banks are not significantly dependent on market funding, while any losses from structured products and other risky investments have been comfortably absorbed. The 10 Saudi banks rated by Moody's not only have established and defensible local franchises, but have also improved their risk-management culture in recent years aided by Basel II implementation. Moody's stable outlook is further supported by the Saudi banking system's strict regulation, close monitoring and systemic support, which have ensured that the sector remains adequately funded and liquid and is well-prepared to cope with economic downturns. “We note that current operating conditions remain tough, with nominal GDP in 2009 likely to decline by 10-15 percent due to the reduction in oil revenue. Although we expect these conditions to lead to deterioration in the Saudi banking sector's financial metrics, we believe that the metrics are likely to remain supportive of the banks' current ratings,” the report said. The downside risks implied by the volatile market conditions could be exacerbated by a further deterioration in the operating/macro conditions and a worse-than-anticipated deterioration in asset quality. In particular, private sector corporate and family-owned businesses remain the most vulnerable loan category. If these weaker-than-anticipated parameters do materialize - and this is a key risk - then the profitability and capitalization metrics of Saudi banks would also be affected, it said. “This outcome could prompt us to consider changing the outlook for the sector, reflecting the sector's resilience and its ability so far to absorb the impact of the global financial crisis and deteriorating macroeconomic conditions. Although the Saudi Arabian banking system has proved to be robust, well-regulated and relatively stable, “we believe that some operating and regulatory environment challenges remain.” Indeed, the Saudi banking sector has to cope with the high concentrations in lending and deposit, mismatches in the maturity profiles of assets and liabilities, scarce human capital, the continued limited diversification of the Saudi economy beyond the hydrocarbons sector and volatility in the country's real and nominal output, and the strong loan growth of recent years, which is only now being tested by more challenging operating conditions, Moody's said. Moreover, Moody's said the Arab world's banking sector, as a whole, “has proven fairly resilient to the current crisis, mainly due to profitable domestic markets, ample liquidity and successful banking reforms. Bankers in the Arab world have had little incentive to seek inflated returns abroad and their activity in domestic markets helped to part-insulate the banking systems across the Maghreb and Mashreq. We also consider that regulation and supervision within banks in the Arab world has improved dramatically, helping financial institutions to better allocate assets and manage their risks more efficiently.” However, the report added that “this does not mean that risk-immunity is something that characterizes the banking systems and asset types of the Arab world.” The risks in the region are more idiosyncratic than globally driven, but mainly center around the maintenance of political stability (both regional and local), and the price of oil. Our ratings have, however, we believe accurately reflected these factors and the concentration risks and volatility, all of which have culminated in largely stable ratings on banks in the Arab world. On Islamic finance, Moody's said both structural factors and economic cyclical drivers have contributed to the rapid increase in the size of Islamic finance since the early years of the current decade. Islamic banks have so far been very resilient, it noted. Altogether, the industry is still heavily dependent on oil for its own liquidity requirements and growth. There is a close correlation between oil prices and the pace at which Islamic finance has expanded; for as long as hydrocarbons remain expensive, Islamic finance will continue to grow. Islamic finance is expanding geographically, despite the crisis. It has extended its influence into Western banking markets, and in Muslim Asia. This implies that the gradual internationalization of Islamic finance has been due more to structural features rather than economic cycles. Today, the market is driven by demand, not supply, as was the case around 30 years ago. Islamic banks' main competitive advantage comes from the structure of their deposits base, which is dominated by retail deposits that are ample, stable and cheap. Therefore, margins are wide, which helps sustain both capital and liquidity - a critical strength in times of global financial turmoil. Diversity has been increasing in Islamic banking, which now comprises three broad categories of market participants (i) relatively diversified commercial banks; (ii) specialised financial institutions, mainly in retail and mortgages; and (iii) Shariah-compliant investment banks. In a bull market, the latter outperforms the two first categories (as was the case between 2003 and 2007); but in times of financial stress, Islamic investment banks are the most severely hit. They do not suffer because they are Islamic, but because they have no access to retail deposits, and suffer from high funding concentrations while their assets remain volatile, risky and concentrated. The Sukuk market was the other compartment of the Islamic market that reacted immediately to the liquidity drought. Under normal conditions, Sukuk issuance should have reached at least $50 billion in 2008, but only $15 billion was successfully priced and placed in the market. Spreads widened to the point where issuers did not really consider Sukuk as a credible alternative for funding (despite similar spread widening across all types of debt). In 2009 however, the market recovered, essentially because of sovereign intervention. Corporates and banks are still lagging this recovery as they are more concerned with stabilising their funding sources, managing their risks, and monitoring existing portfolios rather than issuing debt.
