The Saudi banking sector is projected to be among the most profitable and efficient in the GCC region with a net interest spread of 3.5 percent, return on equity of 24 percent, and an average capital adequacy ratio (CAR) of around 15 percent, a comprehensive research report on the Saudi Arabian banking sector released recently by EFG-Hermes, a leading investment bank in the Middle East and North Africa (MENA) region, said. The report, entitled “Best of Both Worlds!,” provides an in-depth analysis of the Kingdom's banking sector, which is the second largest in the GCC region by asset size, currently estimated at $290 billion as of December 2007, after the UAE's banking sector, which registered total assets of $336 billion in the same period, though the degree of concentration in the former's banking sector is moderately high with only 12 banks compared to 49 in the latter. EFG-Hermes predicted in the report that increasing corporate credit, which registered 23 percent growth in 2007, would mark the beginning of a new credit growth cycle for Saudi banks. “We believe that the banking sector in Saudi Arabia is in the midst of a structural upturn. After a brief lull lasting from the middle of 2006 to the middle of 2007, demand for credit rebounded sharply, posting 23 percent year on year growth in 2007. The trend has continued into the first quarter of 2008 with total loans of the banking sector rising 33 percent compared to the first quarter of 2007,” it said. “We believe that this is the beginning of a cycle of strong credit growth for Saudi banks, driven by the economic diversification drive supported by the government and rising domestic demand, which are leading to an increase in investment in domestic production capacity. Over the last 18 months, projects amounting to $380 billion have been announced, which include expansions as well as the establishment of new companies in refining, fertilizers, petrochemicals, aluminum, electricity generation, as well as the establishment of new economic cities.” EFG said the pickup in the investment cycle had shifted the focus of banks on growing their corporate loan books after spending most of 2006-2007 dealing with the slowdown in consumer finance and declining brokerage income. “Corporate credit, in our opinion, is likely to be the key driver for banks in the medium term, with much of it being absorbed by infrastructure spending and industrial expansion. With the development of mortgage financing laws potentially providing strong further impetus to loan growth, we are of the opinion that the Saudi banking sector has all the balance sheet drivers required to perform strongly,” the report said. Despite a quite impressive outlook, however, EFG noted some concerns about the lending capacity of Saudi banks on the short term due to the increased cash reserve ratio requirement set by the Saudi Arabian Monetary Agency (SAMA). “Credit demand continues to remain strong and banks have been able to grow their loan book aggressively despite higher reserve requirements. On the funding side, banks have been able to raise deposits without much effort owing to high liquidity and strong money supply growth, which has been averaging over 20 percent during the last 18 months,” it said. “We believe that SAMA is likely to relax its stance once inflation subsides from its current levels starting in the second half of 2008 owing to the high base effect. This is likely to further enhance the capacity of banks to grow their loan books aggressively,” it further said. “The other concern, which we believe has been overplayed, is investor uneasiness as to the extent of exposure of Saudi banks to US mortgage related investments." "The concern has been amplified by the provisioning undertaken by some of the banks on the investment book and more recently, trading losses, which we believe reflect mark-to-market adjustments on investments,” the report said. EFG estimated that the total exposure of listed Saudi banks to North American investments, investment and non-investment grade combined, stood at less than 5 percent of total assets, which is not significant. “We are of the view that while Saudi banks do not have any direct exposure to US mortgage related investments, they have indirect exposure through their externally managed funds.” It highlighted some factors that give strength to the Saudi banking sector including a low non-performing loans ratio of 1.7 percent in 2007, and a cost-to-income ratio of 30 per cent. Saudi banks also enjoy a unique funding cost advantage compared to the rest of the region as demand deposits account for over 40 per cent of total sector deposits, which has led to a lower average deposit cost. “Penetration is the lowest in the GCC as total loans-to-GDP reached 43 per cent, the ratio of deposits-to-GDP stood at 50 per cent and one branch for over 20,000 people. Demographic trends are also favourable, with 50 per cent of the population under the age of 19, while the immediate economic environment is also supportive with strong GDP growth and rising government spending,” the report said. EFG forecast strong growth in loans during the 2008 to 2012 period, predicting Saudi banks' earnings growth to also be strong. It sees high capital adequacy ratios will remain during this resulting from high earning retention by banks and SAMA's policy of maintaining a strong financial sector. “CARs for the listed Saudi banks stood at 17.4 percent at end of 2007 against the regulatory minimum total CAR of eight percent. We believe that banks are likely to maintain high CARs in the short term.” However EFG expected decline in CAR on the medium term due to the next phase of Basel II implementation and the expected normalization in asset growth. “We believe that Saudi banks would not be required to raise fresh capital or continue to retain a high level of earnings to fund the growth in their risk weighted assets. We have therefore lowered our CARs over our projection period to reach a range of 12 to 13 percent, resulting in a rising payout ratio.” On the share prices of listed Saudi banks, EFG said prices have been on a roller-coaster ride since the middle of 2007 and experienced a strong rally toward the end of the 2007 and continued into January 2008. “Banking stocks have lost almost 24 percent of their value since that time, on the back of concerns regarding earnings growth and potential losses on account of exposure to US mortgage-related investments. Results of the first quarter of 2008 have revealed no major write-downs. We believe the lack of a major hit from US investments and strong balance sheet growth has turned sentiment around, which has helped the banking sector index surge by 10 per cent since mid-April.” __
