Across the GCC, banks are engaged in an ongoing struggle to recapture the profitability that was once their virtual birthright. The days of regular annual double-digit percentage increases in net income are distant, despite a steady increase in oil prices and revenues.
Last year, the net profits of listed Gulf banks grew by 6.7 per cent compared to 2016, according to consultants KPMG. Solid, perhaps, and certainly better than the 3.2 per cent contraction in net profits witnessed in 2016 as geopolitical turbulence and low oil prices dampened performances. But compared to the 14 per cent net profit rate seen in 2014 – the last full year before oil prices started falling – it is nothing to shout about.
Starting in 2015, GCC banks experienced a slowdown in loan demand, and an increase in provisions for loan losses as businesses ran into financial difficulties. Pressure was exerted on their bottom line, amid fragile growth conditions and crimped liquidity. In key markets like the UAE, a sustained downturn in the bellwether sector proved a drag on profits. In addition, banks have been forced to take short-term hits through the introduction of VAT (in the UAE and Saudi Arabia, at least), which was also timed with the introduction of International Financial Reporting Standard No. 9 (IFRS 9) in January 2018.
IFRS 9 sets out requirements for the classification and measurement of financial instruments, the impairment of financial assets, and hedge accounting. According to ratings agency S&P Global Ratings, Gulf banks’ implementation of IFRS 9 led to an additional provision of 1.1 per cent of total loans, equivalent to one-third of their net operating income before loan loss provisions. In the ratings agency’s view, some banks have become more cautious in a bid to avoid future volatility of net income caused by the initial impact of IFRS 9 on shareholders’ equity. IFRS 9 provisioning needs will keep the cost of risk higher for longer.
Nonetheless, profitability may soon be within reach, with evidence of governments adopting a more proactive fiscal stance. Abu Dhabi’s AED13.6bn stimulus package, announced in June, should have beneficial impacts on Abu Dhabi and UAE banks. “The UAE has been seeing some extra liquidity in the form of government and government-related entity deposits going into banks, so seeing more liquidity coming back,” says Redmond Ramsdale, Gulf bank analyst at Fitch Ratings.
Despite the beneficial impact on liquidity, the outlook for Gulf banks this year is “less negative”, rather than “more positive”, says Ramsdale. “Things are looking better this year but it is all relative – this is not a return to the pre-2015 profit levels.”
One potential source of confidence is the rising interest rate environment. Gulf central banks are tracking the US Federal Reserve’s upward trajectory, with the UAE adding 25 basis points to its benchmark interest rate on 14 June. Banks are well placed to prosper in this climate, says Ramsdale. “They have proven their ability to reprice their assets, much of which are floating rate lending and on the liability side a good proportion are CASA (current account, savings account) deposits, so as rates go up, you reprice the floating and the differential on the liability side – the CASA – does not reprice as fast. A highly competitive banking sector might result in some players benefitting more than others.”
Despite the better conditions, much will depend on what regional governments do about debt issuance. If the oil price recovery is sustained, there may be less need to tap the debt capital markets. Some Gulf bankers nonetheless expect aggressive government expansion plans, with significant outlays on infrastructure schemes. This could require increased debt capital market issuance.
So far though, the signs are that debt issuance is lower than last year. Saudi Arabia, which issued $36bn in debt in 2017 to finance the budget deficit, says it would raise only $31bn this year. According to investment manager Franklin Templeton, total new GCC debt issuance in 2018 is forecast at $80bn, down from $90bn in 2017.
Gulf banks will be under renewed pressure to clamp down further on costs. Some progress has been made, with the sector’s cost-to income ratio declining by 1.2 per cent in 2017, mainly as a result of cost management initiatives, says KPMG.
Cost reductions, operational efficiencies and digitalisation are now the buzzwords for GCC banks. Fintech (financial technology) is viewed as a way of cutting the costs of administrative overheads and retail services, particularly for low-value transactions such as cross-border money transfers and payments. Gulf banks are considering collaborations with fintech start-ups, with the encouragement of regulators.
In February of this year, SAMA signed an agreement with US-based fintech firm Ripple to offer a pilot programme for cross-border payments. Participating Saudi banks can explore a solution for cross-border transactions using distributed ledger technology (or blockchain), while SAMA and Ripple provide programme management, training and other support to banks.
“Whenever banks are faced with a slowdown, the natural response is to try to be more efficient with costs. Certainly Gulf banks are getting quite good at managing their cost bases, and it has been a prudent time to do it,” says Ramsdale.
With the Gulf private sector in recovery mode, regional banks should be better placed to extend credit than has been the case over the past three years. The UAE reported an increase in lending to the private sector, growing almost 4 percentage points in March 2018 in year-on-year terms, while seeing an almost 13 per cent contraction in lending to government-related entities. Qatar National Bank, one of the region’s largest lenders, forecasts that the private sector will contribute around 50 per cent of lending growth in 2018, up from 22.5 per cent in 2017.
This should not imply an across-the-board explosion in private sector lending. “Loan growth in the UAE will not be much higher than 5 per cent this year, and that is down on what we saw in 2014,” says Ramsdale.
Still, high loan growth may be good for profitability metrics, but often masks asset quality issues. Impaired loans remain a challenge for the Gulf banking sector.
Above all, perspective is needed. The high single-digit profit increases expected in 2018 may be low by Gulf banks’ recent standards, but many other parts of the world can only look enviously on the region’s ability to generate such earnings growth.