Monday 08, October 2018 by Jessica Combes

Rising interest rates will boost Saudi banks' profitability

 

On 26 September, the Saudi Arabian Monetary Authority (SAMA) raised its key reverse repo rate by 25 basis points to 2.25 per cent, in step with the US rate increase owing to the Saudi riyal's peg to the US dollar.

The rate increase is credit positive for Saudi banks because it will support their profitability through higher net interest margins, according to credit ratings agency Moody’s.

The reverse repo rate is the reference rate for Saudi banks’ lending and their deposits with the central bank. Despite subdued credit growth, Saudi banks' net interest margins have been widening since 2016. The widening reflects banks' ability to re-price corporate loans (64 per cent of total bank loans as of June 2018), which are typically extended on a floating-rate basis, and a favourable funding structure, supported by a large base of non-interest-bearing demand deposits (63 per cent of total bank deposits as of June 2018).

In line with rate increases in the US, SAMA has raised its policy rate three times in 2018 to prevent capital outflows as Saudi investors and depositors seek higher returns. As a result, the three-month Saudi Interbank Offered Rate, a benchmark that influences banks’ lending rates in Saudi riyals, has continued to rise this year, reaching 2.7 per cent in October 2018, its highest level in 10 years.

However, Saudi banks' assets have historically been more sensitive to interest rate changes than their liabilities, because a high proportion of the assets carry variable rates while a high proportion of the liabilities are non-interest-bearing deposits.

On the liabilities side, we do not expect rising rates to create immediate upward pressure on interest expenses, given the modest recovery in credit growth (two per cent in the first half of 2018) and Saudi banks’ favourable funding profile. The funding profile is underpinned by a high proportion of low-cost current and savings accounts, and an average net-loans-to-deposits ratio of 84 per cent as of June 2018.

Saudi banks' funding situation has also improved significantly since 2015-16, when plunging oil prices and large sovereign debt domestic issuances reduced the funding available to Saudi banks and pushed up their funding costs.

Since 2017, the average cost of funding for domestic banks has been broadly stable around one per cent, the lowest in the Gulf Cooperation Council region. As a result, the average net interest margin of Saudi banks has strengthened significantly in recent years, reaching 3.1 per cent during the first half of 2018 from 2.5 per cent in 2016.

Moody’s expects the gap between Saudi banks’ lending rates and low cost of funding to continue to widen because rate hikes are likely to continue. The improvement in net interest income will vary by bank, with banks that have a large proportion of demand deposits and/or a large proportion of corporate loans benefiting the most.

Accordingly, Al Rajhi Bank (A1 stable, a33), National Commercial Bank (A1 stable, baa1), Samba Financial Group (A1 stable, a2) and Saudi British Bank (A1 stable, a3) are expected to benefit the most from rising interest rates.

Nonetheless, although rising rates will provide a boost to banks’ profitability, further rate hikes are likely to weigh on the borrowing costs of corporates and households and affect their debt servicing capacity. This in turn could result in higher asset risks for banks in the longer term, especially for cyclical industries with relatively high financial leverage and problem-loan formation, such as the construction and commerce sectors.

As economic conditions remain soft in Saudi Arabia, Moody’s expects that Saudi banks' ratio of problem loans to gross loans will increase to around 2.5 per cent over the next six to 12 months, from around two per cent as of June 2018. 

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