As oil prices realign to a new equilibrium in the short to medium term, there is a new liquidity paradigm that Gulf banks are looking to deal with. The context is all well known, primarily driven by three core factors:
1. An unprecedented GCC sovereign budget deficit, estimated to be $140 billion this year.
2. A spurt of sovereign bonds that’s drawing out liquidity from the system. GCC’s sovereign gross commercial long term borrowing had grown from $4 billion in 2014 to $40 billion in 2015.
3. And a rising interest rate regime, also driven by the hike in dollar interest rates.
The deposit balance of governments parked with commercial banks is on a downward trend. Public sector deposits are estimated to be 23 per cent of the total GCC deposits, and declined by 2.8 per cent in 2015 compared to 2014. The impact of this situation could be observed from two perspectives: while on the one hand deposit growth has slowed down with government draw down, there is also an adverse impact on credit offtake driven by a higher cost of funds.
This shrinkage in the deposit book has also adversely impacted the loan-to-deposit ratio (LDR), which is slowly but steadily crossing guidance limits. For instance, Saudi Arabia has crossed the 85 per cent guidance mark, and UAE is quite in excess of 100 per cent. The options available to banks can be quite limited in such a context, especially when the sovereign credit ratings are also moving southward.
The implications from a treasurer’s standpoint is twofold. From a short-term standpoint, the hikes in interbank lending rates can create havoc on the cost structures. From a medium to long-term standpoint, it’s going to be a tight rope walk to have the NIM (net interest margins) margins protected, without creating a huge asset-liability mismatch.
Sovereign bond subscriptions are seen as a good barometer of the liquidity situation, and the shrinkage driven by increasing supply and reducing demand is visible in the reduced level of oversubscriptions. Governments are therefore tapping into international markets with surplus liquidity such as Japan, or issue bonds to government-owned institutions to help reduce the domestic volatility in the banking sector. Yet, the tremors are quite palpable.
And that brings us back to the core question. How should banks and their treasury functions deal with the new liquidity paradigm? Perhaps it’s time to get back to the basics.
1. Obviously, driving an optimal CASA (current account savings account) share of the liability book is the most sustainable and logical fix to keep the cost of funds under control. Name of the game would therefore be in driving retail, low cost deposit relationships — both through acquisition and retention of the existing base.
2. The other alternative would be to look for cost-effective funding through sukuks, to build a healthy medium term liquidity profile. Quite a few GCC banks have adopted this approach, and quite successfully so. Structuring the issue appropriately and running an effective campaign will be key.
3. Defining and working towards an optimal asset mix would be paramount in these circumstances. A typical healthy mix would constitute 65-75 per cent of the asset book as loans and advances, 15-20 per cent as investments, with the balance being cash, bank placements and other assets. A higher skew on the advances or bank placements could have an adverse impact, especially in volatile liquidity conditions.
4. Provisions to the portfolio can skew the profitability adversely during tight liquidity conditions, as the degree of impairment is always directly proportionate to the cost of capital. This is more pronounced with small and medium enterprises who operate with lower margins. Investing in early warning triggers and proactive risk governance would be crucial, and will be quite rewarding.
Finally, a word of caution: while it may be quite enticing for banks to play the pricing game and attract short-term liquidity with higher interest rates, past experiences of this approach have taught us that this has always been quite costly, for banks across the globe.
Short term liquidity always comes with a higher price — not just literally (for it does cost more!), but also in the larger sense, as it can prove be a quicksand that’s hard to get out of. End of the day, for banks to be genuinely banked upon, just three core principles matter: Governance, Assurance and Prudence!
The writer is a Partner at Cedar Management Consulting International LLC, an US based firm. He can be reached at v.ramkumar@cedar-consulting.com
