Dubai: Confidence in the outlook for Saudi Arabia’s banking sector is gaining momentum as most leading banks have shown resilience in balance sheet growth and profitability while improving asset quality during the first half of 2017.

Banking sector analysts expect the outlook is set further brighten in the second half of the year on improved net interest margins (NIM), lower cost of funds, stronger loan growth and lower impairments.

Bank of America Merrill Lynch (BoAML) analysts expect to see an improved outlook for Saudi banks in to the second half of 2017 and beyond on themes such as NIM expansion accelerating on the back of the three US Federal Reserve rate hikes observed since December 2016, as well as a further four interest rates hikes expected over the next 18 months. Bank results for the full year are also likely to reflect the lower than expected cost of funding, as observed in the second quarter of 2017.

Strong cost discipline on the part of banks, which has driven operating costs below expectations, as well as stronger asset quality than originally anticipated, and a potential pick up in asset growth, particularly from 2018, have boosted confidence in the sector.

“[The] seven largest Saudi banks increased dividends by an average 67 per cent year on year in the first half of 2017, despite aggregate earnings falling 5 per cent. In our view, this sends a strong signal on management confidence on the outlook for NIM progression as well as asset quality,” said Hootan Yazhari, research analyst at Bank of America Merrill Lynch.

NIM expansion

BoAML’s analysis of balance sheet maturity profiles of the Saudi banks suggests that they are highly sensitive to movements in the Saudi Arabia interbank offered rate (Saibor) and thus underlying dollar London interbank offered rates (Libor) largely on account of having a currency which is pegged to the dollar.

“We currently expect four rate hikes between now and the end of 2018 [the first coming in December and three further hikes in 2018]. All in, we expect average NIMs to rise from 3.2 per cent in 2016 to 3.5 per cent in 2018, before levelling off,” said Victoria Cherevach, an analyst with BoAML.

Samba, SABB and Al Rajhi are best placed to benefit from rising interest rates, given the relatively short duration of their assets and the longer duration nature of their funding base — even when excluding largely non-interest bearing/low interest CASA deposits.

Saudi banks demonstrated strong NIM expansion in the second quarter of 2017, with NIMs expanding about 10 basis points (bps) on average during the quarter. The expansion came largely on the back of easing funding costs, as the liquidity pressures on the banking system eased during second half of 2016 on the back of the government issuing new international bonds and oil prices reversing from the lows observed in the first half of 2016.

In the first half of the year, margins improved as a result of delayed asset re-pricing and lower funding costs, rising by 28bps year on year. Although Saibor declined in the first half of 2017 from the previous corresponding period, asset yields have benefited from continued asset re-pricing and increased credit restructuring.

“Cost of funding should increase again in the second half of the year due to higher Libor and potential widening of Saibor-Libor spreads. Balance sheet expansion should improve only slowly in the second half of this year, with deposit growth picking up as government deficit is now better funded, easing liquidity pressures,” said Jaap Meijer, director of research at Arqaam Capital.

Whilst analysts expect funding costs to edge up somewhat, they believe the increase will be lower than asset yield improvements, especially given the relatively high proportion of CASA funding at the Saudi banks. CASA ratios stood at about 70 per cent on average for the Saudi banks covered at the end of the second quarter of 2017.

Saudi banks have increasingly focused on reducing their cost base via cost control and efficiency programmes, and to meaningful effect. Cost-to-income ratios have fallen more than 200bps in 2Q17, allowing Saudi banks to achieve one of the lowest cost-to-income ratios amongst regional peers.

The cost savings have largely come from a reduction in staff costs and other general operating costs, likely through increased digitisation and the reduction of non-core operations.

Whilst economic growth has slowed in the kingdom, asset quality has held up more robustly than expected. More specifically, non-performing loan (NPL) ratios have not deteriorated as sharply.

Looking ahead, anlyts expect loan growth to accelerate from the second half of the year on the back of rising private sector investments for the National Transformation Plan (NTP), rising growth rates in the kingdom as oil prices stage a recovery from current levels, and as consumer sentiment improves following the implementation of the welfare programme to offset the impact of falling subsidies for lower income households.