The greater part of the Saudi Arabian banking industry "enjoys a good financial position and strong franchise" says Moody's Investors Service, which offered a stable outlook for the industry's average D+ financial strength rating.

The banks' Baa3/Prime-3 ratings for foreign currency bank deposits have a positive outlook, linked to the outlook for the sovereign. The conclusions were part of "Saudi Arabia: Banking System Outlook", an annual update to the markets that is not a formal action to alter credit ratings.

Seen as strengths by Moody's are the overall caliber of management in the Saudi banking sector and the quality of technical management agreements between the joint-venture banks and their foreign parents. Both of these factors are regarded as important rating issues.

In addition, earning power remains buoyant and the loan quality situation is comfortable at most banks. Moody's also believes that the Saudi government's economic liberalisation, while welcome, "will present significant challenges to the banks, both in the form of changes to their balance sheet risk profiles, as well as increased operational risks."

The reforms are part of the country's preparation for membership in the World Trade Organisation. "We expect to see growing exposure of the banks to the private sector and to retail business, and less exposure to the public sector risk as a result of the government's efforts to reduce its involvement in the economy and to promote the private sector," says analyst Mardig Haladjian, author of the report.

"This will raise banks' balance sheet risk profile especially since the future quality of certain areas of retail lending remains unclear." Economic reform is also expected to increase competition, both from other banks and via the Internet, which along with increased pressures on banks to increase the number of Saudi nationals on their staffs "could challenge their levels of operating efficiency and competence."

Over the medium term, Moody's believes that these trends will mostly benefit the larger and better-managed banks, while challenging the capabilities of the smaller and weaker institutions whose credit health may suffer.

"Of course, there is always the possibility that the pace of economic reforms may slow down due to internal resistance to change, especially since government revenue levels have strengthened," says Haladjian.