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Saudi banks to face margin pressure in the face of US rate hike

Dubai: Saudi Arabia’s bank’s performed better than their global peers in profitability and low risk profile, but with the rising global interest rates posing a risk to interest margins, banks will be forced to improve their profitability from higher lending volumes and fee incomes, according to credit rating agency Standard & Poor’s.

Saudi banks now face a budding threat to its historically strong profitability as further compression in net interest margins from potential increase in US interest rates. Previously, the biggest threat to banks’ profits has been the higher cost of risk since 2008 and the global financial crisis. But with the cost of funds now near a low tide and the spectre of the US Federal Reserve beginning a move to higher interest rates, possibly in 2015, Saudi banks are likely to look for ways to squeeze higher profits from expanding their balance sheet.

The prevalence of low-cost funding (non-interest-bearing demand deposits which accounted for 59.7 per cent of total domestic deposits as at the end of 2013) and strong operational efficiency contributed to the strong profitability of Saudi banks in the past.

The falling and low rates on deposits that have prevailed since 2008 effectively neutered any reward for depositors. Although high deposit concentrations, primarily from the public-sector gives solid funding base, asset and liability maturity mismatches are expected to remain a key structural challenge for banks.

“The structural mismatch between the short-term nature of Saudi banks’ funding — overwhelmingly customer deposits — and the longer tenors of their lending will likely translate into a temporary pincer effect that further compresses margins,” said Paul-Henri M. Pruvost, an analyst with S & P.

Rising interest rates could give depositors incentives to move away from the non-remunerated deposits that helped banks buffer falling yields on lending since 2008.

In this context, analysts expect lending volume to be the strongest variable of Saudi banks’ profitability, especially because the banks have little headroom left to further improve efficiency.

At around 34 per cent, Saudi banks enjoy very good cost efficiency by international standards — with a cost-to-income ratio typically in excess of 50 per cent to 60 per cent in well-run banks in developed markets.

Prospects for higher lending volumes remain sound in both the corporate and retail banking segment given the kingdom’s need to address the demands of a young and fast growing population. The country’s overall robust economic growth to continue to create lending opportunities and support credit conditions for the banking system.

Despite such favourable conditions, S & P do not expect that Saudi lending growth to exceed 10 per cent yearly over 2014-2015, forcing banks to focus more on non-interest income streams.

“Government spending is likely to remain stable, and we expect the banking system and the regulators to focus on a steadier approach to growth to maintain current financial profiles. Generating fees will be a prime component of all banks’ strategies and competition will therefore be fierce,” Pruvost said.