Islamic Finance

Fitch Ratings: Fed Rate cuts add pressure on Saudi banks

Fitch Ratings-Dubai/London-19 March 2020: Saudi Arabia's banking sector faces extra pressure on margins as a result of the US Federal Reserve's latest interest rate cuts, Fitch Ratings says. Banks could also see rising funding costs and stressed liquidity if the Saudi government withdraws deposits to fund a widening deficit. The US rate cuts in response to the coronavirus outbreak exceeded market expectations and the Saudi Arabian Monetary Authority (SAMA) followed by cutting its official repo rate by 50bp on 3 March and by a further 75bp on 16 March due to Saudi Arabia's currency peg to the US dollar. The rate is now 1%, its lowest level ever.

We placed all ten Saudi banks' Viability Ratings and four banks' Issuer Default Ratings on Rating Watch Negative earlier in March, reflecting the risk of severe and prolonged deterioration in the operating environment following the rate cuts and sharp fall in oil prices. With little visibility on the authorities' response in terms of government spending, there are uncertainties about the length and impact of a potential shock. (See Fitch Places Saudi Arabian Banks on Rating Watch Negative.) Pressure on margins as well as the impact of lower oil prices will influence how we resolve the Rating Watches.

Link to Infogram: SAMA Repo Rate vs Effective Federal Funds Rates

The rate cuts will mean lower interest income for Saudi banks in 2020. Pressure on net interest margins (NIMs) will be higher than in 2019, when rates were higher at the start of the year and rate cuts were lower and spread over several months.

Lower rates will affect banks' NIMs in different ways. Banks with larger corporate loan portfolios are likely to be affected first, as these reprice quicker. This is to some extent balanced with a higher ability to pay lower rates on deposits as the portion of non-interest bearing (NIB) deposits is typically lower than in retail-focused banks. NIMs at banks with large corporate loan portfolios are therefore less sensitive to rate fluctuations.

In contrast, banks with higher retail NIB deposits can have extremely low funding costs and their NIMs are therefore more sensitive to a sharp decrease in rates as lower interest income is to a much lesser extent offset by lower funding costs. However, these banks' large higher-yielding retail loans reprice less quickly, which supports NIMs over time.

NIMs will erode from strong levels (sector average of 3.7% in 2019) as the system remains largely funded by NIB deposits (61% of total deposits at end-2019). But the magnitude of the cut means the impact could be high. Banks will look to protect margins by growing high-yielding retail mortgages where demand remains high. However, banks with weaker retail franchises are unlikely to benefit much from this demand and the market will be increasingly competitive as growth in other areas will be muted.

Lower interest income will affect banks' profitability further amid the spread of the coronavirus. Credit growth will be challenged by a softening operating environment due to lower oil revenue. The Saudi government will keep a rein on public spending, which key sectors of the economy rely on. It approved a 5% cut in its 2020 budget and will take additional measures as the outbreak intensifies.

The support package announced by SAMA on 15 March will aim to help SMEs to weather adverse conditions and mitigate weakening cash flows for the coming six months. While this will ease short-term pressure on asset quality, it does not address the possibility of a prolonged downturn.

There is uncertainty over the scale of support that will be needed, as the impact of sustained lower oil prices and the virus outbreak remain unclear. Certain sectors are highly sensitive to the present environment, especially building and construction, transport, hospitality and retailers.

We expect problem loans and impairment charges to increase. Under IFRS 9, Saudi banks have to project weaker economic conditions and higher probability of corporate defaults in their expected credit loss (ECL) assumptions. While fee income generation from the increasing demand in mortgages could mitigate the cost of provisioning for higher ECLs, low trade volumes and subdued economic activity will be negative.

Nevertheless, large portfolios of fixed-rate bonds at some Saudi banks act as a hedge against interest rate variations and will partially offset the negative impact of lower interest rates.

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