S&P Global Ratings believes conventional and Islamic banks in the Gulf Cooperation Council (GCC) countries will see significantly reduced revenue and credit growth in 2020. The sharp drop in oil prices and measures implemented by regional governments to contain transmission of the coronavirus (COVID-19) will take a toll on important sectors such as real estate, hospitality, and consumer-related. Under our base-case scenario, we assume that these measures will be relatively short lived and forecast a gradual recovery in nonoil activity from third-quarter 2020. However, the severe shock could cause irreparable damage to some parts of the nonoil economy. Furthermore, if the recovery takes longer than we expect, GCC banks could feel greater pressure (see "Composition Of Our Sample" section for additional details).

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the COVID-19 outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. As the situation evolves, we will update our assumptions and estimates accordingly.

We Expect A Significant Slowdown In Lending Growth In 2020

Although growth rates last year were almost the same as 2018, GCC conventional banks saw faster increases than Islamic banks. This was mainly explained by acquisitions. Emirates NBD, for example, acquired DenizBank in Turkey, increasing its total assets by almost one-quarter. Other transactions were mainly local or regional with Abu Dhabi Commercial Bank absorbing two other local banks (including one Islamic) and Saudi British Bank taking over another local bank. In 2020, we expect slower organic and nonorganic growth, with Islamic and conventional banks seeing similar rates of 2%-3%.

We project average real GDP growth for the six GCC countries will slightly accelerate in 2020 compared with 2019, but this will be primarily spurred by higher oil production (see chart 1). With the significant decline in oil prices--our assumption for 2020 is now an average of $30 per barrel, down from $60 at the start of the year--and government measures to contain the spread of COVID-19, we think that nonoil growth will decline. This will result in fewer growth opportunities for banks. We also expect banks to focus more on asset-quality indicator preservation than generating new business. In our forecasts, we assume that measures implemented by the GCC governments to contain COVID-19 are relatively short lived. If this assumption does not materialize, the effect on their economies and banking systems would be stronger than we currently forecast. This risk is exacerbated by delays or cancellations of important events scheduled in the region. The delay of Expo 2020 for Dubai and cancellation of the pilgrimage season for Saudi Arabia, for example, now depend on the spread and containment of COVID-19. If either event is cancelled, the impact on regional economies could be stronger than we currently expect and further increase risks for banks.

Chart 1

Table 1

Cost Of Risk Will Increase

Lower economic growth and significant shocks to vital economic sectors such as real estate, hospitality, and consumption mean that GCC banks' asset-quality indicators (both Islamic and conventional) will deteriorate in 2020. At year-end 2019, the average nonperforming financing (NPF) ratio reached 2.8% for Islamic banks compared with 3.0% for conventional banks in our sample (we don't see much significance in the slight difference). The coverage ratios were also comparable at 155.5% for Islamic banks and 154.6% for conventional banks at the same date. For 2020, we think that NPF ratios could easily double, and cost of risk could reach 1.5%-2.0% of total loans. Moreover, we believe that most of the deterioration would come from small and midsize enterprises (SMEs) and companies operating in the real estate, hospitality, and consumer-related sectors. In our assumptions, we factor the measures decided by GCC governments to support their economies (see Appendix). Although these measures are helpful, they will primarily give banks time rather than resolve problems related to lost activity of clients with cash flow pressure. In our view, recapitalization or stronger measures to alleviate pressure on clients' bottom lines could make a difference, but there are no indications that governments will move in this direction.

Table 2

The International Financial Reporting Standards (IFRS) 9 numbers for banks that reported them in our sample provide a similar picture (see chart 2). At year-end 2019, about 10% of Islamic and conventional banks' assets were in the Stage 2 category. The proportion of problematic assets (Stage 2 and 3) for both industries stood at about 13% of total assets at the same date. We expect some migration to Stage 3 from Stage 2 and think the overall amount of problematic assets could increase to about 20% of total loans by year-end 2020. Our expectation is based on two assumptions:

• Banks recognize the full extent of their asset-quality problems this year. If not, we think the effect will show in 2021.
• Nonoil activity normalizes from third-quarter 2020. The pace of that normalization remains uncertain, however.

Chart 2

In our view, Islamic banks are somewhat more vulnerable than their conventional peers. This is because they tend to have higher exposure to the real estate sector due to the asset backing principle inherent to Islamic finance. Furthermore, they cannot charge late payment fees (unless these are donated to charities at the end of the exercise) meaning that clients tend to prioritize payments on conventional exposures versus Islamic. However, GCC governments' requests for all banks not to charge late payment fees when they reschedule financings to affected companies partially mitigates this distinction.

These vulnerabilities are also somewhat mitigated by the comparable business models of both bank types, consisting primarily of collecting deposits and extending financings to the real economy in their countries. Some market observers might argue that Islamic banks should be more resilient because of the asset backing principle, which results in stronger collateral coverage. We believe that collateral realization is still difficult in the GCC, although some authorities have implemented more creditor-friendly regulation over the past three years. In addition, real estate is one of the most preferred collateral instruments and its value has been declining for all the GCC markets over the past three years.

Funding And Liquidity Remains Good

Growth in customer deposits was strong in 2019 for both types of banks thanks to the recovery in oil prices. The funding profile of Islamic and conventional banks also remained stable, with total financing to total deposits of about 93% at year-end 2019. We see two main risks in 2020. These include the concentration of the deposits base on government and government-related entity (GRE) deposits, which account for 10%-35% of total deposits. These entities might burn cash as the drop in oil prices and less supportive economic environment affect their activities. Furthermore, we note risks related to deposits outflows once the COVID-19 pandemic is contained and the full effect on employment is known. Some expatriates might increase remittances to their home countries.

Despite this pressure, we continue to take comfort from GCC banks' good liquidity indicators. We note that Islamic banks are in a weaker position (see table 3), but think that this is because the calculation below excludes some of the interbank deposits reported as commodities murabaha.

Banks' funding profiles remain a strength in most GCC countries. We reflect this in our Banking Industry Country Risk Assessments (BICRAs) through systemwide funding, which positively influences our assessment of the starting point (anchor) for some bank ratings. The use of wholesale or external funding sources by regional banks remains relatively limited and we don't think this will change in the short term. The only exception is Qatar, where the banking system still carries significant net external debt. We think that this position will reduce because of COVID-19-induced market volatility. We also take comfort from the government's strong capacity and willingness to provide the sector with support in case of need. The government of Qatar and its related entities injected up to $42.5 billion in 2017 to help the banking system deal with boycott-related outflows.

Table 3

External Headwinds Will Lower Earnings But Most Banks Will Remain Profitable

We anticipate that both Islamic and conventional GCC banks' profitability will take a hit in 2020.

This is because financing growth will remain limited, with banks focusing more on preserving their asset-quality indicators than generating new business amid the COVID-19 pandemic. We also believe intermediation margin will decline given the reduction in interest rates and the structure of GCC Islamic and conventional banks' funding profiles (with a significant contribution of noninterest-bearing deposits). Furthermore, we expect asset quality will deteriorate and cost of risk will increase. In fact, we do not exclude a doubling of credit losses. During the previous oil price drop, the move to IFRS9 and the charging of the opening effect to equity helped banks. This time, the economic shock is stronger and the full impact will be reflected on banks' bottom lines. In our view, the support measures enacted by GCC governments will at best delay this problem, in the absence of additional measures.

However, we believe banks will continue to benefit from their relatively low cost base and potential additional cost-saving initiatives from 2021. Some banks announced employment-preservation measures for 2020 but cuts will probably come next year if the environment doesn't improve. Investment revenue is also likely to support the bottom line of some banks this year as the drop in interest rates increases the market value of these instruments and banks decide to offload them, thereby realizing gains.

It is important to repeat our assumptions of COVID-19 containment and the resumption of nonoil activity by third-quarter 2020. Should this take longer, it would mean lower profitability and even losses for some banks.

Table 4

Capital Buffers Remain Strong

GCC Islamic and conventional banks included in our sample continue to display strong capitalization by international standards, with an unweighted average Tier 1 ratio of 17.9% for Islamic banks and 16.6% for conventional banks at year-end 2019. After dropping in 2018, this ratio increased slightly in 2019 as some banks raised new capital in the form of Tier 1 instruments before the market turmoil. Under our base-case scenario, we expect capitalization to continue to support the creditworthiness of GCC banks in 2020.

It is our understanding that Oman is the only GCC country to progress toward a recovery and resolution regime. The sultanate approved a framework but the implementation timeline is unclear. We believe rolling out these regimes would require a profound change in the mentality and approach to bank support. GCC governments have not hesitated to rescue banks, as shareholders, or to safeguard the financial stability of their banking systems.

Chart 3

A Second Wave Of Mergers And Acquisitions Could Begin

When the dust settles and the full effect of current conditions on banks' financials is visible, we think there could be a second wave of mergers and acquisitions (M&A). The first wave was spurred by shareholders' desire to reorganize their assets. The second wave will be more opportunistic and driven by economic rationale. The current environment might push some banks to find a stronger shareholder or join forces with peers to enhance resilience. We think a second wave of M&A might involve consolidation across different GCC countries or emirates in the United Arab Emirates (UAE), for example. This would require more aggressive moves by management than those seen in the past. The added hurdles of convincing boards and shareholders, who face the possibility of seeing their assets diluted or losing control, might be easier if they have to recapitalize their banks anyway.

Which Banks Will Be Most Affected?

In response to the COVID-19 pandemic, GCC governments have announced several measures to help corporates and retailers navigate the challenging environment. Some governments have opted for reduced taxes and levies. Other have asked banks to extend additional subsidized loans to affected clients to maintain employment and avoid production capacity destruction during what is expected to be a short-term event. To our knowledge, no regional governments have announced wide measures that would remove credit risk from banks' balance sheets or inject additional capital. As a result, we think that risks will continue to build and ultimately weigh on banks' financial profiles if the crisis worsens.

In this environment, we see banks in the UAE, Oman, and Bahrain as the most exposed. For Oman and Bahrain, the lack of capacity to support the banking system (in the form of capital injections if needed) means that these governments would need to prioritize the allocation of their limited financial resources if the shock is stronger than expected. For the UAE, the simultaneous shocks to several sectors of the economy and the federal structure of the country would also likely result in a greater effect on asset quality and potentially some selectiveness in extending support to corporates and GREs. The large debt of Dubai-based GREs and lack of access to capital markets will potentially accentuate this pressure. Moreover, the question of resource allocation between smaller and richer emirates might be raised if conditions worsen. We continue to believe that, in case of need, the federal authorities will intervene and support banks in the UAE.

For Kuwait, we think that even if the situation worsens the government will use its vast financial resources to directly support the financial system, given its long track record of doing so. In Qatar, we also expect direct intervention in terms of exposure buybacks or capital injection should the need arise. We think that Qatari banks' asset-quality indicators will deteriorate but the large state footprint in the economy will act as a backstop. In Saudi Arabia, we also think that asset-quality indicators will deteriorate, especially given current conditions come at a time when the private sector was already under significant pressure. However, we note that most bank growth in recent years was spurred by mortgages to Saudi nationals, who are predominantly working for the government. If the pilgrimage season is cancelled, we think the shock to the private sector will be stronger and the effect on asset-quality indicators will be more visible.

Composition Of Our Sample

To assess the financial performance of Islamic and conventional banks in the GCC, we used a sample of 16 Islamic banks and 26 conventional banks with total assets in excess of $2.2 trillion and sufficient financial disclosures. We have not included the Islamic windows/activities of conventional banks, owing to a lack of disclosure and the risk of data distortion (since these windows/activities benefit from the overall support of their respective groups in the form of funding or cost sharing, for example).

Study Sample Details

Table 5

Table 6

Appendix

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• Ratings On Two Kuwaiti Banks Lowered On Weaker Support Assumption, March 30, 2020
• Outlooks On Five UAE Banks Revised To Negative On Deteriorating Operating Environment, March 26, 2020
• Prolonged COVID-19 Disruption Could Expose The GCC's Weaker Borrowers, March 11, 2020