Rated banks in the GCC face an uphill struggle in the next 18 months due to the protracted nature of the economic recovery and the expected gradual withdrawal of regulatory forbearance measures. S&P Global Ratings' base case is that a COVID-19 vaccine will be widely available by around mid-2021 and that the oil price will stabilize at an average of $50 per barrel. We also foresee that the GCC economies will expand by an average of 2.4% in 2021, compared with a contraction of 5.6% in 2020. Without these glimmers of light, things could be even worse for GCC banks.

We expect that lending growth will remain muted, with the exception of Saudi Arabia, where mortgages have been expanding rapidly on the back of a government initiative to increase home ownership in the country. The cost of risk will continue increasing as problematic asset recognition accelerates in the absence of additional support measures. Interest revenues will remain below their historical levels due to the U.S. Federal Reserve's policy of lower-for-longer interest rates. Therefore, GCC banks' profitability will continue declining, with a few reporting losses because of their exposure to high-risk asset classes--such as small-to-midsize enterprises (SMEs) and credit cards--or in few instances, because of under-provisioning. This will push banks' management teams to look more carefully at costs, try to leverage opportunities related to fintech, and reduce the number of physical branches.

In this challenging environment, GCC banks' funding profiles and capitalization provide some support for their creditworthiness. Funding remains dominated by core and stable deposits, with a limited contribution from external funding. Qatar is the exception to this, but the Qatari government's strong willingness and capacity to inject foreign-currency liquidity when necessary mitigate the risks to a large extent. Capital is strong, both quantitatively and qualitatively, and protects the banks from stronger-than-expected shocks. As of today, 65% of our outlooks on GCC bank ratings are stable and 30% are negative. Only one rated GCC bank has a positive outlook because of an upcoming merger. Downside risks include a lower oil price than we expect, an escalation of geopolitical risks, and lack of control over the pandemic by the middle of next year. If such risks materialize, the impact on GCC banks could be much greater than we currently forecast.

The picture differs slightly for Islamic banks, compared with conventional counterparts. Having looked at the credit fundamentals of the 16 largest Islamic banks and 30 largest conventional banks in the GCC, we consider that Islamic banks might prove less resilient to a protracted downturn than their conventional peers. This is because of Islamic banks' strong entrenchment in the real estate sector and the absence of late payment fees; under Islamic law, banks must give such fees to charity. Moreover, the exposure of some Islamic and conventional GCC banks to weaker markets will probably add to their asset-quality problems. Turkey is one such country. We expect a significant deterioration in Turkish banks' asset-quality indicators, and therefore, in our view, the country remains a major source of risk for exposed Islamic and conventional GCC banks. On a positive note, most of the Islamic and conventional banks in our sample entered this difficult period from a relatively good position in terms of asset quality, profitability, and capitalization. See the section below titled "Sample Composition" for a list of the banks we assessed.

Nevertheless, the COVID-19 pandemic and lower oil price could mark the start of a new era for banks in the GCC. Beyond our two-year outlook horizon, we expect banks' reduced profitability to be structural due to lower-for-longer interest rates, weaker lending growth, and the significant proportion of noninterest-bearing deposits in banks' funding profiles. It remains to be seen to what extent banks can compensate for this by consolidating or leveraging fintech solutions.

Lending Growth Will Remain Muted, Except In Saudi Arabia

GCC banks' lending growth slowed in first-half 2020 to an annualized rate of 6.6%, compared with 9.4% in 2019 for our sample. Banks have reduced their risk appetite and limited their activity to either recycling the liquidity injected by their respective central banks, or honoring their committed credit lines. Corporates have reduced their capital expenditure and focused on cash preservation. They have drawn down some of their committed credit lines to continue covering their operating expenses while their revenues contracted. We believe that lower lending growth will continue in 2021, at about 5% for most countries, due to the protracted economic recovery (see chart 1).

One exception to this trend is Saudi Arabia (see table 1). Lending growth in the country was strong in the first six months of 2020, owing to a backlog of corporate financings in the first quarter of the year and continued double-digit growth in mortgage lending. Under our base-case scenario, we expect overall lending growth to remain higher in Saudi Arabia than in other GCC countries in 2021, but lower than in 2020, as the mortgage market starts to mature and we do not foresee a meaningful recovery in corporate lending. Our assumptions reflect the wide availability of a COVID-19 vaccine by mid-2021 and the stabilization of the oil price at $50 per barrel. We exclude any additional significant stimulus programs by the GCC governments.

Chart 1

Table 1

Asset Quality Will Continue To Deteriorate

Measures that the various GCC governments have implemented to control the pandemic and the drop in oil prices have plunged the economies of the GCC countries into deep recession. The measures have also affected some vital economic sectors, such as real estate, hospitality, and commerce. At the same time, the regulators have responded with various measures of their own, including asking banks to defer the repayments on their loans to struggling companies and retail clients and providing banks with liquidity. The regulators have also asked banks not to classify their loans as nonperforming solely due to COVID-19-related cash flow pressures. This exemption doesn't apply to borrowers with pre-existing structural risks to business viability. The regulators' ultimate objective is to preserve their countries' productive capacity, which is the result of several years of pushing for economic diversification.

These measures explain why in first-half 2020, we have not seen a spike in nonperforming loans (NPLs). On June 30, 2020, the ratio of NPLs to total loans reached 3.7%, compared with 3.2% at year-end 2019 (see chart 2). The largest deteriorations to date have been in the United Arab Emirates (UAE)--due to a fraud case at one large corporate and a few cases of firms skipping payments--and in Kuwait--due to the decline in real estate prices and the activities of some Kuwaiti banks in riskier countries (see table 2).

However, in the next six-to-12 months, we expect the authorities to withdraw the forbearance measures progressively to maintain confidence and avoid major repercussions for their banking systems. We therefore expect the average NPL ratio to increase to about 5%-6% in the next 12-24 months for our sample of banks.

Although the banks have increased their provisioning to prepare for the likely deterioration in asset quality once the regulatory forbearance measures expire, the coverage ratio has still dropped. It reached 140.2% on June 30, 2020, compared with 147.6% at year-end 2019, and we expect it to drop to about 80%-100% in the next 12-24 months for our sample.

We believe that most of the deterioration in asset quality will be down to struggling SMEs and companies in the real estate, construction, hospitality, and consumer-related sectors. Our assumptions exclude any additional support from the GCC governments directly to corporates, or to banks in the form of buybacks of loans or recapitalizations, as we have no indication that the governments will move in this direction.

Chart 2

Table 2

A picture of weakening asset quality also emerges from the disclosures of banks in our sample that reported under International Financial Reporting Standard 9 (see chart 3). On June 30, 2020, the volume of stage 3 loans was almost stable, while the volume of stage 2 loans increased by one percentage point to 12.4% of total loans. The overall proportion of problematic loans in stages 2 and 3 now stands at about 16.4%, and we expect it to increase to about 20%-22% in the next 12-24 months. Our expectation reflects two assumptions. First, that banks recognize the full extent of the asset-quality problems in the next 12-24 months as the authorities progressively withdraw the regulatory forbearance measures. Second, that nonoil (economic) activities start to expand in 2021.

Chart 3

The NPL and coverage ratios are similar for Islamic and conventional banks. On June 30, 2020, the average NPL ratio reached 3.3% for the Islamic banks in our sample, compared with 3.9% for the conventional banks. The coverage ratio was 144.9% for Islamic banks and 137.6% for conventional banks on the same date (see table 3). We consider these ratios comparable and don't read too much in the slight differences between the segments.

Table 3

However, in our view, the Islamic banks could be more vulnerable to the current operating environment than their conventional peers. This is because:

• Islamic banks tend to have greater exposure to the real estate sector due to the asset-backing principle inherent to Islamic finance.
• Islamic banks cannot charge late payment fees, unless they donate them to charity, meaning that their clients tend to prioritize payments on conventional loans over Islamic financings. However, the fact that the GCC governments asked all banks not to charge late payment fees when they reschedule their loans to companies under stress partly mitigates this difference between Islamic and conventional banks.

These weaknesses are also lessened by the fact that the business models of both Islamic and conventional banks are comparable, consisting primarily of collecting deposits and extending financing to the real economies of their respective 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. Yet we are of the view that collateral realization is still difficult in the GCC, although some authorities have implemented more creditor-friendly regulations over the past three years. In addition, real estate is the preferred form of collateral and its value has been declining for most of the GCC markets over the past three years.

In terms of risk-absorptive capacity (net operating income corrected for lower interest rates and excesses or deficits in the provisioning of existing NPLs), the rated GCC banks had already used almost $6 billion of their $36 billion of capacity--about 16.7%--at the end of first-half 2020. The biggest use was by some UAE and Kuwaiti banks, for the reasons we detail above (see chart 4).

Chart 4

A Few Banks Will Suffer Losses This Year And Next

We anticipate that GCC banks' profitability will take a hit in 2020 and 2021 (see chart 5), for the following reasons:

Lending growth will remain muted because of the mild recovery we forecast for 2021

Moreover, most banks will be busy dealing with the impact of the operating environment on their asset-quality indicators as regulators progressively lift their forbearance measures.

Intermediation and interest margins will remain lower for much longer

This mirrors the trend for global interest rates and the structure of GCC banks' funding profiles, with a significant contribution from noninterest-bearing deposits.

The cost of risk will continue to increase

This follows a jump of 40% in the cost of risk in first-half 2020 as banks started to set aside provisions in preparation for more stress. We think that cost of risk is likely to remain at least at the current level, and might even increase further for some banks due to their exposure to vulnerable sectors or companies.

The support measures that the GCC governments have enacted have delayed recognition of the problem. In our view, the governments will withdraw the support measures progressively to avoid destabilizing the banking systems or hurting investor confidence. In our base case, we exclude any additional systemic support measures, particularly in the form of buybacks of loans or capital injections. Banks will also cut their cost bases further as the pandemic and related lockdown measures have shown that they can conduct a large number of their activities remotely and in a more cost-effective manner.

Overall, we think that the majority of GCC banks will show positive results in 2020 and 2021, but a few might be loss-making because of greater exposure to specific sectors or riskier countries. In our base-case scenario, we assume that a vaccine will be widely available from mid-2021 and that the oil price will average $50 per barrel in 2021. If that is not the case, the impact on GCC banks' profitability could be greater.

Chart 5

Funding And Liquidity Remain Good For Now

We see funding as a relative strength for most of the GCC banking systems. The use of wholesale funding sources remains relatively limited and will not change anytime soon. The only exception is Qatar, where the banking system still carries significant net external debt. We think that this debt will decline slightly because of lower lending growth.

Core customer deposits are the main funding source for GCC banks and we do not foresee any change in the next few years. Growth in customer deposits dropped to about an annualized 4.8% in the first six months of 2020, compared with 9.7% in 2019. However, the drop was primarily due to the lower oil prices and the fact that some corporates had to use their deposits to cover their operating costs while their revenues contracted. We have not observed significant outflows of expatriate deposits despite significant job losses. That means that expatriates' contribution to the overall deposit base in these countries is probably small, and that expats are probably keeping most of their savings in their home countries.

Banks in our sample have consistently shown a ratio of loans to deposits below 100% over the past five years (see table 4), with Qatari and Omani banks being the only exceptions. Kuwait is close to the 100% mark, as most of the banks there do not report some of the deposits from government-related entities as part of their core deposits. If these deposits were reintegrated into the calculation, the ratio would look stronger.

External funding is a significant source of refinancing for Qatari banks, and to a lesser extent, for Bahraini and Omani banks (see chart 6). Other banking systems are in a net asset position and we expect them to remain so. For Qatar, we take comfort from the government's highly supportive stance toward its banking system. This was evident in 2017, when the boycott on Qatar was implemented. At that time, the Qatari banking system saw about $20 billion of outflows and received twice that amount in the form of injections from the government and its related entities. For Bahrain, we understand that a portion of banks' funding relates to other GCC countries and has been stable in the banking system for several years.

We also continue to take comfort from GCC banks' good liquidity. At June 30, 2020, the banks in our sample had almost one-quarter of their assets in liquid forms. The abundant global liquidity and increase in investors' risk appetite that we have observed over the past few months compared with earlier in the year mean that GCC banks are likely to retain their access to external deposits and other capital market instruments.

Table 4

Chart 6

Strong Capital Buffers Should Help

The GCC banks in our sample continue to display strong capitalization by international standards, with an unweighted average Tier 1 ratio of 17.2% on June 30, 2020 (see chart 7). This ratio has been fairly stable over the past three years, but might decline slightly in 2020 and 2021 as the operating environment impinges on banks' profitability. At the same time, we expect that banks will reduce their dividend payout ratios, with some regulators restricting them from distributing any dividends. We expect GCC banks' capitalization to continue to support their creditworthiness in 2020-2021.

We understand that Oman is the only GCC country that approved a framework for the resolution regime, but the implementation steps are unclear. We believe that rolling out such regimes would require a profound change in the GCC governments' mentality and approach to bank support. GCC governments have not hesitated to rescue banks, either as shareholders or to safeguard the financial stability of their banking systems.

Chart 7

Mergers And Acquisitions Might Resume When The Dust Settles

A second wave of mergers and acquisitions (M&A) could start when the full impact of the weaker operating environment on banks becomes apparent. The first wave of M&A was driven by shareholders' desire to reorganize their assets. We consider the upcoming merger between The National Commercial Bank and Samba Financial Group, if approved by their regulators and shareholders, as the most recent transaction of the first wave. The second wave will be more opportunistic and driven by economic rationale. The operating environment might push some banks to find a stronger shareholder or to join forces with other banks to enhance their resilience. This might involve consolidation across the different GCC countries or the different emirates in the UAE, for example. It would require more aggressive moves by management than we have seen in the past. Clearing the additional hurdle of convincing boards and shareholders--who face the possibility of seeing their assets diluted or of losing control--might be easier if they have to recapitalize their banks anyway.

Banks Exposed To Risky Sectors Are Worse Off

The GCC governments' measures to help corporates and individuals navigate the challenging environment have taken various forms. Some governments have opted to reduce taxes and levies. Others have asked the banks to extend additional subsidized loans to their clients to maintain employment and avoid the destruction of productive capacity.

To our knowledge, none of the governments have announced broad measures that would reduce the credit risk on banks' balance sheets, for example, guarantees on new borrowing or injections of additional capital. As a result, risks have been building and have started to affect banks' financial profiles. In such an environment, banks that are heavily exposed to riskier sectors (real estate, construction, hospitality, and general commerce, for example) or segments (SMEs, expatriates, and credit cards) will see more of an impact than others. Some banks might even report losses in 2020 and/or 2021.

In terms of the different GCC banking systems, we think that the UAE, Oman, and Bahrain will take longer to recover than the rest. We expect the fiscally constrained Omani and Bahraini governments' to be less able to support their economies than elsewhere in the region. In the UAE, particularly Dubai, the simultaneous shocks to several sectors of the economy and the federal structure of the country are likely to have a greater impact on banks' asset quality, and potentially, make them selective in extending support. The question of how to allocate resources among the smaller and richer emirates might arise at some stage. That said, we continue to believe that in case of need, the federal authorities will intervene and support systemically important banks in the UAE.

In Saudi Arabia, we expect the cost of risk to normalize gradually from 2022, but we expect that Saudi banks' profitability will remain lower than before the pandemic due to lower-for-longer interest rates. Qatar is another country where we also foresee a quicker normalization of the cost of risk. The high state involvement in the local economy and the upcoming world cup in Doha in 2022 will certainly help. For Kuwait, we consider that the provisions banks have accumulated over the past few years will help them navigate this challenging time. However, given the government's current liquidity constraints, support to the economy is likely to be relatively muted, which could exacerbate pressure on the banking system.

The Pandemic And Drop In Oil Prices Could Mark The Start Of A New Era

This new era is characterized by a decline in oil wealth, a lower multiplier effect in the local economies, and lower profitability. In the past, when oil prices stabilized above a certain level, economic activity, asset prices, and banks' profitability benefited. This happened most recently between 2010 and mid-2014, when oil prices hovered at about $100 per barrel. Yet the pandemic accelerated the drop in oil prices and we now expect them to hover at about $50-$55 per barrel for the next few years. We also expect that central banks in developed countries will maintain lower interest rates for much longer than we originally expected.

That said, we think that GCC banks' reduced profitability will be longer lasting due to the domination of noninterest-bearing deposits in their funding structures and lower revenues on the asset side. In addition, we think that, in the next few years, GCC banks might start to import capital more aggressively as local funding sources prove insufficient, which is already the case for Qatar. This would add to the pressure on banks' profitability. It remains to be seen to what extent banks could compensate for that pressure by consolidating or leveraging fintech solutions to cut costs.

Chart 8

Sample Composition

To assess the credit fundamentals of Islamic and conventional banks in the GCC, we used a sample of the 16 largest Islamic banks and 30 largest conventional banks, with total assets in excess of $2.3 trillion and sufficient financial disclosures (see tables 5 and 6).

Table 5

Table 6

Related Research

• Global Banking: Recovery Will Stretch To 2023 And Beyond, Sept. 23, 2020
• How Resistant Are Gulf Banks To The COVID-19 Pandemic And Oil Price Shock?, April 22, 2020
• Will COVID-19 And Cheap Oil Reset The Market For GCC Tier 1 Instruments?, April 22, 2020
• GCC Banks Face An Earnings Shock From The Oil Price Drop And COVID-19 Pandemic, April 6, 2020
• The Energy Transition: How It Could Affect GCC Banks, Feb. 16, 2020
• Coronavirus Increases Risks For Gulf Economies, Feb. 16, 2020