S&P Global Ratings believes banks in the Gulf Cooperation Council (GCC) have demonstrated resilience to the COVID-19-related economic shock and last year's sharp decline in oil prices. Western and local central banks' unprecedented interventions, which took the form of liquidity injections and regulatory forbearance measures, helped cushion regional banks from wider uncertainty and masked the true hit to their asset quality indicators. However, a gradual recovery in private sector economic activity, supportive public sector demand for credit, and higher oil prices (S&P Global Ratings assumes an average of $75 per barrel [/bbl] in 2021 and $65/bbl in 2022) have also helped amortize the impact on banks. In turn, nonperforming loan (NPL) ratios increased only 20 basis points (bps) for the top GCC 45 banks between year-end 2020 and June 30, 2021.

We expect the NPL ratio to rise in the next 12-24 months without exceeding 5%-6%, compared with 3.8% at June 30, 2021, as forbearance measures are gradually withdrawn and the pandemic's impacts on weaker businesses are laid bare. However, we also expect the GCC economies to expand at an unweighted average of 1.8% in 2021 and 4% in 2022, in part facilitated by increased credit growth. These factors underpin our expectations for average regional cost of risk to decline in 2021 and start to normalize from 2022. Saudi Arabia will be an exception, with continuing strong lending growth, driven primarily by mortgages and to some extent the implementation of Vision 2030 investments. In contrast, cost of risk is likely to remain high in the United Arab Emirates (UAE), despite the extension of the central bank's Targeted Economic Support Scheme (TESS). Dubai's hosting of the World Expo (Expo 2020), starting October, and other factors will improve economic sentiment, but it is unclear if this will continue when the event ends in March 2022.

After an improvement in first-half 2021, we expect GCC banks' profitability to stabilize in 2021-2022. Lower cost of risk and good efficiency--with an average cost to income of 38% in first-half 2021--will likely compensate for a lower but stable margin of 2.4% over the same period. Return on assets will therefore also stabilize at 1.0%-1.2%, below historical levels but higher than the 0.8% for the top 45 banks in the region last year. In our view, banks will continue to leverage fintech opportunities, move staff to cheaper locations, and cut physical branches to reduce costs.

GCC banks' funding profiles remain supportive of their creditworthiness apart from Qatar, where external funding continues to increase. These risks are somewhat mitigated by the Qatari government's strong willingness and capacity to inject foreign currency liquidity when necessary. However, the pace of external debt buildup means that Qatari banks are now vulnerable to a shift in investor sentiment or a scaling back of western central banks' liquidity support.

Today, 82% of our outlooks on GCC bank ratings are stable, mirroring banks' resilience to the COVID-19 shock and an improving macroeconomic forecast. Downside risks include a lower oil price than we expect, an escalation of geopolitical risks, and new pandemic concerns such as the emergence of more contagious or vaccine-resistant variants.

Lending Growth Slightly Accelerates

GCC banks in our sample saw lending growth accelerate slightly in first-half 2021 to an annualized 8.4%, compared with 6.6% in 2020, due to higher oil prices and improving economic sentiment. Saudi Arabia continued to drive the sample numbers with lending up 7.9% in the first half. We expect this to continue since mortgage production remains strong and we see some corporate lending activity. Lending growth in the UAE remained muted at about 0.6%, with some banks' lending books reducing in the first half. We expect a slight acceleration in lending in second-half 2021 as UAE economic sentiment continues to improve, especially with the start of Expo 2020. That said, it is unclear if this will continue when the event ends in March 2022. Overall, we believe that credit growth will be slightly higher in 2021 than 2020 (see chart 1).

Chart 1

Table 1

Asset Quality Has Been Resilient Given The Magnitude Of The Shock

Banks' asset quality continued to deteriorate with the NPL ratio reaching 3.8% on average for our sample of banks at mid-year 2021, compared with 3.1% at year-end 2019 (see chart 2). That said, a more significant increase was prevented by regulatory forbearance measures implemented by GCC governments to help their banks and corporates navigate the stressed economic environment. We now see more positive economic sentiment, aided by higher oil prices and stronger vaccination rates than other emerging markets. Although cash flows are still below historical levels for many corporates, most have managed to generate enough revenue to remain current on their bank financings. Therefore, we have observed a reduction in deferred exposures in most GCC countries. However, with regulatory forbearance measures ending either this year or by mid-year 2022, we see NPLs increasing but not exceeding 5%-6% on average. In the meantime, cost of risk will keep declining and normalize from 2022 and 2023 for some systems.

Chart 2

The largest asset quality deteriorations have been in the UAE due to a fraud case at one large corporate and pressure on the construction, real estate, and hospitality sectors (see table 2). For Saudi Arabia, strong lending growth kept asset quality indicators stable, despite an increase in NPLs.

Regionally, cost of risk has declined because banks are sitting on good provision cushions to meet the expected NPL increase. At June 30, 2021, the average coverage ratio remained stable at 146.1%, ranging from a strong 229.5% in Kuwait to a just adequate 91.8% in the UAE. We expect the regional coverage ratio to reduce slightly in 2021-2022 but remain well above 100%. Most of the expected new NPLs will be from struggling small and midsize enterprises and companies in the real estate, construction, hospitality, and consumer-related sectors. Our assumptions exclude any additional support from GCC governments directly to corporates, or to banks in the form of buybacks of exposures or recapitalizations, since we have no indication that they will move in this direction.

Table 2

We also note the relatively stable asset quality from our sample banks' International Financial Reporting Standard 9 disclosures (see chart 3; based on the data of 32 banks). On June 30, 2021, the volume of Stage 3 loans increased 10 bps, while the volume of Stage 2 loans dropped 40 bps. The overall proportion of problem loans in Stages 2 and 3 now stands at about 15.3%, and we expect this to increase to about 16%-18% in the next 12-24 months, which is slightly better than our previous expectations of 20%-22%.

Chart 3

NPL and coverage ratios are similar for Islamic and conventional banks. On June 30, 2021, the average NPL ratio reached 3.5% for Islamic banks in our sample, compared with 4.0% for conventional banks. The coverage ratio was 157.3% for Islamic banks and 139.5% for conventional banks on the same date (see table 3). We consider these ratios comparable and don't read much into the slight differences between the segments.

Table 3

Despite their higher exposure to the real estate sector, Islamic banks have been as resilient as their conventional counterparts. In addition, because banks were asked not to charge customers for the deferral of exposures, Islamic banks have not been hit by Sharia rules that prohibit late payment fees. In the GCC, the business models of Islamic and conventional banks are comparable and consist primarily of collecting deposits and extending financing to the real economies of their respective countries. Although on paper, Islamic banks might be perceived as more resilient due to the asset backing principle of Islamic finance, which results in higher collateralization, we believe that collateral realization is still difficult in the GCC. In addition, real estate is the preferred form of collateral and its value has been declining in most GCC markets over the past three years.

Profitability Will Remain Lower Than Historically

Although improving compared with last year, we expect GCC banks' profitability to stabilize at current levels (see chart 4). This is because we believe:

Intermediation and interest margins will remain at current levels.  This mirrors the trend for global interest rates and the structure of GCC banks' funding profiles, with a significant contribution from noninterest-bearing deposits. We do not expect any increase in interest rates in the next 12 months.

Cost of risk will slowly normalize.   This follows a drop to 1.1% in first-half 2021 compared with 1.6% in 2020. Higher oil prices and the start of Expo 2020 in Dubai this year and the World Cup in Qatar next year are likely to further improve economic sentiment, boost confidence, and support business revenue. Therefore, we expect a normalization of cost of risk by 2022 or 2023. The lifting of regulatory forbearance measures is likely to be gradual as central banks will avoid the risk of destabilizing their banking systems or hurting investor and consumer sentiment. In our base case, we exclude any additional systemic support measures, particularly in the form of exposure buybacks or capital injections.

Banks will continue to reduce costs.  Banks will also continue to cut their cost bases where possible as the pandemic and related lockdown measures have shown that they can conduct many activities remotely and in a more cost-effective manner. Some banks are moving staff to cheaper locations and others are cutting their branch networks. Most are also looking at opportunities offered by higher digitalization.

Chart 4

External Funding Is A Source Of Risk For Qatar

We see funding as a relative strength for most GCC banking systems. The use of wholesale funding sources remains relatively limited and will not change any time soon. The only exception is Qatar, where the banking system still carries significant net external debt. Although the Qatari government's capacity, willingness, and track record in providing support are mitigating factors, risks are rising. In our view, Qatari banks are now vulnerable to a shift in investor sentiment or a scaling back of western central banks' liquidity support measures.

Core customer deposits are the main funding source for GCC banks and we do not forecast any change in the next few years. Growth in customer deposits remained stable at about an annualized 6.6% in first-half 2021, compared with 6.3% in 2019. This mirrors the ongoing recovery in some corporate activity and rising consumer spending compared with first-half 2020, when most GCC countries were under months of strict lockdowns.

Banks in our sample have consistently shown a ratio of loans to deposits below 100% over the past five years, with Qatari and Omani banks the only exceptions (see table 4). Kuwait is close to the 100% mark, because most banks there do not report some deposits from government-related entities as part of their core deposits. If these deposits are reintegrated into the calculation, the ratio would look stronger. In Saudi Arabia, the loan to deposit ratio is also increasing and crossed 90% for the first time in five years in 2021.

External funding is only a significant source of refinancing for Qatari banks, and to a lesser extent Bahraini and Omani banks (see chart 5). Other banking systems are in a net asset position and we expect them to remain so. Given the pace of external debt build-up in Qatar, we now see banks as vulnerable to a shift in investor sentiment or a scaling back of western central banks' liquidity support measures. For Bahrain, we understand that a portion of banks' funding relates to other GCC countries and has been stable for several years.

We also continue to take comfort from GCC banks' good liquidity. At June 30, 2021, the banks in our sample had about 22% of their assets in liquid forms. This ratio dropped compared with last year as banks have increased investments to extract more revenue from their asset base.

Chart 5

Table 4

Strong Capital Buffers Should Help Performance

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, 2021. This ratio has been stable over the past three years (see chart 6). We expect banks to increase their dividend payout ratios in 2021-2022 as profitability stabilizes, with capitalization continuing to support their creditworthiness over the same period.

Oman is the only GCC country that has approved a resolution regime framework, but the implementation timeline is unclear. We believe that rolling out such regimes would require a profound change in 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 6

No Major Acquisitions Are Expected

After the merger of Saudi's National Commercial Bank and Samba Financial Group, which was driven by common shareholders like other recent activity, we do not expect significant acquisitions in the next 12-24 months. We could see some movement at the tail end of overbanked systems, such as the UAE or Oman, as the new profit reality pushes banks in competitive markets to regroup.

Some Systems Are More Resilient Than Others

We think that the UAE, Oman, and Bahrain will take longer to recover than the other GCC banking systems. The Omani and Bahraini governments' more limited capacity to support their economies means they would need to prioritize the allocation of limited financial resources. In the UAE, while economic sentiment is improving, it is unclear if this will continue post Expo 2020. Moreover, the federal structure of the country means that support to corporates could be more selective. We maintain our view that, in case of need, the federal authorities will intervene and support systemically important banks in the UAE.

In Saudi Arabia, rapid mortgage growth and an expected increase in corporate lending activity are supporting banks' financial metrics. In Qatar, the large state footprint in the economy helped banks navigate stress with a minimal impact, with further positive momentum expected from the 2022 World Cup. In Kuwait, banks have strong cushions, but uncertainty continues relating to the fiscal impasse. This is casting doubt on future economic performance and the government's capacity to support its banking system, should the need arise. However, for now, we continue to expect that the government will remain highly supportive.

Environmental, Social and Governance (ESG) Issues Are Capturing Board And Management Attention

Over the past 12 months, several banks in the region have announced plans to focus more on ESG factors in their businesses. This shift comes in part through a desire to remain on investors' radars in the next few years. The oil sector is an important component of GCC economies, and we expect this to remain the case for the foreseeable future. Although banks' direct exposure to the hydrocarbon sector is limited, indirect exposure (via the overall dependence of the regional economy on hydrocarbons) is substantially higher. Going forward, we think that GCC banks will increasingly incorporate ESG considerations in their decision-making processes, although we do not expect a radical change in their balance sheet composition. The social environment is characterized by weaker consumer protection compared with developed markets, lower female participation in the labor force, and difficult conditions for workers in some sectors (such as construction). It remains to be seen if this will have implications for the cost and availability of financing for the region's banking sector over the longer term.

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 29 largest conventional banks, with total assets of more than $2.5 trillion and sufficient financial disclosures (see tables 5 and 6).

Table 5

Related Research

• Government Support And Improving Economic Sentiment Help Mitigate Sector Vulnerabilities For GCC Banks, Sept. 26, 2021
• The Global Sukuk Market Is Returning To Traditional Risks, July 5, 2021
• External Auditing Of Sharia Compliance Will Likely Strengthen Governance In Islamic Finance, May 24, 2021
• Vision 2030 Will Push Forward Saudi Arabia’s Debt Capital Market, May 4, 2021
• Islamic Finance 2021-2022: Toward Sustainable Growth, May 3, 2021
• Stress Scenarios: How GCC Banks Will Perform Amid Further Potential COVID-19 Shocks, March 21, 2021