S&P Global Ratings believes that the earnings performance of banks in the Gulf Cooperation Council (GCC) will recover almost to pre-pandemic levels in 2022, thanks to the economic recovery. Banks are also getting a boost from high oil prices, improving confidence, and for some countries--specifically Saudi Arabia--large government-sponsored projects. We expect cost of risk to return to normalized levels for most countries and higher interest rates to support banks' bottom lines, and foresee no major regional merger or acquisitions on the horizon.

But things look less certain for 2023. We see three main sources of risk:

• The expected slowdown of the global economy, which could affect the region primarily through commodity prices. Under our base-case scenario, we assume the Brent oil price will average $85 per barrel in 2023 and $55 in 2024 and beyond, resulting in lower growth for the GCC economies and fewer opportunities for their banking systems.
• Banks' exposure to riskier countries. A few GCC banks have ventured into countries with higher credit risk, particularly Turkiye and Egypt. Given the significant challenges these two countries face, we expect to see some impact on GCC banks. In Turkiye, for example, the lira's depreciation has resulted in significant unrealized losses for exposed GCC banks. Moreover, the application of International Accounting Standard 29 on financial reporting in hyperinflationary countries has hit the bottom line of exposed Gulf banks. The impact has been manageable so far and banks have benefited from revaluation gains on their nonmonetary position, reported in comprehensive income.
• Potential liquidity constraints to fund growth as local and global liquidity becomes less abundant. In Qatar, for example, the proportion of external funding is declining due to lower and more expensive liquidity globally. Nonresident deposits dropped by $19.5 billion at Aug. 31, 2022 from year-end 2021. This was offset by an increase in resident deposits of about $19.2 billion (60% public sector and 40% private sector). In Saudi Arabia, the channeling of oil receipts to the Public Investment Fund rather than to the banking sector, alongside strong lending growth, resulted in some temporary liquidity constraints in first-half 2022. We expect periodic episodes of liquidity pressure counterbalanced by central bank actions or the deployment of deposits by government-related entities.

Despite these risks, at Oct. 15, 2022, our outlook bias was firmly positive, with about 35% of ratings carrying positive outlooks either for potential improvement in their respective sovereign's creditworthiness or idiosyncratic reasons. The remaining 65% of ratings had a stable outlook, mirroring banks' expected resilience and still-supportive operating environment. Nevertheless, risks to global and local economic prospects are increasing.

Saudi Arabia Leads The Slight Acceleration In Lending Growth

Based on the data reported by the top 45 GCC banks, lending growth accelerated slightly in first-half 2022 to an annualized 9.5%, compared with 7.8% in 2021, due to greater economic activity and improving sentiment related to high oil prices. Saudi Arabia continued to propel the sample numbers with lending up almost 10% in the first half. We expect corporate lending to contribute to future growth as projects related to Vision 2030 are implemented. We also expect mortgages to continue contributing to growth, although more slowly than in the past couple of years, as the sector matures and increased interest rates reduces demand somewhat.

Lending growth remained muted in Qatar as projects related to the World Cup have been delivered and no significant new projects are being launched for now. We expect to see some lending growth for working capital and consumption in 2022. We then expect lending to accelerate slightly from 2023 as investment resume. For Kuwait, we expect to see accelerated lending growth from stronger economic growth and investment from the government. Finally, for the United Arab Emirates (UAE), lending growth has sped up thanks to improving sentiment. In 2023-2024, we expect to see slower overall lending growth in the region from the expected slowdown in economic growth.

Chart 1

Of importance, the continued depreciation of the Turkish lira impaired lending growth for some of the large banks in the GCC with subsidiaries in Turkiye. Under our base-case scenario, we expect the lira's depreciation will continue in 2023 and that we could see a repeat of this, although not as great.

Table 1

The Pandemic's Lingering Effects And Higher Interest Rates Will Contribute To Slight Asset Quality Deterioration

Banks' asset quality indicators held up fairly well compared to the magnitude of the pandemic's economic shock. Regulatory forbearance measures and timely liquidity support for the banking system helped affected corporates during the pandemic and they are now in a position to start repaying their debt as these measures are lifted. Some of this exposure has been restructured and could slip to nonperformance in 2022. We expect the overall impact on banks' financials to remain contained. Write-offs and increasing real estate prices have helped in 2021-2022. Nevertheless, interest rate increases will contribute to weaker indicators in 2023, partly mitigated by our expectations that banks will pay close attention to the trade-off between the positive impact on profitability and asset quality deterioration. Under our base-case scenario, we expect nonperforming loan (NPL) ratios to increase but not exceed 5% by year-end 2023 unless the global economic slowdown proves more severe than our expectations. We also expect cost of risk to reach levels close to what we observed pre-pandemic.

Chart 2

Banks continue to sit on a comfortable cushion to cover additional inflows of NPLs. At June 30, 2022, the average coverage ratio increased slightly to 161.8%, ranging from a strong 297.2% in Kuwait, where part of the provision is driven by mechanical regulatory requirements, to an adequate 97.7% in the UAE. We expect the regional coverage ratio to decrease slightly in 2022-2023 but remain well above 100%. Most of the expected new NPLs will be from struggling small and midsize enterprises and companies in commercial real estate and hospitality, where demand has yet to fully recover.

Table 2

The resilience is also confirmed when looking at the International Financial Reporting Standard 9 disclosures for banks in our sample that reported these numbers (based on the data of 38 banks). As of June 30, 2022, the volume of stage 3 loans had dropped 20 basis points (bps) and that of stage 2 loans 10 bps. The overall proportion of problem loans in stages 2 and 3 stands at about 14.2% at June 30, 2022, compared with 16.7% at year-end 2020. We expect this proportion to increase slightly in the next 12-24 months given the economic slowdown.

Chart 3

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. On paper, Islamic banks might be perceived as more resilient due to the asset backing principle of Islamic finance, which results in higher collateralization. However, in our view, realizing this collateral in practical terms is still difficult in the GCC. Real estate is one of the preferred forms of collateral and its value has been recovering in most GCC markets over the past 12 months. This is why we do not read too much into the slight difference in the numbers reported by Islamic and conventional banks and see their asset quality indicators as comparable.

Table 3

Profitability Will Be Near Pre-Pandemic Levels

We expect profitability to improve and almost reach pre-pandemic levels by the end of 2022. This is because we believe:

Intermediation and interest margins will improve.  This mirrors the Fed's hawkish stance, the currency pegs between GCC currencies and the U.S. dollar, and the structure of GCC banks' funding profiles, with a significant contribution from noninterest-bearing deposits. In the first six months, we have seen a slight increase in margins for some systems. Systems where the funding profile is dominated by corporate deposits (Kuwait), external funding (Qatar), or large assets at fixed rates (Saudi Arabia) have not yet reaped all the benefits from the increase in rates. However, we expect some positive impact in the second half.

Cost of risk will slowly normalize.   Stronger economic growth and support measures implies that cost of risk is likely to return to about 100 bps for the top 45 banks. In 2023, we don't expect a significant increase in cost of risk unless the situation is much more stressed than we forecast.

Banks will continue to enjoy strong efficiency.  This is thanks to a low cost of labor and smaller branch networks. Over the past couple of years, banks were more attentive to costs and some cut their branch networks even further or moved staff to cheaper locations.

Chart 4

External Funding Remains A Risk For Qatar, Despite Improvements

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. The central bank has revised regulations to reduce the attractiveness of external funding, and since the beginning of the year, external deposits dropped by $19.5 billion (or 25%) as of August 2022. Moreover, the banking system is not expanding much in 2022, so some of this funding is no longer needed. Finally, an increase in resident deposits of $19.2 billion offset this drop, with 60% coming from the public sector and 40% the private sector. Furthermore, the Qatari government has a strong capacity, willingness, and track record of providing support if needed.

Core customer deposits are the main funding source for GCC banks and we do not forecast this changing in the next few years. Growth in customer deposits was lower than lending in Saudi Arabia. This has caused some liquidity pressure and prompted SAMA (the Saudi Central Bank) to reportedly inject liquidity to ease the pressure. We expect SAMA to continue intervening whenever needed as the banking system is one of the main pillars in implementing Vision 2030.

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, and more recently the Kuwaiti banks as exceptions. However, for Kuwait, the ratio's increase also follows most banks there not reporting some deposits from government-related entities as part of their core deposits. Including these, the ratio would look stronger. In Saudi Arabia, the ratio is also rising rapidly given the continued rapid increase in lending.

Table 4

External funding is only a significant source of refinancing for Qatari, and to a lesser extent Bahraini and Omani, banks. Other banking systems are in a net asset position and we expect them to remain so, especially now that foreign funding sources are more expensive. 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 view positively GCC banks' good liquidity. At June 30, 2022, the banks in our sample had about 22.8% of their assets in liquid form. This ratio has been stable and banks in some systems refrained from selling investments to finance their lending growth to avoid crystallizing unrealized losses given increasing interest rates.

Chart 5

Strong Capital Buffers Continues To Support Banks' Creditworthiness

The GCC banks in our sample continue to display strong capitalization by international standards, with an unweighted average Tier 1 ratio of 16.6% on June 30, 2022. This ratio has been relatively stable over the past three years. We expect banks to maintain stable dividend payouts in 2022-2023 as their profitability improves, with capitalization continuing to support their creditworthiness.

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

Chart 6

We Expect No New Major Acquisitions Within The Region

Kuwait Finance House's acquisition of Ahli United Bank (AUB) proceeded in 2022 after stalling for a couple of years. The process of integration is expected to take a relatively long time as AUB will have to convert a portion of its activity to Sharia compliance. There is no indication that other significant acquisitions will happen in the next 12-24 months. However, we could see some movement at the tail end of overbanked systems, such as the UAE or Oman. We view the recent acquisition of a stake in Credit Suisse by SNB as a one-off and specific to Saudi Arabia.

The Expectations Differ By Country

Bahrain:   We expect Bahrain's economic recovery to continue in 2022 because of higher oil prices and increasing regional economic activity. We believe that further deterioration in banks' asset-quality indicators will remain contained as the economy recovers. Although its contribution to the overall funding profile is moderate, external debt could prove vulnerable to domestic or regional stresses. A mitigating factor is that a large portion of the banking sector's external funding is from GCC countries and likely to remain stable, assuming no domestic or regional stresses.

Kuwait:   Lending growth continued on government projects. We expect to see some NPLs in the second half from the commercial real estate sector (mainly offices) that has not yet fully recovered. Other compartments of the real estate sector were either immune (villa segment for nationals) or are recovering (apartments rented to expats).

Oman:   Real GDP growth recovered in 2022, but we expect another slowdown in 2023-2025 via a drop in oil prices. While we expect the recovery to reach some sectors, others like the construction, hospitality, and transportation sectors are likely to remain under pressure and contribute to banks' asset-quality deterioration. Banks continue to rely heavily on public sector deposits, but we view positively their relative stability over a full economic cycle.

Qatar:   Credit growth is slowing with the completion of most FIFA World Cup projects. We think most of the growth ahead will come from consumption and working capital loans. Cost of risk remained stable as banks manage their profitability and due to additional risks from Turkiye and Egypt. External debt is declining due to increasing rates but also changes in regulation giving less credit to external deposits in regulatory ratios.

Saudi Arabia:   In first-half 2022, growth continued to be strong thanks to mortgages and (increasingly) corporate lending. Banks will benefit from higher rates thanks to the significant nonremunerated deposits (although less so for banks with significant fixed-rates mortgages). There was a bit of pressure on liquidity as lending growth continued to exceed deposits, but SAMA intervened. Cost of risk dropped in the first half, but we think that it will go back to normalized levels due to some pandemic hangover.

UAE:   We expect the UAE's economic activity will accelerate in 2022 as the country benefits from higher oil prices and increased real estate and hospitality activity. We think further deterioration of banks' asset-quality indicators will remain contained as the economy improves and corporate activity recovers. Structural weaknesses, including high exposure to cyclical sectors, high single name concentration, and exposure to struggling government-related entities, pose a risk to the banking sector.

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 $2.8 trillion and sufficient financial disclosures.

Table 5

Table 6

Related Research

• Credit Conditions Emerging Markets Q4 2022: Clouds Are Gathering, Sept. 27, 2022
• GCC Banks Return To Form, Can It Last?, Sept. 22, 2022
• Why GCC Banking Systems Are Resilient To Geopolitical Stress Scenarios, June 22, 2022
• Which Emerging Market Banking Systems Are Most Exposed To External Funding Stress And Why, June 13, 2022
• Gulf Banks' Strong Capitalization Supports Resilience To Cyber Risk, May 16, 2022
• When Rates Rise: Saudi Banks’ Profits Follow, April 11, 2022
• What The UAE's Inclusion On FATF's Gray List Will Likely Mean For Corporates, Banks, And Insurers, March 7, 2022