At A Glance

Higher interest rates will reduce GCC banks' credit growth, but Saudi and UAE banks' performance will be more resilient.   We expect higher interest rates will reduce Kuwaiti banks' credit growth to about 3%, from almost 8% in 2022, and soften Saudi banks' total lending growth to about 10% in 2023, from 14% in 2022. UAE banks, on the other hand, will benefit from still robust non-oil GDP growth, which will somewhat mitigate the negative effect of higher interest rates on credit growth. We expect UAE banks' credit growth will improve to approximately 7% in 2023, compared with 5% in 2022. Yet, a long period of higher interest rates and the slowdown of the oil economy could pose challenges. Qatari banks, unlike their GCC peers, will continue to experience a sharper decline in credit growth. This is because the country's main infrastructure projects, which are a key driver for credit demand through contractors, were completed in time for the 2022 FIFA World Cup.

We expect a slight deterioration in asset quality metrics but believe the negative effect on banks' returns will be limited.   Higher interest rates have resulted in a steep rise in borrowing costs. We think the resulting sluggish demand in the rental real estate market will weaken Qatari and Kuwaiti banks' asset quality metrics (see chart 1). In addition, Qatari banks' weaker foreign lending exposures will contribute to loan loss charges. Nevertheless, Qatari banks' robust public sector exposure and Kuwaiti banks' high provision buffers will contain the adverse effects and limit the increase in nonperforming loan (NPL) ratios. We expect the UAE will report strong non-oil GDP growth of 6% in 2023. This, in combination with recoveries from provisions booked in the past two years, will reduce UAE banks' credit costs in 2023, compared with 2022. Even though credit costs in the GCC region, with the exception of the UAE, will increase, we still expect GCC banks' return on assets (ROA) will improve in 2023, mainly due to higher margins and still satisfactory, albeit lower, lending growth in some GCC countries (see charts 2-3).

Chart 1

Chart 2

Chart 3

Saudi Arabia's Vision 2030 program provides a growth catalyst for Saudi banks that will continue to contribute to a higher ROA, compared with GCC peers.   We expect Saudi banks will achieve an ROA of 2.2% in 2023, compared with the GCC peer average of 1.8%. While higher interest rates will decrease Saudi banks' total lending growth, Vision 2030-related projects will keep credit growth well above the GCC average rate of 4% in 2023. Increased corporate lending, higher interest rates, and portfolio seasoning will likely lead to an slight increase in NPLs and credit costs. Yet, Saudi banks' asset quality metrics will remain better than the peer average, due to a high exposure to government-backed mortgage lending. We expect an NPL ratio of 2.1% and credit costs of 60 basis points (bps) for Saudi banks in 2023, compared with 3.5% and 90 bps, respectively, for GCC peers.

Liquidity conditions will tighten.   For Saudi banks, we expect tighter liquidity conditions will reduce the benefit of higher asset yields. This is because banks will have to pursue costlier funding options, while deposits will continue to migrate to interest-bearing instruments. Qatar is another country to watch, as banks progressively reduce their recourse to external funding and substitute some of it with more volatile sources, for example by replacing non-resident customer deposits with non-resident interbank deposits.

Capitalization remains a strength for GCC banks.   GCC banks have always operated with comfortable capital buffers, and we do not expect this to change. We think slower credit growth and higher earnings mean that GCC banks' capital metrics will remain stable. The banking systems in Saudi Arabia, the UAE, Qatar, and Kuwait reported a tier 1 regulatory capital ratio of 15% and above in 2022.

Saudi Arabia: Asset Quality Metrics Remain Strong

Saudi banks' earnings growth will slow in 2023, primarily due to lower credit growth and higher impairment charges.   We expect Saudi Arabia's banking fundamentals will remain robust. As the mortgage market becomes more saturated, we expect that the related demand will reduce and that corporate lending will drive credit growth over the rest of 2023 and in the medium term. Smaller banks will buck the mortgage lending trend in the medium term, while larger banks' mortgage growth will slow down. Higher interest rates will soften total lending growth to a still solid 10% in 2023, from 14% in 2022. On a positive note, we expect margins will improve, even though banks with a stronger retail focus will experience some downside pressure on their margins. Further migration to long-term deposits will partly offset the benefits that derive from higher yields from corporate loans.

Banks' increasing shift to unsubsidized corporate loans as part of Saudi Arabia's Vision 2030 program will lead to an increase in NPLs and credit costs, but higher bottom lines will support capital buffers.   This development stands in stark contrast to 2022, when impairment charges were low and banks were able to recover after they had front-loaded in 2021 and 2020. We expect impairment charges will increase in 2023. However, we expect banks will report higher bottom line growth, compared with 2022, due to higher margins and strong credit growth. Additionally, robust return on equity (ROE) will support capital buffers.

Banks will continue to report strong asset quality metrics.   Stage 2 loans accounted for 5.2% of total loans in 2022, while stage 3 loans contributed 1.8%. We expect the stage 3 ratio will increase to 2.1% in 2023, which is better than the average GCC stage 3 ratio.

Funding risk will be one of the main challenges for the Saudi banking sector.   The Saudi government continued to inject deposits into the system to help banks finance their growth. Because of lower oil prices, however, government deposits at the Saudi central bank decreased. While not our base case scenario, the Saudi government and government-related entities may start to withdraw their deposits at some stage, which could potentially result in renewed tight liquidity conditions, similar to those we saw last year. We also note that the Saudi banking system is still in a net external asset position, but a further material build-up of external debt could signal increased vulnerability to global liquidity conditions.

UAE: Profitability Benefits From Higher Interest Rates

UAE banks' performance improved in the first half of 2023, on the back of lower credit losses and higher interest rates.   We expect higher interest rates will continue to support banks' profitability and, in combination with still high noninterest-bearing deposits, will moderate the increase in the cost of funding. The recovery of the non-oil sector has led to higher lending growth, compared with 2022. Yet, higher-for-longer interest rates and a slowdown of the oil economy could limit the pace of lending growth.

We expect asset quality deterioration will be limited.   The economic slowdown and higher interest rates will lead to a slight deterioration in asset quality, with the stage 3 loan ratio reaching 5.3% in 2023. On June 30, 2023, stage 3 loans as a percentage of gross loans stood at 5.2%, compared with 5.5% at year-end 2022, while stage 2 loans accounted for 5.5%. The banking sector could face a rise in problem loans in the construction and trade sectors and in the small and midsize enterprise segment. That said, we believe the non-oil economy remains supportive enough to help contain an increase in NPLs. In addition, banks have booked precautionary provisions over the past couple of years, which will help them withstand the challenges ahead. Coverage ratios, for example, improved to 100% in the first half of 2023, from 85% in 2020. We expect some normalization in the cost of risk to 80 bps–90 bps in 2023 and 2024, versus 100 bps in 2022.

Banks' funding will continue to benefit from their strong deposit franchises in the UAE.   Banks have accumulated local deposits over the past 18 months. Since we do not expect an acceleration in lending in the second half of 2023, banks' funding profiles should continue to strengthen. One potential downside risk for UAE banks is the country's large number of expatriates, which could make deposits more prone to higher volatility in the case of economic shocks. That said, deposit volatility was largely stable during past extreme events.

Qatar: Domestic Funding Sources Come To The Fore

We expect private sector credit will continue to grow at a significantly reduced pace through 2023.   Credit to the private sector expanded by less than 1% at the end of May 2023, well below the growth rates of recent years. The completion of the country's major infrastructure projects in time for the 2022 FIFA World Cup means that credit to contractors is no longer required. Trade and consumption lending are still likely to see the strongest growth, buoyed by the wealthy population and the still relatively high oil prices Qatar's liquefied natural gas prices are linked to. Qatari banks' overall credit supply, as opposed to private sector credit, could decrease in 2023, as the Qatari government gradually reduces its debt burden.

We expect a slight deterioration in asset quality, but robust public sector exposure remains significant.   We anticipate that higher-for-longer interest rates and subdued real estate prices could put pressure on Qatari borrowers and retail sub-sectors. Additionally, macroeconomic strains in Turkiye and Egypt will likely contribute to loan losses in 2023. We expect loan losses for Qatar's entire banking system will increase to 120 bps-130 bps in 2023, from 112 bps in 2022, and forecast an increase in NPLs to about 3.6% this year, from 3.3% in 2022 and above 3% at the end of 2021.

We expect higher interest rates will continue to support profitability.   Some banks' balance sheets shrunk in the first half of 2023, but most banks reported gains in net profitability, which supports our expectation that ROE will expand in 2023. Banks' underlying performance should bolster capitalization, but potentially higher domestic funding costs and adjustments relating to the performance of subsidiaries in Turkiye could limit profit growth.

External indebtedness has started to reduce but remains a key risk.   Both lower demand and the introduction of new prudential regulations to disincentivize nonresident-driven balance sheet growth has led to a reduction of nearly 10% ($18 billion) in total external funding between the end of 2021 and May 2023. The reduction of almost 10% includes a decline in nonresident deposits of 37% and an increase in interbank lines of 25%. We expect overall external liabilities will continue to decrease gradually for the rest of the year, as domestic funding sources replace shorter-term interbank borrowing. That said, replacing nonresident deposits with domestic sources will likely increase overall funding costs.

Kuwait: Credit Losses Offset Higher Net Interest Income

Subdued demand means the real estate sector will remain under pressure, which could weaken Kuwaiti banks' asset quality.   Rising borrowing costs and the sluggish recovery in the rental market weighed on Kuwait's investment property market, which primarily consists of rental homes for expatriates. In addition, even though it somewhat recovered last year, the commercial real estate sector, which mainly comprises offices, remains subdued, due to lackluster demand for office space amid excess supply. Banks' exposures to these sectors represented 18% of the total lending book at June 30, 2023. Furthermore, some Kuwaiti banks are exposed to riskier countries, such as Turkiye, Egypt, and Algeria. We expect additional provisions will emanate from these countries, since their operating environments remain less supportive than that of Kuwait. Overall, we expect cost of risk will increase and normalize at about 60 bps-70 bps in 2023 and 2024, from 40 bps in the first half of 2023 and at year-end 2022. Nevertheless, high provision buffers, which can counterbalance a potential increase in NPLs, will enable banks to maintain a broadly stable NPL ratio.

Lending growth will remain subdued.   Banks' lending books expanded by an annualized 3% in the first half of 2023, well below the loan growth of 8% in 2022. We expect higher interest rates will lead to lower demand from corporate and retail borrowers, which will translate into low single-digit loan growth for the banking sector. In addition, recurrent political deadlocks could delay the implementation of government-sponsored projects and contribute to slow corporate credit growth.

We expect profitability will remain high.   Kuwait's banking sector is well positioned to benefit from the higher-for-longer interest rate environment. That said, the higher net interest income will be somewhat offset by the migration from noninterest-bearing to interest-bearing deposits and increasing credit losses. Nevertheless, the banking sector's funding profile continues to benefit from a strong local deposit base and a net external asset position. This translates into positive investor sentiment.