Credit risks source of concern for Gulf banks in future; asset quality deterioration could impede banks role in providing credit

The International Monetary Fund said that the holding of government securities by Gulf banks as a percentage of their total assets increased by 2020 in some countries. Al-Rai has learned it ranges between 5 and 14 percent in Bahrain, Kuwait, Oman, Saudi Arabia and the UAE, and more than 20 percent in Qatar on average between 2009-2015.

A recent report entitled: “Assessment of the Weaknesses of the Banking Sector in the Gulf Cooperation Council Countries in the Aftermath of Covid-19” said that at the end of 2020, banks’ claims on the government increased from 6 percent and 8.5 percent to 10 percent (five-year average) of the total assets of banks in Oman and the UAE, and from 12 percent and 15 percent to about 17 percent in Saudi Arabia and Bahrain, respectively.

However, it decreased from 5 percent to 2 percent in Kuwait and from 20 percent to 17 percent in Qatar. Moreover, the share of banks’ holdings of government securities in total government debt decreased from an average of 50 percent during 2014/2019 to 30 percent in 2020, as the Gulf countries increased their reliance on external financing, taking advantage of declining profit margins and investors’ search for returns.

The report pointed out that Gulf banks are the dominant owners of government securities, and government deposits remain the main source of bank financing in some of these countries. On the other hand, the report showed that banks’ exposure to state-owned enterprises (SOEs) has remained relatively stable since 2014, albeit unevenly across the region. Bank claims on state-owned enterprises amount to 2 to 4 percent of total credit in Kuwait and Saudi Arabia, 11 to 13 percent in Oman and the UAE, and as much as 20 percent in Qatar.

Despite increased government exposure, Gulf banks have continued to play a critical role in supporting the flow of credit to the economy during the pandemic. The ratio of banks’ ownership of government securities to the credit granted to the private sector decreased in Kuwait and Qatar, while it remained stable in Bahrain, Oman and Saudi Arabia, with a slight increase in the UAE.

The International Monetary Fund addressed the repercussions of the pandemic on the corporate sector, and said that even before the spread of the Corona pandemic, non-financial companies in the Gulf region were showing a tendency to increase weaknesses, until the Covid-19 crisis came and exacerbated these weaknesses, including the links between banks and companies potentially intensive through (1) loan guarantees and job insurance, (2) loan deferrals, (3) corporate concessional credit facilities, and (4) government-backed loans.

The report added that companies’ performance measured by profitability, leverage, and debt servicing deteriorated over time. While the region’s return on equity has continued to decline over the past 15 years, this decline has been more rapid in the Gulf countries than in emerging market economies.

On average, the data shows that return on equity fell from 15 percent in 2005 to 4 percent in 2020. Despite the significant decrease in leverage in the wake of the global financial crisis, corporate debt continued to rise, although it remained lower than in emerging markets with the exception of Kuwait and Oman. The rise in leverage was broad across sectors.

Higher leverage is reflected in rising debt costs, as measured by the interest coverage ratio, which has shrunk sharply since 2007. This could deteriorate the quality of banks’ assets and materialize contingent liabilities once the measures are withdrawn.

The International Monetary Fund data show that the return on equity in the Kuwaiti corporate sector was the only one that recorded negative growth in 2020 compared to its counterparts in other Gulf countries, although the return on equity decreased in all Gulf non-financial companies as previously mentioned, as recorded Kuwait has the lowest revenue growth rate among Gulf companies in 2020 on an annual basis.

Meanwhile, the report said that the Gulf region faced significant economic losses as a result of two double shocks resulting from the pandemic and a drop in oil prices in 2020. In addition to the direct impact of the pandemic on economic activity, the sharp drop in oil prices and production cuts under the OPEC Plus agreement affected the oil sector .

It is estimated that the total GDP contracted by 4.8 percent in 2020, with a decrease in the hydrocarbon GDP by 5.9 percent and a contraction in the real non-hydrocarbon GDP by 3.9 percent, while some sectors — in particular — such as construction, hospitality, transportation, wholesale and retail trade were the most affected.

And while Gulf banks entered the COVID-19 crisis with abundant capital and liquidity, continued support for the policies put in place by governments to confront COVID-19 could mask financial vulnerabilities.

The report pointed out that monetary and financial measures were implemented to ease the burden on families, companies and banks. With signs of recovery, policy support measures are increasingly targeting the hard-hit sectors, especially small and medium-sized enterprises.

Despite the banking system entering into a crisis with large reserves of capital and liquidity, banks faced a difficult operating environment resulting from a prolonged health crisis and its impact on economic activity, especially in the sectors most affected, and the difficult operating environment of financial control, low profitability, and increased provisions.

Moreover, given the uncertainty about the strength of the recovery, credit risk remains a concern going forward.

The International Monetary Fund believes that the role of banks in providing credit to support economic recovery and diversification can be hampered by deteriorating asset quality.

On the other hand, the report indicated that the double shocks strengthened the links between governments, banks and the real economy.

While policy support measures have helped mitigate the negative impact of the crisis on the economy, they have intensified the relationship between the sovereign economy, banks and the real economy and potential vulnerabilities through increased exposure to sovereign debt, higher potential contingent liabilities, and increased credit concentration.

Prior to these shocks, the Gulf states experienced two decades of significant fiscal deepening and increasing cross-sectoral linkages.

During this period, bank credit and capital inflows financed the expansion of the non-oil sectors and helped governments smooth the business cycle during the decline in oil prices.

However, the fiscal deepening has also come with increased interdependence, which during a crisis can turn into a set of vulnerabilities and facilitate cross-sector contagion.

Among these, the balance sheet linkages between the government sector, the banking system, and the real economy act as a transmission and amplification mechanism for real and nominal shocks.

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