Prospects for the Middle East banking sector improve

The economic growth in the Middle East region recovered in 2018 from a contraction in 2017, benefiting from the increase in average oil prices. Meanwhile, the pace of fiscal consolidation eased and the non-oil economic activity picked up. Private sector economic activity strengthened in countries like Saudi Arabia, United Arab Emirates (UAE) and Qatar, although the overall private credit growth remained subdued. Supported by increased oil revenues, most Middle East economies have seen some improvements in their fiscal and external balances. The oil production rose after the Organization of Petroleum Exporting Countries (OPEC) and its allies agreed to boost output in June 2018, but they may cut oil production in 2019 despite pressure from the United States to lower oil prices.

Overall, the economies in Middle East are set to show stronger gross domestic product (GDP) growth in 2019.The oil price is expected to remain firm, which will support stronger government spending. Non-oil sector will continue to grow, albeit at a slow pace. The implementation of government stimulus packages such as the Saudi Arabia’s National Transformation Program 2020, Expo 2020 in the UAE and 2022 FIFA World Cup in Qatar will continue to spur the growth in the region. Nevertheless, the economic growth for the region remains vulnerable to the volatility in oil markets, escalating trade and geopolitical tensions, and faster increases in US interest rates.

In recent years, Middle East countries have carried out a number of reforms, which aims at streamlining business procedures, attracting foreign investments, supporting job creation and expanding the role of the private sector. Despite the economic recovery in the region, the governments need to continue the fiscal and structural reforms to achieve consistent and sustainable economic growth. The delay in the implementation of these reforms could weigh negatively on the region’s economic outlook.

Thanks to the improvements in macroeconomic conditions, Middle East banking sector will see better overall financial performance in 2019. The profitability pressure in regional banking system will be alleviated, largely driven by widening net interest margins and increasing lending activity, as well as their strong culture of cost management. Banks have significant low-cost demand deposits on their balance sheets. They reprice loans as the interest rates rise in line with US monetary policy tightening, and thus their net interest income will be higher. Moreover, the lending growth picked up modestly in 2018 and will accelerate slightly in 2019 on the back of higher government spending. This will result in some improvements in the profitability of banks. However, lending growth is projected to remain in the mid-single digits and profit growth is forecast to be modest. In addition, banks in the region are making consistent efforts to manage operating costs effectively. Their cost to income ratios have been well controlled, although they have invested heavily in digitalisation. 

Most banks in the region are expected to be able to withstand sudden stress. Their loss absorption buffers have been stronger, partially due to the implementation of International Financial Reporting Standards 9 (IFRS 9), which came into force on January 1, 2018. However, high levels of credit concentration and related-party lending remains a key risk, and a modest rise in problem loans is expected due to the lagging effect of the economic slowdown. Overall, the impacts of IFRS 9 on banks are manageable. The capital positions of banks will remain broadly adequate, as the lending growth will be modest and the profitability will be stable. Moreover, governments’ willingness and capacity to support banks remain high. In addition, Middle East banking sector’s liquidity will remain at a healthy level in 2019, on the back of current oil prices and sovereign support. Banks’ funding has been less pressured and is expected to remain stable. 

Nevertheless, the financial performance of Qatari banks has been affected negatively by the continued boycott imposed by other Gulf states. Some banks in the country also face potential risks posed by their international operations, specifically the exposure to Turkey. In addition, the profitability of banks in Oman and Bahrain is expected to deteriorate, because of the higher loan loss provision charges. The fiscal balances of Oman and Bahrain continues to be under pressures, which reduces the governments’ capacity to support banks. In October 2018, Bahrain received $10 billion (BHD 36.73 billion) in financial aid from Saudi Arabia, Kuwait and the UAE, and its government announced a package of reforms that aims to balance its budget by 2022. 

Middle East banks are increasingly looking to gain scale and stay competitive through consolidation. Many banks in the region have been involved in takeover or merger talks, especially those in the UAE and Saudi Arabia. For example, Abu Dhabi Commercial Bank announced that it is in merger talks with Union National Bank and Al Hilal Bank in September 2018, and National Commercial Bank, Saudi Arabia’s biggest lender, has started initial talks with Riyad Bank for a merger in December 2018. However, only some of these talks can result in a merger. Bank mergers are complex in the region, largely due to substantial government ownership of major banks. Increasing regulatory demand, higher compliance costs, and rapid technological innovations are also key drivers of consolidation. Looking forward, the bank consolidation and merger trend is expected to continue in the region, which will help further consolidate the over-crowded banking systems and improve banks’ funding and profitability. 

In conclusion, despite the downside risks, the outlook for the Middle East region is positive. The economic growth for the region is expected to strengthen in 2019, and the banking sector on the whole, will deliver good financial performance.