Introduction
Saudi banking system is characterized by strong fundamentals and staunch government support. This has enabled the industry to position itself to weather a challenging operating environment. In the current economic scenario Saudi banks expect a lower volume of business in the year 2009 and have therefore have relied heavily on government-related projects. The banks also have attempted to have a relook in their lending rates to maintain the performance levels. The first quarter of the year 2009 has ended with positive results for the banks (AME Info). This result shows a significant improvement of the banks over their performance in the last quarter of the year 2008, when there was an all round fall in the domestic as well as world financial markets. There were various other factors like the funding and liquidity base of the Saudi banks coupled with a high growth rate of customer deposits have helped the Saudi banking industry to withstand the economic storm. Since none of the Saudi banks were relying on the funding from wholesale or debt capital markers which were virtually dried up globally, the banks could sail through the difficult economic situation easily. Even though the performance of the Saudi banks for the year 2006 and 2007 was peaked, it cannot be said to be better as compared to the performance in the year 2005. In this context this paper analyzes the performance of the Saudi banking sector during the period from 2003 to 2007 in general and that of Riyad Bank, one of the major players in the Saudi banking industry during the same period.
Key Fundamentals of Saudi Banking Industry
The major strength of Saudi banking sector is the strong support the industry gets from the government. Apart from the funding and liquidity base, the banking industry gets support from the government in the form of injection of funds to maintain liquidity on a continuous basis which enables the industry to perform efficiently. Saudi Arabian Monetary Agency (SAMA), being the apex banking institution controlling all the banks in the country, by its timely decisions regarding the operations of the banks in the form of lowering the reserve requirements and repo rates is able to secure a consistent performance by the commercial banks. Another important factor that helps the banks is the reliance on their own retained earnings to supplement the capital. The asset quality has been found to be satisfactory which also helps the banks to do a healthy business. Even though the ratio of non-performing loans has suffered a set back in the recent periods because of rapid loan growth, and large write offs of the retail exposures beyond 180 days period, the ratio has been at a satisfactory level of 1.4% of the amount of gross loans during the year 2008 (for the year 2007, the ratio stood at 1.8%) (AME Info).
There was a declining trend in the performance of the Saudi banking system during the second half of the year 2008 with the lowering of the asset valuation. In spite of this market decline, the profitability of Saudi banks was at a satisfactory level for the whole of 2008. Strong core revenues earned by the banks acted as a counter for the increased impairment charges and reduction in the fair values of the investment portfolios of banks. A high inflation rate of about 10%, geopolitical risks and excessive dependence on oil revenues are some of the factors that act against the growth of the banking sector in the country. Despite these shortcomings the overall impact of the banking sector on the economy appears to be positive. The accommodative operating environment prevalent in the country has enabled the Saudi banks to maintain strong fundamentals throughout the period protecting them from the worldwide felt economic downturn.
The banks have found their market position stronger by their continued penetration in the under-developed market segments including retail banking and Islamic banking services. The banks have also found themselves well-placed to capitalize on the upcoming mortgage law. Another sound fundamental character of the Saudi banks is their risk management culture. The banks have substantially improved their risk management culture in the recent past. In general, the banks exhibit a moderate risk appetite and this quality has helped them to get exposed to subprime/structured products at a relatively lower level (Arabnews).
However, there are certain structural factors which act to deter the progress of the Saudi banking system. These factors include the increased concentration of the banks in the lending and deposits, mismatches in the maturity profile of assets and liabilities, limitations on the geographical diversifications and lack of pool of experienced human capital. In addition the limitations on the diversification of the economy beyond the hydrocarbon sector, volatility in the real and nominal output of the country also act as barriers to the growth of the banking system beyond a certain level. There is strong loan growth in the recent years which has not been tested in more adverse conditions add to the slack in the growth of the sector (Arabnews).
Riyad Bank – An Overview
Riyad bank is one of the largest financial institutions in Saudi Arabia. The bank has a strong financial and customer base with 201 branches and more than 2000 Automated Teller Machines (ATMs) operating in the country. The bank has extended its operations from retail banking to project financing and thus emerging as a lead financier participating in a number of large syndicated loans extended to various sectors including oil, petrochemicals and power. The bank has been recognized as the leading investment performance bank by the Investment Product Committee of SAMA. Riyad bank has achieved a net income of SR 2,639 million for the year 2008 with a total assets value of SR 160 billion as at the end of the year 2008. While the shareholders equity for the year 2008 was maintained at SR 25.7 billion the deposits from the customers was in the region of SR 105 billion as against the loans of SR 96.4 billion for the year 2008 (Riyad Bank). The bank has achieved highest credit ratings from many of the renowned rating agencies.
Financial Performance of Riyad Bank
The bank achieved a net income of SR 3,011 million in the year 2007 which is a 4% growth over the net income for the year 2006. The net income has shown a consistent growth over the five year period since 2003. The net income for the year 2007 has almost doubled as compared to the net income for the year 2003. The return on equity has also shown a consistent growth over the five year period. From a 17.18% return in the year 2003 the return on equity has risen to 22.84%. This is evident from the fact that there is a significant growth in the earnings per share during the period from SR 2.55 in the year 2003 to SR 4.82 in the year 2007. The table below extracted from the Annual report for the year 2007 of Riyad Bank exhibits the financial performance of the bank during the period from 2003 until 2007.
Table: Five Year Financial Performance of Riyad Bank
Figures in SR Millions
The following graph represents the growth in the net income of the bank during the five year period.
Source: Annual Report 2007 – Riyad Bank
There are a number of financial ratios which can be used to evaluate the performance of a bank. In most instances only a few ratios would help identifying the fundamental performance of the banks and the underlying causes for bad performance. The balance sheet and income statement of the banks provide valuable information source for assessing the effectiveness of risk management capabilities of different banks (FederalReserveCenter).
Return on average assets is one of the important earnings ratios to assess the performance of any bank. In the past a bank earning one percent on average assets was considered to have performed reasonably well. The benchmark later was increased to 1.33 percent in the year 2002 for the banks operating in the United States. Considering this benchmark it can be stated that the bank has done exceedingly well in terms of profitability. The trend of the earnings over the past years also shows a consistent performance in earning capacity of the bank. The trend of earnings is an important consideration in assessing the performance of a bank. It is also necessary to ascertain whether the earnings of the bank meets the forecast or budgeted expectations.
The bank is enjoying a strong financial position which is evident from the increase in the total assets value which has registered a growth of 29% in the year 2007 as compared to the previous year.
Cash dividends to net income is the ratio that indicates how much earnings is paid out to the shareholders and the proportion of the earnings retained to build the capital of the bank. The ratio of dividends to net income for the five year period is provided in the following table.
From the table it may be observed that the bank is retaining a reasonable proportion of the earnings towards the accumulation of its capital. The ratio of loans and advances to total assets indicate a comfortable liquidity position of the bank as evidenced by the ratios in the table. The ratio of loans and advances to customers’ deposits also show a satisfactory working of the bank during the five year period. Tier I capital to average assets also known as the leverage ratio is one of the important ratios for judging the capital adequacy of the banks. The minimum Tier I capital requirements has been set at 8% and in this case the leverage of the bank is more than satisfactory with the capital adequacy ratios for the year 2007 and 2006 as shown in the table (Federal Reserve Center a).
Performance of the Banking Sector
In general SAMA being a prudent regulator has ensured that the banks comply with the requirements of Basel Core Principles for Effective Banking Supervision by instituting a risk-based supervision approach. There are two factors mainly contributed to the growth of the earnings of the bank during the year 2006. They were: (i) increase in the fees and (ii) increase in the income from banking services increased from increased volumes of share trading and the significant growth in the volume of loans (Samba.com).
Capital Adequacy
The banks have been made to implement the Basel II standardised approach for credit risk and the basic indicators approach for operational risk. The minimum capital adequacy ratio is set at 8%. However, the banks could maintain capital adequacy ratios far in excess of this percentage (AbdulrahmanAl-Hamidy).
Asset Quality
SAMA has prescribed detailed guidelines and requirements for the banks to disclose the loans outstanding beyond 90 days, 180-365 days for doubtful loans, and loans outstanding for period beyond 365 days. The loans falling under these categories are classified as non-performing loan and sufficient provisioning requirements have been established by SAMA.
Credit Concentrations
SAMA has placed restrictions on the banks to expose themselves to a single group beyond 25% of their equity. However SAMA may enhance this limit to 50% of the equity under special circumstances. Banks are not allowed to hold stakes of more than 10 percent of any company provided that the value of such stocks shall not exceed 20% of the equity of the bank concerned.
Liquidity
SAMA has prescribed statutory limits for deposits to be maintained by the banks with it for ensuring the liquidity of the banks. There are percentages of deposits prescribed for demand deposits and time deposits which are mandatory for the banks to maintain with SAMA.
The increase in the total assets and loans and advances are presented in the following charts. The key profitability ratios are presented in the table appended below. Return on Average Assets (ROAA) Return on Average Earning Assets (ROAEA) and Return on Average Equity (ROAE) for the Saudi banks have increased to 4.6%, 5.0% and 36% respectively during the 9 months ended in September 2006(AlAhli.com).
Analysis of the Saudi Banking Industry and Riyad Bank Risk
“The banking sector is resilient to a range of single and combined shocks, although the infrastructure to manage liquidity risks could be strengthened. Stress tests, using parameters drawn from past experiences in Saudi Arabia, suggest that the aggregate system is robust to various credit, liquidity, and interest rate events” (Ingves and Khan). This resilience is due to the conservative portfolios of the banks operating in the Kingdom coupled with their large capital cushions.
There has been a rapid increase in the total assets of the banks operating in the industry during the four years ending April 2008, reaching a figure of $ 315 billion as of that date. The deposits stood at $ 202 billion and the loans and advances totalled to$ 183 billion. The nominal GDP of the country was $ 430 billion for the year 2007. The nominal GDP was expected to rise up to $ 450- $ 500 billion for the year 2008. Considering the increased GDP for the year 2008, the banking sector assets to GDP ration stood at 80 percent. The ratio of loans and advances to GDP was under 50 percent (Contributor). The contribution of the banking sector can thus be seen as overwhelmingly important and significant.
There are 11 major domestic commercial banks operating in the country. These banks offer a wide range of products and services to all segments of clients like SMEs, retail clients and corporate clients. The fact that there is only smaller number of banks operating in the country with the policy of the government of not issuing any new licences to banks during 1990 has enabled most of the local banks to increase their operations. With this accommodative environment the banks have built stronger market share for them which also offered them defensible franchise and customer confidence. Because of this backing the sector has become more concentrated. As a result seven of the top banks account for more than 85 percent of the total assets in the banking sector (Contributor).
Over the past years, several new GCC and international banks were granted licences to operate in the country. However, since their presence is limited with one or two branches concentrating on corporate, investment and private banking, these banks have not cut the share of the domestic banks in the more lucrative retail banking segment, where the domestic banks still have a dominant role. The distribution channel of the banking sector consisted of 1,376 branches supported by 8,073 ATMs as of April 2008. There has been an increased use of internet and telephone banking services with 64,406 point-of-sale terminals serving the customers. All of the commercial banks operating in the country, except National Commercial Bank are public companies listed in the Saudi Stock Exchange (Contributor).
Capital Markets Development
During the early 2000s, there have been numerous steps taken by the government to develop the role of capital markets in the financial system of the country. The demand for capital market services from the banking sector remained stronger because of several factors. These factors are: (i) undertaking of large scale infrastructural projects by the government has increased the interest and visibility in the Saudi stock market, (ii) windfalls resulted from higher oil prices, (iii) consequent increase in the demand for equity and other debt market funding and asset management. These factors have ensured the sustenance of the strong market position of the banks in the financial system of the country.
Operating Environment
The leadership position occupied by Saudi Arabia in the global oil production has resulted in a strong economic activity in the country. This has provided an improved government finances leading to an accommodative operating environment for the banking sector. There are plans devised to diversify into other segments like mining, power and water which enhance the role of the banking sector in the economic system. The planned introduction of Mortgage Law, expected stream of new economic cities and the announced infrastructural projects to the tune of over $ 350 billion in the next 10 year period has supported the spectacular performance of the Saudi banking industry during the 2004-2007 periods. However, there are risks associated with the operation of the banking sector in the form of limited diversification of the economy within the hydrocarbon sector, high level of volatility in the real and nominal output of the country and issues relating to the employment and availability of human capital which hinders the progress of the banking sector to some extent (Contributor).
Macro-Economic Conditions
Saudi Arabia witnessed a strong performance of the economy over the years 2003 to 2007. The growth in the nominal GDP was above 16 percent in 2004 and 25 percent in 2005. The GDP growth in GDP was 12 percent 2006 and the increase was the result of sharp and sustained oil prices during this period. However the GDP growth in the year 2007 remained flat with lower oil production. The fiscal surplus of $ 70 billion because of the high oil prices in the year 2006 had resulted in increased government spending with an expected accelerated economic return. The government announced the development of several infrastructural projects over the next decade which resulted in the improved performance of the banking sector in the country.
Risks of Excessive Dependence on Oil Revenue
Saudi Arabia is the global leader of oil production holding nearly 25% of the world proven oil reserves. Even though this fact remains as a positive factor for the economy and the banking sector development, there always remains a potential risk that the economy remaining sensitive to the government spending and the oil price fluctuations. The fact that the oil revenues account for 85% of the total export receipts, 75% of the government revenues and 40% of the nominal GDP of the country is a factor that could affect the economic progress as a whole or the growth of any sector within the economy, if there be a decline in the oil prices. Therefore, it can reasonably be stated that any significant reduction in the prices of oil would lead to a negative medium term impact on the performance of the economy. As a consequence this would affect the performance of the banking sector.
With a view to address the necessity of diversifying the economy away from oil revenues, the government has taken serious steps which have strengthened the capabilities of the banking sector to respond to unexpected macroeconomic shocks. Structural reforms, economic liberalization and diversification efforts have boosted the performance of the banking sector. Accession to the WTO, additional thrust to the privatisation programs, efforts to improve the regulatory environment and improving the role of the private sector are some of the measures taken by the government to diversify the economy which have a cascading effect on the performance of the banking sector operating in the economy.
The robust economic activity fuelled by the higher oil prices and revenues have remained as a major catalyst for the enhanced financial performance of the banks operating in the country. Higher economic activity has resulted in improved customer sentiment and spending which in turn resulted in increased demand for banking services. There was a higher demand for banking services in the areas of project financing, consumer lending, investment banking and asset management. This has led to a triple-fold increase in the amount of loans and advances. Despite the intervention of SAMA to restrict the quantum of consumer lending there had been a higher level of consumer lending in the country, increasing the risk level of the banks.
Factors affecting Performance of Banking Sector
The factors affecting the performance of Saudi banking sector are:
- Economic Stability
Because of the high reliance of the economy on oil revenues, there has been a 10 percent standard deviation observed in the GDP volatility of the country where as the moderate standard for the deviation is about 2.3 percent or lower for industrially advanced countries. However, the concern on this volatility can be partly offset by the fact that the government spending is more consistent as compared to the oil revenues.
- Integrity and Corruption
Based on the World Bank Indicator of the Control of Corruption, Saudi Arabia ranks in the middle of the second quartile. This calls for significant improvements in the corporate governance measures. This is a serious factor affecting the performance of the banking sector.
- Legal System
The rating agency Moody’s have considered the prevailing legal system in Saudi Arabia, based on the effectiveness of the provisions of the commercial contract law, collateral recovery, bankruptcy laws and other legislations and their impact on the operation of the banking industry and have arrived at the conclusion that there still exits significant scope for further improvements in the existing legal system. According to the World Bank’s indicator on the rule of law, Saudi ranks in the middle order on a global consideration, which indicates the scope for considerable improvement in the future. The introduction of new Mortgage Law is a step taken in the direction of improving the legal system of the country which should positively help the banking sector functioning in the economy. During the year 2007, the Saudi economy faced some short term challenges in the form of significant increase in the inflation rate of up to 10 percent and the speculation of a potential currency revaluation. However SAMA reacted by keeping the repo rates at the same level and decreasing the reverse repo rate could address the issue of speculation in Saudi Riyal. The Apex institution also increased its reserve requirements from 7 percent to 13 percent in the case of demand deposits and from 2 percent to 4 percent in the case of time deposits in order to manage the money supply effectively. There are specific concerns on the geophysical instability and security threats which also influence the performance of banking sector in the Kingdom to some extent.
- Government Support
Even though there is no deposit insurance scheme in practice, the authorities of Saudi Arabia have remained supportive to the banks and have demonstrated their ability and willingness to support any bank in the event of their default, irrespective of the size of the banks. Based on this parameter, Moody’s have rated the probability of systemic support to all the Saudi banks as high and therefore their deposit ratings are also rated high because of the underlying support provider.
Importance of Banking System and Investment in the Sector
The importance role of the banking system in the Saudi economy makes it critical to the development of the economy and the fiscal system in the country. On an overall assessment during the period 2002-2007 there has been an increase in the total assets and customer deposits to the extent of 16% on a Compounded Annual Growth Rate (CAGR) basis. During the same period, the domestic credit grew by 23 percent and the total of banking assets is valued at & 287 billion representing approximately 84% of the GDP of the country, thanks to the rising oil prices and revenues during the period. It is therefore advisable to invest in the sector because the banking industry retains a strong growth potential because of (i) the existence of a still under-developed consumer lending market and (ii) huge financing requirements following the government announced infrastructure related projects to the extent of $ 350 billion during the next decade. Moreover, there is no track of any default by any of the Saudi banks, although certain smaller banks have faced financial difficulties in the last 50 year period. There is a high level of interest and willingness on the part of the Saudi authorities to support the banking system. Since the social considerations are a top priority agenda for the government the authorities would go to any extent to prevent a bank from defaulting.
Conclusion
A strong operating environment provided by the position of the country as the global leader in the oil production and distribution coupled with the prudent regulatory efforts of SAMA with a risk-based supervision approach has helped the Saudi Arabian banking system to develop into a robust, well-regulated and relatively stronger industry. Solid financial support from the government and the continuous efforts of the government to diversify the economy has also helped the banking sector to record significant growth since the beginning of the 2000s. Finally there is the relentless support from the Saudi authorities to maintain the liquidity position of the banks stronger irrespective of the size of the bank which enabled the banking system to maintain their strong position in the economy.
References
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AMEInfo. Fitch: Saudi banks well-positioned to weather downturn. 2009.
Arabnews. Credit outlook for Saudi banks is positive: Moody’s. 2008. Web.
Contributor. Saudi Arabian banks: Welcome to the Kingdom. 2008.
FederalReserveCenter. Insights for Bank Directors: Basic Raio Analysis. 2004.
FederalReserveCentera. Insights for Bank Directors: Basic Ratio Analsyis. 2004.
Ingves, Stefan and Mohsin Khan. Saudi Arabia: Financial System Stability Assessment. 2004. Web.
RiyadBank. Corporate Profile. 2008.
Samba.com. The Saudi Economy at Mid-Year 2006. 2007.