WHILE slower economic growth brought on by the lower price of oil has reduced growth opportunities and hindered the performance of the GCC’s banking systems, Mohamed Damak, Head of Global Islamic Finance at S&P Global Ratings, believes the profile of Islamic banks will, absent any major risks, will stabilize this year.
While overall lending growth of GCC banks slowed in 2017, Islamic banks saw rapid growth of 6.9% compared with 3.7% growth seen in conventional banks over the same period. This was mainly supported by a strong performance in a few Islamic banks particularly in Kuwait and the UAE.
In 2018-2019, we expect growth of Islamic banks will converge with that of conventional banks, albeit at a marginally faster rate. We also expect financing growth will reach 4%-5%, supported by strategic initiatives such as the Dubai Expo 2020, Saudi Vision 2030, and higher government spending in Kuwait led by Kuwait 2035 Vision.
Due to the asset-backing principle of Islamic finance, Islamic banks tend to have higher exposure to the real estate sector which results in a weaker asset quality in comparison to conventional banks. Furthermore, because Shariah law forbids repayment delay penalties, some clients tend to prioritize their repayments to conventional banks. Given these two factors are not expected to change, we believe the asset quality indicators of Islamic banks will remain weaker than its conventional peers.
In a normal cycle, banks restructure their exposures to adopt the financing payables to the new cash-flow realities of their clients. Some of these financings generate new nonperforming loans (NPLs). With the recent adoption of IFRS9 and FAS30, the impact of these loans on Islamic and conventional banks' cost of risk will become more visible. Loans that are restructured, or past due but not impaired, will generally necessitate lifetime expected loss provisioning instead of 12-months expected loss provisioning.
Therefore, we expect to see a spike in provisions over the next couple of years. However, we think that banks will try to frontload some of the impact, in 2018, to avoid future volatility of their net income.
We expect the growth in customer deposits seen in 2017, which largely resulted from stabilized oil prices and larger public sector deposits, to continue in 2018.
In certain markets, deploying the new inflow of Islamic liquidity is a challenge for banks, especially in the absence of significant local sukuk issuance. In 2017, sukuk issuance significantly increased primarily due to the contribution of jumbo deals in some GCC countries, however, the issuance volume for 2018 currently remains unclear. Therefore, we expect liquidity will continue to build in Islamic banks' balance sheets. We think banks will use this liquidity to invest in government issuances, government-related entities, and corporates whenever they are available.
Islamic banks in the GCC enjoy strong funding profiles, due to predominance of core customer deposits and their relatively low financing-to-deposit ratios. Last year, the average financing-to-deposit ratio of GCC Islamic banks reached 93.3%, and the liquid assets to total assets ratio was about 21%. Islamic banks usually tend to attract retail depositors due to their Sharia-compliant nature, whereas the use of wholesale funding sources remains relatively limited and we expect this to continue.
In 2017, we saw a stabilization of the return on assets of Islamic banks as strong performance of certain banks compensated for the drop experienced by about half of the banks. However, our calculations suggest that GCC Islamic banks' profitability will deteriorate slightly in 2018 and 2019. Several factors explain our expectations for 2018-2019:
• Financing growth will remain limited. Banks will continue to prioritize quality over quantity and avoid lucrative but higher risk exposures; especially since IFRS9/FAS30 require lifetime provisioning for exposures that experience deterioration of credit quality or repayment issues.
• Cost of risk will increase and stabilize at a higher level. Restructured loans and past due but not impaired loans that will slip to nonperforming categories, and new IFRS9/FAS30 provisions are likely to push cost of risk higher for over a longer period.
• Operating costs are likely to increase because of VAT introduction, although we believe banks will pass most of the impact to end users.
• While banks continue to benefit from large amounts of free deposits, we anticipate that some corporate depositors will seek to improve their profitability and become more demanding as interest rates continue to rise.
We therefore expect revenue growth will decelerate and banks will focus on their cost base to mitigate the impact. Financial technology (Fintech) collaboration and the use of technology for low added-value transactions, such as money transfer and payments, could offer some opportunities in this area. As for their conventional counterparts, we expect the low cost base of GCC Islamic banks to protect their profitability.
Therefore, absent any escalation in regional geopolitical tensions, we expect asset quality of GCC Islamic banks to stabilize throughout 2018 with asset growth remaining in the low single digits over the next two years.
By Mohamed Damak for Saudi Gazette