Business & Finance Club - Riyadh : The outlook for the Saudi banking system is stable, reflecting its resilience and strong financial fundamentals despite the continued challenging operating conditions, said Moody's Investors Service.

The stable outlook issued in its annual Banking System Outlook on Saudi Arabia expresses Moody's expectations for the fundamental credit conditions in the Saudi banking system over the next 12 to 18 months.

'The Saudi banking system's current and historically strong financial fundamentals highlight its resilience during a period when operating conditions have been challenging,' stated Christos Theofilou, Moody's lead analyst for Saudi banks.

This resilience is supported by (1) the government's fiscal stimulus, which has sustained macroeconomic growth; (2) the banks' robust financial fundamentals, including strong liquidity, and adequate profitability and capitalisation; and (3) a prudent regulatory environment.

However, Moody's report says that the low interest rate environment is exerting pressure on the banks' profitability through reduced margins and lower business growth. 'Catalysts for potentially greater lending activity could include the banks' strong liquidity and expectations of a peak in provisioning levels, in conjunction with banks' efforts to maintain market share and margins in the current low-interest/low-growth environment,' Theofilou explained.

There are indications of a pick-up in loans to the private sector, with a healthy pipeline of projects expected over the next 18 months - however, Moody's cautions that growth is likely to remain below pre-crisis levels. Overall, Moody's expects the banks' 2010/2011 net income to be modestly higher than it has been over the past two years, mainly because of expected lower provisioning charges.

As regards asset quality, non-performing loans (NPLs) should remain close to current levels, as the family dispute between AH Algosaibi & Brothers (AHAB) and Saad Group (Saad) is not expected to be settled in the near term and private sector loan quality is expected to stabilise. Furthermore, strict regulation, close monitoring and systemic support should ensure that the sector remains adequately funded, liquid, and well prepared to cope with any further economic downturn.

Most of the rated Saudi banks have solid local franchises, as well as a strong share in their respective market segments. Nevertheless, the rated Saudi banks' limited geographical diversification continues to weigh negatively on Moody's assessment of the banks' overall franchise value as they remain vulnerable to an economy that is still largely dependent on oil. While opportunities for franchise growth were limited over the past two years, Moody's believes that Saudi banks' initiatives to penetrate the retail banking market and expand their Shari'ah-compliant products have strengthened their business franchises and market positions.

The rated Saudi banks' risk management has been improving, their corporate governance culture strengthened and their already moderate risk appetite has been maintained, thereby helping to improve the banks' risk profiles to some extent. However, Saudi banks have high concentrations on both the asset and liability sides of their balance sheets. Additionally, the domestic economy is dominated by a relatively small number of corporate groups, which weighs on Moody's assessment of the rated Saudi banks' overall risk management, despite their otherwise adequate practices.

While the banks remain sufficiently liquid and funded by 'sticky' local deposits and their profile reduces market funding-related vulnerabilities, challenges include high concentrations in deposits and mismatches in the maturity profiles of assets and liabilities. Moody's also notes the scarce human capital, requiring continued efforts to attract, train and retain skilled staff.

Finally, geopolitical instability and security threats remain potential areas of concern, as do the economy's continued limited diversification beyond the hydrocarbons sector and the volatility in the country's real and nominal output, the report said.-