New IFRS 9 accounting standards introduced on Jan. 1 have materially increased Saudi banks' loan-loss reserves. The stock of loan-loss provisions held by the 12 Saudi domestic banks on Jan. 1 increased by 34% to SR44 billion ($11.7 billion) and now stand at around 150% of problem loans and 3.1% of total loans as of March 2018 from 120% and 2.3% respectively as of Dec. 31, 2017, according to Moodys.
IFRS 9 requires banks to calculate their provisioning needs based on “expected credit loss” instead of delaying provisioning until a loss event has occurred, as required under the previous IAS 39 accounting model.
Problem loans have been rising over the last two years as the Saudi economy slowed. Higher provision coverage is therefore a positive development for the banks. For four banks, Al Rajhi Bank (A1 stable, a3), Bank Al-Jazira (Baa1 stable, baa3), Riyad Bank (A2 stable, baa1), and Saudi Investment Bank (A3 stable, baa2), loan-loss reserves rose by more than 50% following the adoption of the new standards.
Despite the higher provisioning, the impact on banks' capital has been modest. The total capital cost for the banks is SR14.7 billion ($3.9 billion), representing 76 basis points of the banks' aggregate Tier 1 capital ratio. The fully loaded effect of IFRS 9 would bring the average Tier 1 ratio to 17.6% from 18.3% at the end of 2017. However the banking regulator, the Saudi Arabia Monetary Authority (SAMA), allows the banks to spread the capital hit from IFRS 9 through 2023. Only three banks experience a capital impact greater than 100 basis points of their Tier 1 ratio as of December 2017. They are Al Rajhi Bank, Bank Al-Jazira (mentioned above), and Samba Financial Group (A1 stable, a2), some of the banks with the highest capital ratios in the system.
Unless macroeconomic expectations change during 2018, we expect provisioning needs to stabilize over the rest of the year, helped by low credit growth and gradual economic recovery. Impairment charges at Saudi banks fell 21% year-on-year in March, and 47% quarter-on-quarter. Lower provisioning needs will benefit banks' 2018 net profits.
Improved provisioning levels
are a positive development
Improved provisioning levels are a positive development at a time when Saudi Arabia's challenging economic environment is pressuring loan quality. We forecast sluggish GDP growth of just 1.3% in 2018, up from -0.7% in 2017. We expect the difficult climate for businesses and households to push up problem loans (NPLs) to around 2.5% of total loans over the next 12 months, from 2.0% at the end of March.
The bulk of Saudi banks' loan-loss reserves are associated with Stage 3 — impaired loans and advances — representing 46% of total reserves. Stage 2 loans — those showing credit deterioration since origination — represent 33% of reserves and Stage 1 loans — those still performing — represent 21% of reserves.
Saudi banks' additional provisioning under IFRS 9 is not correlated with their level of NPLs. Instead, the increase in loan-loss reserves was highest for banks with lower provisioning coverage of their problem loans, namely Saudi Investment Bank, Bank Al- Jazira and Riyad Bank. The variation in provisions related to the first time adoption (FTA) of IFRS 9 as of Jan. 1 represented more than 1% of their gross loans versus 0.8% on average for Saudi banks. The rise in provisions for these three banks was also in line with their high volume of loans that were 90 days past due but not impaired, which they now have to provision under IFRS 9 standards Al Rajhi bank, which posted the fourth largest increase in loan-loss reserves (+52%) as a result of the adoption of IFRS 9, is an exception as it had already the highest level of provisioning coverage amongst Saudi banks, above 300% of problem loans as of December 2017 under IAS 39 reporting standards.
Despite their additional provisioning efforts, Riyad Bank, Saudi Investment bank and Bank Al-Jazira, still had a lower specific coverage of their “Stage 3” impaired loans at 43%, 44% and 65% respectively as of March 2018, against a system average of 79%. This reflects primarily the high level of collateralization of their impaired loan portfolio.
Interestingly, the higher provisioning made by some banks, did not necessarily reflect a higher proportion of “Stage 2” loans, identifying rising credit risk and requiring provisioning charges that reflect the expected losses over the lifetime of the loans. For instance, Alawwal Bank (A3 stable, baa2) has the highest proportion of “Stage 2” loans at 25% of gross loans as of March 2018, but posted a relatively modest increase in provisioning (the increased provisioning represented only 0.5% of its gross loans compared to 0.8% for the system average).
In contrast, due to its largest domestic retail banking portfolio (53% of its total assets as of March 2018), Al Rajhi bank was required to book material “Stage 2” provisions against retail products that are particularly affected by new IFRS 9 provisioning rules, bringing its overall problem loans coverage ratio to around 483% as of March 2018, well above the average for domestic peers of 150%.
Moodys estimate that, although the volume of Stage 2 loans signals increased credit risks, the proportion of Stage 2 provisions booked against these loans in Q1 could also reflect banks' decision to reinforce their overall provisioning, using judgment inherently embedded in IFRS 9 provisioning principles. The favorable first time adoption (FTA) process allows banks to absorb any increase in impairments through their equity rather than earnings, with the option to spread the capital hit until 2023, creating an incentive for banks to scale up their IFRS 9 provisions.
Moodys notes that, as expected under IFRS 9 standards, the highest proportion of 12-months provisioning for the “Stage 1” performing loan portfolio is posted by some of the fastest growing banks in recent years, with Al Rajhi Bank, Bank AlBilad (A3 stable, baa2) and National Commercial Bank (A1 stable, baa1) posting “Stage 1” reserves of more than 1% of their “Stage 1” loans as of March 2018 (against 0.6% on average for Saudi banks).
IFRS 9 impact on Saudi
banks' capital is modest
The implementation of IFRS 9 provisioning rules represents a capital hit of SR14.7 billion ($3.9 billion) for Saudi banks, equivalent to 76 basis points of the system-average Tier 1 capital ratio. Nevertheless, Saudi banks retain very strong capital buffers, supported by solid and stable profitability.
The system-average Tier 1 ratio and Capital Adequacy Ratio (CAR) after a fully loaded IFRS 9 impact would have been 17.6% and 19.6% respectively as of 1 January 2018 versus ratios of 18.3% and 20.4% without the impact. These ratios remain well above the minimum 8.5% and 10.5% regulatory Tier1 and CAR minimum. SAMA has allowed the banks to spread the equity hit until 2023, which means that the annual impact on Tier 1 ratios will be less than 20 basis points on average for the banks.
All banks maintain capital ratios well above the regulatory minimum. Banks with the highest provisioning increases saw the greatest impact on their capital, with capital erosion at Al Rajhi Bank, Al-Jazira and Saudi Investment Bank exceeding 100 basis points.
The greatest impact on capital from IFRS 9 affected the three banks that posted the highest levels of total capital at the end of 2017 (Al Rajhi Bank, Bank Al-Jazira and Samba). In contrast, the two banks the least affected by IFRS 9 implementation on their equity were those with the lowest level of CAR at the end of 2017 (Bank Al Bilad and Arab National Bank (A2 stable, baa1). This may reflect good capital planning of the banks in anticipation of IFRS 9 implementation, or could also indicate the use by the better capitalized banks of judgment embedded in IFRS 9 impairment principles to scale up provisions that can be absorbed through capital rather than through their earnings under the favorable First Time Application process.
Moodys expect additional provisioning
requirements to be modest
Following the additional provisioning efforts required by IFRS 9 implementation, we do not expect any further material increase in impairment charges through the remainder of the year, auguring well for banks' 2018 net profits. Net impairment charges at Saudi banks for the as of March 2018 declined 21% year-on-year and 47% quarter-on-quarter. This resulted in impairment charges of 12% of banks' pre-provision income in the first quarter, down from 15% a year earlier and contributed to a 7.5% year-on-year increase in quarterly net profit (see Exhibit 6). The quarterly decline in impairment charges follows two consecutive years of increases in net impairment charges (50% in 2016 and 3.5% in 2017) that stemmed from rising asset quality pressures in the context of subdued economic growth and fiscal consolidation measures.
Sluggish economic conditions will continue to pressure banks' loan performance over the coming quarters and we expect the sector's NPL ratio to peak to around 2.5% in the next 12 months.
The new IFRS 9 rules have required banks to increase their reserves and coverage ratio before problem loans peak, which will place Saudi banks in a better financial position during the initial stages of the Saudi economic recovery. Moodys expectation of a gradual recovery in economic and credit growth (projected at 1.3% and 4% respectively in 2018), should alleviate risks of material loan quality deterioration that would impact “Stage 2” loan provisioning (there was a 1.5% reduction in Stage 2 provisions in Q1 2018). Moreover, more prudent loan underwriting from Saudi banks (lending contracted 1% year-on-year as of March 2018) will moderate “Stage 1” provisions. Some material write-offs (mainly for Riyad bank, Al Rajhi Bank and Bank Al-Jazira in Q1) have helped stabilizing “Stage 3” problem loans to 2.0% of total loans as of March 2018 in line with December 2017.