The U.S. Federal Reserve’s delay in cutting interest rates bodes well for Gulf Cooperation Council (GCC) banks. In its latest report, S&P Global Ratings expects the profitability of GCC banks to remain strong in 2024 due to the delay in interest rate cuts. The agency also expects asset quality to remain resilient despite the higher-for-longer rates due to supportive economies, contained leverage and a high level of precautionary reserves.
Despite resilient performance in 2024, S&P expects a slight decline in GCC banks’ profitability in 2025 as the Fed starts cutting interest rates. Hence, most GCC central banks will likely follow suit to preserve their currency pegs. In its latest report, S&P also outlines several factors that will mitigate the overall effect of a decline in profitability.
Interest rates’ impact
In its report, S&P states: “Every 100 basis point (bp) drop in rates shaves an average of around 9 percent off rated GCC banks’ bottom lines.” However, lower interest rates will also likely reduce the amount of unrealized losses that GCC banks have accumulated over the past couple of years. Therefore, S&P estimates these losses to reach around $2.8 billion for the GCC banks or 1.9 percent of their total equity.”
S&P doesn’t expect a rate cut before the autumn of 2024. Hence, before it sees several consecutive readings of slowing month-over-month core inflation, interest rates will remain unchanged. Therefore, S&P expects the first rate cut to occur as late as December 2024. “We project that the Fed will cut rates by 100 bps over the course of 2025, to reach 4.00-4.25 percent at year-end,” the report stated.
GCC banks’ positions
GCC central banks typically mirror the Fed’s rate movements to preserve their currency pegs. This has supported their growth in the last couple of years and will continue to do so in 2024. By the end of 2023, the average return on assets of the top 45 banks in the region reached 1.7 percent, up from 1.2 percent by the end of 2021.
As rates drop, S&P expects profitability to decline. However, it outlines four different factors that will mitigate the overall impact:
- Management actions to reposition banks’ balance sheets: GCC banks could fix interest rates at their current level for some exposures. They can also swap variable rates for fixed ones before the rate drop starts.
- Migration of deposits back to non-interest-bearing instruments: In the last few years, deposit migration to interest-bearing instruments in some markets has become more prevalent. In Saudi Arabia, the share of demand deposits to total deposits dropped from 65 percent in 2021 to 53 percent in 2023. Therefore, S&P expects a shift back to non-interest-bearing instruments if interest rates decline.
- Lower cost of risk for banks: As interest rates decline, GCC banks will reprice corporate loans. This will relieve some companies which could help their creditworthiness. This will reduce banks’ provisioning needs.
- Higher lending growth: Higher lending volumes could compensate for lower margins. Moreover, interest rate cuts should reduce the amount of unrealized losses that banks have accumulated on their investments over the past couple of years.
Future outlook
The decline in profitability of GCC banks will vary when interest rates decline. S&P reveals that banks with higher corporate lending will see a larger impact. Thus, corporate lending has variable rates and banks usually reprice those loans fairly quickly.
“The most vulnerable bank in our sample stands to lose around 30 percent of its bottom line with every 100 bp drop in rates,” stated the report. Moreover, some retail banks could also see a moderate impact due to the structure of their balance sheets.
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