Global Finance - As the Ukrainian conflict blows up, the GCC economies hit the jackpot.

As global financial institutions continue to eye US markets nervously, banks in the six-member Gulf Cooperation Council (GCC) are proving resilient compared to their US and European counterparts. But analysts caution that GCC banks’ defenses against a local bank run might come under pressure as the global situation evolves. For now, customer confidence remains intact, and deposits are mainly stable.

Indeed, recent research cited by rating agency S&P Global in a March note says GCC banks’ unrealized losses from exposure to the US banking crisis would dent only profitability rather than capitalization. This existential factor took down Silicon Valley Bank (SVB), Signature Bank and First Republic Bank. On average, if GCC banks were to crystalize unrealized losses, they would need to use just 24.9% of their 2022 net income to absorb revaluation losses, S&P Global estimates.

The GCC banking exception is complex and rooted in a combination of structural differences and significant government deposits on the balance sheets of many GCC banks. It is also cultural, and contrasts the differences in appetite for risk between US and European financial institutions and their GCC counterparts. When interest rates were near historical lows, US banks bought long-dated treasuries that they perceived as low risk.

But when rates increased, those assets’ value fell, leaving many US banks with unrealized losses. Despite not being vulnerable to significant losses from held-to-maturity debt securities, the question is whether GCC banks can continue to be immune from the risk of future contagion amid warnings of further instability.

Almost 190 US banks could yet be at risk of collapse, according to a joint study by the University of Southern California (USC), Northwestern University’s Kellogg School of Management, Columbia University’s business school and Stanford University. The study estimates the US banking system’s market value of assets is $2.2 trillion lower than suggested by their book value of assets—another way of saying many banks are technically insolvent.

Significant capital buffers will continue to cushion GCC banks, argues Damian Hitchen, regional CEO for the Middle East and North Africa at Saxo Bank: “GCC banks are well capitalized, with CET 1 liquidity ratios [common equity Tier 1 compares a bank’s capital against its assets] above Basel III minimums, placing them at the higher end globally. This would suggest that the risk of a repeat of SVB or a Signature Bank scenario is less likely to occur here in the region,” Hitchen says. Liquid assets compared to total assets range between 22% to 38%, Moody’s Investors Services estimates.

GCC Banks: Crisis? What Crisis?

So far, so good. On average, GCC-rated banks’ total exposure to the US accounted for just 4.6% of assets and 2.3% of liabilities at the end of 2022, reflecting an overall exposure ranging from 0.0% to 22% and 11.4%, respectively, S&P Global said in its note. It added that “five of the 19 banks we rate in the region have more than 5% of their assets in the US, while four had more than 5% of liabilities to counterparties in the US.”

Crucially, GCC banks appear to have limited their lending activity in the US, and most of their assets are in high-credit quality instruments or with the US Federal Reserve Bank. GCC banks were nursing an average of 2.6% of total equity in unrealized losses at the end of last year, with the highest being 10.9%, S&P estimates. The relatively low average appears to result from hedging against interest rate volatility.

Still, GCC banks are not entirely decoupled from future turmoil amid growing calls for de-dollarization. Except for Kuwait, which pegs its dinar to a basket of currencies, all GCC states pin their currency to the dollar and mirror US interest rates. Any deterioration in the relative value of the greenback could diminish government income and put a brake on the state funding that is the backbone of many GCC banks. And the role of governments in regional banking is in plain sight.

According to Moody’s, government and public sector deposits constituted on average around 30% of total deposits in the GCC banking systems at the end of last year. Turbulence in developed markets could also hit profitability down the road, says Rajul Sood, senior director of Commercial Lending Services at Acuity Knowledge Partners. But that risk is manageable, she claims.

“These challenges are not expected to pose a threat to the banks’ existence, because governments in the region remain supportive—as they are key stakeholders in the banks—and the banks are well capitalized,” explains Sood. Boosted by buoyant oil prices, GCC economies led by Saudi Arabia and the United Arab Emirates (UAE) have unveiled major plans in a determined bid to overcome their dependency on hydrocarbon revenue.

Sood points to plans by Saudi Arabia under its signature Vision 2030 project. Real estate consultancy Knight Frank estimates just the real estate and infrastructure component of Vision 2030 could see close to $1 trillion in project announcements. Meanwhile, Saudi Arabia’s government earlier said as much as $7 trillion will be injected into the economy by 2030 through a combination of public and private sector investment. Elsewhere, Dubai has pledged to double the size of its economy by 2033 and become among the top three economic cities in the world.

“These ambitious plans, backed by governments, are expected to provide much-required lending opportunities to banks in the region and enable them to remain less exposed to US and European markets,” says Sood. Undeniably, governments, their related entities, and large family-owned businesses are fundamental to the positive outlook of GCC banks.

Governments are simultaneously borrowers, depositors, and principal shareholders, and they recycle hydrocarbon revenue through GCC banks into non-oil sectors of the economy. Islamic finance also increasingly features in the business model of GCC banks.

Rules banning interest payments make Islamic deposits at these banks lower cost than at conventional banks, and support banks’ profitability, particularly at times of high interest rates. In the largest Islamic banking market, Saudi Arabia, quasi-zero-cost deposits accounted for 55% of total deposits at the end of last year, Moody’s estimates.

Future Imperfect

Still, GCC banks’ shield from the US banking rout faces other threats. Oil prices—the lifeblood of most GCC economies—began unwinding, and the outlook for prices is uncertain as the threat of recession looms in major economies. Germany, Europe’s economic powerhouse, slipped into a technical recession in the first quarter of this year, and there are lingering doubts over the health of the US economy. The recent reelection of Turkish President Recep Tayyip Erdoğan may also not bode well for GCC banks.

Turkish subsidiaries of GCC banks are exposed to renewed depreciation of the lira and hyperinflation that has dogged the Turkish economy. Cumulative inflation exceeds 100% over three years, Fitch Ratings estimates. Before Erdoğan’s return to power, GCC banks had already notched $950 million in losses in the first half of last year, with the UAE’s Emirates NBD and Kuwait Finance House being among the hardest hit, Fitch added.

Meanwhile, the GCC’s bellwether economy, Saudi Arabia, slowed in the first quarter of this year despite the promise of future gigaprojects. Based on Saudi Arabia’s May flash economic forecast, Capital Economics (CE) said first-quarter GDP showed the economy contracted by 1.3% quarter-on-quarter on a seasonally adjusted basis and growth slowed from 5.5% y/y in Q4 to 3.9%—the slowest pace since Q2 2021. Saudi Arabia recently revised down its May flash estimate from 3.9% to 3.8%.

CE now predicts the economy will contract 0.5% this year, after Saudi Arabia decided to push through another oil production cut during the OPEC+ meeting in June.

That “Saudi lollipop,” aimed at easing tensions among other members, will heap pressure on the viability of Saudi Crown Prince Mohammed bin Salman’s mind-bending spending plans that have captivated global investors. During the same month, interbank lending rates reached levels not seen since 2001. Last year, Saudi Arabia’s central bank was forced to inject around $13 billion into the banking system to ease a liquidity crunch.

Lower oil prices and broader concerns about slower global economic growth may lead to tighter monetary policy and challenge the GCC’s “Goldilocks” epoch, says Vijay Valecha, chief investment officer at Century Financial, a Dubai-based investment services firm.

“While banks have provisions for nonperforming loans, asset-quality indicators may worsen due to slowing growth and higher interest rates,” says Valecha. He adds that this could further increase inflation and operating costs and affect profitability.

The well-being of GCC banks is firmly intertwined with the decisions of their respective sovereigns, but the signs are that major banks are staying ahead of the curve by overhauling their business models. Digitalization, margin-based lending, securitization and tentative steps into artificial intelligence point to evidence of C-suite readiness, as does dumping riskier assets ahead of a global downturn.

Earlier this year, Abu Dhabi Commercial Bank sold a $1.1 billion nonperforming loan (NPL) portfolio to the US investment management firm Davidson Kempner. This was reportedly the largest NPL transaction ever in the UAE.