Reduced central bank interest rates will compress net interest margins for banks, but there is likely to be potential growth for the sector from a changed monetary regime, and opportunities from new technology. Will GCC banks seize the opportunities?
By Fahad Badar
Banks are essential intermediaries for any economy, as a safe deposit for cash, and provider of credit for households and businesses to help develop the economy. As central bank interest rates are cut globally, with rates likely to be significantly lower in the next two years than in the previous two, there will be impacts, and banks will have to manage the new regime carefully.
September’s 0.50% cut in the US Federal rate, which was followed by Gulf central banks where most currencies are pegged to the dollar, we are likely beginning a period of interest rate reductions.
Most of the balance sheets of banks in the Gulf region are in local currency. Most currencies are pegged to the US dollar, except Kuwait’s, which is pegged to a basket of currencies, but it is weighted towards the dollar.
Banks' assets and liabilities are in a mix of USD and local currencies. The cost of funding of liabilities – which for a bank is the money deposited by customers, Capital market funding, and bank borrowings – will go down as interest rates fall.
The income earned from assets such as loans will also fall. The difference between them will tend to be compressed as central bank interest rates are cut, reducing profitability on this part of a bank’s operations.
An important consideration is that there is usually a time lag, which may be positive or negative for a bank’s profitability depending on the asset-liability mix. Most loans are set on a quarterly basis because operationally, you cannot reset the loans every day. But in the interim, the bank’s cost of funding will be reduced because it is borrowing in international markets. USD Syndications and loans are based on the Secured Overnight Financing Rate (SOFR), which is the successor to LIBOR.
Local currency loans, on the other hand, are typically linked to the respective market's lending reference rate. Bond funding is usually fixed rate, so that will not be repriced, while local currency deposits will be repriced downwards.
Banks have to manage the lower interest rate regime to maintain profitability. They need to manage the net interest income and the fee income mix in their profit and loss account, and manage the time lags.
Fee-based business and products will be the key differentiator between winners and losers. This includes wealth management, ancillary business, and brokerage. Banks also need to address increased competition from telecoms companies and from fintechs – this includes the rise of digital payment systems on cell phones without the need for setting up a bank account.
This is very common in many African countries, and increasingly so in the Middle East as well. Telecommunications companies can offer digital wallets, payment platforms, and remittance services for unbanked and underbanked customers.
In a similar way, fintechs can offer simplicity and accessibility for customers, and services for unbanked individuals. Nowadays they may also offer other services, such as commercial lending, insurance and working capital finance products.
Across different phases of the economic cycle, banks in the GCC are well run. A report by McKinsey in late 2023 found that they had stronger return on equity than a global average, as measured over the previous decade. Operational costs are lower, and the GCC institutions are better capitalised. They score better for resilience, as well as shareholder returns in recent years.
For banks as well as fintechs, advances in AI create new opportunities for client outreach and for efficiency gains in Risk, Compliance, and Operational functions, which can be significant with a switch to a cloud-based operating model and teams replacing conventional silos.
Profits in traditional banking will be squeezed but this can be offset by lowering operational costs, and finding new markets. Some established banks in the region have set up digital spin-off companies.
September’s interest rate cut does not appear to be premature or ill-judged. Inflation had fallen to well below the official rate, so the net effective rate had become significantly positive, risking an economic downturn.
For the Gulf, lower interest rates are likely to provide a stimulus.
Lower interest rates are likely to have a positive impact on asset quality across the GCC. Reduced rates will provide relief for stressed real estate developers for the banks less stress on the quality of the portfolio and maybe lesser provisioning requirements.
Many economists and observers anticipate that there could be up to 150 basis point reductions, taking central bank rates to around 3.25% or under by end of 2025.
The author is a Qatari banker, with many years of experience in the banking sector in senior positions
Fahad Badar
