The banks in the Gulf have started to apply the ninth benchmark of the international standards to prepare financial reports on the financial conditions. The report published on Thursday by Standard & Poor's said these banks would be able to handle the overall impact.
More importantly, classification and measurement under IFRS 9 have a slight influence on the overall effect, due to the good quality of their investment, limited trading activities, the use of the financial asset retention model to collect their contractual cash flows or the model for the collection of contractual cash flows and the sale of financial assets to a big limit.
IFRS 9 is a new reporting standard for financial instruments which specifies the requirements for classifying and measuring financial instruments, impairment of financial assets and hedge accounting. This standard was developed in response to criticism of the previous Standard (IAS 39) that led to the banks’ late recognition of credit losses. The ninth criterion aims at correcting this by requiring banks to keep provisions in advance, based on their loss expectations.
IFRS 9 requires banks to classify their financial instruments in one of three categories, based on the credit quality of the instrument. Class 1 comprises active financial instruments and category 2 is a low-performing financial instrument where credit risk has increased significantly since its issuance, “Class 3” Non-performing financial instruments are considered to be impaired.
Gulf banks’ application of IFRS 9 on 1 January 2018 led to an increase of provisions of 1.1 percent of total loans, equivalent to one third of their net operating income before deduction of loan losses. The last measure is used for illustrative purposes only, since the initial effect of IFRS 9 is reflected in equity in banks. These results are in line with previous expectations that the impact of applying IFRS 9 will be limited to the financial conditions of rated banks.
Saudi Arabia
The average provision for Saudi and UAE banks was slightly higher than the initial forecast. In Saudi Arabia, the adoption of a more conservative policy by some banks, with the impact of economic performance on higher average provisions in the banking sector. The challenges faced by contractors and the real estate sector in general are key factors contributing to this. It also shows that some banks have become more conservative in an attempt to avoid the future volatility of net income caused by the initial effect of applying IFRS 9 to equity.
UAE
The decision of some banks in the UAE to settle their loan portfolios and retain provisions for old loans largely explains the existence of such a difference. Real estate prices in the UAE are expected to push asset quality indicators at banks and provision requirements. Furthermore, it is expected that some large loans of government-linked entities will be transferred to Category 2 (if not primarily from this category) in view of refinancing conditions, which may prompt some of these entities to restructure their debt. Government-linked entities are expected to reach $ 13.5 billion due in 2018-2019 and will need refinancing as global liquidity declines and investor appetite declines as a result of rising geopolitical risks.
Kuwait
It appears that Kuwaiti banks are now the least vulnerable to the effects of applying IFRS 9. Kuwaiti banks have not yet finished working with the regulator to develop assumptions about the impact of the implementation of Standard 9 on their loan portfolios. The regulator requires banks to maintain general provisions for operating facilities equivalent to 1 percent of cash facilities and 0.5 percent of non-cash facilities, which will help to mitigate the impact of the application of IFRS 9 on banks’ financial statements. Total additional allocations are estimated at 0.7 percent of total loans, on average.
Classification and measurement
The impact of classification and measurement on investments was limited, according to the agency, and amounted to about 4 percent of the total effect on retained earnings, on average. This was due to the relative strength of the credit quality of the investment portfolios of classified banks and their traditional business models. For some banks, reclassification of certain investments, from held to maturity investments to investments held at fair value through other comprehensive income, has led to a positive revaluation.
Outlook for this year and next year
Due to the relative weakness of the operating environment in some Gulf countries, it is expected that the growth rate of loans in banks will be between 3 and 4 percent only. Thus, most banks will most likely continue to prioritize quality loans at the expense of size and avoid high-risk profitable exposures. This is in particular because IAS 9 requires lifetime allowances for exposures with impaired credit quality or repayment difficulties.
It is also believed that the cost of risk will continue to rise and will then stabilize at a higher level. The cost of risk will remain high for a longer period as a result of debt restructuring, overdue and undervalued loans, which have seen a remarkable rise in some banking systems, and provisions under the Ninth Standard.
This is what prompted some Gulf banks to absorb the impact of applying the new standard in the first year to avoid potential erosion of their profitability in the future. The agency reflected these factors in its credit ratings for Gulf banks. Therefore, do not expect any major changes to the credit ratings of these banks unless unexpected events occur (for example, geopolitical stability is a major shock).
In fact, most future outlooks are stable, noting that most of the negative outlook banks in Qatar alone, according to the credit rating agency, said in its report: “Qatar’s rated banks were the most affected, as we expected in 2017. The average provisions an additional 1.5 percent of total loans. However, this figure hides significant differences between banks, since the minimum increase was 0.5 percent, while the ceiling was 2.8 percent.
She pointed out that the shift in the operating environment after the boycott of many Arab countries to Qatar, and in particular the pressures on the real estate sector and the hospitality sector, continue to contribute to increased allocations with banks. This is because a larger number of exposures have moved, or will move, to Category 2 under Standard IX, which require larger allocations.
“About 56 percent of the Gulf banks we classify as a result of the application of the ninth criterion since 1 January 2018 were below our expectations of printing losses,” the agency said in its report.
It is important to make it clear that print losses in our calculations represent an additional amount of pressure for the expected losses for 12 months (our calibration is based on a 12-year economic cycle, including 3 years of moderate pressure).
The impact of banks’ implementation of IFRS 9 was somewhat close to our estimate of print losses in economies that experienced a significant slowdown in growth, with a negative impact on cash flow and corporate creditworthiness. This is because some exposures have fallen to Tier 2 and therefore, have required lifetime provisions.
The impact on some banks was much higher than our estimate of print losses. This was not surprising, however, because these banks have also shown a significant increase in restructured loans or overdue and undervalued loans that require life-long provisions under IFRS 9.
