Stable Outlook
Oman’s stable outlook reflects good financial performance in an improving but challenging operating environment, says Moody’s Investor Service in its report ‘Oman – Banking System Outlook’

We maintain a stable outlook on the Omani banks’ financial strength ratings (BFSRs). The banks’ weighted average BFSR is C- and reflects their good franchises in the Sultanate of Oman, robust profitability and good capitalisation levels.

The stable outlook takes into account, on the one hand, the banks’ continued franchise development but also the competitive and somewhat concentrated operating environment. It also recognises that the improved financial performance in recent years has been partly driven by the positive economic cycle.

Franchise development has been relatively balanced across segments and has entailed not only strong growth in personal lending but also continued growth in corporate and commercial banking. We expect the development of major infrastructure projects to contribute to the government’s diversification effort, while further boosting corporate activity in the country and thus the banks’ corporate lending.

Omani banks generate robust profitability levels thanks to their low cost bases and healthy interest margins. Nevertheless, their quality of earnings remains weak in terms of diversity of income streams, with the bulk of the profits being generated from interest-related activities. With the Omani banking sector becoming increasingly competitive and overcrowded, we believe that the banks should strengthen their fee-generating capabilities in order to offset the pressure on the profitability from compressed interest margins and sustain their earning power at the current levels.

Despite improvements in the operating environment, Omani banks continue to operate in a challenging and rather concentrated economy that constrains the upside potential to their ratings. While we do acknowledge the success of the government’s diversification efforts in 2006 to expand the economic activity beyond oil-related business, we note that Oman continues to rely heavily on hydrocarbon exports, which results in considerable cyclicality in the operating environment, which in turn affects the performance of the banks.

Another factor constraining the ratings of Omani banks is their tight liquidity positions. Although liquidity in the country has improved considerably over recent years as a result of high oil prices, Omani banks continue to have tight liquidity levels by international standards that somewhat constrain their BFSRs.

Furthermore, another source of concern for the system is the credit risk that Omani banks continue to face. Although we recognise the improvement in the system’s asset quality metrics over recent years due to generally improved credit risk management policies and good supervision, we also note that the current asset quality benefits from a favourable economic environment and may not be sustainable through the cycle.

In April 2007, Moody’s reviewed all its bank ratings, globally, within the context of the revised BFSR methodology and the introduction of Joint Default Analysis (JDA), which incorporates parental and systemic support into bank deposit ratings. Based on this review, the foreign currency deposit ratings (FCDRs) of all banks remained unchanged, while the senior and subordinated debt obligations of one bank moved upwards (by two notches). The BFSRs of four banks were upgraded by one notch, while for one bank it was upgraded by two notches.

Franchise and Quality of Earnings
Large Omani banks have good franchises that support their BFSRs. The Omani banking system is highly concentrated, with the top five banks accounting for around 70 percent of the sector’s total assets. The four largest commercial banks in the system enjoy strong universal franchises that benefit their bank financial strength ratings (BFSRs).

Bank Muscat (BM) (rated at A1/P-1/C-) is by far the largest bank in Oman, controlling around 33 per cent of the system’s assets. Following BM are the second-tier banks – Oman Arab Bank (controlled by Arab Bank Jordan and rated at A2/P-1/C-), National Bank of Oman (rated at A3/P-2/D+), Oman International Bank (rated at A3//P-2/D+) and Bank Dhofar (rated at A3/P-2/D+) – each controlling a sizeable share of approximately 8-10 per cent of the system’s assets and deposits.

Rapid credit expansion, driven by improved macroeconomic environment, contributes to the banks’ franchise development. Oman’s favourable economic climate during the last three years has kept credit demand at high levels, contributing to the banks’ franchise development. Nominal GDP grew by a significant 16 per cent in 2006, driven by the expansion of both the oil sector (which continues to benefit from sustained high crude prices) and the non-oil sector, which has grown significantly over 2006 thanks to the government’s plan to diversify the local economy. Furthermore, the government’s accelerated privatisation plan, combined with the development of large infrastructure projects, contributed to the strong growth of the banking sector in 2006, which grew by around 30 per cent.

Credit activity is primarily fuelled by strong demand for personal loans. Personal loans (which also includes housing loans) continued to grow at a fast pace in 2006 (up by 23 per cent year-on-year), and were equivalent to 14 per cent of the country’s GDP at end-2006*.

Omani banks have been trying to expand their personal loan portfolios, which provide the highest risk-adjusted return. Charge-off rates remain relatively minimal given that, as is the case in the other GCC countries, personal loans are extended against the borrower’s salary assignments at the bank and mostly to customers that either are government employees or work at very high-quality local and foreign businesses. Furthermore, personal loans enhance the granularity of the banks’ loan portfolios and are considered to be a less volatile source of business.

That said, we note that the banks’ ability to grow their personal loan portfolios is limited by a Central Bank of Oman (CBO) regulation that caps personal loans to 45 per cent of the total credit portfolio (of which 5 per cent can be allocated for mortgage loans), while the 9 per cent interest rate cap on all such exposures limits the upside potential to their interest margins. Personal loans account for the largest single item of the credit outstanding (at 41 per cent) at end-2006, followed by the import trade, manufacturing and services sector.

Development of major infrastructure projects will boost corporate activity. Corporate lending also increased by a significant 19 per cent in 2006, mostly due to a strong growth in the export industry, services, transport and mining sector. We expect the development of major infrastructure projects in Oman to result in a further rise in corporate lending as Omani banks are likely to participate in the financing of such projects.

An increasingly competitive and crowded banking market challenges banks. Fierce competition in the system, exacerbated by the entry of new players in the already crowded Omani market, is the main challenge facing banks, which have seen their interest rate margins being squeezed. The new players have been primarily foreign banks that have been trying to expand their regional operations by investing up to 35 per cent in the Omani banks’ capital (as per the cap applied by CBO regulations). Commercial Bank of Qatar’s entry into Oman reinforces competition. More specifically, the threat of foreign competition became more immediate in 2005, when Commercial Bank of Qatar (CBQ) acquired 35 per cent of National Bank of Oman (NBO) as well as management control, via a three-year management agreement.

While it lacks the global scale and muscle of some international banks, CBQ is a very well-run Qatari bank with substantial resources and regional aspirations. Unlike previous foreign entrants, CBQ now possesses the necessary branch infrastructure and distribution capabilities to be a credible player in retail, SME and corporate banking. Combining CBQ’s financial resources and management skills with NBO’s excellent domestic franchise will be likely to restore NBO to its former strong position and increase competitive pressures within the system.

Alliance Housing Bank’s conversion to a commercial bank to impact competition in the longer term. Among the most recent developments in the banking system was the conversion of Alliance Housing Bank (AHB) to a full fledged commercial bank, and the singing of the agreement between Ahli United Bank (Bahrain) and AHB to invest a 35 per cent in the latter’s capital. Being a small specialised housing bank, we expect the expertise and know-how of Ahli United Bank to contribute to the gradual development of AHB’s franchise in Oman and to impact competition in the longer term. At the current stage, we believe that AHB’s small size, lack of developed infrastructure and limited distribution network are likely to make it challenging for it to build significant market shares and to compete on a equal footing with the other commercial banks. Omani banks generate robust profitability levels that contribute positively to their BFSRs.

Thanks to the low-cost structure of their operations and the high but declining interest margins, Omani banks have been able to keep profitability at strong levels, a factor that supports their BFSRs. The recurring earning power of the commercial banks, although slightly lower than in 2005, was sustained at strong levels in 2006 at 3.6 per cent. At the same time, a controlled growth in costs resulted in a cost-to-income ratio of 38 per cent for FYE2006, while the ratio of non-interest expenses to average assets receded to 2.2 per cent. We also note that the sector’s bottom-line profitability improved considerably in 2006 (by 2.5 per cent), benefiting from reduced specific provisioning expenses due to better credit quality metrics.

Nonetheless, quality of earnings is poor. Omani banks’ earnings quality remains relatively weak in terms of diversity and sustainability of income streams. The banks’ revenues remain heavily reliant on net interest income while their fee-generating capabilities lag behind those of many international banks. This is mostly due to the late development of fee-generating products such as asset management and bancassurance. Fee and commission income remained low and was equivalent to 0.39 per cent of average assets during 2006.

With the level of competition rising and exerting pressure on interest margins to a greater extent, Omani banks will have to diversify their revenue bases through higher fee income in order to maintain current levels of profitability. This has been happening to some extent, but progress remains slow. The banks’ success in improving the stability and diversity of income by growing their retail banking, asset management and fiduciary services will contribute to their franchise and profitability enhancement.

Financial Fundamentals
Although asset quality has improved, credit risk remains the primary source of risk for the Omani banks. Although to a lesser extent than before, credit risk remains the largest source of risk faced by the Omani banks. The banking system had suffered from significant asset quality deterioration back in 2000-2002, mainly due to financial troubles faced by several large corporate clients to which most of the banks were exposed and a stock market crash that affected all banks. Nevertheless, the banks’ concerted efforts over recent years to focus on recoveries and increase write-offs have significantly improved the system’s asset quality, which now stands at moderate levels.

The non-performing loan (NPL) balances** dropped by 10 per cent over 2006 and accounted for 5.2 per cent of the system’s loans at the end of the year (down from 7.3 per cent at the end of 2005). At the same time, loan loss reserves grew further and by year end-2006 provided 100 per cent coverage to NPLs.

Rising consumer indebtednesses raises concerns. Despite the low risk associated with the personal loans segment, the rising consumer indebtedness in Oman raises concerns over the future performance of this sector once new loans start to season. With personal lending accounting for about 14 per cent of GDP, we believe that the average Omani household is quite highly leveraged, with a significant proportion of monthly income dedicated to repayment of personal loan instalments. Despite its success and high returns, we believe that the sector has inherent risks stemming from customer over-borrowing, which raises the likelihood of a systemic repayment problem in adverse economic conditions in Oman and in the event of a prolonged tightening in liquidity.

While the corporate lending environment remains challenging we believe that in Oman, where corporate activity mostly depends on oil, corporate lending can be risky and volatile. Moreover, Oman is dominated by a handful of corporate groups, creating concentrations in the banks’ books, raising their risk profile. Because these names dominate the local economic activity, almost all banks have exposures to them. Therefore, if one conglomerate were to face difficulties, all banks would suffer. Indeed, the problems experienced by several large groups in recent years affected all the banks to some degree, although several banks bore the brunt of the problematic exposures. Nevertheless, we do recognise the prudent limits that CBO has in place with regard to the single large exposures and the total of such exposures, which partly mitigate our concerns***.

Despite rising liquidity levels, Omani banks continue to have tight positions by international standards. Our concerns related to previously tight liquidity conditions have eased considerably in recent years. As a result of higher oil prices, the country has experienced increased inflows from oil exports over the past years, increasing the overall level of liquidity in the system. The liquidity indicators have improved for the Omani commercial banks alleviating negative pressure on their ratings. Nonetheless, their liquidity levels remain relatively low compared to international standards with the system’s net loans-to-customer deposits ratio totalling 100 per cent at the end of December 2006. Furthermore, the system’s core liquidity levels (defined as the sum of cash, interbank placements and liquid securities) improved marginally to 22 per cent at end-2006, although remaining at relatively low levels.

That said, our concerns about liquidity mismatches in the Omani banks’ books are partly addressed by the prudent norms that CBO has in place regarding the banks’ maturity profile for different time bucket. Furthermore, the banks’ foray to the syndicated lending market have enabled them to lengthen the maturity profile of their liabilities, while diversify their funding resources. These loans tend to have a longer maturity (usually between three to five years), therefore easing liquidity concerns to some extent. Furthermore, some banks – notably BankMuscat – have raised funds by issuing bonds in the domestic and international markets, helping to somewhat improve the mismatches on their balance sheets, albeit at higher costs. Moody’s views this step positively, and believes that bond issues in the international markets could be another way of addressing the endemic maturity asymmetries on a bank’s balance sheet, as has already been done to some extent by other GCC banks.

Strong capitalisation is among the primary strengths of the Omani banking sector. Omani banks are well capitalised and meet the capital requirement set by the CBO. Following the Basel II implementation in January 2007, the minimum capital requirement has been adjusted to 10 per cent, from the previous levels of 12 per cent. Omani banks have consistently reported strong capital levels with the system’s total regulatory capital standing at a high 17 per cent at end-2006. Furthermore, thanks to a good internal capital generation during recent years, the shareholders’ equity to assets ratio totalled a respectable 14 per cent at end-2006.

Support Considerations
Global local currency deposit ratings were assigned to Omani banks in April 2007. With the implementation of the Joint Default Analysis (JDA) methodology in April 2007, Moody’s assigned global local currency deposit ratings (GLCDRs) to all Omani banks. According to the methodology, GLCDRs are determined by the incorporation of external elements of support into the bank’s baseline credit assessment (BCA). In calculating the GLCDR for a bank, the JDA methodology also factors in: (i) the rating of the support provider(s), in the form of the local currency deposit ceiling (LCDC) for a country (which in the case of Oman is Aa2), (ii) Moody’s assessment of the probability of systemic or other external support for the bank in the event of a stress situation and (iii) the degree of dependence between the bank’s rating and the rating of the support provider (the LCDC in the case of systemic support).

Very high probability of support from the authorities and major shareholders results in an uplift of the Omani banks’ deposit ratings from their BCAs

All six rated Omani banks are considered to be too important to be allowed to fail. Moody’s views the probability of systemic support for all five large banks in the event of a stress situation to be very high, based on their importance to the Omani financial system due to their strong market shares in the banking assets. In the case of Alliance Housing, the probability of systemic support is again assessed to be very high, stemming from the track record of the Omani authorities, which have in the past supported banks in difficulties. Oman is considered to be a high-support country.

In the case of Bank Muscat, the direct and indirect government ownership is also taken into account in imputing very high probability of systemic support. Furthermore, the GLCDRs of National Bank of Oman and Oman Arab Bank benefit both from the assessment of a moderate parental support from, respectively, Commercial Bank of Qatar (which owns a 35 per cent stake in NBO but has managerial control through a management contract) and Oman Arab Bank Plc (which has a 49 per cent stake in the bank) as well as the very high probability of systemic support in the event of a stress situation.

*Note that, for the purpose of this report, the figures used are for the Omani commercial banks as at end-2006 and exclude Alliance Housing Bank, which has obtained approval to convert to a commercial bank within 2007. The data was taken from the Central Bank of Oman.

**Non-performing loans are defined as the exposures that are overdue by 90 days and above.

***According to CBO, the single obligor limit is up to 15 per cent of the bank’s capital, while the total of such exposures should be capped at 600 per cent of the banks’ net worth.

Prepared by: Moody’s Investors Service

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