Will Fed rate cuts and geopolitics fuel more M&A deals by GCC banks?

Another year, another bumper crop of profits. Banks in the six-member Gulf Cooperation Council (GCC) are set to reap further gains as higher oil prices, increased public-sector spending, and red-hot real estate markets combine to generate a heady lending environment. In the first quarter of this year, the combined profits of 57 listed banks jumped 10.5% to $14.4 billion compared to the same period in 2023, Kuwait-headquartered Kamco Invest said in a May report.

Quarterly performance was similarly robust, with an 11.8% surge in quarter-on-quarter profits.

But there are headwinds, including an expected change in monetary policy by the US Federal Reserve, mounting competition, and geopolitical uncertainty.

Meanwhile, banks in Saudi Arabia and the United Arab Emirates may face liquidity challenges as they scramble to meet strong lending demand driven by governments jockeying to liberalize their economies. That scenario could trigger renewed consolidation, some analysts predict, as GCC banks, with limited regional options, look to other jurisdictions to achieve operating efficiencies and cost savings.

GCC banks have been riffing off the Fed’s last monetary tightening cycle to support earnings; higher interest rates typically boost loan yields and fee income. At the end of 2023, the average return on assets of the region’s top 45 banks reached 1.7%, up from 1.2% at year-end 2021, according to ratings agency S&P Global.

With the exception of Kuwait, where the dinar is pegged to a basket of currencies, GCC governments peg theirs to the US dollar, and so they typically follow US interest rate changes to preserve their pegs.

Yet, a Fed move to lower may pressure some GCC banks. S&P estimates that every 100-basis-point rate drop corresponds to around a 9% reduction in bottom-line profits. The most vulnerable bank S&P rates may see as much as a 30% drop in the bottom line for every 100 basis point cut.

Despite the chances of an erosion in earnings, however, merger and acquisition activity among GCC banks has gone quiet since it reached a pre-pandemic peak in 2019 when 11 deals worth $118 billion were consummated, according to data from PitchBook. Last year saw few blockbuster deals, adding to speculation that a fresh burst of activity might be overdue.

An Overbanked Region?

While it is unclear when the Fed will begin reducing interest rates and by how much, when it happens, the shift could alter GCC banks’ risk profile. The good news is that rate cuts would reduce the number of unrealized losses that institutions in the region have built up amid frenetic lending. These might be as much as some $2.8 billion for rated GCC banks, or 1.9% on average of their total equity at year-end 2023, S&P estimates.

Still, lower profits are not the only consideration for banks when they weigh M&A to achieve cost efficiencies. In recent years, deals among the larger banks have been a shortcut to building market share. But it is widely acknowledged there are too many banks in local banking markets at a time of mounting competition from smaller, more agile rivals.

“Consolidation makes sense for overbanked systems in the region,” says Mohamed Damak, managing director, sector lead financial institutions, Middle East and Africa at S&P Global Ratings. “It can be even more appealing in an environment where interest rates and profitability are reducing.”

Regional banks’ appetite for international acquisitions that diversify them away from their home markets will drive M&A activity. “By deploying capital into high-growth markets, they may be able to compensate for weaker growth opportunities in their home markets,” Fitch Ratings said in May. 

Increasing competition from swashbuckling fintechs could also spur M&A. Challenger banks and neobanks have gnawed away at conventional banks’ market share and are a preoccupation of C-suite executives. Their continuing impact on profits may also spark consolidation, analysts suggest.

Fintech valuations, by contrast, are high, and that may limit outright acquisitions by conventional banks looking to take their rivals’ innovations in-house. Not all banks will be able to compete in the new environment, and governments will be mindful of any threat to systemic stability, says Hiba Chamas, business development director, Americas and MENA, at RTGS.global, a London-based cross-border settlements fintech.

“Regulatory pressures may play a significant role, with authorities mandating mergers to reduce the number of smaller, weaker banks and enhance financial stability in the region,” says Chamas. Smaller banks that lack capital to invest in fintech or build their own products may be compelled to merge with larger institutions, she suggests.

Kicking The Hydrocarbon Habit

Some of the GCC’s larger banks have already bought into corporate marriages as a way to diffuse geopolitical risk and an overweight dependency on oil-related revenue. The UAE triggered an earlier flurry of M&A activity in 2016 when First Abu Dhabi Bank emerged from the union of National Bank of Abu Dhabi and First Gulf Bank, spurred by a desire to leverage scale and deliver cost synergies.

That deal was followed in 2019 by the tripartite merger of Abu Dhabi Commercial Bank, Union National Bank, and Al-Hilal Bank. Other notable GCC deals have included the creation of Saudi National Bank in 2021 through the merger of National Commercial Bank and Samba Financial Group, creating Saudi Arabia’s largest bank. Smaller deals have taken place in Bahrain, Kuwait, Oman and Qatar.

Today, several GCC banks are reportedly looking to acquire financial institutions outside of their domestic markets. But snapping up banks in lower rated jurisdictions could be problematic, warns Fitch Ratings. GCC banks already have substantial exposures in countries such as Turkey and Egypt, and further international expansion would come with uncertainties regarding foreign exchange and interest rate risk, according to Fitch.

Burgan Bank (Kuwait), Emirates NBD (UAE), Qatar National Bank and The Commercial Bank (Qatar) have all seen changes to their rating profiles as a result of exposure to Turkey. Qatar National Bank’s additional exposure in Egypt’s weak economy also makes it vulnerable to changes in the local macroeconomic environment. And Kuwait Finance House has a higher exposure to Turkey and Bahrain, Fitch notes.

Cross-border M&A within the GCC is complicated, too, given large government shareholders in some of the region’s major banks. Strong balance sheets and solid project pipelines reduce the likelihood of consolidation in the GCC, says Junaid Ansari, director of investment strategy and research at Kamco Invest, which could make deals outside the region more attractive. “Consolidation within the region would only be limited to the ongoing deals, but we expect to see an increase in overseas M&A deals by GCC banks.”

Tight liquidity, meanwhile, is resulting in prolific levels of US dollar debt issuance by GCC banks to fund soaring credit demand. Fitch calculates that annual issuance in 2024 and 2025 could exceed the 2020 record of $25.2 billion. With government initiatives including Saudi Arabia’s Vision 2030 and Dubai’s D33, which entail mind-numbing levels of spending, banks’ loose change for M&A might be constrained.

The GCC is also no stranger to Black Swan situations, and a sudden shock event might be enough to force or scupper M&A deals, dealing a blow to business confidence. Of primary concern would be a widening of the Israel-Hamas war or an escalation of attacks by Yemen’s Houthi rebels in the Red Sea. Especially if Iran is drawn into the conflict, the economic impact would be dramatic and possibly lead to a spike in non-performing loans.

“Were the scope of the Israel-Hamas war to widen significantly,” Fitch said in January, “Middle Eastern countries could be affected by further disruption to oil trade routes, or, potentially, production capabilities, and could also experience a marked negative impact on non-oil activity.” That would likely set back their plans for longer-term economic diversification, although higher oil prices could provide an offset.

As the GCC’s second-largest economy, the UAE looks particularly exposed. In 2020, it was a signatory to the Abraham Accords, normalizing relations with Israel. The emirates are now reportedly Israel’s second-largest trading partner in the Middle East, yet it is unclear what level of exposure UAE banks have to nascent bilateral trade.

These concerns are another reason some observers argue that the best bet for GCC banks, bolstered by their healthy balance sheets, is to diversify into markets outside the region, lowering risk and lessening their dependency on hydrocarbon-related income in a region known for springing surprises.