Moody's Investors Service has changed its outlook for the Saudi Arabian banking system to negative from stable, according to its latest outlook research report.
The agency said in a statement that the outlook reflects its expectation that the persistently low oil prices and resultant government spending declines will ultimately weigh on the Saudi banking sector.
"We expect the operating environment for Saudi banks to weaken over the next 12-18 months," said Olivier Panis, a Moody's vice president, senior credit officer.
"With the prospect of lower oil prices for longer and a 14 percent reduction in public spending in 2016, we believe that the credit risks across the system are rising."
Moody's forecasts Saudi Arabia's real GDP growth to slow to 1.5 percent for 2016 and 2 percent for 2017, well below the 3.4 percent growth of 2015, and for average oil prices to stay at $33 a barrel in 2016 and $38 in 2017.
As a result, the rating agency expects loan growth to slow down to between 3-5 percent for 2016, from 8 percent in 2015 and 12 percent in 2014.
Moody's said it also expects asset risk to rise as a result of the deteriorating operating environment.
"We expect non-performing loans to increase to around 2.5 percent of total loans over our outlook horizon, from a very low average 1.4 percent in September 2015 - still lower than for most other Gulf countries," said Panis.
"Banks will also continue to remain exposed to event risks stemming from persistently high single-party exposures - although we estimate that around 10-25 percent of banks' top 20 loans are either to the government or wider public sector."
Moody's added that capital buffers are likely to remain solid,with the sector's average tangible common equity (TCE) ratio remaining broadly stable at around 15.7 percent by the end of 2016, up from 15.4 percent as of September 2015.
Profitability is also likely to remain strong, despite increased funding costs and loan-loss provisions, according to the rating agency, due to the low cost of funding and the banks' lean cost structures and zero corporate tax rate.
Moody's expects that, with an average of 143 percent of non-performing loans covered by provisions, provisioning costs will still remain one of the lowest in the GCC.
"Tightening liquidity - as public-sector deposit inflows and corporate profits moderate - will likely expose banks to greater funding volatility in line with regional pressures." said Khalid Howladar, a senior credit officer based in Dubai.
"However, we expect the local impact to be manageable and funding structures to remain relatively stable thanks to a broad and growing depositor base."
Although Moody's expects government support for the Saudi banking system to remain high, the rating agency notes there are signs that authorities' policy stance may evolve in line with global practices. In addition, government support assumptions could be further challenged on the basis of fiscal pressure for the Saudi government, signaling a potential reduction of government capacity to support banks in case of need, the agency said.For all the latest banking and finance news from the UAE and Gulf countries, follow us on Twitter and Linkedin, like us on Facebook and subscribe to our YouTube page, which is updated daily.
Subscribe to Arabian Business' newsletter to receive the latest breaking news and business stories in Dubai,the UAE and the GCC straight to your inbox.