Saudi banks face fresh liquidity squeeze as Iran war drains deposits

What happened

Saudi lenders are running into a new funding pinch as deposits slow and loan demand holds up, lifting the price of money. The strain ties back to withdrawals by government entities and a pullback by banks in the United Arab Emirates, with the Iran war amplifying both moves.

According to Bank of America's Jean-Michel Saliba, "contagion" driven by tighter liquidity in the UAE plus a sharp cooling in Saudi Arabia's war-strained economy is amplifying the squeeze. He pointed out that UAE lenders play a major role in Saudi interbank activity, and their pullback is driving higher deposit costs and fiercer rivalry for funds.

That compounds a crowded policy agenda for Crown Prince Mohammed bin Salman as he finances big-ticket spending and a multi-trillion economic overhaul. He is already contending with a bigger budget shortfall, an economic downturn, and the possibility that investment activity will wane because Iran-backed Houthi strikes occurring almost daily are upsetting travel, events and trips by executives. This week, Riyadh - the capital - has come under repeated attack, among them a strike that hit Aramco's offices in the financial center.

How the strain shows up in markets

The funding stress is showing up in a wider gap between Saudi and US short-term rates. The gap separating the three-month Saudi Interbank Offered Rate (Saibor) from the US Secured Overnight Financing Rate (SOFR) sits around 120 basis points, versus a typical level near 70. That matters in a currency pegged to the dollar because it is a quick read on local liquidity.

Raising money overseas has also become more expensive, as central banks across the US, the European Union and Japan have increased rates in recent months to curb inflation tied to the Iran war that began in February. The Saudi central bank tracks the Fed closely because of the riyal's dollar peg.

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The real economy angle

Credit growth is now running ahead of funding. Data from the Saudi central bank indicate lending increased 2.4% in the third quarter, whereas deposits declined 1.8%, largely reflecting withdrawals by government entities. Tim Callen at the Arab Gulf States Institute said wartime spending pressures contributed, and warned the squeeze could slow the expansion of lending and lead both government-related and private-sector borrowers to rethink planned projects. "All-in-all, it's another sign of how the war is affecting the non-oil economy," he said.

That strikes at the core of the diversification drive. Monica Malik at Abu Dhabi Commercial Bank said that a combination of higher funding costs, project-driven demand for credit, and regional geopolitical uncertainty is creating additional drag on non-oil activity. If higher borrowing costs curb project spending, it could stall momentum under Vision 2030, which aims to turn Riyadh into a global hub across sectors from tourism to investment.

What could ease - or extend - the squeeze

Goldman Sachs's Farouk Soussa expects the impact of tighter liquidity to be short term. He said Vision 2030 development will outlast any temporary funding squeeze and noted the central bank has tools to ease a crunch. In 2022, it injected billions of dollars as deposits into liquidity-starved banks to alleviate a severe crunch. Bank liquidity appeared to improve earlier this year as lenders constrained lending, but that proved short lived.

There is a potential release valve. Christou said pressures could ease in coming months if oil prices rise and Saudi oil production recovers, though "history suggests this is no guarantee." Heavy spending, capital leakage, and projects with long timelines that produce minimal near-term cash flow can stop increased oil income from flowing into bank deposits and leave overall system liquidity constrained. The bottom line: a wider Saibor-SOFR spread and retreating deposits raise funding costs for the government, the array of affiliated bodies such as the Public Investment Fund, and for private firms that opt to take bank loans to finance diversification projects.

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