Morgan Stanley analysts Daniel Cowan and Suha Urgan also downgraded Arab National Bank to “equal weight” from “overweight.”

They also cut price targets on shares of Arab National, Riyad Bank, Samba Financial Group and Saudi British Bank, while raising their target on Al Rajhi Bank shares.

Saudi lenders had a difficult year in 2009 with profitability eroded by a doubling of provisions for non-performing loans to almost SR11 billion as a rising number of Saudi and regional firms ran into financial problems.

Second-quarter results at Arab National Bank, HSBC’s Saudi affiliate SABB bank and Saudi Investment Bank (SAIB) also reflect a challenging period for the region’s banks as they struggle to cover loan losses in a flat market still reeling from the global financial crisis.

Morgan Stanley analysts, however, said the market is ignoring the prospect of higher policy rates offsetting the lower loan growth of 10 percent that they expect in 2011.

They estimate that higher policy rates will lift 2011 net interest margins by an average of 45 basis points, returning them to 2008 levels. Consumer borrowing also seems to be showing the first signs of life since 2006, Morgan Stanley analysts said.

They named “overweight”-rated Riyad Bank and Samba Financial their top picks among Saudi banks.