Saudi Arabian bank deposits fell the most in nine months in May as lenders facing higher interest rates cut back fixed deposits to reduce costs and boost profit.

Total deposits at the 23 lenders operating in the largest Arab economy fell for a second month, dropping 0.5% in May, the most since last August, to 1.14tn riyals ($ 304bn), the latest central bank data show.

Borrowing costs in the kingdom have risen at the fastest pace in the Gulf Cooperation Council this year as lending picks up amid state plans to spend more than $ 500bn building infrastructure and industry, and creating jobs. This has put pressure on banks’ margins, the difference between interest earned on assets and that paid on liabilities. Net interest margins at Al Rajhi Bank, the biggest Saudi lender by market value, fell to 4.8% in the first quarter from 5.1% in the last quarter of 2011, data compiled by Bloomberg show.

“Banks have shed some of the expensive time deposits to manage their funding costs,” Murad Ansari, Riyadh-based analyst at investment bank EFG-Hermes Holding, said by phone on June 27. “Banks manage their funding cost and their liquidity based on how the deposit liquidity is shaping up.”

The three-month Saudi interbank offered rate, which has some influence on how banks set deposit rates, has risen 20% this year to 0.9375% today, near its highest since April 2009. That compares with a 1.6% drop in the equivalent UAE rate, 5.7% advance in Qatar, 6% increase in Bahrain and a 12% drop in Kuwait, the data show.

The Saudi rate’s spread over the three-month London Interbank Offered Rate has more than doubled this year to 48 basis points, according to data compiled by Bloomberg. The yield on Saudi Arabia’s one-year treasury bills gained seven basis points this year to 0.58126% at a sale yesterday. The six- month bill yield is up 4 basis points over the same period to 0.44449%.

Saudi bank deposits fell by 7.4bn riyals in May from March levels, data of the Saudi Arabian Monetary Agency show. Demand deposits, which pay no interest, rose by 7.5bn riyals, while interest-bearing fixed deposits declined by 10.2bn riyals, according to the data. Foreign currency deposits also decreased by 1.9bn riyals.

The shift has taken place as banks’ margins get squeezed. The net interest margin at Saudi British Bank, which is 40% owned by HSBC Holdings, narrowed to 2.65% in the first three months of this year from 2.76% in the fourth quarter, data compiled by Bloomberg show. Samba Financial Group’s net interest margin fell to 2.85% last year from 3.12% in 2010.

“Banks would like to focus on maintaining margins as we are seeing a lot of margin contraction,” Mahmood Akbar, a Riyadh-based analyst at NCB Capital Co, said by phone on June 27. “Although the deposits are virtually non-interest bearing, every little bit helps, particularly for maintaining or holding back margin compression.”

Demand deposits comprise 60% of the total, while savings deposits make up 26%, central bank data show.

Saudi companies borrowed $ 8.7bn so far this year in syndicated loans, more than doubled the amount they borrowed in the year-earlier period, data compiled by Bloomberg show. Loans to private businesses grew 13% in May, near the fastest pace in three years.

Loan growth has supported the economy, which is set to expand 4.8% this year, the GCC’s second-fastest pace after Qatar, a survey of 12 economists by Bloomberg shows. That surpasses estimated expansion of 1.3% for Group of 10 nations.

Still, lower oil prices and declining crude output may slow growth. Oil tumbled 18% in New York in the three months ended June 29, the biggest quarterly drop since the final three months of 2008, on concern a worsening in the euro region’s debt crisis could affect energy demand.

Opec oil production fell from the highest level in more than three years in June as Iranian output dropped to a 20-year low with European sanctions set to take full effect this month, a Bloomberg survey showed.

A decline in deposits is “usual” for the summer, Akbar at NCB Capital said. “There is also some slow down, the stock market volume is also quite low, the oil prices have also been slightly slower compared to the previous months, so that also has a knock-on effect on total customer deposits.”

The country’s loan-to-deposit ratio is low relative to its peers in the GCC at about 80% - compared with more than 100% in Qatar and Oman and 94% in the UAE, central bank data show.

If “banks have excess deposits than what they typically need, they would like to hold them as demand deposits so that they don’t incur a cost on it,” Ansari of EFG-Hermes said.