The agreement, announced by the two banks on Wednesday but still non-binding, would create a lender with assets of around $77 billion, and is seen strengthening the banking system as Saudi Arabia embarks on a plan to transform its economy and cut its dependence on oil revenues.
SABB is 40 percent owned by HSBC Holdings and Alawwal is 40 percent owned by RBS Holdings NV, a consortium that includes Royal Bank of Scotland (RBS), which has been trying to reduce its stake for some time. Selling a small stake in a larger merged entity could make it easier for RBS to find a buyer, two sources close to the merger said.
If approved, the merger deal would see SABB acquire smaller peer Alawwal for 18.6 billion riyals (3.7 billion pounds). The boards of the two banks reached a non-binding agreement on the share exchange ratio, subject to several conditions, the banks said in joint statements to the Saudi Arabian bourse.
"A binding agreement is yet to be entered into between Alawwal Bank and SABB," they said. "Any binding agreement to proceed with the merger will be subject to a number of conditions, including SAMA [the central bank], other regulatory authorities, and the shareholders' approval."
Merger talks began last year but progress had taken longer than expected, partly because the regulatory environment for bank acquisitions in Saudi Arabia is relatively untested. Shareholders were also assessing any potential impact from the kingdom’s anti-corruption drive, two sources told Reuters in January.
RBS, which acquired its stake in Alawwal via its 2007 purchase of ABN Amro, has been looking to sell it for a number of years as it retreats from international operations and tries to bolster its capital base.
Through the consortium, RBS owns about 15 percent of Alawwal. RBS's stake in the new entity will be 5 percent, an RBS source said.
The merger would reduce Alawwal-related risk-weighted assets on RBS's balance sheet from 5.9 billion pounds ($7.95 billion) to just under 1 billion pounds, the RBS source said.
The steps still to be agreed in the merger include completion of due diligence and agreement on a number of other commercial issues, SABB and Alawwal said.
It would be the first major Saudi banking tie-up since Saudi American Bank merged with United Saudi Bank in 1999, forming one of the largest local banks at the time.
If everything goes to plan, the process could be completed by the end of 2018, two sources close to the merger said.
"[The] merger would be a win-win situation. It would create the third-largest bank in the kingdom in terms of assets and net profit, which could reach 5.9 billion riyals annually," said Mazen al-Sudairi, head of research at Al Rajhi Capital.
Based on the preliminary agreement, Alawwal shareholders would receive 0.485 SABB shares for each Alawwal share, they said.
Based on the exchange ratio and the closing price of 33.5 riyals ($8.93) per SABB share on Monday, the merger would value each Alawwal share at 16.3 riyals and Alawwal's existing issued ordinary share capital at approximately 18.6 billion riyals, the banks' statement said. This represents a premium of 28.5 percent to the Alawwal share price, the banks said.
The combined entity is valued at a price to book ratio of 1.4 and 14 times price to earnings for the full year of 2018, said Jaap Meijer, managing director and head of equity research at Arqaam Capital in Dubai.
SABB and Alawwal said they did not expect the merger to result in any involuntary layoffs of staff.
(Additional reporting by Saeed Azhar in Dubai and Marwa Rashad in Riyadh; Editing by Jason Neely and Susan Fenton)
By Tom Arnold and Hadeel Al Sayegh