Lending a hand: Government support and regulatory action have helped the sector weather the storm

The modern era of Kuwaiti banking began in 1952 with the creation of the first national bank in the Gulf region, National Bank of Kuwait (NBK). Founded by prominent local merchants to serve the national interest and invigorate the economy, it established the country as a regional banking centre. The intervening years have seen new financial markets emerge across the region, yet the sizeable assets and global reach of its key players have enabled Kuwait’s banking sector to retain its prominent place among them. As with other markets, Kuwait’s banks have operated in a challenging environment since the global economic crisis, but aided by the adroit response of both the government and central bank they are emerging from the period ready to grow with the wider economy once again.

“The banking sector in Kuwait has been resilient,” Ali Yousef Al Awadhi, the chairman of the Commercial Bank of Kuwait, told OBG. “Whereas all around the globe banks have had to deal with bankruptcies and required injections of capital, Kuwaiti banks have managed to survive alone.”

MARKET STRUCTURE: The nationalisation of the Kuwaiti banking sector in 1971 allowed the unhindered development of its domestic operators, which accounts for the strong market position of the 11 local banks today. Warba Bank, licensed by the Central Bank of Kuwait (CBK) in 2010, is the most recent entrant to the domestic segment, where it joins a vibrant mix of five conventional and five sharia-compliant lenders. However, the blue camel logo of NBK remains the most ubiquitous financial symbol, and the country’s oldest bank still accounts for around one-third of the market as defined by customer deposits, total assets or the extension of credit. Kuwait’s top five domestic lenders by total assets, NBK, Kuwait Finance House (KFH), Gulf Bank, Burgan Bank and Commercial Bank of Kuwait, accounted for 82.8% of total sector assets in 2011 (see analysis). The Islamic banking segment is led by the nation’s second-largest bank (and the only sharia-compliant lender in the “big five”), KFH. Another four Islamic banks operate in the market: Ahli United Bank (formerly the conventional operator Bank of Kuwait and the Middle East); Kuwait International Bank (formerly Kuwait Real Estate Bank); Boubyan Bank; and the recently arrived Warba. With KFH they claim about 39.3% of total sector assets FOREIGN PLAYERS: The promulgation of the Direct Foreign Capital Investment Law in 2004 allowed foreign banks to enter the market for the first time in decades, and the arrival of multinational lenders has greatly enriched the sector. HSBC was among the first to commence operations under the new legislative regime, establishing its branch in 2005 after a 33-year absence. Other multinationals, such as Citigroup and France’s BNP Parisbas, were quick to follow, and have since been joined by regional heavyweights such as National Bank of Abu Dhabi, Qatar National Bank, Bank Muscat, Doha Bank, Mashreq Bank and Saudi Arabia’s Al Rajhi Bank, the world’s largest Islamic bank. In November 2010 the CBK approved the opening of the UAE’s Union National Bank, making it the most recent foreign player to begin operating in the market.

The mixture of local, foreign, Islamic and conventional banks that has emerged since 2004 has lent new vigour to the sector, yet the legislative changes of that year did not entirely remove the protection enjoyed by domestic operators. Foreign banks are limited to opening a single branch in the country and are prohibited from entering the retail market, their activities being confined to investment banking. They are forbidden from directing clients to borrow from branches outside Kuwait’s jurisdiction and are subject to a maximum credit concentration – effectively less than half the limit of the largest local lender.

MARKET CHARACTERISTICS: The limited competition from foreign banks has helped establish Kuwait’s domestic banking system as one of the most robust in the MENA region. Locally incorporated banks generally have strong liquidity positions, with the aggregate capital adequacy ratio (CAR) increasing from 16.7% in 2009 to 18.8% in 2010 – primarily a result of a CBK directive to most banks to increase their share capital. A sector average loans-to-deposits ratio of 73.7% in 2011, significantly below the 85% maximum set by the CBK, reveals room for banks to expand their loan portfolios, and has ignited a debate as to whether modest lending levels are the result of the banks’ conservative stance or a lack of lending opportunities in the wider economy (see analysis).

CAUTIOUS: One reason for the caution with which banks currently extend credit is the concentration risk evident in historic sector lending: the high exposure of banks to real estate and investment companies (25% and 10%, respectively, of the aggregate loan book in 2010) was the most challenging factor arising from the global credit crisis. Another notable characteristic of the domestic banking sector is an asset-liability mismatch: over 95% of customer deposits have a maturity period of less than a year, while 38.8% of credit extended by local banks is categorised as long-term by the CBK. However, the non-alignment of assets and liabilities is a common feature of the wider GCC banking industry, where concerns regarding such ratios are mitigated by a history of sustained liquidity, as is the case in Kuwait, and strong sovereign support.

PERFORMANCE: The balance sheets of Kuwait’s banks have come under significant pressure as a result of the global economic crisis. Against the backdrop of a cooling regional economy, three interrelated factors have proved particularly troublesome to local lenders: a national stock exchange that lost over 40% of its value in 2008, and on which trading volumes remain a fraction of their former level; a subdued real estate sector that had previously accounted for around a quarter of aggregate lending activity; and the difficulties faced by local investment companies, which have compelled the banks to raise their provisioning against non-performing loans (NPLs).

All three have played a part in the downward pressure exerted on banks’ profitability: while Kuwait’s banking sector was the only one in the GCC to show an increase in aggregate profit in 2009, this was a result of NBK’s 3.87% rise in earnings; the country’s other banks saw net income declines of up to 80%.

However, while bottom-line growth remains subdued in comparison to 2007 levels, the financial position of local banks improved significantly in 2010. The concluding statement of the IMF’s Article IV Consultation, delivered in May 2011, notes that recapitalisation through capital injection and subordinated debt issuance resulted in the CAR rise achieved in 2010, while the sector leverage ratio remained at a “comfortable” 13%. Moreover, three of Kuwait’s top five lenders showed an increase in net profit during 2010, with aggregate net profits reaching KD575.3m ($2.07bn), a 62% increase from KD355.8m ($1.28bn) in 2009.

The renewed profitability was reflected in an improvement in return on average equity, which grew to 10.4%, up from 7.5% in 2009. The improvement continued into the beginning of 2011 on the back of decreasing provisioning against suspect loans, with aggregate net profits that climbed by 13.9% in the first half of 2011, though market fears caused them to fall in the second half of the year, according to data available from KIPCO Asset Management Company (KAMCO).

As earnings from the first half of 2011 were made public, showing sustained profitability by Kuwait’s major players, Moody’s Investors Service changed its outlook for the sector from negative to stable, stating that it expected net profit for financial year 2011 to be higher than 2010, due to receding credit charges for loan losses and improvement in the operating environment stemming from the nation’s “ongoing economic recovery, supported by increasing government spending and high international oil prices.”

LENDING: While Kuwait’s banks were successful in growing their bottom line over2010, credit growth in the sector remains modest. Gross lending by the country’s banks expanded by 42.9% between 2006 and 2007 to reach KD22.94bn ($82.7bn). By 2010 it was continuing to grow at a year-on-year rate of just 0.56% for a total KD29.44bn ($106.1bn).

The tightening of lending criteria by banks hit hard by rising NPL rates is largely responsible for the slowdown, with banks revisiting not just statistical limits but also their lending philosophy. “We used to lend based on assets. Now the new criteria for lending is cash flow,” Michel Accad, the CEO of Gulf Bank, told OBG, “Therefore, more loans are going to operating companies which pay from an actual cash flow that is generated by operations, rather than to finance non-productive assets.” Yet the stagnant credit arena is not solely the result of the sector’s response to bad debt; reduced demand has also played a part, leaving well-capitalised banks with a shortage of prudent lending opportunities. “Today, the reason why you may not have larger growth in lending is because the borrowers are reluctant. In a world of uncertainty, as an investor, you try to reduce your borrowing. It is the demand for credit that has dropped, not the supply,” said Accad.

However, while the anticipated return to sustained credit expansion in the banking sector has yet to materialise, efforts made by Kuwait’s banks to clean up their loan portfolios and improve asset quality have left them in a good position to benefit from it when it does (see analysis). “Although corporate lending has been reasonably flat in Kuwait for the past three years, the availability of financing remains strong,” Simon Vaughan Johnson, the CEO of HSBC Kuwait, told OBG. “Banks still have an appetite to lend, but in the recent economic downturn corporate customers in our target segments have been looking to deleverage where they can.” Aggregate NPLs fell from KD3bn ($10.8bn) in 2009 to KD2.5bn ($9bn) in 2010 after two years of restructuring and debt rescheduling with struggling corporates.

REGULATION: As the industry regulator, the CBK has been playing an important role in the process of restructuring and reform. Established in 1969, the institution is tasked with the supervision of the banking system, issuing the Kuwaiti dinar on behalf of the state, directing credit policy to assist social and economic progress and – as an overarching mission – encouraging the growth of national income. In its oversight role it applies the legislation responsible for its own foundation: Law 32 (passed 1968), known as the Central Bank Law.

The law’s provisions are wide-ranging, covering monetary issues and defining the scope of the CBK’s remit and the organisation of the banking business ( including licensing, supervision, reporting and inspection regimes). Although the 1968 legislation still pertains to the banking sector, it does so in a modified form. The promulgation of Law 28 in 2004 applied a number of amendments to the Central Bank Law, with the aim of raising the standard of regulation in Kuwait to conform with international best practice and to bring about the liberalisation of financial services within the context of Kuwait’s responsibilities to the World Trade Organisation and under the terms of the General Agreement on Trade in Services.

The new law has greatly enhanced the CBK’s supervisory reach, allowing it to exchange data and information with foreign supervisory bodies and inspect the growing number of external branches and subsidiaries of Kuwaiti banks. It also grants the CBK the means to respond vigorously to infringements – outlining a graduated scale of violations and penalties to act as an effective deterrent – and increases the market’s stability by limiting individual ownership (with the exception of government entities) in a bank to 5% of its capital, unless consent is obtained from the CBK.

FOREIGN INSTITUTIONS: However, the most significant provisions of the 2004 legislation are those in regard to foreign institutions. The new law has amended the 1968 regime to allow foreign banks to enter the market without participation from the government or domestic institutions in their capital. A minimum capital requirement for foreign branches of KD15m ($54m) was applied, while that for local banks was raised to KD75m ($270m) in a bid to ensure the reinforcement of the domestic capital base.

Kuwait’s Islamic banks are also governed by the Central Bank Law of 1968, Chapter III of which was amended in 2003 to include a number of articles specific to sharia-compliant institutions, such as the establishment of independent sharia supervisory boards and the sharia-derived financial concepts – such as murabaha (cost-plus financing or credit sales), musharakah ( joint ventures) and mudarabah (profit sharing arrangement) – that they may employ. Conventional banks are not permitted to operate Islamic windows, which are popular in some regional markets (see Islamic Financial Services chapter).

SUPPORT: Both the CBK, in its role of regulator, and the government have been instrumental in the industry’s successful transition through the challenging post-crisis period. The CBK acted early to shore up confidence in the sector with a blanket guarantee on deposits, which came into effect in November 2008. Considered by many to be the single most important step that was taken by the regulator, the guarantee provides unlimited coverage for all creditors (whether domestic or foreign) and deposit types (whether they be wholesale or retail). Other remedial measures that were taken by the CBK included liquidity injections to banks through central bank repossession operations, swaps and direct collateralised placements, and an easing of the loan-to-deposit ratio in order to encourage credit growth (see analysis).

“The CBK is considered one of the most conservative and strictest central banks when it comes to applying the basic principles that are aimed at restraining bank recklessness,” Adel Abdul Wahab Al Majed, the vice-chairman and managing director of Boubyan Bank, told OBG. “This policy produced positive results for the banking sector during the financial crisis.”

The government was quick to respond, placing direct deposits with some commercial banks and promulgating the Financial Stability Law (FSL) with a speed not always seen in the nation’s legislature. Ratified in May 2009, the law’s triform structure addresses banks, productive sectors in the economy and investment companies, aiming to protect these from the effects of economic exigencies, and establishes the government’s right to respond in a muscular fashion in some instances, such as altering the organisational structure of ailing investment companies.

While some investment companies continue to struggle for economic stability, banks have responded well to the combined effort of regulator and government to strengthen the sector: in the difficult years since 2008 only one has resorted to the use of public funds for the purposes of recapitalisation (through a rights issue to existing shareholders backstopped by the Kuwait Investment Authority). In 2010 a liquidity test by the IMF showed the nation’s lenders had adequate buffers to withstand a substantial deposit run without needing external financing.

FUTURE GROWTH: While Kuwait’s banks have shown a return to profitability, the future growth of the sector rests on the continued expansion of the economy and the lending opportunities that this will provide. Here again, the government is playing a central role. Much of the economic growth anticipated in the short term, which Moody’s predicted in 2011 would result in real GDP growth of 5.3% for the year, will come as either a direct or indirect result of a spending plan announced by the government in February 2010.

The 2010-14 development plan is aimed at reviving the economy and overcoming the recessionary pressures that have prevailed since 2008. It includes 1100 projects, on which the government will spend an estimated total of KD37bn ($133bn), while the participation of the private sector will come primarily through build-operate-transfer (BOT) schemes.

The private sector component represented by the BOT agreements envisaged will provide Kuwait’s banks with much-needed opportunities to extend credit lines over the coming years. Unsurprisingly, the pace of the plan’s implementation has been keenly observed by the industry, and some concerns regarding delays have arisen, although progress has been made.

Of the 884 projects due to commence in the 2010/11 fiscal year, half had reached the financial/design approval or implementation phase within the first six months of the fiscal year, according to research from Kuwait Financial Centre.

Set against an improving macroeconomic background brought about in part by a strengthening oil price and improving consumer demand, the government’s continued efforts to spur the economy are expected to provide a welcome fillip to the sector.

OUTLOOK: Banks maintained their conservative lending policies in 2011, and this approach is not expected to alter in the short term. “There are strict lending criteria across the sector, because banks were hit hard in the crisis – particularly by their exposure to real estate and investment companies, which forced them to book billions of dollars in provisions,” Majdi Amin Gharzeddeene, the senior vice-president and head of KAMCO’s investment research department, told OBG.

The challenges presented by asset quality that have come about as a result of the troubled stock market and the difficulties faced by the real estate sector and investment companies remain the most significant issues facing the banking industry.

An IMF risk analysis carried out in 2010 found that 49% of total credit is exposed directly or indirectly to these sectors, and noted any further decline in them could increase the level of NPLs (and therefore costly provisioning) significantly.

However, with the real estate sector showing signs of renewed growth, the economy on track for continued expansion, the government committed to a comprehensive spending plan and the banking sector emerging from a period of restructuring that left it highly liquid and ready to lend at opportune moments, there looks to be plenty of room for optimism when looking at the sector’s future. Despite setbacks in the second half of 2011, overall sector health looks good.