Principled assets: A regional centre for the sharia-compliant financial industry

Over the past decade Kuwait has seen the emergence of one of the largest and most diverse Islamic financial services (IFS) industries in the world. According to Kuwait Finance House (KFH), as of September 2012, the country was home to $70.4bn in Islamic finance assets, some 5-6% of global sharia-compliant assets. Numerous Islamic financial institutions have set up shop in Kuwait in recent years. As of 2012 five of the country’s 10 local banks were fully sharia-compliant, and, while full-fledged Islamic banking windows are not allowed in Kuwait, the remaining five commercial banks all offer Islamic products and services of some kind. As of September 2012, 42.3% of Kuwait’s total banking assets were Islamic, which was the highest rate in the GCC at the time. Additionally, more than half of the investment companies, investment funds and insurers registered in the country operate on a sharia-compliant basis. With these figures in mind, Kuwait is well positioned to continue to build upon its reputation as a global centre for IFS in the foreseeable future.

HURDLES: However, the sector faces some challenges. The regulatory regime has not kept pace with the industry’s rapid expansion and maturation over the past decades. Oversight duties are split among a handful of government entities, which has had a negative impact on the sector’s reputation. In February 2013 the Capital Markets Authority (CMA) – a government agency with a mandate to oversee the investment sector – issued a statement calling for local Islamic financial institutions to shore up their internal oversight capabilities to ensure they are fully compliant with standard regional interpretations of sharia law. The industry also faces other issues, including a low-growth economic environment as a result of the international financial downturn; geopolitical risks associated with the Arab Spring protests; and a relatively small financial workforce. Nonetheless, the sector is expected to play a key role in Kuwait’s ongoing economic expansion.

HISTORY: For the first decade after Kuwait achieved independence in 1961 IFS was non-existent in the country, and throughout most GCC member states.

Beginning in the early 1970s Kuwait’s government was a key participant in a series of international meetings put together by the Organisation of the Islamic Conference (later renamed the Organisation of Islamic Cooperation, OIC). These gatherings served as a catalyst for – among other things – the liberalisation of the regional financial sector and the development of sharia-compliant products and services throughout the region.

Indeed, the OIC meetings are widely considered to mark the birth of the modern IFS industry.

In March 1977 Kuwait’s government passed Law No.

72, which established KFH as the country’s first sharia-compliant financial institution. The new company was formed by special decree, which meant that it functioned independently of oversight from the Central Bank of Kuwait (CBK), the government institution that regulates the financial sector at large. Indeed, the CBK Law, which was passed in 1968 and serves as the basis of financial regulation in the conventional financial sector, did not include any mention of Islamic banking until the early 2000s. KFH’s independence allowed the company to compete with other nascent regional IFS institutions at the time, namely Dubai Islamic Bank, founded in 1975, and Bahrain Islamic Bank, established in 1979.

These three institutions are now among the largest Islamic financial institutions in the world and are widely considered to be among the industry’s pioneers.

EXPANSION: KFH was Kuwait’s sole sharia-compliant institution until 2003, when the government amended the CBK Law to include a section on Islamic finance, allowing for the creation of a new IFS industry. In the years since, a handful of new sharia-compliant entities have set up shop in Kuwait, including Boubyan Bank in 2004, Kuwait International Bank (KIB) in 2007, Ahli United Bank (AUB) in 2010 and Warba Bank in 2010, among others. In 2007 the country’s rejuvenated IFS sector posted expansion of 44.3%, making it the single fastest-growing IFS industry in the Gulf. Despite increased competition since 2004, KFH has remained the domestic market leader in terms of total assets and most other indicators by a substantial degree (see analysis).

While Kuwait was generally well insulated against the 2007-08 financial downturn, prolonged economic sluggishness in the US and the EU over the past five years has had a negative effect on the country’s banks and other financial institutions. A number of local sharia-compliant investment companies have been forced to undergo restructuring as a result of rapidly increasing levels of indebtedness since 2008.

According to a number of studies carried out by the World Bank and the IMF, Islamic financial institutions around the world performed better than their conventional counterparts during the crisis. Indeed, investment companies aside, the majority of the sharia-compliant institutions in Kuwait escaped the downturn mostly unscathed. There are several reasons for this. Unlike traditional banks, sharia law prohibits Islamic institutions from dealing with gharar (uncertainty) or maisir ( gambling), which effectively bars them from investing in most derivatives and the other speculative, leveraged products that were hit the hardest during the crisis. IFS institutions also tend to rely heavily on tangible assets, which put them in good stead during the downturn. At the same time, the sector’s reliance on real estate as an underlying asset in many transactions has caused some issues in more recent years (see analysis).

REGULATION: As mentioned, the legislation that underpins Kuwait’s IFS sector was passed in a 2003 amendment to the CBK Law, which itself was drawn up in 1968. Under the law each registered IFS institution is required to maintain an independent sharia supervisory board (SSB) made up of at least three members capable of ensuring that all of a given institution’s products and services are in line with sharia law. In case of differing opinions either within or among various SSBs, the final authority on sharia matters in Kuwait is the Ministry of Awqaf and Islamic Affairs. Like their conventional counterparts, all Islamic banks are required to operate within the central bank’s general financial framework and overarching monetary policy.

A variety of government authorities are charged with regulating the IFS sector. The CBK, which started operating in 1969 following the passage of the CBK Law, is charged with managing Kuwait’s monetary policy, national accounts and economic development. Additionally, the central bank oversees lending institutions, including conventional and sharia-compliant banks. Until recently, the CBK was responsible for regulating all investment companies (ICs) as well. However, under the government’s new Capital Markets Law, which was passed in early 2010 and came into effect in 2011, ICs Domestic Islamic banks by assets, 2012 were required to choose to focus on either investment activities or lending activities. This split, which is in line with the UK Independent Commission on Banking’s current “ring-fencing” proposal and the now-defunct Glass-Steagall Act in the US, is meant to limit overlap between commercial and investment banking activities. Under the law, ICs that have chosen to focus on investment activities will fall under the oversight of the newly created CMA, while ICs that choose to focus on lending activities will come under the aegis of the CBK.

The takaful (Islamic insurance) industry, meanwhile, is overseen by the Insurance Department at the Ministry of Commerce and Industry (MoCI), which is also charged with regulating conventional insurance providers. The lack of a unified regulatory framework for the IFS sector is widely considered a central challenge for the industry moving forward.

BANKING: Kuwait’s sharia-compliant banking system, like the majority of the rest of the economy, is underpinned largely by the country’s enormous hydrocarbons wealth. Indeed, the formation and subsequent rapid expansion of KFH in the late 1970s can be attributed primarily to energy-related liquidity flows. As the sector has matured, IFS institutions have increasingly come to focus on corporate business, which currently accounts for a substantial percentage of revenues at most institutions. Kuwait implemented the Basel II monetary guidelines in 2005, making it the first Arab country to do so. Basel III, which was introduced in 2010, is expected to be implemented over the next few years.

As of the end of 2012, Kuwait’s five domestic sharia-compliant banks boasted total assets of KD20.6bn ($73.6bn). Of this total, KFH accounted for KD14.7bn ($52.5bn), or around 71.4% of the total; followed by AUB, with KD2.63bn ($9.4bn), or around 12.6%; Boubyan, with KD1.88bn ($6.7bn), or 9.1%; KIB, with KD1.2bn ($4.3bn), or 5.8%; and Warba, with KD223m ($796.5m), or 1.1%. Additionally, Saudi Arabia-based Al Rajhi Bank – the largest Islamic finance institution in the world – operates a branch in the country (see analysis).

As mentioned previously, Islamic institutions account for 42.3% of total banking assets in Kuwait, which as of September 2012 was the highest percentage in the GCC by a substantial degree. In both Qatar and Saudi Arabia, sharia-compliant institutions accounted for 22.9% of total banking assets at that time, whereas in the UAE they made up 12.9% and in Bahrain they made up 12.8%, according to KFH. As of the end of September 2012, Islamic banking assets in Kuwait had grown by 7.8% compared to the same period the previous year.

Steady growth in recent years has resulted in an increase in lending. Indeed, in the first nine months of 2012 credit volumes at sharia-compliant institutions in Kuwait reached KD11.1bn ($39.6bn), up 13.2% from the same period the previous year. Credit volumes at conventional banks, meanwhile, hit KD18.6bn ($66.4bn) in the first three quarters of 2012, up 5.6% when compared to the same period the year before.

MAJOR PLAYERS: The development of Kuwait’s IFS sector is synonymous with the rise of KFH over the past three decades. Founded in the late 1970s, as of early 2013, 51.1% of the firm was listed on the Kuwait Stock Exchange (KSE), while 24.1% was held by the Kuwait Investment Authority (KIA), the government’s sovereign wealth fund; 10.5% was held by the Public Authority for Minors’ Affairs; 8.3% was held by the Kuwait Awqaf Public Foundation; and 6% was held by Public Institute for Social Security. KFH offers a wide range of personal and corporate products and services in Kuwait, including real estate financing facilities, investment funds and private banking. The firm operates a domestic network of 54 branches. KFH is active in numerous major banking markets around the world, either directly or through a raft of subsidiaries, which include Saudi Kuwaiti Finance House in Saudi Arabia, KFH Malaysia in Kuala Lumpur, KFH Financial Services in the Cayman Islands and Diyar Al Muharraq in Bahrain.

AUB, Kuwait’s second-largest Islamic bank by total assets, operated as a conventional institution called the Bank of Kuwait and the Middle East until April 2010, when it was converted to sharia-compliance and rebranded. The institution is overseen by Bahrain’s AUB, which owns 74.9% of its shares. Like KFH, AUB offers a full range of retail and corporate banking products via a domestic network of 26 branches. Boubyan Bank, which was founded in 2004 and is owned by a handful of local conventional institutions, operates both in Kuwait and in a number of foreign markets. Other sharia-compliant banks that currently carry out business in Kuwait include KIB, which was converted to an Islamic model in May 2007; Warba Bank, which was established by royal decree in April 2010; and, as previously mentioned, Al Rajhi Bank, a Saudi-based institution that was established in 1957 and is the largest Islamic financial institution in the world (see analysis).

INVESTMENT COMPANIES: In addition to the five domestic institutions and one foreign bank, as of 2012 Kuwait was home to 95 ICs in total, 51 of which carry out business in line with sharia principles. ICs are a relatively recent phenomenon in Kuwait. The first investment firms set up shop in the 1990s, encouraged by the oil-based economy, low barriers to entry, easy access to credit and a relatively light touch in terms of regulation. In the early and mid-2000s the number of ICs in the country increased rapidly. At the end of 2001, there were 11 Islamic ICs in Kuwait, according to the CBK, with total assets of some KD654.9m ($2.3bn). The number of sharia-compliant firms jumped considerably over the course of the decade, rising to 23, with assets of KD2.7bn ($9.6bn) at the end of 2005; then 39 at the end of 2007, with assets of KD6.6bn ($23.6bn); and 54, with assets of KD6.4bn ($22.9bn), by the end of 2010.

DOWNTURN: Like their conventional counterparts, in the early and mid-2000s Islamic ICs took advantage of cheap short-term lending to invest heavily in equities and real estate. When the financial downturn swept through the region in the latter half of the decade, both of these asset classes dropped off quickly. Due to their high exposure, many firms were hit hard by rapidly rising debt levels during the crisis. According to data from the IMF, as of June 2010 five ICs had defaulted on their debt. In late 2008 Global Investment House (GIH), Kuwait’s largest IC, defaulted on loans of around $200m. While the company moved quickly to restructure its debt, GIH has posted annual losses since then, due to a series of related ongoing financial issues. In late 2012 the firm launched another restructuring effort – valued at around $1.7bn – which is expected to have a positive long-term effect on GIH’s capital structure and financial position. Other conventional local ICs that defaulted in the wake of the crisis include Gulfinvest International and the Kuwait Finance and Investment Company.

Some Islamic firms have also defaulted. In May 2009 The Investment Dar (TID), the largest sharia-compliant IC in Kuwait, defaulted on a $100m sukuk (Islamic bond). The firm sought protection under the Financial Stability Law (FSL), which was passed in the wake of the crisis in March 2009 and is designed to serve as an efficient mechanism for debt-restructuring negotiations. By December 2009, TID had reached an agreement with its creditors and in 2011 the firm restructured around $5bn of debt under the FSL. As of early 2013 the company was continuing to work to shore up its accounts. In early March 2013, TID announced that it would sell its $92m controlling stake in Bahrain Islamic Bank, a Bahrain-based sharia-compliant financial institution. The International Investment Group (IIG), another local Islamic IC, defaulted on a $200m sukuk in 2010. As of 2012 the company was in the midst of negotiating a restructuring deal with its creditors.

While most sharia-compliant ICs in Kuwait managed to avoid defaulting, the sector has seen declining revenues since the downturn. As of the end of February 2013 the country’s Islamic ICs boasted total assets of KD5.1bn ($18.2bn), according to data from the CBK, down from KD5.3bn ($18.9bn) at the end of February 2012, KD6.1bn ($21.8bn) at the end of February 2011, KD6.5bn ($23.2bn) at the end of February 2010 and KD7.1bn ($25.4bn) at the end of February 2009. In an effort to strengthen the system, the government has announced that it would like to see a round of mergers and acquisitions among ICs in the coming years.

SUKUK: Kuwait’s first sukuk issuance took place in 2005, when the Commercial Real Estate Company – a local conglomerate – issued a $100m Islamic bond in the midst of a boom in domestic bond issuances. According to the Kuwait Financial Centre (Markaz), between 2003 and 2009 Kuwait experienced $99.7bn in new bond issuances, equal to around 40% of the GCC bond market in the same period. The government issued 93% of this debt. The state’s willingness to issue debt – both conventional and sharia-compliant – encouraged corporate issuance as well during this period. While conventional debt accounted for the majority of issuances, as of the mid-2000s Islamic bonds were on the rise. By the end of 2009, 15 sukuk had been successfully put forward in Kuwait, including a $100m issue by TID, a $200m listing by AREF Investment Group, a $190m sukuk by Gulf Holding Company and a $475m sukuk by National Industries Group Holding, the latter of which remains the country’s largest sukuk offering to date.

The sukuk issued by Kuwait-based entities in this period share a number of characteristics. All but one featured five-year tenors, for example, and 13 of the Takaful gross written premiums, 2007-11 issuances originated in either the financial services or real estate sector. Also, due to the lack of a comprehensive regulatory framework for domestic sukuk issues in Kuwait, all of the Islamic bond sales were made outside the country itself. The local sukuk market suffered during the 2007-08 downturn and as of early 2013 had yet to recover to pre-crisis levels, though a raft of new regulations is expected to jump-start issuances in the coming years. In 2010 the country saw just $1bn of conventional issuances and no sukuk issuances. In 2011 and 2012 sukuk activity consisted of just a handful of issuances. A draft law that would establish a comprehensive legal framework for new issuances has been under discussion in the National Assembly for the past few years. If the law is passed, the market is expected to expand dramatically, as it would allow firms to issue Islamic debt within Kuwait for the first time.

Indeed, with a solid regulatory framework in place, Kuwait could potentially become a major player in the rapidly expanding global sukuk market. According to a recent report released by Standard & Poor’s (S&P), an international ratings agency, in 2012 global sukuk issuance hit $138bn, up 64% from the previous year. As a centre for a variety of other sharia-compliant products and services, Kuwait is well positioned to take a greater role in sukuk issuance in the coming years.

TAKAFUL: As of 2012 the domestic insurance market was home to 11 takaful insurers, one takaful reinsurer and one foreign takaful firm. While the number of sharia-compliant insurance providers has expanded substantially over the past decade, the industry is relatively small by regional standards. According to a recent report released by Capital Standards, a local ratings agency, in 2010 Kuwait’s insurance penetration rate was 0.58%, compared to a regional average of 1.3%.

The Islamic segment has grown considerably in recent years. In 2011 takaful providers brought in KD37.8m ($135m) in gross written premiums (GWPs), according to Capital Standards, which was equal to 16.9% of total GWPs, up from 16.5% in 2010, 15.4% in 2007 and 14.5% in 2006. The majority of takaful premiums come from motor underwriting, primarily third-party liability lines, which are compulsory for all drivers in Kuwait. In 2011 nearly 53% of sharia-compliant premiums were from the motor segment, while 19% came from life and health underwriting, 8% came from marine and aviation underwriting and 7% came from fire coverage. The remainder came from a handful of other smaller lines.

First Takaful Insurance, which was established in July 2000, was Kuwait’s first sharia-compliant underwriter. The company was launched by KFH – the sole Islamic bank at the time – and a number of other local investors, including the International Murabaha Company, International Inventor and the IIG. In January 2013 Capital Standards assigned First Takaful an insurer’s financial strength rating of BB-, citing the firm’s “strong and well-established market position, conservative reserving strategy and good reinsurance programme”. The second takaful operator to be established in Kuwait was Wethaq Takaful Insurance Company, which was launched in October 2000 and is controlled primarily by TID. Other major takaful players currently active in Kuwait include Gulf Takaful (controlled by GIH), Boubyan Takaful ( controlled by Boubyan Bank) and National Takaful, among others. The country is also home to Al Fajer Re, which was set up in 2008 and is one of only a handful of sharia-compliant reinsurance firms in the world.

OUTLOOK: Kuwait’s IFS players face several challenges. The country’s regulatory framework remains relatively underdeveloped when it comes to sharia-compliant business practices, which has had a negative effect on the industry’s reputation. Since 2008 many segments have experienced slow growth and development, but at the same time many segments have become increasingly competitive, resulting in downward pressure on margins, particularly among takaful providers. While many segments – notably ICs and takaful – would likely benefit from a round of consolidation, there is not much precedent locally for mergers and acquisitions. Finally, despite its oil wealth, Kuwait is not completely immune to regional economic and political shocks, of which there have been no small number in recent years.

Many of the challenges the sector faces are simultaneously considered opportunities for long-term growth. New Islamic governments in Egypt and other countries affected by the Arab Spring could eventually drive a jump in demand for IFS products and services across the region. According to a September 2012 report by S&P, the GCC is home to an estimated 80% of Islamic assets, but only 6% of the world’s Muslim population. This mismatch points to great potential for cross-border Islamic financing deals, especially between GCC states and South-east Asia. Indeed, some of Kuwait’s sharia-compliant financial institutions are already active in Malaysia, Indonesia and other major IFS markets in Asia. Many sharia-compliant banks and other financial institutions have also seen steadily increasing interest in IFS among non-Muslim populations, both in the Gulf and other parts of the world. With one of the largest sharia-compliant industries in the world, Kuwait is well positioned to take advantage of these opportunities.