Kuwait's sharia-compliant financial sector on the rise

Over the course of the past decade Kuwait has worked to shore up its longstanding reputation as a centre for Islamic financial services (IFS), leading to the rapid expansion of sharia-compliant banks and investment companies (ICs) in recent years. Islamic banking assets, which accounted for just over 20% of total banking sector assets in 2005, grew to around 45% of total assets by the end of 2013. Sharia-compliant ICs saw a similar jump in the same period, from around 29% of total assets in 2005 to more than 42% at the end of 2013. The rapid growth of the industry appears to have continued relatively unabated through 2014 and the first half of 2015. For example, as of early 2015 the Commercial Bank of Kuwait (CMBK), a conventional lender, was in the process of exploring a conversion to sharia-compliant status. Assuming that the institution’s transition moves ahead as planned, it will soon become Kuwait’s sixth Islamic bank, and reduce the number of conventional lenders by one, to a total of five. The move by CMBK has been widely interpreted as the most recent sign that sharia-compliant financial services are currently on the rise in Kuwait.

History

Along with its neighbours in the GCC, Kuwait has helped drive the development of Islamic banking and other sharia-compliant financial services since the sector first took off in the early 1970s. In 1969, eight years after Kuwait became an independent state, the country’s government worked with a range of other predominantly Muslim-majority countries to establish what is now known as the Organisation of Islamic Cooperation (OIC), a loosely organised political and economic coalition of countries that cooperate on a wide range of issues. An early focus of the OIC was the development of Islamic banking in member countries. Throughout 1970s and 1980s the OIC organised a variety of meetings and conferences on various topics related to sharia-compliant banking in particular, as well as other Islamic financial instruments and services, with the objective of building a new IFS industry from the ground up. During this period Kuwait and other early proponents of IFS introduced many of the industry standards that are in use today.

State Services

Kuwait Finance House (KFH) – one of the oldest and largest Islamic banks in the world – was established as a government-owned and -controlled entity in March 1977, as a result of the passage of Law No. 72. The institution was created in large part as a response to similar multinational, state-led institutions that had been set up in Saudi Arabia and the UAE in the preceding years, namely the Islamic Development Bank (IDB), which was launched in Jeddah in 1973, and Dubai Islamic Bank (DIB), which began operations in 1975. Bahrain Islamic Bank (BIB), meanwhile, was established two years after KFH, in 1979. These four institutions dominated the sharia-compliant financial sector in the Gulf and across much of the Middle East throughout the 1980s and 1990s. They all continue to hold sizeable shares of the market in their respective countries and in the region as a whole.

Under the Central Bank of Kuwait (CBK) Law of 1968, which established the nation’s central bank and to this day continues to serve as the backbone of the banking sector (see Banking chapter), Islamic banking was not allowed to operate. As a state-run entity primarily focused on regional and domestic corporate business, KFH was largely exempt from the 1968 regulatory framework. KFH’s independence was deemed necessary to allow it to effectively compete with IDB, DIB and BIB, all of which were engaged in developing new products and financing schemes during this early period.

Stepping Ahead

Kuwait’s modern IFS industry began to grow in earnest in 2003, when the government amended the 1968 CBK Law in order to permit the establishment of new sharia-compliant entities in the country. Boubyan Bank, which is today the third-largest Islamic bank in Kuwait by assets, was established in 2004. Kuwait International Bank (KIB), which had been operating in the conventional market as the Kuwait Real Estate Bank since the early 1970s, converted its business to sharia-compliant status in May 2007, becoming Kuwait’s third Islamic bank at the time. Two more players joined the sector in 2010. The first, Ahli United Bank (AUB), had previously operated as the conventional lender Bank of Kuwait and the Middle East and was the first bank inaugurated in Kuwait, where it has remained for over 72 years. The second, Warba Bank, is a newly launched institution. By 2011, then, there were five sharia-compliant banks operating in the country. This figure will rise to six if CMBK completes its transition to sharia-compliant status.

The Investment Sector

In addition to Islamic banking, Kuwait has been home to a vibrant sharia-compliant investment industry since at least the mid-1990s. In 1994 there were 14 local Islamic ICs operating in the country, with total assets worth around KD1.48bn ($5.1bn).

By the end of 2008 the number of sharia-compliant ICs operating had increased by one, to 15 in total, while assets had jumped considerably, to KD7.67bn ($26.42bn). This rapid increase, which also took place in the conventional investment sector, can in large part be attributed to rapidly rising prices in property and equity markets throughout the Gulf region, which drove investment demand.

ICs in Kuwait and elsewhere in the region largely funded their investments in large part with cheap credit from local lenders, which was readily available and easy to access from the late 1990s through to the early and mid-2000s.

Kuwait’s financial sector as a whole – including both the country’s conventional and Islamic institutions – was relatively well insulated against the 2007-08 international economic downturn, in contrast to many Western banks. While many domestic financial institutions maintain close ties to and regularly do business with a wide range of foreign institutions, Kuwait’s financial sector generally speaking remains risk-averse and conservative. Nevertheless, a number of ICs and local banks were negatively impacted by the global economic downturn, primarily as a result of their real estate and equity holdings, many of which lost a considerable amount of value in the wake of the crisis.

Regulation

The CBK regulates Kuwait’s Islamic banking sector, the Capital Markets Authority (CMA) oversees the investment sector, the Ministry of Commerce and Industry (MoCI) oversees the takaful (Islamic insurance) segment, and the Ministry of Awqaf and Sharia Affairs (MASA) has authority in areas of the industry that are directly related to sharia legal provisions. The fact that local Islamic financial institutions are required to abide by rules laid down by four different regulatory bodies is widely regarded as a major impediment to sector growth.

In addition to sharia law, Islamic banks must abide by the same rules and regulations as their conventional counterparts, as codified in the 1968 CBK Law and various more recent amendments. In general, all new pieces of legislation introduced by the CBK apply to both the conventional and Islamic banking segments. Major new rulings that have affected the banking sector since 2003 include a 2004 law that allowed foreign institutions to set up shop in Kuwait; a 2012 ruling aimed at shoring up corporate governance, transparency and banks’ internal risk assessment capabilities; and in early 2014 a law requiring the banking sector to implement Basel III fiscal principles by 2018 (see Banking chapter). Ahmed Zulficar, deputy CEO of AUB, told OBG, “The central bank’s new guidelines and regulations have been received positively overall, and most banks have reported improved profitability and solid capitalisation for 2014, with further growth anticipated.”

The CMA was erected in 2010 following issuance of the Capital Markets Law, which had the effect of overhauling the regulation of the investment sector. Since then the authority has taken a relatively strict approach to the sector, imposing fines on listed companies that fail to meet reporting requirements, for example, and in some cases temporarily de-listing firms with repeated or long-term infractions. According to many local players, these efforts have had a positive impact on the capital markets sector as a whole (see Capital Markets chapter).

Kuwait’s takaful market is regulated by the Insurance Department at MoCI, which has a mandate to ensure that local insurers abide by Kuwait’s 1961 Insurance Law No. 24, which was the first piece of formal insurance legislation to be introduced by any Gulf country. In 2011 the government announced that it was considering establishing a new independent insurance authority to regulate the industry, as part of a new insurance law currently making its way through parliament. At the time of publication it remained unclear when the law would come into effect (see Insurance chapter).

Sharia Principles

Sharia-compliant banks have been allowed to operate in Kuwait since 2003. In order to qualify as Islamic under this amendment, a financial institution must retain the services of an independent sharia advisory board, which is required to include no less than three members, each a sharia scholar. The sharia advisory board must approve all new products and services by consensus, qualifying them as permitted under sharia law. If a given board cannot reach a consensus on a particular product or service, MASA may be called in to make a ruling on the issue in question. MASA may also audit rulings made by individual sharia advisory boards, although this is rare in practice.

In a speech delivered in February 2014, Mohammad Y Al Hashel, the governor of the CBK, called for the establishment of a new, independent legal entity to oversee and ensure the implementation of sharia standards at all financial institutions in the country. The central bank governor is not the first person to argue for the creation of a comprehensive sharia finance oversight entity, although he is one of the idea’s highest-profile supporters. The debate has to do with a perceived conflict of interest among sharia advisory board members, who are employed by the same companies that they are ostensibly meant to regulate.

“Usually the responsibility for religious rulings and subsequent sharia audit is assigned to the sharia supervisory authority maintained by most Islamic financial institutions,” said Al Hashel in his speech. “This practice is by no means in line with the sharia supervision governance fundamentals.”

Sharia Oversight

As IFS has grown to account for a greater share of the overall financial services market around the world over the past decade, a number of countries have made moves to bring together sharia-related oversight in the form of a central organisation. In 2013 the government of Malaysia – which is home to a sizeable IFS industry – carried out a complete overhaul of the sharia-compliant financial oversight framework, putting in place new rules and regulations for banks and sharia scholars. Similarly, in December 2012 the government of Oman introduced three-year term limits for sharia scholars in the country, who are now allowed to serve just two terms, consecutively. Lastly, in 2014 the Central Bank of Bahrain introduced new legislation aimed at shoring up governance and profitability in the IFS industry, including new rules for sharia advisory boards.

The Banking Sector

According to a report by the IMF released in December 2014, Kuwait’s sharia-compliant banking sector is the fifth largest in the world in terms of assets, with more than KD20bn ($68.9bn) in total. This figure represented around 39% of total domestic banking assets, up from some 23% in 2005. Since the 2010 launch of Warba Bank and the conversion of AUB to sharia-compliant status, the Islamic banking sector has been “systemically important” to Kuwait’s banking system, according to the IMF. Given that the industry has grown at rates exceeding 8% in recent years – and faster than the expansion of the banking sector as a whole – as well as taking into account CMBK’s possible conversion to Islamic status, Kuwait’s domestic banking sector is expected to be predominantly Islamic in terms of assets in the near future.

Sector Heavyweight

KFH is both the oldest and the largest Islamic bank operating in Kuwait, and one of the largest in the region. At the end of 2014 KFH had KD17.2bn ($59.26bn) in assets, up more than 12% from KD15.3bn ($52.71bn) at the end of 2013. The bank accounts for around 70% of total Islamic assets and 26% of total banking assets in the country. In 2014 KFH pulled in profits of about KD126.5m ($435.8m), up more than 9% over 2013 figures. The bank’s dominant shareholder is the Kuwait Investment Authority, the country’s sovereign wealth fund, with around 24%.

A handful of key state entities – including the General Organisation for Social Insurance, the General Authority for Minors Affairs and the Public Authority for Investment – hold around 26% of KFH’s shares in total, and the remaining shares are traded on the Kuwait Stock Exchange. While KFH earns a large percentage of its annual revenues within Kuwait, it also remains active in a wide range of other countries, including Bahrain, Saudi Arabia, the UAE, Turkey and Malaysia, to name only a few. In 2013 KFH wrapped up a five-year consolidation and improvement programme, whereby it updated numerous aspects of its operations in an effort to boost competitiveness within the region as well as around the world (see analysis).

Banking Range

AUB is the second-largest Islamic bank in Kuwait, with around 14% of sharia-compliant banking assets and 5% of total banking assets, according to IMF data. The bank’s history goes back to the early 1940s, when a group of British investors launched one of the earliest formal banking institutions in the GCC region. The government of Kuwait bought the bank in 1971, renaming it the Bank of Kuwait and the Middle East. In 2002 the AUB Group, a Bahrain-based corporation, bought the bank. As mentioned previously, the bank was converted into an Islamic institution in 2010.

Further rounding out the list are Boubyan Bank, which had around 9% of Islamic banking assets according to the IMF; KIB, with 5%; and Warba Bank, with 2% (see Banking chapter).

Sukuk

Beginning in the early 2000s, corporates and the government alike looked to Kuwait’s nascent debt market for financing. While bonds took a hit during the 2007-08 downturn, the market appears poised to surge again, particularly in the Islamic segment. A variety of privately held and state-owned firms have mentioned plans to issue sharia-compliant debt in the coming years. Companies that have formally or informally stated future sukuk (Islamic bond) issuance plans include the state-owned airline Kuwait Airways and KFH, the latter of which announced in June 2013 that it planned to establish a $100m sukuk fund, with which the bank intends to purchase investment-grade US dollar notes in markets around the world. In 2013 Al Ghanim Industries, a Kuwaiti conglomerate that is active throughout the Gulf region, successfully issued KD12.5m ($43.1m) in Islamic debt in two tranches.

Since then the sukuk market has been much quieter, although many local players expect to see a significant uptick in market activity in the near future. This is in part due to a speech delivered in April 2014 by Al Hashel, the governor of the CBK, in which he in called for new legislation to encourage the state to issue sovereign short- and long-term sukuks. This would have the intended effect of helping to establish a yield curve for Islamic debt financing in Kuwait, which would, in turn, presumably facilitate greater issuance of corporate sukuks as well.

Given the recently announced five-year Kuwait Development Plan, as well as the drop in oil prices in the latter half of 2014 and early 2015, the government may need to source a large amount of financing in the coming years. A renewed sukuk market could help to meet this demand.

TAKAFUL: Kuwait’s Islamic insurance market has grown considerably since the early 1990s, when the first takaful companies set up shop in the country – and well before most other takaful industries were established in the Gulf. As of the end of 2012, the sector was home to 11 domestic Islamic insurers, which together accounted for KD47.4m ($163.3m) in gross written premiums (GWPs), according to the most recent statistics available from the MoCI at time of publication. This figure was equal to around 18.7% of total insurance sector GWPs at the time. Takaful GWPs rose by around 4.3% in 2012, slightly down on the growth rate of 4.5% that was seen in 2011. According to EY’s “Global Takaful Insights 2014” report, Kuwait accounted for some 2% of the GCC’s estimated gross takaful contributions of $8.9bn in 2014, or around $178m.

As with most other types of Islamic finance, takaful operates on the basis of profit sharing. As such, Islamic insurers must distribute excess profits to their policyholders. However, when a firm ends the year in deficit, it must make up the difference with no-interest loans, which has a negative impact on shareholder profits and overall valuation. This makes it particularly hard for takaful firms to lower their prices, which is a major challenge in a price-sensitive insurance market like Kuwait (see Insurance chapter). Given this situation and the relatively slow growth of the insurance sector as a whole in recent years, many Kuwaiti takaful firms consistently operate at a loss, which is unsustainable in the long term.

Local players regularly cite the lack of an independent regulatory framework for the takaful market as a key challenge. This issue affects conventional underwriters as well, but takaful firms argue that they are at a distinct disadvantage as a result of their higher operating costs and the complexity of their business model. The government of Kuwait has been discussing the introduction of a new, independent insurance regulator since 2012, when a draft insurance law was put into circulation. The draft legislation reportedly features a separate set of rules and regulations for takaful operators, which would likely benefit the segment greatly. The law was initially set to come into effect at the beginning of 2015 but late in 2014 was postponed until mid-2016.

Outlook

Most of firms currently operating in the IFS segment are relatively new to Islamic finance and face a variety of challenges. While Kuwait’s banking sector as a whole is well developed, and KFH is one of the most experienced sharia-compliant banks in the world, activity in other areas is slower. According to the IFIS Sukuk Database, as of mid-2014 the country had issued $2.9bn in sukuk, which accounted for just 2% of total issuance in the GCC. Boosting activity in this segment is considered to be a key objective in the coming years. Furthermore, while Islamic financial institutions were relatively well insulated against the 2007-08 international economic downturn, many of these firms are still holding a large amount of equity and real estate investments today. This represents a potential medium- and longterm risk, given volatility in property markets and the potential for future downturns.

Furthermore, assuming that the central bank’s discount rate remains unchanged during 2015, the outlook appears to be similar to 2014 by maintaining almost similar levels of revenue, growth and capitalisation. Increasing the minimum required capital motivated the board of directors of many banks to explore the idea of raising more capital through right issues or different Tier 1 instruments. Many local sharia-compliant players are looking forward to further growth in the coming years. As home to one of the oldest sharia-compliant banks in the world, as well as an expanding number of other Islamic financial institutions, Kuwait has indeed taken a range of measures to ensure that the country’s IFS industry will continue to thrive for the foreseeable future.