Kuwait's banking sector navigates short-term risks to realise longer-term gains

With a raft of large-scale, government-led development projects on the docket, rising retail deposits and strong support from regulators and other authorities, Kuwait’s banking sector is widely considered to be poised for a period of long-term growth. This follows a difficult period linked to the broader economic volatility that has impacted the Gulf region in recent years. Nonetheless, according to the Central Bank of Kuwait (CBK), as of the end of the first quarter of 2016 the nation’s 11 domestic lenders had KD59.8bn ($197.8bn) in total assets, up considerably from KD56.7bn ($187.5bn) at the end of the same period in 2015. Relatively plentiful liquidity has contributed to rising levels of credit issuance in 2015 and 2016, with data from the National Bank of Kuwait (NBK), which is the country’s largest lender and one of the largest financial institutions in the GCC region, showing industry-wide credit growth in excess of 8% over the course of 2015, for example. Similarly, according to the KIPCO Asset Management Company, Kuwait’s listed banks, which includes all domestic lenders, accounted for slightly more than 50% of total corporate earnings on the Kuwait Stock Exchange (KSE) in 2015, pulling in profits of KD858m ($2.8bn) in total, up from KD802m ($2.7bn) in 2014.

Shoring Up

While the sector’s long-term outlook is broadly positive, local banks face a variety of short- and medium-term challenges. Kuwait, like many other countries in the Gulf in recent years, has been negatively impacted by the drop in the price of oil in international markets since mid-2014. In March 2016 the Ministry of Finance (MoF) rolled out a new strategy aimed at curbing public expenditure and ramping up income, after the government forecast a budget deficit of KD12.2bn ($40.4bn) in 2016/17, up nearly 50% on the previous year. While most domestic banks are relatively insulated against day-to-day oil price fluctuations, the sector as a whole is reliant on state spending. Furthermore, the extent to which Kuwait’s economy, broadly construed, relies on oil revenues cannot be overstated. As such, many local lenders have continued to exhibit caution in recent years, despite steadily improving monetary conditions. “The banking sector has good liquidity now, as compared to a few years ago,” Abdulhamed Alhaffar, head of market research and customer insights at local lender Gulf Bank, told OBG in early 2016. “Nonetheless, we see that banks are being cautious still. There has been a major drop in advertising spending among the domestic banking industry, for example.”

New Rules 

Despite these challenges, however, most local players remain optimistic about the future. A central component of this positive outlook is the government’s KD34.15bn ($113bn) five-year strategy, known as the Kuwait Development Plan (KDP). Approved by Kuwait’s parliament in February 2015, the plan is made up of more than 500 projects, including major infrastructure upgrades and expansion initiatives, housing ventures and industrial investments. Cornerstone KDP projects include the construction of a new port and much-needed work on Kuwait’s international airport and metro, among other things. While financing for this work has yet to be finalised, local banks have already and will likely continue to put up a significant percentage of the funding for KDP-related projects.

Local banks have also benefitted from a series of new regulations introduced by the CBK in recent years, with the aim of improving corporate governance and risk management frameworks across the sector, strengthening competition in the market, and ensuring investor and consumer protection. “All local banks have lent substantial amounts to the construction sector recently,” Masud Ul Hassan Khalid, the financial controller at local lender the Commercial Bank of Kuwait (CMBK), told OBG. “Assuming the state moves ahead with its building work and continues spending on the KDP, the outlook is positive.”

History

The country’s domestic banking industry dates back to the early 1940s, making it one of the oldest financial services sectors in the Gulf region. Kuwait’s first lender was the Bank of Kuwait and the Middle East (BKME), which was launched by a group of British investors in 1941, under a 30-year concession issued by the emir at the time, Sheikh Ahmed Al Jaber Al Sabah. Over the following three decades a handful of banks were established in the country. NBK was set up by local businessmen in 1952, while CMBK and Gulf Bank were both launched in 1960 on the eve of Kuwait’s independence in June 1961.

In the run-up to independence in the late 1950s and in the early 1960s the nation’s financial system was overhauled by the government. Prior to this period, Kuwait did not have its own currency. Instead, both private and public business was carried out in a mix of regional monies, including Indian rupees and Gulf rupees, both of which were issued by the state of India. The Kuwait Currency Board (KCB), which was set up by the government in 1960, oversaw the development and management of a new national currency, the Kuwaiti dinar. The dinar went into circulation a year later in 1961 and its remains the country’s currency today. Under Law No. 32, which was introduced by the government in 1968, the KCB was dissolved and replaced by the newly established CBK. The law also formally introduced the nation’s first comprehensive financial regulatory framework, and it continues to serve as the basis for banking and financial regulation today, though it has been amended and updated a number of times since then.

Volatile Period

When the BKME’s concession expired in 1971, the government of Kuwait nationalised the banking system, in what was seen at the time as an effort to facilitate long-term stability and economic growth in the country. This move was part of a wave of Arab nationalisation projects in the region in the 1960s and 1970s. A minor capital market crash in 1977 led the government to introduce a new, stringent set of rules governing share issuance and trading in Kuwait. The legislation prompted many investors, including several local banks and other financial institutions, to move their money into a new, informal market on the outskirts of Kuwait City. Known as the Souk Al Manakh after the building out of which it operated (a former camel market), trading on this exchange ramped up rapidly during the late 1970s and early 1980s.

In August 1982, however, the market crashed after a trader bounced a post-dated cheque, sending Kuwait’s financial system into disarray. By the time the government stepped in to shutter the bourse and assist with recovery, the Souk Al Manakh crash had generated debts worth more than $26bn in 1983 US dollars, and effectively overwhelmed the domestic financial industry. NBK was the only local institution that managed to remain solvent during this period. In the wake of the crash, the CBK and the MoF bailed out a number of systemically important banks and institutions, and worked with the financial industry to draw up and institute a new, more comprehensive regulatory framework. One of the key outputs of this period of reform was the establishment, in 1983, of the KSE (see Capital Markets chapter).

Less than a decade later Kuwait’s financial system was once again destroyed, this time as a result of the 1990-91 Gulf War. During the six-month conflict, which began with the Iraqi invasion of Kuwait, banks were shuttered, foreign employees fled, capital and other assets were stolen, and a vast number of financial documents were destroyed. By the time the war ended in early 1991, the lack of records meant that many Kuwaitis had effectively been separated from their savings and banking assets. Once again, the government stepped in, working with local institutions to draw up a recovery plan, write off losses and ensure that nationals had access to their deposits.

Upward Trajectory

By the mid-1990s, with the assistance of the CBK and MoF, most local banks had largely recovered from the war. Rapid regional economic growth during this period was a boon to Kuwait’s banking sector, which, like neighbouring financial industries throughout the Gulf, posted exponential expansion beginning in the late 1990s. Driven by high oil prices, an influx of state-led infrastructure and real estate development, and high stock market returns, Kuwait’s banking sector grew rapidly during this period. From the end of 1996 through the end of 2006 domestic banking sector assets more than doubled from KD11.5bn ($38.03bn) to KD26.9bn ($89bn), according to data from the CBK. Much of the activity in the sector during this period was fuelled by credit issued to local investment companies (ICs), which borrowed cheaply from domestic lenders in order to invest in the booming property market and in securities on the KSE. When the international economic downturn hit the region in 2008, a number of these ICs were left holding a considerable amount of bad debt.

Consequently, during this period most Kuwaiti banks saw an uptick in non-performing loans (NPLs), though not nearly to the extent of institutions in some neighbouring countries. Indeed, most domestic lenders had acted relatively responsibly during the pre-crisis boom years. As such, the industry suffered only a slight stall in the 2007-10 period. Total domestic banking assets grew from KD29.1bn ($96.3bn) to KD35.6bn ($117.8bn) over the course of 2007 alone, and then continued to expand to reach KD39.2bn ($129.7bn) by the end of 2008. At this point the after-effects of the downturn reached Kuwait and banking growth slowed, with total domestic assets reaching KD40.3bn ($133.3bn) by the end of 2009, KD41.4bn ($136.9bn) by the end of 2010 and KD44.1bn ($145.9bn) by the end of 2011.

Strength & Stability

The relatively strong performance in the years following the crisis was at least partly due to the government’s quick response to the situation. In legislation passed in the wake of the downturn, the CBK introduced a handful of far-reaching and effective means by which financial institutions might restructure their debts in an effort to seek relief. Aimed squarely at the handful of Kuwait-based ICs that were hit the hardest by the downturn, these tools included the Financial Stability Law, which was passed in March 2009, and in 2010 the Capital Markets Law (CML), a sweeping new regulatory framework for the country’s capital markets.

The CML resulted in the establishment of a new capital markets regulatory agency, the Capital Markets Authority, which has jurisdiction over all publicly listed firms, including all of nation’s domestic banking institutions (see Capital Markets chapter). Since then the CBK and other financial regulatory entities have continued to work to ensure that the sector remains stable and transparent (see analysis). Cesar Gonzalez-Bueno, CEO of Gulf Bank, told OBG, “I remain optimistic about the sector moving forward given the countries general wealth and its ability to cultivate strong human capital resources.”

Additionally, after the crisis local lenders were forced to provision heavily against NPLs, which had the intended effect of steadily wiping out bad debts in the commercial banking system. Beginning in 2011-12, a steadily improving economic situation at home and throughout the region supported a surge in deposits and, consequently, lending among Kuwait-based banks. Nonetheless, lenders continued to provision during this period, and this, along with the CBK-mandated introduction of improved corporate governance and risk management tools, has contributed to increased stability. By most measures, Kuwait-based lenders are currently among the most fiscally sound in the region. For example, gross NPLs as a percentage of outstanding loans decreased substantially during this period, falling from 8.9% at the end of 2010 to just 2.9% at the end of 2014 and 2.8% at the end of 2015. Elham Y. Mahfouz, CEO of CMBK, told OBG, “The fundamentals of the banking sector are sound, which positions us well to handle large-ticket capital expenditures.”

Similarly, the domestic banking industry’s NPL coverage ratio, which is a measure of provisions as a percentage of NPLs, more than doubled over the same period, from 62.3% at the end of 2010 to 163.9% at the end of 2014, according to data from the CBK. As this data suggests, the banking sector has recovered considerably since the downturn. “Over the past seven to eight years we have worked to move away from certain asset classes, like high-risk property and securities,” Ul Hassan Khalid told OBG. “This effort is in line with the rest of the domestic banking industry, which is much stronger and more reliable now than it was previously.”

Current Performance 

Despite the challenging national and regional macroeconomic situation, Kuwait’s banks have continued to post strong numbers in 2015 and 2016. As of the end of March 2016, as previously mentioned, total assets at domestic institutions had reached KD59.8bn ($197.8bn), up 5.4% from KD56.7bn ($187.5bn) in the same period the previous year, according to consolidated balance sheet data reported by NBK. The bulk of these assets were credit facilities, which saw 8.4% growth over the same period from KD31.1bn ($102.9bn) at end-March 2015 to KD33.7bn ($111.5bn) a year later. A considerable percentage of this loan growth went towards the construction sector, a key beneficiary of the KDP (see Construction chapter). A critical recent source of asset growth among Kuwaiti banks has been core liquid assets, and primarily deposits, from both the retail and government side. Indeed, cash and CBK deposits held in the commercial banking system jumped by almost 68% from March 2015 through March 2016, even as CBK’s bond holdings and time deposits both dropped off significantly.

In line with the rising asset base and strong demand for construction financing, Kuwaiti banks ramped up lending over the course of 2015 and early 2016. Total domestic banking liabilities increased by 5.8% over the 12 months prior to end-March 2016 from KD49.1bn ($162.4bn) to nearly KD52bn ($172bn), according to NBK data. Since the beginning of 2015 the banking system’s exposure to the domestic property market has been a cause of concern among analysts and bank managers. According to a recent report published by Canadian investment research house BCA Research, as of the end of 2015 some 62% of all bank credit was composed of consumer and real estate loans. Given this concentration risk, plus the potential for slowing energy exports to negatively impact Kuwaiti liquidity for the foreseeable future, BCA foresees challenging times ahead for the country’s financial system. “There are definitely concentrated risks in the banking system here,” Ul Hassan Khalid told OBG. “Some firms, particularly some family-owned firms, have borrowed a lot from the banking sector to invest in securities and property, just like before the 2007-08 financial crisis. Given this exposure and the poor performance of the stock market and property market in recent years, banks are preparing for a tough time.”

Key Player 

NBK is the largest bank in Kuwait, and leads the sector in a range of metrics, including overall assets, lending, deposits and capitalisation on the KSE. In 2015 the institution reported a net profit of KD282.2m ($933.4m), up 7.8% on the previous year’s profits of KD261.8m ($865.9m), according to NBK. The bank attributed the bulk of this growth to the booming project financing market, which grew rapidly in 2015 on the back of KDP-associated government spending. By the end of 2015 NBK’s total assets reached KD23.6bn ($78.1bn), up 8.3% on end-2014 figures. “With the size of our balance sheet, our regional and international presence and relationships, we are the largest beneficiary of the growing government expenditure, leveraging the high growth opportunity in the project finance business,” Nasser Al Sayer, the bank’s chairman, said at the NBK’s annual general assembly meeting in early 2016.

While Kuwait is NBK’s primary market, the bank is active across the GCC region and further afield, with business interests in more than 15 countries in total, including in France, Turkey, Egypt, the UK, the US and China, among other places. In 2012 NBK acquired a 58.4% stake in Boubyan Bank, a local Islamic lender. The acquisition has proven to be a profitable one, as Boubyan has gained market share in recent years.

Major Bank

Kuwait’s second-largest bank at the end of 2015 was Kuwait Finance House (KFH), which reported net profits of KD145.8m ($482.2m) in 2015, up 15.3% from KD126.5m ($418.4m) the previous years. Founded in 1977, KFH is both the oldest sharia-compliant bank in Kuwait and the second-largest Islamic financial institution in the world, with holdings throughout the Middle East and around the world. In 2013 KFH wrapped up a five-year corporate restructuring project, and since then the bank has worked to improve asset quality and strengthen its financial position by diversifying its sources of revenue. For instance, while corporate financing is expected to provide the bulk of the banks’ revenue for the foreseeable future, KFH has also made an effort to reach small and medium-sized enterprises.

Rounding out the top five banks in Kuwait by year-end 2015 were Burgan Bank, with KD6.8bn ($22.5bn) in total assets; Gulf Bank, with KD5.4bn ($17.9bn) in assets; and CMBK, with KD4.04bn ($13.4bn) in assets. “Like the sector as a whole, our business has been impacted recently by the government’s cost-cutting efforts, which could impact construction and development spending in the coming years,” said Alhaffar. “Almost all of our corporate customers come from either the hydrocarbons sector or the property development sector, so we will likely see the impact of spending cuts in these areas in the future.”

Islamic Banking

Five of Kuwait’s domestic lenders currently operate under an Islamic business model. In addition to KFH and Boubyan Bank, this list includes Kuwait International Bank (KIB), Ahli United Bank Kuwait and Warba Bank. CMBK, which received shareholder approval to convert its operations to sharia-compliant status in April 2014, will be the sixth Islamic player in Kuwait’s banking sector, assuming it moves forward with the transition.

As in many other Gulf markets and in Islamic financial centres around the world, sharia-compliant banking has become increasingly popular among retail and corporate Kuwaiti clients alike. As of the end of 2005, Islamic banks held around 23% of banking sector assets, but by mid-2014 this figure had jumped to just below 40%. In early 2016, however, international ratings agency Fitch Ratings noted that tough operating conditions throughout the Gulf region had the potential to impact Kuwait’s Islamic banks to a greater degree than conventional lenders. Given the focus on real estate assets in Islamic financial models, Kuwait’s sharia-compliant banks reportedly have a higher exposure to property markets than their conventional counterparts. Given this concentration, they also tend to have weaker loan portfolios. Even so, Fitch said Kuwait’s Islamic segment is “expected to remain profitable despite weaker operating income and higher impairment charges. We expect margins to remain healthy due to the Islamic banks’ low-cost funding structures.”

Outlook

Strong economic expansion in 2013, 2014 and 2015 has generated solid returns among Kuwait’s banks, which currently boast strong financial positions. Nonetheless, the cheap price of oil and its impact on public expenditures have caused local lenders to look closely at their business models.

Moving forward, many institutions are expected to work to streamline their operations, both in preparation for weathering a potentially volatile short-term period and in order to ensure medium- and long-term financial stability as the state implements its development programme and pursues greater economic diversification. “We shut down our international loan portfolio after the 2007-08 crisis,” Ul Hassan Khalid told OBG. “In 2012 we opened it back up again, but since then we have been extremely selective in the types of projects we choose to finance. Our plan moving forward is to remain cautious.”

At the same time, most local players remain optimistic about the future. Indeed, in 2015 project contracts worth KD9.7bn ($32.1bn) in total were awarded, which represents an increase of around 20% over the previous year. The bulk of this spending was directly linked to the government’s infrastructure development programme, as well as the state’s effort to boost oil production to 4m barrels per day by 2020 (see Energy chapter).

In 2016 alone, the state plans to spend an additional KD16.7bn ($55.2bn) on development and oil and gas projects. Even if actual spending falls significantly short of this projected figure as a result of cost-cutting measures, the high number of projects either currently under way or in the development pipeline bode well for Kuwait’s financial institutions. “The banking sector is in a good position to benefit from increased government borrowing in the years to come,” Hassan Al Azem, a research consultant at Kuwait-based investment bank The International Investor, told OBG. “Domestic banks are well capitalised and stable, thanks in large part to central bank regulations instituted over the past five years.”