Government reforms strengthen Kuwait's banking sector

In a lower oil price environment such as the one that has persisted since late 2014, banking sectors in the GCC find themselves under heightened scrutiny. Kuwait is no exception, but where other banking sectors in the region have been compelled to face sizeable cutbacks in government spending, the nation’s deep reserves have enabled it to defend the development pipeline on which so much of the industry’s business depends. Though challenges through 2016 put pressures on profits and credit growth, these were not seen as threats to sector stability.

Nevertheless, difficulties remain. The recent economic downturn has highlighted the sector’s dependence on government spending, while an increasingly comprehensive regulatory environment is starting to affect some of the industry’s key ratios. Exploiting untapped areas of the economy and seeking new efficiencies are therefore emerging as the key priorities for the industry in the year ahead.

History

During its relatively long history in the context of GCC banking, Kuwait’s lenders have survived far more significant economic shocks than the current oil price scenario. The domestic banking industry dates back to the early 1940s, making it one of the oldest financial services sectors in the GCC.

The first bank to be established in Kuwait was the British-owned Bank of Kuwait and the Middle East (BKME), which enjoyed a 30-year concession before the government bought 51% of its stock during the era of bank nationalisations across the Gulf. By this stage, Kuwait’s domestic banking segment was already thriving. National Bank of Kuwait (NBK) became the first locally owned bank in the region when it was established in 1952. Founded by a group of well-known merchants who felt underserved by BKME, it quickly established itself as a regional leader in terms of growth and innovation. More national banks followed, some of them, like the Credit and Savings Bank, the Industrial Bank of Kuwait and the Real Estate Bank of Kuwait, mandated to perform specific functions within the economy. These services included financing domestic projects, agriculture and housing. This flowering of domestic institutions was accompanied by increasing government control over the sector.

Early Regulation

Prior to Kuwait’s emergence as an independent state in the early 1960s, the country did not possess its own currency, relying instead on a mix of regional monies, including Indian rupees and Gulf rupees. The Kuwait Currency Board (KCB) was established in 1960 to rectify this situation, and subsequently oversaw the issuance of a new national currency, the Kuwaiti dinar, which entered circulation in 1961. Under Law No. 32, which was promulgated by the government in 1968, the KCB was dissolved and replaced by the newly established Central Bank of Kuwait (CBK), which remains the sector’s regulator. The law also resulted in the nation’s first comprehensive financial regulatory framework which, after numerous amendments, forms the backbone of the modern regulatory structure.

Past Financial Crises

The financial regulatory framework initially put in place by the CBK was not enough to protect the sector from the financial crash of 1982, caused by an overheated unofficial stock market – the Souk Al Manakh. The former camel market had become a centre of unregulated financial speculation, with investors using post-dated cheques to create an unsustainable expansion of credit. The moment of crisis came when one of these cheques bounced, and by the time the government stepped in to close the market the crash had generated debts worth more than $26bn in 1983 US dollars.

The financial system was overwhelmed: NBK was the only bank in Kuwait to remain solvent, and the CBK was compelled to bail out a number of systemically important institutions. The longer-term response of the regulator was to introduce tighter supervision of sector activity, but the 1990-91 Gulf War saw the total disruption of the banking sector once again. Bank branches were closed down, foreign employees left the country, capital and other assets were stolen, and a vast number of financial documents were destroyed. In the post-war period the lack of records meant that many Kuwaitis were separated from their savings and banking assets, compelling the government to work in conjunction with banks to implement recovery plans, write off losses and reunite citizens with their deposits.

After 2008

More recently, the 2008 global economic crisis challenged the stability of the financial sector. The worldwide liquidity crunch followed a period of sustained growth for Kuwait’s financial institutions, which saw banking sector assets more than double between 1996 and 2006, from KD11.5bn ($38bn) to KD26.9bn ($89bn), according to data from the CBK. When the crisis hit, Kuwait’s tightly regulated banks were well defended against the external shock, evidenced by non-performing loans rising a relatively modest amount by regional standards in the 2007-10 period, while banking assets continued to expand – albeit at a slower rate than before.

The large number of investment companies in Kuwait during this time were more adversely affected. Their business model of borrowing cheaply from banks to invest in the booming property market left them badly exposed to the crash, and their resulting defaults are still discernible in the market today.

Today’s Market

The modern Kuwaiti banking sector is a diverse mix of local and foreign institutions. A limit on the number of branches that foreign banks can operate means that the domestic players account for the bulk of assets in the sector. However, foreign banks can now open more than one branch, and a couple of banks have already received approval for a second branch. As of 2017, 11 Kuwaiti banks were licensed to operate in the country, the largest of which is NBK. A total of 12 foreign banks have established operations in Kuwait, ranging from global giants such as HSBC, BNP Paribas and Citibank, to prominent regional players such as National Bank of Abu Dhabi and Qatar National Bank. Kuwait is therefore a relatively densely banked market.

According to the World Bank, there were 14.8 commercial bank branches per 100,000 people in 2015, compared to a global average of 12.7. In regional terms, Kuwait’s branch density is well above Saudi Arabia’s 8.9, and more in line with the highly competitive market of the UAE, which exhibited a branch density of 12.1 the previous year, according to the most recent statistics available.

The Kuwaiti banking sector can be further broken down into conventional and Islamic components – and the rise of the latter is one of the most salient trends in terms of market structure. In 1977 Kuwait Finance House (KFH) was established as the first Islamic bank in Kuwait, and it has since been joined by four others. Combined, Islamic banks account for 38% of sector assets. The growth rate of Islamic financiers has outpaced that of their conventional counterparts in recent years and this trend is likely to continue. “Islamic banks did not go down the route of taking big risks in pursuit of profits as conventional banks did prior to the crisis,” Michel Accad, CEO of Al Ahli Bank, told OBG. “Having a sharia board means growth is undertaken in a more controlled fashion.”

Non-Bank Competition

More competition is added to the sector by the presence of several finance companies and a larger number of investment companies. The former compete with Kuwaiti banks in retail segments such as motor finance and personal lending, and in corporate services such as fleet finance, inventories, capital assets and contracts. The latter, numbering 72 in total, compete with banks solely in the field of wealth management, but – like the finance companies in the market – operate at a disadvantage in terms of cost of funding. In 2011 the CBK handed the bulk of its supervisory responsibilities concerning this part of the financial sector – which is still suffering effects from the 2008 crash – to the country’s Capital Markets Authority.

Major Players

Despite the fragmented structure of the banking sector, a relatively small number of institutions have dominated the market in recent years. The two largest banks account for around 50% of total lending, according to data compiled by the Kuwait-based Arzan Financial Group. Kuwait’s “big five” banks in terms of deposits, meanwhile, claim a combined market share of around 75%. All of them are listed on the Kuwait Stock Exchange and are universal banks, which offer consumer banking, wholesale banking, Treasury and financial services.

The largest of them, with assets of KD24.2bn ($80.1bn) at the close of 2016, is NBK. Its loan book is also the biggest by some margin, accounting for around 32% of the sector’s total credit. Since its establishment as the first indigenous bank in Kuwait in 1952, its high capitalisation and asset quality have helped it to establish the largest international branch network of all Kuwait’s lenders. In 2017 NBK had branches on four continents and included operations in leading financial centres such as London, Paris, Geneva, New York, Singapore and Shanghai, as well as the regional centres of Saudi Arabia, the UAE, Lebanon, Egypt, Iraq and Turkey. The bank retains a majority stake of 58.4% in Boubyan Bank, its Islamic banking subsidiary and one of the smaller but quickly growing players in the domestic market. NBK’s shareholder base has not changed since being founded by a group of leading Kuwaiti merchants, with only one shareholder owning more than 5% of the bank’s share capital – the Public Institution for Social Security (PIFSS) owns 5.53% as of October 2016.

KFH, with assets of approximately KD16.5bn ($54.6bn), is the second-largest bank in the country and Kuwait’s biggest Islamic financial institution. It is also the second-largest sharia-compliant bank in the world, with holdings in Bahrain, Saudi Arabia, the UAE, Turkey, Malaysia and Germany. Its largest shareholders include the Kuwait Investment Authority, Kuwait Awqaf Public Foundation, the Public Authority for Minors’ Affairs and the PIFSS.

With total assets of KD7.3bn ($24.1bn), Burgan Bank is Kuwait’s third-largest bank. Founded in 1977, the institution is a subsidiary of Kuwait Projects Company Holding, which has interests in financial services, media, real estate and manufacturing, and consolidated assets in excess of $32.7bn. The bank is best known for its corporate activity, but it has a growing retail base in Kuwait and has established four majority-owned subsidiaries: Gulf Bank Algeria, Bank of Baghdad (Iraq and Lebanon), Tunis International Bank (Tunisia), and the fully owned Burgan Bank (Turkey).

Gulf Bank is Kuwait’s fourth-largest lender, with total assets of KD5.5bn ($18.2bn). Founded in 1960, its major shareholders are the Kuwait Investment Authority (18.5%), Alghanim Industries (14%), Alghanim Trading Company (13.2%) and the Behbehani Investment Company (6.1%). It has a large domestic branch network, but no foreign presence.

Rounding out Kuwait’s big five, with total assets of KD4.1bn ($13.6bn), is Commercial Bank of Kuwait (Al Tijari). Founded in the same year as Gulf Bank, its two largest shareholders are the Kuwait-based investment management company, Securities Group (44.3%) and Al Sharq Holding (23.1%), which also owns stakes in a number of companies in the manufacturing, financial and agricultural sectors.

Performance

Kuwait’s banks have faced economic headwinds over the past year as a result of suppressed oil prices. The banking sector is highly dependent on government spending on large projects as well as on government employment of Kuwaitis who have had a high level of job security. Uncertainty surrounding project slowdowns or cancellations in 2015 adversely affected industry sentiment. Kuwait’s strong external position and its large sovereign wealth fund have helped it to maintain its capital spending programme, but larger banking groups in the country have faced slowdowns in the business of their regional branches as governments around the GCC have delayed payments or shelved non-essential projects. Nevertheless, total credit facilities to the local private sector grew from KD33.3bn ($110.1bn) in 2015 to reach KD34.4bn ($113.5bn) at the end of 2016, according to CBK data, a gain of more than 2.9%. While this represented a slowdown from the previous year, when it rose by 8.5%, it demonstrates a robust performance at a time when banking sectors across the region are facing liquidity squeezes and slowing growth. Importantly for the sector’s growth prospects, the reduction of the deposit base, which in other markets has resulted in a deteriorating liquidity scenario, has not materialised in Kuwait. According to the CBK, both private and public deposits increased over FY 2015/16, and the interbank rate has shown only a fractional rise. Looking to the big five, an OBG analysis of their 2016 performance shows 2.08% growth in aggregate total assets and a modest decline in customer deposits of 1.22%. Despite their relative stability, Kuwait’s larger banks experienced a challenging year in terms of profitability as they are more exposed to external economic currents than their smaller competitors. Aggregate net profit in 2016 was down by 3.82% on the previous year, with both KFH and Burgan Bank showing losses for the period.

Lending

Loans and advances were of particular interest to market observers over the past year in the context of tightening regional liquidity. Kuwait’s relatively robust liquidity position meant that the big five were able lend at a similar rate in 2016 as they did the year before, for a total of KD34.6bn ($114.5bn) as against the KD34.8bn ($115.1bn) of 2015. In terms of loan type, the single largest category in the market is instalment loans, which in Kuwait are defined as long-term personal facilities used for non-commercial purposes, usually to purchase a private residence. In December 2016 they accounted for 29.4% of the industry’s aggregate loan book, according to CBK data. In total, personal facilities, including shorter-term consumer loans and loans for the purchase of securities, accounted for 41.9% of total lending in Kuwait. Commercial loans, therefore, account for the majority of loans and advances in the market, and within this segment the largest recipients are the real estate sector, with about 22.2% of the total, followed by trade with 9% and industry with 5.5%.

Small Business Potential

While Kuwaiti banks have assiduously pursued both corporate and retail opportunities in the domestic market, the small and medium-sized enterprise (SME) segment remains underserved. The Institute of Banking estimates that the nation’s SMEs account for less than 10% of GDP, a modest size in global terms, demonstrating that they have historically been overlooked by financial institutions. Only 7% of banking credit is directed towards SMEs, according to the institute. “The challenge in SME lending is often in assessing a foreign partner’s commitment to the project,” Elham V Mahfouz, CEO of Commercial Bank of Kuwait, told OBG.

Many banks have yet to establish dedicated SME divisions, instead dividing their SME business between corporate and retail units, depending on ticket size. Kuwait’s SME economy is at an early development stage, and for smaller banks, the higher risk of SME lending precludes a concerted thrust into the segment. For larger banks, however, the case for investment in SME-dedicated infrastructure is more compelling. Nonetheless, significant expansion of SME activity is unlikely to occur during the challenging economic backdrop which currently prevails. One aim of the National Fund for Small and Medium Enterprise Development, which has KD2bn ($6.6bn) of assets, is to decrease risk for banks lending to SMEs by acting as guarantor on behalf of businesses, thereby allowing more banking credit to be directed to this segment.

Regulation

In addition to economic challenges, banks have faced increased regulatory pressures. Central banks in the GCC are in the process of aligning their regulatory frameworks with the latest supervisory standards issued by the Basel Committee, and in many cases the last year has seen an intensification of this effort. Kuwait was among the first in the region to implement the major components of the Basel III set of reforms. In October 2015 it applied Basel’s net stable funding ratio – which aims to ensure the ability of banks to ride out short-term economic shocks – to local conventional and Islamic banks. Basel’s capital adequacy ratio standard, the financial leverage ratio standard and liquidity coverage ratio standard were all introduced during 2014 and 2015. Kuwait’s banks have accommodated the introduction of the Basel III framework without significant difficulty. The most challenging aspects of the implementation – the new definitions applied to capital and the raising of capital ratios – have, however, had an impact on some of the sector’s key indicators. According to Kuwait’s Institute of Banking Studies, 60% of the 2.7% reduction in the sector’s common equity Tier-1 (CET1) ratio in 2016 was attributable to changes in the definition of capital brought in by the Basel process. The remaining 40% of the reduction was the result of changes in risk-weighting rules, also connected to the implementation of Basel regulations. Most of Kuwait’s biggest lenders saw reductions in their CET1 ratios of between 1.1% and 3.4% as a result of the new framework.

All of Kuwait’s banks were operating comfortably above the minimum capital thresholds in 2014, and despite the reduction in capital ratios that came about as a result of the Basel III implementation, they continued to surpass thresholds in 2016. From a technical perspective, then, Basel has not posed a significant challenge. However, in terms of market behaviour, Basel’s impact will be seen in the strategies of some institutions: banks that are closer to capital thresholds will monitor their larger transactions and the activities of their regional subsidiaries more closely.

The general reduction of capital ratios under Basel III also raises the question of whether or not Kuwaiti banks will raise their ratios to the levels at which they stood when Basel II was applied. Their strong capital buffers may mean this is not a necessity, but gaining the approval of international ratings agencies may play a role in any decision to raise funds.

Outlook

With no significant oil price recovery on the horizon, most of Kuwait’s banks see a year of modest credit expansion ahead. However, the market is not without opportunity. The prospects for booking loans are supported by the Kuwait Development Plan, in which the government intends to inject KD4.75bn ($15.7bn) into projects over FY 2017/18. Around half of this funding is expected to come from the government, but the quasi-state-run oil companies and the private sector will make up the remainder, meaning that banks will have no shortage of big-ticket lending prospects over the medium term. The government’s ability to continue with its development strategy – thanks to its reserves – differentiates Kuwait from its neighbours, where major fiscal consolidation threatens financial sector growth.

For local banks, many of the challenges over the next year will relate to regulation rather than the business environment. For example, a number of high-profile data breaches in the GCC have propelled the issue of cybersecurity to the top of the agenda, and local banks will likely face more stringent regulation surrounding their increasingly complex digital services. “Security is a growing market in Kuwait, but it is an area where the market requires education in order to take advantage of services available. Stronger regulation of the market will help ensure quality as demand increases,” Mohammed Al Ali, general manager of G4S, told OBG. Furthermore, the introduction of International Financial Reporting Standard 9 is scheduled for late 2017. While this may be beneficial for global convergence, implementation will enlarge the reporting burden on local institutions.