A key player in the global sharia-compliant financial industry

Kuwait has become a major global centre for a wide variety of activities in the Islamic financial services (IFS) sector in recent years. By the end of the first half of 2013, the country housed more than $70bn in sharia-compliant banking assets, which was equal at the time to 6% of total global Islamic banking assets, according to data from the research arm of the local market leader Kuwait Finance House (KFH). This figure is widely expected to grow in the coming years. Indeed, half of Kuwait’s 10 domestic banks were fully sharia-compliant as of the end of 2013, and all of the nation’s conventional operators are active in the Islamic space in some way or another.

Other recent IFS growth drivers include a sector-wide focus on asset diversification, new opportunities in the sukuk (Islamic bond) market and the potential conversion of the Commercial Bank of Kuwait (CMBK), a conventional lender, to sharia-compliant status. This latter piece of news, which was announced in April 2014, has the potential to shift the banking asset balance in Kuwait, turning the country into an IFS-dominant market.

History

Kuwait has been one of the foremost players in the IFS industry ever since the early 1970s. Eight years after the country achieved independence in 1961, Kuwait’s government played a key role in the establishment of what is now called the Organisation of Islamic Cooperation, a pan-Islamic coalition of countries that came together with the goal of boosting cooperation across a variety of economic and political fields. Beginning in the early 1970s, Kuwait helped organise a series of international meetings on topics related to Islamic finance. These gatherings would help pave the way for the liberalisation of various domestic financial sectors throughout the Middle East, as well as the establishment of a handful of new entities that would eventually come to play a central role in the burgeoning IFS industry.

Chief among these was KFH, which was established as a result of the passage of Law No. 72 in March 1977. As the sole sharia-compliant financial institution operating in Kuwait at the time (indeed, for the next two and a half decades), and as a result of its status as a state-owned firm, KFH operated largely outside the regulatory framework established by the CBK Law of 1968, the legislation that continues to serve as the backbone of Kuwait’s conventional financial legislation today.

Regional Role

This independence meant KFH was able to develop innovative new products and services quickly, and thereby compete effectively with the handful of other newly formed IFS institutions coming up elsewhere in the Gulf, including the Jeddah-based Islamic Development Bank, which was launched in 1973; Dubai Islamic Bank, which was established in 1975; and Bahrain Islamic Bank, which was set up four years later, in 1979. Today all four of these entities occupy dominant market positions not only in their home markets but also globally.

Up until the early 2000s KFH was the only Islamic financial institution operating in Kuwait. This changed in 2003, when the government introduced an amendment to the 1968 CBK Law with the goal of encouraging the development of a fully fledged sharia-compliant industry. Under this new legislation a variety of institutions were able to set up shop in the country. Boubyan Bank was launched in 2004, for example, while Kuwait International Bank (KIB) converted to sharia-compliant status in 2007. Both Ahli United Bank (AUB) and Warba Bank were set up in 2010. The sector grew exponentially through the early and mid-2000s on the back of a booming regional real estate market and rapid growth at the Kuwait Stock Exchange (KSE). Over the course of 2007 the domestic sharia-compliant industry expanded by more than 44%, which was the highest rate of growth among IFS markets in the Gulf for that year.

A Challenge Period

The financial sector in Kuwait, including the Islamic segment, was relatively well insulated against the 2007-08 international economic downturn, compared to many Western banks. Generally speaking, most local Islamic financial institutions did not have any direct exposure to troubled banks in the US or the EU. That said, in the wake of the downturn, a number of local investment companies (ICs) were left holding troubled assets, particularly property and equities.

Crisis Effects

According to a variety of studies carried out by the World Bank and other international organisations, Islamic banks and other sharia-compliant entities were better suited to weather the crisis itself and, furthermore, to compete effectively in the challenging environment of the post-downturn years. This was certainly the case in Kuwait, where the growth of the Islamic segment continued largely unimpeded in the years following the financial crisis. The buoyancy of local IFS institutions can be attributed in part to the rules underpinning the segment. Under sharia rules, Islamic banks and other financial entities are required to avoid riba ( interest), gharar (uncertainty) and maisir (gambling).

These rules have been designed to encourage risk avoidance and minimisation. In order to maintain a sharia-compliant portfolio, Islamic firms are required to avoid speculative and leveraged investment instruments such as derivatives, many of which were hit the hardest by the crisis and its aftermath. On the flip side, as a result of the fact that many conventional investment products are off-limits, sharia-compliant companies tend to hold large amounts of real estate and other tangible assets, which dropped dramatically in value after the crisis.

Regulation

A significant hurdle to the ongoing expansion of the sector is the absence of a single, comprehensive regulatory body. As of the end of 2013 the IFS industry was overseen by a number of overlapping entities, including the CBK, the Capital Markets Authority (CMA) and the Ministry of Awqaf and Sharia Affairs (MASA), among other organisations. Like their conventional counterparts, sharia-compliant banks and other institutions are required to abide by the government’s general monetary policy and regulatory framework.

Banks are required to operate under the 1968 CBK Law, which was amended to allow for sharia-compliant activity in 2003. Since then, the central bank has issued a handful of policies, all of whichhave applied to both conventional and Islamic operators. These include a 2004 law that opened up the sector to foreign players and a June 2012 piece of legislation that was meant to enforce stronger corporate governance and risk management throughout the local financial sector. Finally, the government announced in February 2014 that local banks would be required to implement Basel III monetary standards by 2018 (see Banking chapter).

Under the 2003 CBK amendment that opened up Kuwait for competition in the Islamic segment, each sharia-compliant institution is required to maintain an independent sharia supervisory board made up of no less than three members. The board is required to come to a consensus about all new financial products and services developed by the institution, thereby deeming them legal under sharia law. However, if a supervisory board is unable to make a decision as to the legality of a given product or service, the ruling in question is passed up to MASA, which has a mandate to enhance, disseminate and defend the influence of Islam on Kuwaiti society.

In addition to the CBK and MASA, Islamic ICs are overseen by the CMA, which was established in February 2010 as a result of the introduction of the Capital Markets Law (CML). Under the CML, banks, ICs and other financial institutions were required to split their investment and traditional lending activities into separate entities, with the goal of minimising risk on the retail side in particular. It also aims to ensure that the rapid rise in speculative lending and dubious investment activity that contributed to the downturn is not repeated in the future. Additionally, under the CMA, Kuwait’s investment banking sector as a whole was required to boost transparency, risk management and corporate governance. These changes have been implemented alongside a variety of other major new initiatives in the country’s capital markets sector. These have included the introduction of a new trading platform at the KSE and the ongoing effort to privatise the exchange (see Capital Markets chapter).

Kuwait’s takaful (sharia-compliant insurance) sector falls outside the jurisdiction of both the CBK and the CMA. Instead, the insurance segment as a whole (including both Islamic and conventional firms) is regulated by the Insurance Department at the Ministry of Commerce and Industry (MoCI).

The government announced a plan in mid-2012 to establish a new regulatory agency for the insurance sector and to update Kuwait’s insurance law accordingly, with the goal of strengthening oversight throughout the sector as well as encouraging market growth. However, as of early 2014 the timeline for these initiatives had yet to be announced.

The Banking Sector

Kuwait’s Islamic banking assets are heavily concentrated in KFH, the country’s oldest and largest bank. Established in 1977, the institution was founded largely on the back of oil inflows, which continue to play a central supporting role in the financial sector – both on the conventional and Islamic sides – today. Much like their conventional counterparts, local Islamic banks rely on corporate activity for the majority of their revenues. In the years immediately following the downturn, local banks tightened up their lending criteria and began to set aside large amounts of capital as a buffer against NPLs and other bad debts.

This provisioning effort has gone on continuously over the past half decade, with the result that many institutions are currently sitting on a substantial amount of liquidity. Consequently, retail lending has expanded quickly since early 2012, and many local players also expect corporate lending to jump into the fray over the coming years.

By the end of 2013 the five banks that made up the domestic sharia-compliant banking sector had total assets of KD23.39bn ($82.24bn), according to data compiled from annual reports. This is up substantially on 2012, when the Islamic segment had total assets of KD20.6bn ($72.43bn). The expansion over the past year is widely regarded as a signal of the steadily improving economic situation in Kuwait, which has had a knock-on effect on lending activity and investor sentiment. KFH accounted for the great majority of the 2013 total, boasting assets of KD16.14bn ($56.75bn) at the end of the year, which was equal to just under 69% of total Islamic banking assets in Kuwait at the time. This percentage is down slightly on 2012, when KFH made up more than 71% of total sharia-compliant banking assets.

The slight drop in KFH’s dominance in the sector is representative not of a decline in expansion at the sector’s leading player, but of rapid growth at other smaller institutions. AUB was the second-largest domestic Islamic bank operating in Kuwait at the end of 2013, with total assets of KD3.16bn ($11.11bn), which was equal to 13.5% of total assets.

AUB was followed by Boubyan Bank, with KD2.19bn ($7.7bn) in assets (9.4% of the total); KIB, with KD1.5bn ($5.27bn) in assets (6.4%) and Warba, with KD405.5m ($1.43bn) in assets (1.7%). In addition to the five domestic banks, Saudi Arabia’s Al Rajhi Bank, which is currently the single largest sharia-compliant financial institution in the world – is active in Kuwait. As a foreign operator, Al Rajhi is required to limit its activities to the investment side – the bank is not allowed to carry out traditional banking activities such as lending – through a single branch office.

Murabaha Sales

IFS institutions in Kuwait offer a wide variety of products and services, most of which were pioneered by KFH in the 1970s, 80s and 90s, when the bank was the country’s sole sharia-compliant operator. KFH was involved in the development of murabaha sales, for example, which involve the bank purchasing an asset or commodity, before selling it on to a buyer at a pre-arranged higher price, in doing so avoiding riba (interest). This model is frequently used in the Gulf, primarily as a means of financing property and other assets or trade. Other commonly used forms of sharia-compliant financing among Kuwaiti banks include istisnaa, a flexible sales contract that allows for deferred payment and is primarily used for custom orders; ijara wa iqtina (lease and ownership), which is regularly used in lieu of a conventional mortgage; as well as salam contracts, which are generally applied to the production and trade of raw materials, such as agricultural products. Other sharia-compliant products and services that are used widely in the local banking sector include mudaraba, a profit-sharing agreement; musharaka, which involves sharing equity; sukuks (see analysis); and takaful. Sukuks, or Islamic bonds, for instance, became a major source of funding in the country from the mid-2000s, and is on the brink of a surge in new issuance, despite a dip in demand following the financial crisis.

KFH

KFH was established as a government-controlled bank in the mid-1970s, and remains state-owned to this day. While 51% of the bank is listed on the KSE, the remainder is held by a number of public sector entities, including the Kuwait Investment Authority, with a 24% stake, the Public Authority for Minors Affairs, with 10%, the Kuwait Awqaf Public Foundation, with 8%, and the Public Institution for Social Security, with 6%. KFH is active in a wide variety of foreign markets around the world.

As of the end of 2013 the bank had a global network of 355 branches staffed by more than 8000 employees, in addition to 475 ATMs throughout the Gulf and further afield. In addition to its regional activities, spanning Saudi Arabia, Bahrain and the UAE, KFH is active in Turkey, where it operates the Kuwait-Turkish Participation Bank; in Malaysia, where it operates the subsidiary KFH-Malaysia and in Australia, where it has a representative office. In Kuwait and throughout its network, KFH offers a variety of personal, corporate and investment products and services, including private banking, real estate funding and trade finance (see analysis).

As of the end of 2013 KFH was the third-largest IFS institution in the world, according to the 2013 State of the Global Islamic Economy Report published by Thomson Reuters, after the Saudi-based Al Rajhi Bank and Iran’s Bank Maskan. Like most other banks in Kuwait, KFH’s revenues dropped slightly in the wake of the downturn, though in the five years since then the bank has posted solid expansion. In 2013 KFH reported operating revenues of KD996m ($3.5bn), up 14.2% from the previous year; and net profit attributable to shareholders of KD116m ($407.89m), up 45% from 2012.

The bank’s solid recovery since the crisis can be attributed in large part to a major overhaul of its operations following the financial crisis of 2007-08, which resulted in asset and revenue diversification, boosting corporate governance and implementing a strict risk management regime. In a manner similar to that of its competitors in Kuwait, KFH has also provisioned heavily over the past five years. As of the end of 2013 the bank’s NPL ratio was at 4.4%, down from 5.7% in 2012. Similarly, the bank’s capital adequacy ratio was at 17.44% at the end of 2013, which is high by international standards.

Ahli United

AUB traces its history back to 1941, when a handful of local British investors established the first formal banking institution within the GCC region. Following the completion of the investors’ 30-year concession in 1971, the government bought a controlling share in the bank, in doing so changing its name to the Bank of Kuwait and the Middle East. In 2002 the institution was purchased by Bahrain’s AUB Group, and in 2010 it was converted to the status of an Islamic bank. As of the end of 2013 some 67% of the bank was owned by the Bahrain-based parent company, while an additional 11% was held by Kuwait’s Public Institution for Social Security and 22% was held publicly on the KSE.

In 2013 AUB reported net profits of KD42.46m ($149.29m), up more than 10% from the previous year, when annual profits were at KD38.5m ($135.37m). This increase, which can primarily be attributed to rising revenues in the bank’s core retail and commercial operations, pushed AUB’s assets to KD3.16bn ($11.11bn), up more than 20% from KD2.63bn ($9.25bn) the previous year.

As of the end of 2013 the bank was the second-largest Islamic bank and the fourth-largest company listed on the KSE, with a market capitalisation of KD1.12bn ($3.94bn). AUB’s conversion into an Islamic bank in February 2010 was initiated largely in response to the financial crisis. Additionally, AUB has focused on shoring up its corporate governance and risk management regimes in recent years, in line with recent guidance policies put forward by the CBK and other regulatory entities.

Boubyan Bank

Boubyan was established in 2004 as a state-run institution, under the management of the Kuwait Investment Authority. The government launched the bank in an effort to participate in and further develop the IFS sector, which had been liberalised earlier that year. Soon after it was created the state distributed most of Boubyan’s shares among a wide swath of Kuwaiti citizens – an estimated 90% of nationals were given shares in the bank.

As of the end of 2013 just under 22% of Boubyan was publicly held on the KSE. The remainder has been bought up over the past decade by two leading conventional banks, namely the National Bank of Kuwait (NBK), which owns a controlling 58% of Boubyan; and the Commercial Bank of Kuwait, which owns around 20%. NBK, which is the largest bank in Kuwait, boasting assets of KD18.6bn ($65.4bn) at the end of 2013 – began purchasing shares of Boubyan in early 2009, and by mid-2010 it had a controlling stake in the bank. Since then it has upped its stake a number of times, most recently in early 2013.

In 2010 Boubyan instituted a five-year transformation programme, which has seen the bank concentrate on shoring up its core retail and corporate business lines. In practice this has resulted in the bank’s expansion within Kuwait, opening a number of new branches in key population centres.

By mid-2013 the bank had opened a total of 25 branches in Kuwait; this number was projected to grow to 35 by the end of 2014. Additionally, Boubyan has worked to introduce a variety of new products and services since the transformation plan was put in place, including mobile banking, consumer services aimed at high-net-worth individuals and syndicated finance for corporations. Boubyan has also made a handful of acquisitions over the years. By the end of 2013 the bank owned the Boubyan Takaful Insurance Company, a local sharia-compliant underwriter, in addition to stakes in a variety of foreign organisations, including the UK-based Bank of London and the Middle East, Indonesia’s PT Bank and Sudan’s United Capital Bank, among others.

Boubyan’s efforts appear to have paid off in recent years. In 2013 the institution reported KD13.4m ($47.12m) in profits, up 33% from KD10m ($35.16m) the previous year. This growth resulted in the bank’s total assets expanding 16.3% over the course of the year, from KD1.88bn ($6.61bn) at the end of 2012 to KD2.19bn ($7.7bn) in 2013.

Other Banks

The two remaining sharia-compliant banks currently operating in Kuwait are both relatively new entrants to the Islamic market. While KIB was initially established in May 1973 as the Kuwait Real Estate Bank, it did not become a fully sharia-compliant entity until May 2007. Just under 68% of KIB is listed on the KSE, while the remainder is controlled by a handful of local players, including the private Al Hoda for Hotels and Tourism Company, which owns an 18% stake in the bank. Like Boubyan, KIB owns a controlling stake in a sharia-compliant insurance operator, the Ritaj Takaful Insurance Company. In 2013 KIB reported a nearly 14% jump in revenues, from KD138.5m ($486.98m) in 2012 to KD157.39m ($553.4m) that year.

Warba was established by the government in April 2010, and the Kuwait Investment Authority owns a controlling 24% share in the institution. The remaining 76% of the bank was distributed evenly among the Kuwaiti population, which today collectively owns 76% of the bank. As the youngest bank currently operating in the Islamic segment, Warba has spent the past few years setting up new branches and launching a variety of products and services, with the aim of building its customer base. In 2013 the banks total assets grew by 81% – albeit from a fairly low base – from KD223m ($784.1m) in 2012 to KD405.5m ($1.43bn) a year later.

In early April 2014, CMBK – a conventional institution – announced that it had plans to convert its operations to the Islamic sector. While this plan has yet to be confirmed by CMBK’s shareholders, it is nevertheless in keeping with recent market trends. Indeed, according to KFH Research, from 2008 through 2012, Kuwait’s Islamic banking assets as a whole grew by 12.2% while conventional banking assets expanded by 4.7% over the same period.

The Investment Sector

As of the end of 2013 there were 91 ICs operating in Kuwait, 49 of which carried out business according to sharia principles. These numbers are down from 95 and 51, respectively, at the end of 2012. The IC segment grew rapidly during the late 1990s and early 2000s, fuelled in large part by access to cheap credit and Kuwait’s booming capital markets and real estate sectors.

At the end of 1994 there were just 14 sharia-compliant ICs operating in Kuwait, with a total of KD1.48bn ($5.2bn) in assets. By the end of 2008 there were 15 sharia-compliant investment firms up and running in the country, and assets had swelled to KD7.67bn ($26.97bn). In the aftermath of the downturn the IC segment as a whole saw a rapid decline in assets, as many companies were forced to finance large amounts of property and equity-related debts that had gone bad. By the end of 2010 Islamic IC assets had fallen to KD6.53bn ($22.96bn) and by the end of 2013 this number was down further to KD4.76bn ($16.74bn). At the same time, local banks saw a spike in non-performing loans (NPLs) during this period, as a result of credit defaults at ICs and other borrowers. By the end of 2009, less than a year after the downturn began, the ratio of NPLs to the nation’s total loan portfolio was at 10.3%, up considerably from the previous year.

Since the downturn a handful of sharia-compliant ICs have entered into debt restructuring deals, either under the government-run Financial Stability Law (FSL), which was introduced in March 2009, or on an independent basis. By mid-2010, for example, five firms had reported defaulting on their debts. ICs that have gone into restructuring include Global Investment House, which was the largest IC in Kuwait when the downturn hit; the Kuwait Finance and Investment Company; and the sharia-compliant firm The Investment Dar, which defaulted on a $100m sukuk in May 2009 and has been working with the government to restructure under the FSL since.

While the great majority of local ICs did not default on their debts after the economic crisis, the segment as a whole has seen declining revenues as a result of the challenging operating environment over the past half-decade. With this in mind, a round of mergers and acquisitions is potentially on the cards, according to the government, which has worked to encourage this in recent years.

Takaful

Islamic insurance operates on the principle of shared responsibility and shared risk, whereby losses and profits are distributed equally among shareholders. As with other IFS companies, takaful operators are prohibited from making leveraged investments. The takaful industry in Kuwait dates to a period of sector liberalisation in 2000, and the number of sharia-compliant operators grew rapidly through the early and mid-2000s, in particular.

By the end of 2012 – the most recent year for which data was available – there were 11 active domestic sharia-compliant companies operating in Kuwait, compared to just 13 conventional underwriters. The burgeoning segment was negatively impacted by the 2007-08 downturn, primarily as a result of the fact that when the crisis hit most local operators had not yet had time to build up significant capital reserves as a buffer.

In 2012 Kuwait’s takaful providers earned KD47.4m ($166.66m) in gross written premiums (GWPs), according to data from MoCI. While this figure is up 4.3% from 2011, it was equal to just 19% of total insurance sector GWPs for the year. Takaful providers face a number of challenges. Key issues include the lack of a dedicated takaful law, which is widely considered to be a major hurdle to the continued development of the sector, and a relatively low level of awareness of the benefits of Islamic insurance among the general population (see Insurance chapter).

Outlook

The sector remains faced with a wide variety of challenges in the coming years. The 2007-08 economic downturn had an adverse impact on the industry as a whole, and the repercussions of the crisis have continued to reverberate throughout the entire industry in recent years. Many local Islamic institutions have retained a considerable amount of exposure to real estate, equities and other sectors that were hit hard during the downturn and the ensuing global credit crunch. Other hurdles to development include the wide range of official entities currently involved in regulating the sector; the close link between the IFS industry and the property market; and the lack of a well-trained local workforce.

However, there remains a consensus among most players that the country’s IFS sector will be able to post substantial growth for the foreseeable future. “Sharia-compliant institutions constitute an important part of our financial system,” Sami H Al Anbaee, the manager for the Economic Research Department at the Central Bank of Kuwait (CBK), told OBG. “This market is growing considerably at the moment – even the smaller institutions are doing very well.”