Kuwait's sharia-compliant financial industry works to increase its influence

Driven by rising demand for new sources of financing in the face of weak oil prices, Kuwait’s Islamic financial services (IFS) sector is increasingly considered to be a core component of the nation’s development. The industry’s steadily improving profile is largely a result of the government’s efforts to shore up the sector’s reputation over the past decade, most recently by rolling out new sukuk (Islamic bond) regulations in November 2015. As a consequence of this effort, local Islamic banks, investment companies (ICs) and sharia-compliant insurers have gained market share at a rapid pace, in the process turning Kuwait into one of the world’s leading IFS markets.

As of the end of 2015 more than 45% of the nation’s domestic banking sector assets were controlled by sharia-compliant institutions, up from around 20% a decade earlier, according to data from the London-based professional services firm EY. Similarly, according to statistics published by the Central Bank of Kuwait (CBK), as of the end of 2015 ICs that operated according to Islamic principles accounted for nearly 43% of total IC assets. With these trends in mind, many local players are broadly optimistic about the future of IFS in Kuwait. “The banking sector as a whole has posted strong growth in recent years,” Masud Ul Hassan, the financial controller at local conventional lender the Commercial Bank of Kuwait (CMBK), told OBG in early 2016. “But some institutions – mostly Islamic banks – have seen dramatic expansion, particularly on the retail side.”

Early Development

Kuwait played a major role in the early days of the modern IFS industry in the Gulf region, which dates back to the late 1960s. In 1969 the government was involved in the establishment of what is today known as the Organisation of Islamic Cooperation (OIC), a broad-based economic and political organisation that aims to encourage cooperation between Muslim-majority countries around the world. The OIC – which today has 56 member states and is based in Jeddah, Saudi Arabia – began to look into the development of sharia-compliant financial services in the early 1970s. Over the following two decades OIC member states hosted a series of meetings and conferences on various IFS topics, including the development of Islamic standards for banking, sukuk, takaful (sharia-compliant insurance) and various other instruments.

Kuwait worked closely with other Gulf governments on this project, while at the same time investing in the development of a handful of major new IFS initiatives and institutions at home.

First Of Its Kind

In March 1977 the government passed Law No. 72, which resulted in the formation of Kuwait Finance House (KFH), the nation’s first sharia-compliant bank. Today KFH, which was originally set up as a wholly state-run entity and remains controlled by state-affiliated investors today, is among the largest and oldest IFS institutions in the world. As of the end of 2015 the bank controlled more than 70% of all Kuwait-based Islamic assets, plus more than a quarter of the country’s overall banking assets. During this early period various other Gulf countries also set out to build up domestic IFS industries of their own. Hence Saudi Arabia launched the Islamic Development Bank (IDB) in Jeddah in 1973, the UAE established Dubai Islamic Bank (DIB) in 1975 and Bahrain created Bahrain Islamic Bank (BIB) in 1979. Like KFH, these three sharia-compliant banks were founded by their respective federal governments and continue to hold large market shares.

KFH played a unique role in Kuwait’s banking sector through the 1980s and 1990s, during which period it was the country’s sole sharia-compliant operator. Indeed, under the CBK Law of 1968, which established both the central bank and the initial regulatory framework for the financial services sector, privately operated Islamic financial institutions were not allowed to operate in Kuwait.

As such, KFH had an effective monopoly on the domestic sharia-compliant market until the country’s central bank initiated a change in rules in the early 2000s. At the same time, a considerable percentage of the institution’s business came from the regional GCC market, where KFH was forced to compete with the IDB, BIB and DIB.

Expanding Market

In the late 1990s market liberalisation, the ease of obtaining inexpensive credit and exponential growth in real estate and securities markets across the Gulf region kicked off a period of rapid expansion among banks and ICs. In an effort to take advantage of this situation, in 2003 Kuwait’s government amended the 1968 CBK Law by passing Law No. 33, which for the first allowed time for the creation and operation of new sharia-compliant institutions.

Consequently, over the following decade a handful of new entities set up in Kuwait. In 2004 Boubyan Bank became the first newly established Islamic lender to open its doors since KFH was launched in the late 1970s. This was followed in May 2007 by the conversion of the Kuwait Real Estate Bank – which had carried out business as a conventional lender since 1973 – to sharia-compliant status. The bank was subsequently renamed Kuwait International Bank (KIB). Three years later, in 2010, Ahli United Bank (AUB) also converted its business so as to operate in the Islamic market. AUB, which was previously known as the Bank of Kuwait and the Middle East, is the country’s oldest lender, having been established locally in 1941. Finally, also in 2010, Warba Bank, a new sharia-compliant institution, opened its doors for business. These five banks – KFH, Boubyan, KIB, AUB and Warba – are currently Kuwait’s only Islamic banks.

Such expansion looks set to continue. In April 2014 CMBK, a conventional lender and the country’s fifth-largest bank as of end-2015, announced it had received shareholder approval to institute a sharia-compliant business model. As of July 2016 the bank had yet to move forward with this plan, with the delay being attributed in part to the drop in oil prices and the challenging macroeconomic environment in Kuwait and throughout the region. Nonetheless, assuming this is conversion goes ahead at some point in the next few years, it is likely push the share of Islamic finance in Kuwait’s overall banking sector above that of the conventional sort. “Islamic banking worldwide is steadily gaining in depositors due to its inherited stability and principled core values,” Mohamed Said El Saka, acting CEO of Kuwait International Bank, told OBG.

The Investment Sector

Though they account for a significantly smaller percentage of the country’s total Islamic assets than the five banks, ICs constitute a key component of the overall IFS sector in Kuwait. While the sharia-compliant investment industry dates back to the early 1990s, it expanded rapidly during the late 1990s and early to mid-2000s, in line with broader trends in the conventional market and economy as a whole. Indeed, from 1994 through to the end of 2008 assets controlled by Islamic ICs expanded five-fold, from KD1.48bn ($4.9bn) to KD7.67bn ($25.4bn), according to CBK data. As of the end of 2015 some 47 sharia-compliant ICs were operating in Kuwait, as compared to 38 conventional ICs. However, during the same period the conventional investment segment had considerably more assets under its control than the Islamic segment – KD5.73bn ($19bn) as compared to KD4.1bn ($13.6bn).

While Kuwait’s financial industry as a whole was relatively well insulated against the 2007-08 global economic downturn, a handful of ICs suffered considerable losses as a result of their exposure to the Kuwait Stock Exchange (KSE) and the regional property market. In the wake of the downturn the government moved quickly to shore up the sector. Under the March 2009 Financial Stability Law (FSL), for example, the state offered those ICs that were left saddled with a considerable amount of debt options for restructuring and refinancing. A number of Islamic firms benefitted from the law. In 2011, for example, The Investment Dar (TID), which is today one of the largest sharia-compliant ICs in the country, entered into negotiations with its creditors under the FSL. These talks were ongoing at the time of writing. Indeed, in May 2016 TID announced a new effort to restructure KD813m ($2.7bn) in outstanding debts.

A Shrinking Segment

Since the downturn the IC segment as a whole has shrunk, due in large part to stricter investment controls that have been put in place by the government. Leading this effort is the Capital Markets Authority (CMA), which was established in 2010 with a mandate to improve corporate governance and ensure the long-term stability of Kuwait’s capital markets.

The CMA has introduced a range of new rules and regulations for ICs, listed companies and other companies involved in the investment sector. Most recently, the authority issued a draft version of a new set of executive by-laws to the 2010 Capital Markets Law, which serves as the backbone of Kuwait’s capital markets legislation.

The new by-laws aim to clarify the country’s legal framework with regard to transparency, reporting requirements, governance and a wide range of additional issues (see Capital Markets chapter).

The CMA’s efforts in this vein have resulted in a shrinking IC segment over the past decade. At the end of 2009 Kuwait was home to 100 ICs in total, which controlled KD14.37bn ($47.5bn) in total assets. Some 54 of these firms were Islamic ICs, which controlled just under 47% of total assets. By the end of 2015 these figures had shrunk to 85 ICs, with total holdings of KD10bn ($33.1bn), of which 47 sharia-compliant firms held around 43%, according to data from the CBK.

Oversight & Regulation 

In May 2003 the CBK amended the 1968 CBK Law to allow – for the first time in the state’s history – for the operation of sharia-compliant banks and other institutions. Under the law an institution qualifies as Islamic when it provides products and services that operate on known sharia-compliant contractual structures, including murabaha (cost-plus financing), musharaka (joint venture) and mudaraba (profit sharing) frameworks, among others. These structures make use of profit and risk-sharing and eschew interest, which is not allowed under sharia. Furthermore, sharia-compliant institutions are required to maintain an in-house, independent committee of sharia scholars, which is responsible for reviewing new products and services to ensure they are in line with Islamic principles.

In addition, a statement produced by the committee is also to be included in the institution’s annual report, and may be subject to review by the CBK and other institutions.

In terms of formal oversight, all Islamic institutions must also adhere to rules put forward by a handful of federal institutions. Sharia-compliant banks are overseen by the CBK, and must operate according to the same regulatory framework that applies to conventional lenders (in addition to the standards maintained by a bank’s internal sharia committee). The CMA, meanwhile, has jurisdiction over Islamic ICs, collective investment schemes and public traded sharia-compliant firms. The takaful segment, meanwhile, is overseen by the insurance department at the Ministry of Commerce and Industry (MoCI). Under a new insurance law that is expected to come into force before the end of 2016, an independent insurance regulator may eventually be established to take over from the MoCI (see Insurance chapter).

Finally, all Islamic institutions in Kuwait are formally overseen by the Ministry of Awqaf and Islamic Affairs, though in practice the ministry rarely intervenes in the financial sector.

In recent years the lack of a single, comprehensive IFS sector regulator has been widely cited as a hurdle that the government must address in order to ensure the industry’s future. The reliance on separate, independent sharia boards at Islamic banks is considered to be a key impediment to sector growth. As noted by the Dubai-based magazine Business Islamica in 2015, Kuwait’s fragmented IFS regulatory framework “creates uncertainty in application and unfair advantages gained due to the lack of standardised rules”.

Key Players

Holding the lion’s share of Kuwait’s total Islamic assets, the country’s five sharia-compliant lenders are at the centre of the domestic IFS industry. KFH, the country’s largest Islamic institution by a considerable degree, reported profits of KD145.8m ($482.3m) in 2015, up some 15% from KD126.5m ($418.4m) the previous year.

Since it was established nearly four decades ago, KFH has expanded in the Gulf region, the broader Middle East and further afield. As of the end of 2015 it had offices throughout the GCC, plus Malaysia, Turkey and Germany, among other locations. Just over 50% of KFH is listed publicly on the KSE, while an additional 24% of the firm is held directly by the nation’s sovereign wealth fund, the Kuwait Investment Authority. A handful of additional government-managed entities are also major shareholders in the bank, including the Public Authority for Minority Affairs and the Kuwait Awqaf Public Foundation and the Public Institution for Social Security, among others. By the end of 2015 KFH boasted KD16.5bn ($54.6bn) in total assets, making it one of the top-three largest IFS institutions in the world.

Since the completion of a comprehensive five-year restructuring effort in 2013, KFH has been organised into three top-line entities, namely KFH Capital, KFH Investment and KFH Real Estate. In the years since the 2007-08 downturn the bank has worked to streamline its operations, improve corporate governance and boost transparency, in line with sector-wide regulations put in place by the CBK. Like Kuwait’s banking system as a whole, KFH holds significant capital – as of the end of 2015 the institution’s capital adequacy ratio was 16.67%, well above the 13% minimum required under the Basel III capital requirements, which are currently being enacted in Kuwait (see Banking chapter).

Steady Expansion

AUB, which was converted to Islamic status in 2010, was the second-largest sharia-compliant lender in the country at the end of 2015, with total assets of approximately KD10.3bn ($34.1bn), an increase of 1.6% on the previous year. Since 2002 the bank has been majority-owned by the publicly-quoted AUB Group, a Bahrain-based lender, along with other shareholders, including the Public Institution for Social Security.

In recent years AUB, like most of its peers, has focused on its core business lines, which include corporate and retail credit issuance and facilitating cross-border business with a focus on entities looking to enter Kuwait, as well as Kuwaiti companies looking to do business abroad.

Boubyan, with KD3.1bn ($10.3bn) in total assets at the end of 2015, was the third-largest Islamic lender in Kuwait at the time. Since it was established more than a decade ago, the bank has steadily gained market share. In 2015 Boubyan reported an overall growth rate of 25%, with profits of KD35.2m ($116.4m), as compared to KD28.2m ($93.3m) in 2014, for instance. This expansion was largely driven by a 15% jump in customer deposits and a 20% increase in the financing portfolio. Similarly, as of end-2015 Boubyan’s share in terms of retail financing was at 10%. In late April 2016 Boubyan issued a $250m sukuk, which was more than five times oversubscribed, reaching $1.3bn in total (see analysis). The final two Kuwait-based Islamic banks are KIB, which reported total assets of KD1.79bn ($5.9bn) at the end of 2015; and Warba, with KD776.1m ($2.6bn) in assets at the same period. The latter institution, which has moved aggressively to gain market share in recent years, saw a 770% growth in net profit in 2015.

Debt Instruments

The issuance of sukuk by Kuwaiti corporates has dropped off significantly in recent years, though a recently introduced law has shown signs of reviving the country’s debt market. Conventional and Islamic bonds took a hit in 2007-08, with many firms that had announced plans to issue debt either putting those plans on hold or cancelling them outright in the wake of the crisis. By 2011-12, however, the economy had improved to the point that a handful of companies were once again planning to raise capital via debt issuance, with sharia-compliant issues a popular choice. Since the decline in the price of oil in mid-2014, however, the sukuk market throughout the region has largely gone quiet, with many firms waiting to see improvements in the regional economy before moving forward with debt issues.

Nonetheless, in Kuwait a handful of issues have taken place recently, including Boubyan’s $250m listing in May 2016. Furthermore, a month earlier, in April 2016, the MoF announced that before the end of the year the government planned to issue KD2bn ($6.6bn) in sharia-compliant debt, in what will be the country’s first sovereign sukuk issuance to date (see analysis). “Sukuk is becoming more attractive to investors, both in Kuwait and across the GCC, wishing to diversify their investments away from traditional asset classes,” Richard Groves, CEO of AUB, told OBG.

Islamic Insurance

With a share of around 2% of the GCC Islamic insurance market at the end of 2014, Kuwait is widely considered to be an increasingly important source of growth for sharia-compliant gross written premiums (GWPs). The domestic takaful industry has grown rapidly over the past decade and half. As of the end of 2015 some 14 of the nation’s 23 domestic insurers operated according to Islamic principles, which require profit-sharing among policyholders. The majority of these firms are relatively new to the market.

While the number of new underwriters carrying out business in Kuwait has expanded rapidly in recent years, the five largest insurance firms in the country – none of which is Islamic – have continued to dominate the market, pulling in more than 60% of total GWPs in 2014, for instance.

Given the relatively high cost of operating a takaful firm (as compared to a conventional insurer), many of Kuwait’s Islamic underwriters have operated at a loss in recent years. This situation has been exacerbated by the domestic and regional economic situation, which has caused firms to cut back on expenses, including insurance coverage. In an effort to better support the industry and facilitate growth, in May 2016 the insurance department at the MoCI – the chief insurance regulatory entity – announced that it planned to push for the adoption of a new insurance law before the end of the year (see Insurance chapter).

Outlook

While the IFS sector has become a key source of financing and other financial services in Kuwait in recent years, the industry faces a handful of challenges. According to a February 2016 report released by the US-based international ratings agency Fitch, tightening operating conditions in Kuwait and across the GCC region have the potential to negatively impact growth throughout the domestic financial services industry, and particularly among sharia-compliant banks and related institutions. Indeed, the continued lower price of Brent crude – the international oil price benchmark – and the flagging regional economy suggest weakening asset quality at Islamic banks and ICs, both of which tend to have higher exposures to real estate markets than their conventional peers. At the same time, the government’s ongoing efforts to cut costs and boost revenues has the potential to negatively impact the IFS sector for the foreseeable future.

Despite these and other issues, the majority of local IFS players are broadly optimistic about the future. At the end of 2015 Kuwait boasted a 10.1% market share of all global Islamic assets ( excluding Iran), according to EY. This figure is significant, given the size of Kuwait’s population and economy. Perhaps more to the point, by most accounts the global IFS industry remains on a strong growth track, and Kuwait is well positioned to benefit from and contribute to the sector’s future expansion.