Prudent regulation and years of provisioning at Kuwaiti banks result in solid metrics and promising financial performance

The performance of the banking sector has rebounded since the 2007-08 global financial crisis. Banks’ balance sheets show that net profit, assets, loans and deposits are all growing strongly, financial metrics look robust, and various industry assessments show that the industry is well capitalised. “It has been several years of effort and costs for banks following the implementation of Basel III,” Waleed Al Awadhi, executive director of supervision at the Central Bank of Kuwait (CBK), told OBG. “Banks have come through it stronger, non-performing loans (NPLs) are at record lows, capital adequacy is high and profits are rising.”

History

Kuwait’s modern banking sector was created in 1941, when a group of British investors obtained a 30-year concession from then-Emir Sheikh Ahmed Al Jaber Al Sabah to establish the the Imperial Bank of Persia, the first domestic lender. The bank changed its name to Bank of Kuwait and the Middle East when it became fully owned by the Kuwaiti government in 1971. National Bank of Kuwait (NBK), which is now the largest lender in the country, was founded in 1952 by merchants of Kuwaiti origin, followed by Gulf Bank and Commercial Bank of Kuwait in 1960. That year also saw the foundation of the Kuwait Currency Board (KCB), which created the Kuwaiti dinar in 1961 as the new national currency. With Law No. 32 of 1968, the government introduced the first comprehensive financial regulatory framework and replaced the KCB with a new regulator, the CBK. The first domestic Islamic financial institution, Kuwait Finance House (KFH), was launched in 1977. Boubyan Bank was the first Islamic bank to be established in Kuwait per the Law of Islamic Banks No. 33 of 2003.

The sector continued to develop throughout the 1980s and early 1990s despite internal and external instability – the most notable source of which was the 1990-91 Gulf War. The conflict necessitated the complete shutdown of domestic lending institutions, and saw the physical destruction of bank buildings and financial documents, as well as asset theft. Following the rebuilding of the banking sector after the war, there was a period of rapid expansion. Beginning in the mid-1990s, most lenders reported exponential profit growth as a result of high oil prices, the introduction of a raft of new public development projects and a surge in private investment activity – particularly in the real estate sector. These trends, which mirrored growth trajectories in financial sectors across the broader Gulf region, continued through the mid-2000s.

Damage Control

However, Kuwait suffered particularly acutely from the repercussions of the 2007-08 global financial crisis. Initially, Gulf Bank was found to have suffered losses in its derivative book of around $1.2bn. In order to quell lingering fears in the market, the state stepped in to guarantee all deposits in domestic banks without any apparent limits on the amount or type of deposit. The fallout then spread to Kuwait’s numerous investment companies.

While other banks were relatively insulated from the shock, the proliferation of investment companies – with over 100 operating by 2008 – led to many of them being caught holding bad credit after the crisis, primarily in the form of property and Boursa Kuwait securities purchased with loans from the banking sector. As a result, domestic banks reported a sharp increase in NPLs during the post-crisis period.

The central bank mandated stringent provisioning for bad loans, which banks were forced to take from profits for a number of years, leading to a serious drag on performance in the post-crisis era. However, this process of provisioning for and writing off bad debt is now almost complete. Investment companies have reduced their leverage, and bank exposure to bad debt has declined from approximately 12% of bank assets during the crisis to 2% as of 2017.

Oversight

The banking industry is regulated by the CBK, whose board of directors oversees sector functions. The board includes representatives from the Ministry of Finance and the Ministry of Commerce and Industry. The role of the central bank is to maintain a stable currency, manage credit to support GDP and oversee the banking system, among others. The CBK is widely regarded as a conservative regulator, which has kept banks well insulated and aided them in recovering from the financial crisis. According to the IMF’s April 2019 Article IV consultation, prudent regulation and supervision in Kuwait has protected the sector from potential credit, liquidity and market shocks.

Major recent regulatory developments overseen by the CBK include lending caps and the implementation of the International Accounting Standards Board’s new International Financial Reporting Standards (IFRS) 9, which came into effect on January 1, 2018. Kuwait began implementing new lending regulations in November 2018, lifting the cap on consumer loans from 15 times the monthly salary up to a maximum of KD15,000 ($49,400), to 25 times the monthly salary and a maximum KD25,000 ($82,300). However, there remain other constraints on borrowing that will prevent the new rule from significantly impacting credit levels. Monthly loan payments are not permitted to be more than 40% of individual salaries, and the limit on housing loans remains set at $231,000. As many consumers are already fully utilising their instalment limits, the capacity for them to increase consumer borrowing remains limited. “The new regulations were really just to clarify a split in the overall global limit. There will be very little impact since borrowers are still subject to the 40% debt service-to-income limit,” Al Awadhi told OBG. “In our calculations, it is only those earning over $50,000 who will be impacted; most other people will still be constrained by the global limit on debt service to income, at 40% of salary.”

The CBK is overseeing the implementation of IFRS 9, which can be characterised by a more forward-looking approach to provisioning. However, given the CBK’s conservative stance, its own rules were already more stringent than the IFRS 9 requirements; therefore, the changes have had little impact on the banking system. As provisioning is already fairly high, some lenders suggest they may even receive money back as a result of the new regulations. The central bank agrees that there may be surplus provisions once IFRS 9 rules are implemented but is uncertain on its stance to allow banks to draw down the provisions. “In dialogue with the banks, we have decided to maintain the surplus from IFRS 9 as a buffer for now,” Al Awadhi told OBG. “It could be premature to release the cash now, so we will review the situation on a quarterly basis.”

System Stability

The banking sector remains fundamentally sound thanks to good regulation. According to the IMF, prudent regulation and supervision by the CBK has helped keep bank metrics strong. It added that further efforts should focus on strengthening cross-border supervision, enhancing the crisis management and liquidity forecasting frameworks, and deepening capital markets. The IMF and the CBK carried out recent stress tests to analyse the stability of Kuwait’s banking sector. The IMF found it to be resilient to simulated shocks. “The IMF has its independent view, and we in the central bank carry out our own stress tests,” Al Awadhi told OBG. “We came up with the same results. We carried out a range of different tests, including bottom-up stressors with banks affecting their own balance sheets, and our own view of how bank balance sheets will be stressed in different scenarios. In all situations we found the banking sector to be resilient – even when we combined solvency, liquidity and credit shocks all at once.”

Structure

As of mid-2019 Kuwait was home to 10 domestic banks, five of which are sharia-compliant. In addition, there are 12 foreign banks, which are permitted to have up to two branches in the country. Industry assets are concentrated among a few of the most prominent institutions, with NBK, the largest conventional lender, holding KD27bn ($88.9bn), or 34% of total assets at the end of 2018, while the largest Islamic lender, KFH, comprised KD17.7bn ($58.3bn), or around 22% of the total. Islamic financial institutions held 38% of total sector assets, while foreign banks, which are limited in size, accounted for less than 4%.

Given the small, concentrated market, banks are more likely to look overseas for expansion, and foreign assets grew to account for 20% of the sector total in 2018. KFH, for example, is in the process of acquiring Bahraini lender Ahli United Bank, creating the largest financial institution in Kuwait and the sixth-largest in the GCC region, with approximate assets of KD94bn ($309.6bn). The IMF cautions against some risks that this may entail, saying that “while foreign exchange mismatches appear negligible due to the small net open positions, the growth of foreign operations may pose a challenge to effective supervision”.

While some regard the sector overbanked, the regulator may not see it this way. “The sector is not crowded; it is not too large for the size of the economy, and there is no official stance on the question of mergers and acquisitions in the banking sector,” Al Awadhi told OBG. “We are as concerned about monopolistic factors as we are about the sector being overbanked. We would not say a definite ‘no’ to any merger, but it would not be an easy ‘yes’ either. We would need to evaluate the overall sector and any impact the deal may have on financial stability.”

Bank assets mainly comprise loans to the local private sector, concentrated on households (43% of total credit, predominantly for home purchases and repairs), real estate and construction. Hovering between 17% and 19% of risk-weighted assets in recent years, capital adequacy remains well above the Basel III minimum requirement of 13%. Meanwhile, the liquidity ratio is high and continues to rise – thanks to robust government spending – reaching 31% at the end of 2018. The IMF wrote in April 2019, “Banks operate relatively simple business models and continue to see their activity grow despite the fall in oil prices.”

Performance

Sector profits have largely recovered from the post-financial crisis era. Insolvencies and bad debt among investment firms hit bank profits hard after the financial crisis but have now rebounded. NPLs rose to over 11% of total loans in 2009 but have since fallen, reaching 1.6% by end-2018. Banks took some time to build up provisions and write off bad debts, but provisioning is now very high, at over 200%. Since 2017 the sector has recorded solid bottom-line profit growth, with a particularly stellar year in 2018: profits were up 19% at KD984m ($3.2bn), from a low of KD531m ($1.7bn) in 2013. Average return on equity has risen in line with profits, reaching 10.7% at end-2018, up from a low of 7.4% in 2013. Banks have also been helped by the approval of major government projects. “From 2013 to 2014 the Parliament worked with the government to approve a raft of infrastructure projects. This led to an increase in lending to construction companies,” Masud Ul Hassan Khalid, CFO at the Commercial Bank of Kuwait, told OBG. “This included clean fuels, Kuwait International Airport, hospitals, roads, bridges and $20bn-30bn in Chinese investment for the Silk City mega-development. This has led to higher demand for credit and greater profits for banks. It also draws in global firms that need facilities, letters of credit and other banking services.”

Loans Growth

The strong performance of banks has come despite pressure on interest margins. The cost of funds has been pushed up as a result of interest rate increases by the US Federal Reserve and the recent escalation of regional tensions. Although shortterm liquidity is ample, meeting the net stable funding ratio required under Basel III is further elevating the cost of funds. At the same time, the banking sector is highly competitive, which is driving down loan rates. In September 2019 the CBK announced that it would keep its policy rate unchanged at the current 3%, choosing not to increase rates as rapidly as the Federal Reserve. As a result, the difference between the lending and deposit rate shrunk to 290 basis points in early 2019, compared to over 300 basis points in 2017 and 2018. Overall loan growth in the banking sector was 0.6% in 2018, down from 7% in 2017. This was mainly a consequence of a winding down of largescale public sector projects. Meanwhile, banks’ profits were sustained by the lower burden of provisions as NPLs fell at the end of 2018. Deposit growth exceeded 3% in 2017 and 2018, which has driven a build-up in liquidity and means that banks are comfortably funded to meet any demand for credit. Given the sector’s strong performance, growing numbers of foreign companies are entering the local market and starting to diversify their scope of operations. “Kuwait is a promising market,” Leon Pang, general manager at the Kuwait Branch of the Industrial and Commercial Bank of China, told OBG. “There are great opportunities for Chinese companies to expand throughout the country over the coming years,” he added.

Financial Inclusion

To generate jobs for the large number of Kuwaitis expected to enter the labour market in the coming years, the government is prioritising the development of small and medium-sized enterprises (SMEs). Encouraging SME growth has been identified in the New Kuwait 2035 long-term development strategy as integral to economic growth. As a result, the CBK gives preferential risk weights for SME loans, making it cheaper for banks to lend to them. Meanwhile, the National Fund for SME Development was established in 2013 to finance small and medium-sized projects submitted by Kuwaiti nationals.

Despite these efforts, banking penetration has fallen in recent years, measured by total loans as a share of non-oil GDP, from 70% in 2012 to less than 60% in 2018, suggesting that the banking sector is having difficulty deepening its lending portfolio. Additionally, access to finance for smaller players remains weak, with only 2.5% of total bank credit going to SMEs. Surveys have shown that SMEs still struggle with access to finance. The main issue appears to be that the SME sector is too small to pique the interest of banks. While efforts are being made, it may be that more SMEs are needed before banks will become interested in serving the segment. “SMEs will be an important driver of the economy going forward,” Al Awadhi told OBG. “Banks need to enhance their ability to serve SMEs at a reasonable cost. They could enable SME growth by offering advisory services.”

Outlook

Continued government spending and major projects should support bank lending and profits. “Government spending, especially on infrastructure, is the main driver of growth. So far, there is little link between performance of the banking sector and oil prices,” Al Awadhi told OBG. However, the public infrastructure project pipeline has slowed recently. “If no new projects are launched soon to replace the current pipeline, there could be a slowdown in credit and profit growth,” Khalid told OBG. For now, this has been offset by increases in oil production capacity, fuelled by over $100bn in spending from 2015 to 2020. “There is a backlog of projects in the petrochemical, energy, refinery, power and water sectors that will lead to a pickup in the banking sector,” Saade Chami, group chief economist at NBK, told OBG. Even with lower capital spending, banks may remain largely unaffected. Many lenders report growing profits from multiple business lines as well as strong consumption growth.

Additionally, the government might require financing for operational expenditure, making project spending less important for banks in the short term. According to the IMF, the financing needs of the government are considerable. Once the transfers to the Future Generations Fund have been made and investment income has been deducted, the fiscal deficit is forecast to average 12% of GDP per year up to 2025, requiring approximately $116bn in cumulative net financing. Ongoing issues with getting a new debt law passed through the Parliament mean that the government is likely to call heavily on financial institutions to meet public spending requirements.