A vibrant market: Sharia-compliant banks remain relatively healthy while the takaful sector is crowded

While business activities undertaken according to the principles of Islamic law, or sharia, have been a feature of the Gulf region for over a millennium, recent years have seen the emergence of a modern Islamic financial services (IFS) sector that has established itself as an important component of regional economies. Kuwait is no exception. Its Islamic banks, investment companies and insurance providers have steadily expanded their operations on the back of the country’s hydrocarbons-powered economy and presently form one of the most diverse IFS sectors in the GCC, while the nation’s track record of issuing sovereign debt has helped to establish the country as a leading originator of sukuks, or Islamic bonds. While the global financial crisis has altered the economic landscape and presented the sector with a number of challenges, sharia-compliant finance remains central to Kuwait’s economic future.

HISTORY: The development of Islamic finance in Kuwait benefitted from government support from the very beginning. Just two years after the establishment of the Dubai Islamic Bank in 1975 ( generally considered to mark the start of the modern era of global Islamic banking) the government of Kuwait passed legislation (Law 72 of 1977) to create Kuwait Finance House (KFH). For nearly three decades this institution, in which the government retained a 49% stake, remained the only Islamic bank in the country, and as such drove a process of innovation in sharia-compliant financing which introduced Kuwaitis to concepts such as the now-familiar ijara (the Islamic equivalent of leasing), istisna (a contract of exchange with deferred delivery, applied to specified made-to-order items) and murabaha (the sale with a mark-up or profit clearly added in the sale contract), and brought them to a global audience as it expanded its operations to become one of the largest Islamic banks in the world.

At home, it remains the dominant player in the local market, but the government’s decision in 2004 to open up the Islamic banking sector to other players to create a competitive sharia-compliant arena ushered in a new era of Islamic finance which saw the IFS sector expand to include a plethora of new banks, investment firms and insurance providers. By 2007 the nation’s sharia-based financial assets were the fourth-largest globally, behind Iran, Saudi Arabia and Malaysia, at $63.1bn – and a growth rate for that year of 44.3% established the local IFS sector as the fastest expanding in the region.

ROLE: Kuwait, then, has played a significant role in what has become one of the fastest-growing sectors in the global financial industry, thanks largely to a government amenable to the concept of sharia-compliant financing and the large liquidity flows associated with its hydrocarbons wealth. As with other markets, it has seen the focus of Islamic finance shift from the personal domain – KFH started operations with just 170 retail accounts in 1977 – to the corporate sphere, wherein Kuwait’s Islamic financial institutions possess both the capital and the operational know-how to finance and insure major local and international development projects.

The impetus given to Kuwait’s Islamic banking sector by government support in the early stages of its development has resulted in one of the most vibrant sharia-compliant banking markets in the region. In 2010 it accounted for nearly 17% of total GCC banking assets and, as home to KFH (the region’s second-largest Islamic bank with total assets of around $47bn in the first quarter of 2011) it continues to play a significant role in the evolution of sharia-compliant finance in international markets. Within Kuwait, Islamic banks hold 35% of total banking assets (the highest proportion in the GCC) and, growing at an estimated rate of 20% per annum according to a recent KFH report, are expanding more rapidly than their conventional counterparts.

LARGEST BANKS: Of Kuwait’s 10 local banks, five are now fully sharia-compliant, the largest of which is KFH. In 2010 it grew its assets by 11.1% to reach KD12.6bn ($45.4bn), which grants it a 27.5% market share – second only to the conventional player National Bank of Kuwait (NBK), with 28.2%. Since the company’s inception 35 years ago, its activities have expanded to include real estate and trade finance, corporate and investment banking, treasury operations and an expanding range of retail products and services. KFH’s international reputation rests not only on its role at home, but also on exporting its business model to international markets. It has established operations in Bahrain, Turkey, Jordan, Saudi Arabia, Malaysia, Singapore and Australia, and affiliates in the UAE, Oman and Bangladesh – an international footprint of such influence in global sharia-compliant financing that Forbes dubbed it the “Harvard of Islamic banking” in 2007.

The Central Bank of Kuwait’s (CBK) decision in December 2009 to allow the Bank of Kuwait and the Middle East to transform itself into an Islamic operator created the nation’s second-largest sharia-compliant bank, with total assets of KD2.5bn ($9bn) at the close of 2010. The transfer to sharia-compliant activity took place in the second quarter of 2010, which also saw it change its name to Ahli United Bank. This reflects the 75% stake that the Bahrain bank of the same name retains in the institution.

With total assets of KD1.1bn ($4bn), Kuwait International Bank is the fourth-largest locally incorporated Islamic lender. Formerly the Kuwait Real Estate Bank (incorporated in 1973), it took its current name in 2007 when it transformed itself to a fully sharia-compliant operation, and it has used its 38-year history to bring a sense of institutional stability to its Islamic retail and commercial operations.

Kuwait’s third largest Islamic lender, Boubyan Bank, was created in 2004 by Amiri Decree 88 as a shareholding company in which the Kuwait Investment Authority, the nation’s sovereign wealth fund, retained a 20% stake, while Kuwaiti citizens were granted 76% of its equity. In 2009 the NBK gained approval to buy up to 40% of the bank’s shares – a limit that was increased to 60% in 2010. NBK’s interest in the bank, which posted total assets of KD1.3bn ($4.7bn) at the close of 2010, is indicative of an increasing appetite from investors for sharia-based products; for some conventional lenders this issue is most readily addressed through investment in their Islamic counterparts.

Finally, Kuwait’s newest Islamic lender, Warba Bank, was officially registered by the CBK in April 2010. Its establishment follows a model similar to the 2004 launch of Boubyan: created by decree and capitalised at KD100m ($360.5m), Kuwaiti nationals hold 76% of the shares, with the Kuwait Investment Authority holding the remainder.

FOREIGN ENTRANTS: The formation of Boubyan and Warba Bank is one of the more visible indicators of government support for the nation’s Islamic banking sector, but the market has also benefitted from its 2004 decision to allow foreign banks to operate within the country.

The 10 foreign banks which have been granted licences to date include global conventional giants such as BNP Paribas, HSBC and Citibank, as well as regional heavyweights such as National Bank of Abu Dhabi, Qatar National Bank, Doha Bank, Mashreq Bank and Bank Muscat. It also includes the largest Islamic bank in the world, Saudi Arabia’s Al Rajhi Bank, which has brought its considerable capital and know-how to Kuwait’s already dynamic Islamic banking sector, although, as a foreign-owned bank, it is restricted to opening just one branch and to providing only investment banking services instead of a wider range of offerings.

PERFORMANCE: Kuwait’s Islamic banks exhibit a similar profitability trend to their conventional counterparts: rapid growth in the boom years leading up to the 2008 financial crisis followed by slow or stagnant expansion, and in some cases contraction, in the years since. Aggregated interest income for Kuwaiti banks dropped by 10% in 2010 as a result of falling interest rates, tight credit conditions and conservative lending policies, while non-interest income remained moribund (at -1%), largely as a result of reduced private sector activity.

However, while banks have not been able to match the growth rates of 2007, when most of them posted their historic highs, the four Islamic lenders that published financial results for 2010 achieved relatively healthy net profits given the challenging market conditions. KFH posted the largest net profit for the year, at KD106m ($382.1m), down from KD118.7m ($427.9m) in 2009 and the 2007 high of KD273.5m ($986m); followed by Ahli United Bank, at KD27.2m ($98.1m), up from KD14.3m ($51.6m) in 2009; Kuwait International Bank, at KD16.6m ($59.8m), an improvement on its KD8.2m ($29.6m) loss in 2009; and Boubyan, which posted a net profit for 2010 of KD6.1m ($22m), a welcome recovery from the KD51.7m ($186.4m) loss recorded the previous year.

Moreover, all four banks were able to grow their net operating profits over the year, with Kuwait International and Boubyan reversing the losses on net operating income seen in 2009. The robust performance of Kuwait’s Islamic banks has resulted in each of them receiving an A- or above long-term rating from Standard & Poor’s, or the equivalent from Moody’s or Fitch, with the exception of Boubyan, which has been granted a Baa2 from Moody’s as a result of the bank’s “short track record of operation, as well as its very limited franchise and scale in the Kuwaiti banking sector, in which Boubyan represents approximately 2.1% of the system’s assets”.

INVESTMENT COMPANIES: While Kuwait’s sharia-compliant banks remain the foundation of its IFS sector, since the 1990s the rapidly expanding roster of investment companies (ICs) operating in the country has taken on an increasingly Islamic character. Of the 100 ICs licensed by the CBK at the end of 2010, 54 operated along sharia-compliant lines. During the years prior to the financial crisis their growth was driven by the same factors that fuelled their conventional counterparts – of which the availability of cheap credit and a buoyant, hydrocarbons-based economy were the most salient.

By 2009 two of the top five ICs by assets – Aayan Leasing and Investment Company and the Investment Dar (TID) – were Islamic operators, playing a leading role in an industry worth around KD14bn ($50.5bn) at its 2008 high water mark. However, sharia-compliant ICs exhibited the same vulnerabilities as those operating in conventional segments, derived largely from an asset/liability mismatch resulting from excessive short-term debt, overly ambitious expansion policies during the boom period, exposure to risky assets and an undeveloped culture of risk management – a combination which was to see them suffer more than Kuwait’s banks as the global economic crisis of 2008 took hold.

The 38 Islamic ICs listed on the Kuwait Stock Exchange reported an aggregate 8.9% decrease in their balance sheets at the end of 2009 compared to the previous year, with total assets for the segment shrinking from KD7.2bn ($26bn) to KD6.5bn ($23.4bn). The slide, which continued into 2010 and saw a number of companies withhold their financial reporting, resulted in two high-profile defaults by Islamic players that were still being resolved in 2011. In 2009 TID defaulted on a sukuk and, after a period of litigation, had by mid-2011 avoided liquidation and undertaken a process of debt restructuring. In 2010, The International Investment Group, another sharia-compliant IC, was unable to meet payments on its sukuk, which prompted its shareholders to reduce the company’s capital by 55% to cover losses. The company has appointed KPMG to advise it on the process of restructuring its business.

In the meantime, the investment sector results for the first quarter of 2011 highlighted the challenging nature of market conditions with which both conventional and Islamic ICs are confronted. Out of the 52 listed companies, 28 announced their first quarter results, revealing an aggregated sector loss of KD19m ($68.5m), while 24 withheld their financial results and remained suspended from trading. While Kuwait’s Islamic ICs travel the path to recovery and come to terms with a new economic environment, the CBK is already taking steps to ensure that they are better equipped to respond to any future market corrections.

TAKAFUL’S FIRST DECADE: Growing alongside Kuwait’s Islamic banks and investment companies is a sharia-compliant insurance industry which has steadily increased its market share vis-à-vis conventional operators since the establishment of First Takaful Insurance and Wethaq – the first dedicated providers of takaful, or sharia-compliant insurance – in 2000. The increasing popularity of takaful brought with it a steady stream of new operators coming into the market, peaking in 2004 and 2005, which saw three or more companies join each year.

In 2011, 11 of the 30 insurance companies licensed to operate in Kuwait by the Ministry of Commerce and Industry were dedicated takaful operators, accounting for 16.5% of direct gross written premiums (DGWP), the largest being National Takaful, claiming 3.2% of the local market. Market pioneer First Takaful is ranked second of the sharia-compliant providers, with a market share of 2.7%, while the Islamic top five is rounded out by Gulf Takaful (2.6%), Al Muthanna (1.9%) and Wethaq Takaful (1.5%). The increasing competition within the takaful sector has been fuelled by the response of the conventional players, all of which have opened up takaful operations of some sort – either through subsidiaries, windows or perhaps some form of new integrated sharia-compliant offerings.

SATURATION: The crowded nature of the market has made the recovery from the economic disturbances of 2008 all the more challenging, although the aggregated results for 2010 showed a modest improvement for the takaful segment. Figures released by the Ministry of Commerce and Industry reveal that, although takaful operators lost nearly a percentage point of market share to their conventional rivals, they were able to grow their aggregated DGWP from KD29.7m ($107.1m) in 2009 to KD34.1m ($122.9m) in 2010. Three of the top five – National Takaful, First Takaful and Al Muthanna – grew their DGWP by 10% or more (41% in the case of the latter), while Gulf Takaful and Wethaq showed modest contractions of 11.4% and 8.3%, respectively.

Future growth in the segment is underpinned by the sustained demand for sharia-compliant products and a development pipeline that has been boosted by the gradual implementation of the KD30bn ($108bn) five-year plan announced by the government in the first quarter of 2010. However, while the 1100 projects envisaged in the strategy have already brought new financial services opportunities to the market, some of Kuwait’s takaful operators feel that substantial growth will only come with the introduction of mandatory lines seen in more developed insurance markets (see analysis).

REGULATION: Kuwait’s IFS sector is not governed by a unified legal framework. The Islamic banking sector was opened up to competition in 2004 by an amendment to Central Bank Law 32 of 1968, which ended the monopoly of KFH and brought it under the regulatory authority of the CBK, but the regulatory regime by which Islamic lenders operate is the same as that which is applied to their conventional counterparts in banking provision.

The CBK also oversees the activities of Kuwait’s sharia-based ICs, which have absorbed much of its attention since the onset of the global economic crisis. In response to the difficulties faced by some of them, it introduced a number of new regulations in 2010, most notably a new liability/equity ratio of 2:1 and a limit of 50% of total equity, or 25% of total liabilities, on foreign debt. The deadline for compliance with the new requirements, which have been welcomed by many in the industry as essential for creating and ensuring long-term stability in the sector, has been set for June 2012.

In the shorter term, weaker investment companies have recourse to the Financial Stability Law, introduced in 2009. The law (Decree No. 2 of 2009) offers support facilities to creditworthy banks and investment companies, such as CBK guarantees on credit facilities and a Special Circuit Court that is designed to hear restructuring requests as well as manage the actual process of restructuring.

The country’s takaful industry, meanwhile, is governed by the Ministry of Commerce and Industry (unlike regional neighbours Bahrain and Saudi Arabia, where the central bank retains the supervisory role). As with banks, both takaful and conventional insurance providers are governed by a single piece of regulation – Law No. 24 of 1961, which sets low capital requirements in comparison to those seen in other GCC economies and does not address sharia-specific issues. However, a draft insurance law currently under review is set to overhaul the regulation in place, as well as introduce a separate code for takaful providers (see analysis).

SUKUKS: Sukuks originating in Kuwait are also due for a regulatory overhaul. Currently, there is no regulatory framework by which sukuk issuance is governed, but the new sukuk and trust laws being formulated by the government aim to help restore the flow of sharia-compliant bond issues that has been adversely affected by economic turbulence in regional markets (see analysis).

OUTLOOK: The legislative decisions of Kuwait’s government have been largely conducive to the growth of Islamic finance in the country, and have over time helped to create one of the most dynamic IFS sectors in the entire region.

However, the changing economic backdrop of recent years has highlighted the need for a comprehensive regulatory structure to complement the legal framework, and the implementation of a new layer of regulations, such as the anticipated takaful code and increased governance of sukuks, will be greatly beneficial to the expansion of the sector in the short to medium term. While challenges within the sector remain, the opportunities provided by a national development programme underwritten by a hydrocarbons-driven economy and blessed with regular budget surpluses provide the most obvious rationale for the IFS industry’s continued growth.