Kuwait’s Islamic banks face an unconventional future

Just as it comes to terms with the fallout of the global economic crisis, the Islamic sector must prepare for political instability. Published in Euromoney, April 2011

One of the most troubling episodes faced by Kuwait’s Islamic ­finance industry could at last be on the way to being resolved. The Investment Dar, a Shariah-compliant finance company, ­defaulted on a $100 million sukuk in April 2009 and has been trying to come up with a restructuring plan for its debts of more than KD1 billion ($3.6 billion) ever since. A vote by creditors was due before the end of March on the latest plan, which would involve their injecting a further KD20 million into the business over the next year. In return, they would gain an additional 10% stake and their debts would be repaid over the following six years.

Previous restructuring plans have failed to gain the backing of sufficient creditors but if they approve this one the plan could be finalized by the end of June. A source close to the bank, who did not want to be named given the sensitive nature of the discussions, hopes that it will go through, if only because it is the least worst option.

"It looks as if the majority [of creditors] will approve the plan, because the alternative is not pleasant for anyone," he says. "Either you agree on the terms of a plan or there will be disagreement and there will be lots of litigation, expenses, court cases – you name it. There is no other alternative."

The Investment Dar was not the only Islamic finance company in Kuwait to suffer problems as a result of the global economic crisis, although it has proved to be one of the most high profile and intractable. Many other Shariah-compliant banks and investment companies in Kuwait, as in the rest of the region, have also been hurt by high levels of debt and their exposure to the failing real estate and construction sectors.

The 2008 economic crisis hit the conventional banking industry first. For a time, many insisted that Islamic banks would be able to avoid the worst of the downturn because of their lack of exposure to the sub-prime mortgage market and other toxic assets. That optimism soon vanished when it became clear that the knock-on effects would hit all areas of economic activity. The pain for Islamic banks, in the end, was only delayed by a year.

"In 2008, Islamic banks were to some extent shielded from the impact of the crisis because in that year most of the losses came from investments in toxic assets and derivatives, which are assets that Islamic banks cannot, by default, invest in," says Maher Hasan, deputy division chief for the Middle East in the IMF’s monetary and capital markets department. "In 2009 the impact of the crisis moved to the real economy and started affecting the loan portfolios of Islamic and conventional banks. In 2009, on average, they fared worse than conventional banks, while in 2008 they fared better than conventional banks."

According to IMF statistics, Islamic banks in Kuwait were among the most seriously affected institutions anywhere. Their collective profits fell by 78% between 2007 and 2009 – a sharper fall than in any other important market except Bahrain, where profits plunged 112%. Over the same period, the asset and credit growth achieved by Kuwaiti banks was slower than in any other country, at 22% and 31% respectively.

The banks were particularly affected by their exposure to real estate lending, something that has come back to haunt them as property prices and construction activity around the Gulf, including Kuwait, dropped off. Almost 19% of all loans by Islamic banks in Kuwait in 2008 were to the real estate and construction sector, according to the IMF, compared with 15% for conventional banks.

"The difference between Islamic financial institutions in Kuwait and Islamic banks in general is that they have been even more exposed to the property sector," says Anouar Hassoune, a senior credit officer at ratings agency Moody’s Investors Service. "Therefore, their provisioning needs in terms of property-related bad loans have been far greater than for conventional banks."

Unconventional outperformance

Nonetheless, there was still growth and Kuwait’s Islamic banking sector has even managed to outperform its conventional banking rivals by some measures over recent years. The country’s conventional banks’ profits fell by 60% overall between 2007 and 2009 but their credit growth was just 18% and their asset growth was essentially nonexistent, with a rise of just 0.5%.

As a result, the Islamic banks have been steadily increasing their market share in Kuwait, although with a population of 3.6 million it remains a relatively small market. The Islamic banking sector is dominated by Kuwait Finance House (KFH), which was set up in 1977 and now has 53 branches – almost as big a network as all the other Islamic banks’ branches put together. KFH accounted for 72% of all the assets held by the country’s Islamic banks in 2009 and every year makes more profits than all of its rivals combined.

"Kuwait Finance House appears as the dominant player by far, and will remain so," says Hassoune. "It’s not just a matter of size. It is also due to geographic diversification, a wider operating diversity beyond lending, and a massive retail platform that brings stability."

However, it has a growing number of rivals. Unlike in some other Gulf Cooperation Council states, conventional banks in Kuwait do not operate Islamic windows. However, there are now five other institutions on the central bank’s Islamic bank register, including Warba Bank and Alhi United Bank, both of which were included for the first time last year. The latter was previously known as the Bank of Kuwait & the Middle East but transformed itself into an Islamic bank in March 2010, changing its name at the same time.

In comparison, there are only five conventional commercial banks in the country, led by National Bank of Kuwait (NBK), although their combined branch network of 228 still far exceeds the 112 Islamic bank branches. Some of these conventional banks have been expanding into the Islamic sector by buying stakes in Shariah-compliant institutions. NBK, for example, has a 47% stake in Boubyan Bank, while Commercial Bank of Kuwait and The Investment Dar are in dispute over a further 20% of Boubyan. In addition, nine other foreign conventional banks have branches in the country.

According to the Central Bank of Kuwait, at the start of this year there were also 98 investment companies, 54 of which were Islamic, and 112 investment funds, 54 of which were Islamic.

New business

The market share of the Islamic industry has increased sharply since the Islamic bank register was first drawn up in 2003. At the end of that year, the value of assets held in Kuwait by Islamic institutions was $2.5 billion, compared with $20 billion held by conventional rivals, according to figures from the American ­University of Kuwait and Liquidity Management House. Islamic bank assets had grown to $56 billion by 2009 and close to $63 billion by 2010, out of a total asset base in the banking sector of $141 billion and $149 billion respectively.

The dominance of KFH in the Shariah-compliant sector of the industry means it is not a level playing field – for the newer, smaller banks in particular it can be hard to win new business.

"KFH does not have any convincing competition on the Islamic banking side in Kuwait for the time being," says Paul-Henri Pruvost, bank credit analyst at Standard & Poor’s. "It is a hard time for the new Islamic banks. They can grow, because there are opportunities domestically, but we don’t think they will offer real competition to an established player like KFH that has been in operation for years and has a track record.

"Banks have been focused on managing their existing relationships in 2009 and 2010, dropping those customers that might be a bit weak and grooming the existing ones that are good. So what is left out there in the market for the new players in terms of corporate customers might not be the best. It’s not obvious that the new players will be able to attract good customers right away, unless they want to sacrifice on price."

There will also be a natural limit to the proportion of the banking market they can ultimately win, unless they can come up with new Shariah-compliant products to compete effectively against everything the conventional banking industry has to offer.

In general, Islamic finance structures tend to be more expensive than conventional banking options and although there are some people that will always be prepared to pay a small premium, the price difference will dissuade others. That much is clear from the fact that so much business has remained with the conventional banks since Kuwait passed an Islamic banking law in 2003 to regulate the sector. In addition, Islamic banks still struggle to compete with the short-term, unsecured loans that conventional banks can offer because they need a physical asset to support any loan facility they offer.

Limited coverage

"If Islamic institutions can fulfil all the niches that conventional banks do and at a competitive price, they will get a majority share," says an industry analyst who didn’t want to be named because he wasn’t authorised to speak to the press. "The problem is that they haven’t been able to cover every niche because the Islamic structures just aren’t there."

This is an issue for Islamic banks across the board. For the industry’s veteran, however, there is another problem. KFH’s dominant position in the market means it now has little room to grow domestically.

"The incremental cost for KFH to win another percentage point of domestic market share is very high," says Hassoune. ­"Therefore, for Kuwait’s flagship Islamic financial institution, international business is the only avenue for growth. Smaller Kuwaiti banks do not have incentives to expand inter­­nationally. It’s not in their mandate to do so and they are not ­financially or operationally equipped to perform wide geographic diversification."

KFH already has subsidiaries in Bahrain and Malaysia, a majority stake in Kuveyt Turk bank in Turkey and subsidiaries involved in project finance, real estate, aircraft leasing and other activities around the region. Such international exposure can bring its own difficulties, however.

"It’s a truism in banking that the highest margins and profitability are in your home market," says the analyst. "Kuwait has been a very profitable market because they charge for things there that nobody else would get away with charging. So, if you go abroad your return on assets is likely to fall."

More troubling, however, is the rise in political risk around the region. The unrest that has swept across the Middle East and North Africa has led to some short-term bank closures and creates longer-term uncertainty that could undermine the prospects for economic growth.

The instability has made its presence felt in Kuwait, although to a limited extent so far. Emboldened by the events in Tunisia, Egypt, Bahrain and elsewhere, groups have been protesting on the streets of Kuwait City this year, calling for prime minister Sheikh Nasser al-Mohammad al-Sabah to step down. It seems likely that protests will continue, although it is impossible to say how widespread or potent they will become.

In an effort to try to stem the protests, the government launched a $4 billion handout to its citizens in late January, equivalent to about $4,000 a person. There is no guarantee this will prove sufficient.

High oil prices that have resulted from political instability will help the government’s revenues and means such cash handouts can easily be afforded. Income from oil sales accounts for a little over 93% of total government revenues. The government has drafted a budget for this year based on an average oil price of $60 a barrel but prices are currently over $100 a barrel and could rise far higher, so the country will almost certainly run a healthy surplus this year. Other implications, however, are more difficult to gauge.


"It is not clear how much impact [the regional political instability] will have," says Hasan. "There are two things that are playing out at the same time. There is uncertainty, which will hurt everybody; at the same time there are high oil prices, which will boost confidence in Kuwait and other oil-producing countries. There is also a response from authorities to increase spending, which could help the economy. It is hard to say what the net outcome of all these factors – the uncertainty, the high oil price, the government spending – will be. There are positive factors and there is also uncertainty."

The level of government revenues also means that, should the business environment for the country’s banks, whether Islamic or conventional, get worse, the state will be easily able to bail out any struggling institutions. An explicit state guarantee of all bank deposits was approved in October 2008 and credit ratings agencies say that they regard the government as interventionist when it comes to supporting the banking sector.

Some issues that arose from the economic crisis and that still need to be addressed by the country and its banks could help them to weather any further political or economic storms. Among them is the need for a review of regulations for the Islamic finance sector, particularly for the investment companies.

"The economic crisis has revealed the need for the regulator to beef up part of its existing regulatory framework for the financial system," says Pruvost. "They have been doing that. It is a work in progress and it is still to be seen what the effects will be. Much of the work done will be felt on the investment companies side. The investment company segment is indeed experiencing substantial restructuring."

Islamic banks and investment companies also need to review their risk management policies. Having emerged from the economic crisis bruised and battered, Kuwait’s Islamic finance sector must have been hoping for some time to recuperate and recover. But the political upheaval sweeping through the Middle East means it cannot afford to wait too long before addressing the reasons for its past failings.

"If one invests in the market, it is impossible to avoid the impact of a slowdown in the economy," says Hasan. "I don’t think Islamic banks in general have superior risk management to conventional banks. It is the same tools they are using. Bad risk management, investment or lending decisions affected some Islamic banks, as was the case for some conventional banks. The lesson for Islamic banks is that the ones that exposed themselves to risky sectors such as real estate, or extended large parts of their loan portfolio to a few borrowers, will have to improve their risk management. No one can say for sure that all the risks are behind us right now, and this applies not only to Kuwait but to many countries around the world. The risks remain there."

The immediate future for the Islamic finance sector, as with other parts of the economy, is one of economic uncertainty driven by regional political instability. If it can manage to address its weaknesses, however, it will at least help to ensure that episodes such as the default by The Investment Dar are the exception rather than the rule.