Developing resilience: Recent improvements to the regulatory framework aim to strengthen the sector

Over the course of the past decade the Central Bank of Kuwait (CBK), the Ministry of Finance and the Capital Markets Authority have focused on strengthening Kuwait’s financial sector. The nation’s banks have been key beneficiaries of this effort. At the end of 2015 Kuwait was home to 23 banks in total, including 11 domestic players and 12 foreign institutions. With a total share of more than 95% of banking sector assets, domestic lenders dominate the market, and it is these institutions that have been impacted the most by the numerous new regulations introduced by the state in recent years. The government’s efforts have had the intended effect of improving the quality of most institutions’ loan books, increasing transparency and corporate governance throughout the industry, and ensuring the sector’s long-term stability in the face of a tightening domestic and regional economy. The government’s most recent effort in this regard is the introduction and implementation of Basel III capital regulations, which began in 2014.

Current Obstacles 

These efforts have been put in place to address a handful of structural challenges currently facing Kuwaiti lenders. While the domestic banking sector was relatively well insulated against the full impact of the 2007-08 crisis, some banks did suffer as a result of their overexposure to real estate and securities in the form of large credit issues to aggressive local investment companies (ICs). While heavy provisioning in the years following the downturn has resulted in a sector that is much better prepared to ride out losses than previously, some institutions’ loan books remain heavily concentrated in property and equities. This situation has the potential to become a major challenge in the years to come, particularly if volatility continues or worsens.

More fundamentally, Kuwait’s banking sector, like most other industries in the country, continues to rely to a large extent on state spending and, by proxy, hydrocarbons revenues, which have fallen off dramatically since mid-2014. “The question for the banking sector right now is will the government continue to spend on new projects?” Masud Ul Hassan Khalid, the financial controller at local lender the Commercial Bank of Kuwait, told OBG. “While the state has assured us that all major projects will move forward no matter the price of oil, it remains to be seen whether or not this is actually the case.”

Past Developments

In the wake of the downturn, the state moved quickly to ensure that the banking sector remained liquid and stable. Under the Financial Stability Law, which was passed in March 2009, domestic firms that had been negatively impacted by the crisis were given access to fiscal resources and restructuring expertise in an effort to both support the country’s hardest hit ICs and to reduce pressure on domestic banks. After the downturn many local lenders took a hit to their loan books, which had grown rapidly in the years prior to the crisis.

While in the late 1990s Kuwaiti banks’ credit facilities to the private sector were on par with credit issued to the government, beginning in the early 2000s rising demand for cheap loans from ICs and individual investors contributed to the rapid expansion of the sector’s private loan book. By 2001 private credit facilities were nearly twice as large as government loans. By year-end 2007, on the eve of the financial downturn, the banking sector’s claims on the government totalled KD1.91bn ($6.3bn), while the industry’s claims on the private sector had reached KD21.82bn ($72.2bn), more than 10 times the public sector amount. A considerable percentage of the loan book was tied up, either directly or indirectly via ICs and other investors, in property and securities market, both of which saw a drop during the crisis.

According to IMF data, during the 2004-08 period assets held by ICs grew from 22.3% to 29.4% of total financial sector assets. This had a direct effect on the banking sector: from 2006 through the end of 2009 domestic banks’ direct exposure to ICs increased from 8.8% to 11.5%. As the IMF noted on the boom in ICs in a 2010 report, “the rapid growth in the IC sector was facilitated by low barriers to entry (particularly the capital requirement of only KD15m [$49.6m]), segmentation of the licensing and oversight responsibilities […] and the lack of clear international standards on how to regulate and supervise ICs.”

As a result of these factors, the crisis had a considerable impact on Kuwait’s banking system. In 2008 alone profits across the industry declined by around 70%, according to the IMF, while the ratio of non-performing loans (NPLs) to total loans more than tripled from 3.2% at the end of 2007 to 5.3% in 2008 and 9.7% by year-end 2009. At the same time, the sector provisioning rate declined from 48.2% year-end 2007 to 38.5% at the end of 2009. Provisioning expenses, which were at less than KD150m ($496.1m) for the sector as a whole on an annual basis prior to the downturn, jumped in 2008 to just under KD1bn ($3.3bn) annually, as institutions moved to apportion a more of their assets to ensure NPL coverage. While stress tests carried out by the IMF in 2010 showed that Kuwait’s banking system remained broadly resilient, due primarily to its considerable capital and liquidity buffers, in the years following the downturn the government set out to institute best international practices across the country’s financial system.

Building Capacity

For the Kuwaiti banking sector, this effort has played out primarily in the form of a series of mandated capital increases and new legislation that has targeted improvements with regard to risk management, corporate governance and reporting standards. In November 2013, for instance, the CBK introduced a series of limits on the loan-to-value (LTV) ratio and debt service-to-income (DSTI) ratio for financing issued to individuals for the intended use of developing or purchasing residential real estate. The bounds – which include a 50% LTV limit on the purchase of undeveloped land and a DSTI limit of 50% of all income in addition to a monthly salary plus any income generated by the property in question – function as one set of a broad regulatory framework that requires banks to maintain set levels of liquidity, capital adequacy and corporate governance controls depending on a given institution’s exposure profile, related-party lending status and other metrics.

These and other regulations have had a direct positive impact on the quality of banking sector assets in recent years. According to the IMF, by the end of 2015 gross NPLs as a percentage of total loans had dropped to 2.8%, down from around 10% in 2009. Additionally, CBK data shows that the sector’s coverage ratio – a metric that measures available provisions to NPLs – was at 163.9% at the end of 2014, more than double both the end-2007 coverage ratio of 87% and end-2010 ratio of 62.3%. The decline in NPLs has taken place across the entire Kuwaiti banking loan book, albeit significant declines were recorded in the real estate and construction segments. Conversely, the household sector saw a slight increase in NPLs over the same period, and the share of foreign NPLs in the sector’s credit portfolio grew by 16 percentage points. This jump reflects the tightening regulations at home, some banks’ efforts to source new revenues abroad and considerable global volatility in recent years. According to IMF data, the decline in the overall NPL ratio has allowed domestic institutions to decrease their provisioning expenses from KD677m ($2.2bn) in 2013 to KD511m ($1.7bn) in 2014.

Basel III 

In early February 2014 the CBK announced that it would require all banks to implement Basel III capital requirements, with completion planned for 2019. The regulations, which mandate set levels of capital reserves, liquidity ratios and leverage ratios for all banks operating in a country – plus a more demanding set of requirements for systemically important domestic institutions – were designed to ensure that the global financial system maintains solvency in the face of future challenges.

In Kuwait, where banks have benefitted from high levels of capital and liquidity for decades, most institutions already exceed the baseline Basel III capital adequacy ratio (CAR) of 13%. Indeed, as of the end of 2015 Kuwaiti banks boasted a comprehensive CAR of 17.5%, up from 16.9% in 2014, according to the CBK. Nonetheless, as the IMF recently noted, Kuwait’s central bank could still do more to ensure that domestic systemically important banks (D-SIBs) are able to maintain solvency during large shocks. For instance, in its 2015 Article IV consultation, the IMF recommended that the CBK develop a countercyclical capital buffer framework, which would enable the sector to maintain credit flows during a downturn. Banks, and particularly D-SIBs, should be encouraged to intensify corporate governance regimes to improve supervision and enhance their ability to absorb losses. As the World Bank noted about Kuwait in a spring 2016 report, “the banking sector is well capitalised, yet has exposure to the real estate sector.”