Safeguarding growth: Authorities are working to ensure a resilient banking industry


Banking sector liquidity has not been a concern in the GCC for nearly 10 years, but the rapid decline of crude oil prices that began in the summer of 2014 has made the issue a regional challenge once again. The central role played by oil and gas in GCC economies means that large movements in spot prices and energy futures have the potential to significantly influence the liquidity position of regional banking sectors, undermining the ability of individual institutions to carry out their core activity – extending credit to individuals and businesses.

Oil Prices

Consistent oil revenues in recent decades have enabled governments around the Gulf to implement large infrastructure spending programmes, but the reliance on a single revenue source has rendered them vulnerable to price shocks: any decline in hydrocarbons income tends to be mirrored by a constriction of the project pipeline. This in turn results in a drop-off in business for the whole chain of production – from large multinationals and domestic giants to the myriad small businesses that provide goods and services to them. For the region’s well-capitalised banks, such scenarios are generally a threat to profitability rather than stability. Margins may be squeezed, but fundamental ratios remain above regulatory minimums and business continues. However, a sustained drop in the oil price, such as the one that has persisted since late 2014, threatens more than net profits. Slowing project pipelines mean smaller deposits in banks from institutions and individuals, a phenomenon which is often the first herald of a looming liquidity squeeze. The problem is amplified when governments, attempting to meet the fiscal shortfall caused by falling oil revenues, are compelled to drawdown their deposits with domestic banks in order to meet their spending commitments.

Deposit Base

A basic rule of fractional reserve banking is that the erosion of the deposit base limits the ability of banks to lend, meaning they are unable to perform their proper function in the economy as agents of economic growth. In regulatory language, this involves banks hitting the loan-to-deposit (LTD) ratios set by regulators, which in the GCC tend to be at a conservative level. The result is a slowdown in private sector activity and economic growth as liquidity dries up. In some countries the situation is further exacerbated by governments ramping up their debt issuance programmes in a bid to keep projects moving and satisfy social spending requirements. In many cases the bulk of local-currency sovereign issuance is taken on by domestic commercial banks, further draining liquidity from the system and crowding out credit to the private sector.

Interbank Interest

The concern surrounding liquidity in the Gulf has meant that the interbank rate – the level of interest charged on short-term loans between banks – became one of the most closely monitored banking indicators over 2015 and 2016. During periods of low liquidity the interbank rate rises as available funds become more scarce, a simple correlation which makes it the most popular indicator in liquidity discussions.

The Central Bank of Kuwait (CBK), like most regulators in the region, has historically adopted a conservative stance with regard to its financial stability criteria, and as a result Kuwait’s banks are generally well capitalised and adequately liquid. Nevertheless, as the potential longevity of depressed oil prices became apparent in 2015, concerns were raised as to its effect on the local banking sector. The movement of the Kuwait three-month interbank rate, however, has shown no cause for alarm. Between the start of 2015 and first-quarter 2017, the rate increased from around 0.9% to 1.56%, a modest uptick which has not threatened the transfer of capital between lenders. A glance at the movement of Kuwait’s interbank rate over recent decades helps to place this minor alteration in perspective. During the 1980s, the interbank rate ran at a level of around 8%, sometimes broaching 10%, while during most of the 1990s it continued to remain stubbornly high at around 7%. The 2000s saw a significant improvement, with the rate dipping below 2% for the first time, but a heating economy in the run-up to the global economic crisis and the subsequent worldwide credit crunch saw the rate climb again – reaching around 6% in 2008. By 2010, however, the storm had been weathered and the rate was once more below 2%, where it has remained since.

Resilient Deposits

Kuwait’s stable interbank rate is easily explained. While deposit bases in some countries in the Gulf contracted during the challenging years of 2015 and 2016, Kuwait’s banking sector continued to attract deposits from both the private sector and the government. According to CBK data, resident private sector deposits with local banks increased by around KD1.4bn ($4.6bn), or 4.2%, over FY 2015/16, a gain which was attributable to an uptick in local currency deposits. Government deposits, the drawdown of which has challenged sector growth in other regional jurisdictions over the past two years, increased by KD779.4m ($2.6bn), or 15%, over the same period. While private sector deposits declined slightly later in 2016, the continued expansion of government deposits compensated for the downturn.

The resilient nature of Kuwait’s deposit base means that it has not faced the same liquidity challenge as many of its regional peers, and its banking sector has had no difficulty meeting the more stringent liquidity requirements introduced by the Basel Committee. The CBK’s most recent Financial Stability Report, published in 2016, expressed satisfaction with the liquidity position of its licensed lenders – despite the modest increase in the interbank rate – and highlighted the fact that banks were sitting comfortably above the newly introduced liquidity coverage ratio, which stood at 70% last year. Moreover, most lenders were also above the 100% liquidity ratio benchmark, which will be made effective starting from 2019.

Continued Defence

While the liquidity position of the local banking sector is not a concern, the Kuwaiti authorities have been mindful of the liquidity scenario both in their macroeconomic decisions and with their regulatory approach to the banks. At the macro level, the government’s decision to issue its first international sovereign debt instrument was partly motivated by a desire to borrow funds from the market without sucking capacity from the domestic system. The government chose to approach the market with two tranches, a $3.5bn offer of five-year notes which were issued at 75 basis points over similar-maturity US Treasuries, and a $4.5 issuance of 10-year bonds at a 100 basispoints spread. The appetite for the issuances was high, with the offer attracting around $29bn in bids according to some reports, with a wide geographical demand from the US, MENA and Europe. The government, therefore, succeeded in accessing cheap credit without the need to tap local banks and lower system liquidity (see Capital Markets chapter).

On the regulatory front, the CBK took steps to intensify its oversight of the sector in FY 2015/16. Beyond its routine on-site and off-site supervision, the regulator upgraded its stress-testing scenarios to take the oil price decline into consideration, implemented Basel’s net stable funding ration for both conventional and Islamic banks, and introduced a simplified LTD ratio of 90%, which replaced the previous variable framework of between 75% and 100%, depending on maturity.

Looking Ahead

The liquidity question, although not a pressing one, is likely to remain on the agenda for the medium term. While domestic borrowing by the government from the banking sector is relatively low, and Kuwait has demonstrated its ability to borrow cheaply from international markets, a KD2bn ($6.6bn) domestic borrowing plan will see this level rise. A slowdown in the real estate sector and muted corporate profits have the potential to negatively affect the liquidity scenario, but it is unlikely that the government will be compelled to take significant defensive measures.

However, should it feel the need to, its strong external position means that it is well placed to shore up liquidity by adding new deposits to the system. The liquidity squeeze felt elsewhere in the GCC is absent from the Kuwaiti banking arena, and looks set to remain stable in the period ahead.