Are Kuwaiti banks sufficiently prepared for the future?

Banks at risk as govt slows its spending plans and global economy heads into next recession

This is the first part of a report by Tariq Sayyid Jamal Al-Rifai, an External Consultant on the challenges facing Kuwait’s banking sector.

By Tariq Sayyid Jamal Al-Rifai

Over the past ten years, adoption of new technologies has transformed the banking industry globally. The industry today is much different than it was only a few years earlier. There is no other time in recent history where the banking industry was forced to change at such a rapid pace. In fact, many industry experts have predicted the fall of the traditional banking model as disruptive new entrants take away market share by offering customers a better experience through new technologies and channels.

However, despite the current disruptions in the industry, traditional banks have a bright future if they are willing adapt and innovate. There will be winners and losers over the next few years. The winners will be the institutions that choose to innovate and transform themselves in order to prepare for the future. The future will require banks to be agile and willing to change. The losers will be banks that fail to shift gear and change their business practices. These institutions will be at a high risk of being left behind as their business model becomes obsolete. Staying the same is not an option.

The current landscape has changed significantly from where it was 10 years ago in response to the evolving forces of customer expectations, regulatory requirements, technology, demographics, new competitors and shifting economics. What is unique about the change in the industry today the rapid pace at which it is occurring. The industry has historically changed slowly – evolutionary change. Today’s change is more revolutionary.

Many of the industry leaders are innovating and experimenting with new products, delivery channels and analytics. With the move towards mobile banking and automation, these banks are also having to put a lot of resources on training and building systems that facilitate these changes. In addition, the banks at the forefront of innovation are choosing to reducing their branch networks in favor of investing in new technologies. However, they face intense competition from high-end fintech companies in providing a better experience for users.

What does all this mean for the banking industry in Kuwait? With the globalization of the industry, changes taking place in one part of the world are spreading to other regions. Banking customers in Kuwait have the same desires and expectations as customers in Europe and Asia. The quick adoption of mobile banking in Kuwait coupled with the rise in the importance of social media are putting pressure on the traditional banking model in the country. The challenges facing banks in Kuwait today is no different than the challenges banks face in other countries around the world. The question is, are banks in Kuwait preparing for the future?

Kuwait’s financial services sector is robust and broad-based for the size of its economy. The Central Bank of Kuwait (CBK), the country’s banking regulator, is a conservative regulator playing a more active role in oversight of local banks than other countries in the region. As such, Kuwait’s banking system was able to weather to Global Financial Crisis better than other banking systems in the region.

Though Kuwait’s banks are stronger today than they were 10 years ago, to the credit of the CBK, there are still risks that they face as the global economy heads into the next recession. There are also risks the sector will face should the government slow its spending plans as outlined in its 2035 Future Vision Plan.

The Central Bank of Kuwait currently supervises and regulates 11 Kuwaiti banks and 12 foreign banks. It also regulates the loan books of 56 finance and investment companiesii. Of the 11 Kuwaiti banks, 10 serve the retail sector and one, The Industrial Bank of Kuwait, serves the industrial sector. There is intense competition among these banks for market share. However, two banks dominate the market; National Bank of Kuwait (NBK) and Kuwait Finance House (KFH). Total assets of these two banks represent 56% of the total assets in the banking sector (Fig 1).

Kuwaiti banks have proven to be resilient in the face of the slowdown in government spending in 2016 and 2017, which was caused by the collapse in the price of oil from June 2014 to January 2016. In 2017, Kuwait’s economy experienced a brief recession as a result of this slowdown. In spite of this, however, Kuwaiti banks continued to show improvements in nearly all key financial ratios unlike some of their peers in the GCC, which were impacted by the slowdown in government spending in their respective countries. Over the past three years, performance of the banking sector has improved across most key performance indicators. This has been mainly attributed to improved government finances and a continued and sustained growth in consumer spending.

The loan-to-deposit ratio (LDR) has been slowly rising over the past three years driven by smaller banks’ rise in lending. The LDR is used to assess a bank’s liquidity by comparing a bank’s total loans to its total deposits expressed as a percentage. A high ratio it means that the bank may not have enough liquidity to cover any unforeseen funding requirements. A low ratio indicates that the bank is underperforming and could be a sign of other problems within the bank. It is within range to expect smaller banks, such as Warba and Kuwait International Bank, to have a higher LDR ratio than the larger banks, such as National Bank of Kuwait and Kuwait Finance House. There has been a steady improvement in the LDR of Kuwaiti banks as can be seen in (Fig 2).

The Capital Adequacy Ratio (CAR) is a measure of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposures. Kuwaiti banks have been able to maintain high ratios well above the 13% mandated by the CBKiv and per Basel III rules (10.5%).

Kuwaiti banks, however, have been slightly underperforming their peers in the GCC in terms of Return on Equity (ROE) as can be seen in Figure 4. Five banks; Ahli United Bank of Kuwait (AUBK), Boubyan Bank, Burgan Bank, KFH and NBK, outperformed their peers in Kuwait in 2018. Whereas, Warba Bank and Ahli Bank of Kuwait (ABK) underperformed during the same period.

The Kuwaiti banking sector has the lowest non-performing loan (NPL) ratio in the GCC. Kuwait’s banks have been very successful in lowering this ratio over the past three years, as can be seen in (Fig 5). In fact, the Commercial Bank of Kuwait, for example, reported a 0% NPL ratio in 2018. This sector-wide low ratio is due to higher asset quality, higher provisions requirements and close monitoring by the CBK of all banks’ bad loans. A ratio below 2% is considered to be excellent for a country’s banking system.

Banks in Kuwait, as well as the rest of the GCC, have maintained cost-to-income ratios (CIR) below their peers in other regions, including North America, Europe and Asia. The CIR for Kuwaiti banks in 2018 was 37.9%, compared to a GCC average of 41%. The CIR for banks in Kuwait and the rest of the GCC continues to be much lower than in other regions according to S&P Global. The average CIR for banks in the US was 61.6%, 59.5% in Japan, 76.1% in the UK and 80.7% in Germany.

With the 23 foreign and domestic banks operating in Kuwait, the country is not over-banked when compared to its peers in the GCC as can be seen in (Table 1). Within the GCC, Bahrain is the most overbanked, followed by Qatar and the UAE respectively. Another measure would be to compare the number of bank branches to a country’s total population. However, we believe that the number of licensed banks in the country gives a better indication of the competitiveness in the market.

An issue of more concern is the size of the banks in the country. Two banks in Kuwait; NBK and KFH, dominate the industry with 56% of total banking assets. The remaining eight banks hold 44% of total banking assets. Thus, the Kuwaiti banking sector is dominated by two banks, one conventional and one Islamic.

There are four global trends that can impact the national economy and the banking sector; the aging economic cycle, the shift away from fossil fuels, rising interest rates and a global trade war. These four trends are described below;

The current economic growth cycle, which has lasted longer than all previous economic cycles, is mature and the most likely scenario over the next year or two is that this cycle changes from a growth cycle to a contractionary cycle (recession).

There are already signs of widespread economic slowdown around the world, with the exception of the US, which has seen a sustained rise in economic growth. Outside of the US, GDP growth in the three largest economies; the EU, China and Japan, are all trending lower.

The latest GDP figures from the EU show GDP growth slowing to 1.2% as of Q1 2019 compared with a 2.7% in Q4 2017. In 2017, by the way, the EU witnessed its highest GDP growth rate since 2007, which is another sign of how anemic growth has been across the EU. The primary reason for this is the fact that the EU has been unable to fix the structural problems in its economy and GDP growth has suffered as a result. This lackluster growth coupled with rising debt levels places the EU in a high-risk position during the next economic downturn.

GDP growth in China has also slowed down to 6.4% in Q1 2019, which was its lowest recorded growth rate in 28 years. Economic growth in China has been slowing down for years. The Chinese government has been trying to manage a slowdown so that it does not affect the wider economy. We believe that the economy will slow down faster than the government expects as recent economic indicators have been reported below expectation. As a result, the trend towards slower GDP growth in China also means slower growth in demand for oil, which has been the largest source of new oil demand over the past decade.

In January 2019, the International Monetary Fund (IMF) lowered its global growth forecast for 2019 from 3.7% to 3.5% citing the trade war between the US and China along with economic weakness in EU countries, namely Germany and Italy, as reasons for this lower forecast.

Over the past ten years we witnessed the price of oil collapse twice. This phenomenon had never occurred prior to this period. Over the course of an 18-month period, From January 2007 to July 2008, the price of oil shot up nearly 200% reaching a record high of $143/bbl. An impressive rise by any standard.

It was then followed by the fastest price collapse in the commodity’s history falling over 75% over the next 5 months to settle at around $34/bbl. It took one year for the price to recover above $80/bbl and stayed above that price for the next four years. In June 2014, the second collapse began, falling over 78% over the next 19 months. It took nearly two years for the price to recover above $80/bbl. As can be seen in (Fig 8), price collapses occur suddenly and fall at a faster rate than the price rise period. Since 2008, the price of oil has been unable to reach a new high, and in fact, has been unable to rise up above $100/bbl where it had traded for nearly four years. Thus, the price of oil will remain volatile and its direction will be dependent on the strength of the global economy.

Since 2009, world-record low interest rates were set by the leading central banks as a way to stimulate the global economy after the financial crisis. Ten years later, most central banks are still worried about raising rates believing that their economies have become too dependent on record low interest rates. Some economists view this as a permanent state of central bank economic support and stimulus.

The US Federal Reserve was one of the few central banks that raised rates over the past few years. This has had a noticeable impact on emerging markets as we witnessed last year with first Argentina’s currency collapse, followed by Turkey and other emerging markets. Emerging markets were first to feel the pain of rising rates due to their foreign currency borrowings. In times of rising economic growth, borrowing more can help increase the rate of growth. On the flipside, in a slowing economy rising debt will only amplify a country’s economic problems, especially if they are in foreign currencies.

Higher interest rates in the US are driving US dollars back to the country seeking safety, while emerging markets struggle to keep their currencies stable versus the dollar in order to be able to pay back their foreign currency debts. This can be seen today by the near record high US stock indices and poor stock market performance of emerging markets dependent on foreign capital such as Egypt, Mexico, Pakistan and Turkey. The Federal Reserve has recently started lowering rates again as it has become concerned with the global growth outlook.

Trade wars are not a problem on their own. They are a symptom of other problems in the global economy, namely, unsustainably high national debts coupled with lower than expected GDP growth. The current trade war between the US and China has been going on since March 2018 and has begun to affect global trade.

Higher tariffs between the two countries have been implemented in stages as both sides try to negotiate an end to the dispute. The longer it takes for both sides to reach an agreement, the greater impact it will have on the global economy.

China, however, is in a weaker position than the US. It is far more dependent on exporting to the US than the US is to exporting to China. Therefore, higher tariffs on both sides will disproportionately harm China more than the US. The escalation of the trade war has already begun to impact global economic growth. This, in turn, can directly impact oil prices and Kuwait’s economy. In addition, it’s important to note that China and the US are Kuwait’s largest trading partners respectively.

To be continued tomorrow