Kuwait financial system remains bank-centric Chapter 1

This is the first part of the Financial Stability Report for 2015 published by the Central Bank of Kuwait.

Bank’s Financial Intermediation

After two years of double-digit growth, banking system posted a much slower expansion when viewed on consolidated basis; assets grew by a muted 2.6% during 2015. However, growth in domestic assets was relatively healthier at 5.7% on the back of strong growth in domestic credit which was up by 8.5% compared to 6.3% in 2014. Lending to the households was particularly strong at 10.6%, which made the household sector the top recipient of bank credit in 2015, surpassing the real estate sector. However, as bulk of the lending to households (83.8% in 2015) has been in terms of installment loans for repair and purchase of private homes, banks combined exposure to real estate sector reached almost half of their total credit portfolio. Yet the risk profile of installment loans is markedly different from banks’ direct lending to real estate and construction sector. Moreover, notwithstanding the apparent lack of diversification, banks’ credit portfolio itself has been fairly healthy with non-performing ratios at low levels (see Chapter 2). Finally, growth in banks’ consolidated deposits slowed down to 3% compared to 7.8% in 2014. Domestic deposits grew a tad better, posting 3.3% increase in 2015. Yet the banking system continued to enjoy a stable funding base as 63% of the total deposits were placed in the time deposit category.

Banks’ intermediation has ensured extensive financial inclusion

Financial intermediation by the banking sector continued to improve further in 2015, rather at a relatively sharp pace than what was observed in 2014. Accordingly, intermediation ratios, measured in terms of key banking variables relative to the nominal GDP, climbed up further.

Steady rise in financial intermediation ratios during 2015 was both on account of a relatively decent growth in the key banking variables (i.e. assets, loans and deposits) and sharp contraction in the nominal GDP amid record low oil prices. Specifically, while assets, loans and deposits increased in 2015 by 5.7%, 8.5% and 3.2% respectively, nominal GDP shrank by 22.5%, resulting in a much stronger rise in intermediation ratios than would have been possible in the case of positive GDP growth.

In general, banks’ role as financial intermediaries has ensured a fairly high degree of financial inclusion in Kuwait. For instance, The World Bank’s database on financial inclusion reveals that 86.8% of the population above the age of 15 years in Kuwait has an account with a formal financial institution.

Moreover, gender wise breakdown indicates that 92.7% male and 79.6% females above the age of 15 years maintain an account. These numbers suggest that Kuwait has the highest level of financial penetration compared to other countries in the Middle East & North Africa (MENA) region. Additionally, both male and female customers have fairly similar level of access to finance, when it comes to maintaining an account. As discussed in detail in Box 1.1 of our Financial Stability Report 2014, the level of financial inclusion in Kuwait is fairly high on other counts as well, putting Kuwait in the lead across the MENA region.

Financial system continues to remain bank-centric

Kuwait financial system continues to remain bank centric, as the banking sector accounts for around 82% of the domestic financial sector. Investment companies are the second major player in the domestic financial system with around 14% share as of December 2015. Investment funds, insurance companies, and exchange companies constitute the rest. Domestic banking sector consists of five conventional, five Islamic and one specialized bank. Moreover, Kuwaiti banks have sizeable presence in numerous other countries, with total assets of their subsidiaries & branches abroad accounting for 18.1% of the consolidated banking system.

When viewed on a consolidated basis, conventional banks dominate the overall banking system, with 60.7% share as of December 2015; however, their share has remained broadly the same since 2010. Islamic banks, with 38.3% share in consolidated banking system, represent one of the most significant presence of Islamic banks in any country across the globe with a dual banking system. Strong presence of Islamic and conventional banks underscores the effectiveness of CBK’s endeavors in ensuring a level playing field for both types of banks and also provides customers a variety of choices to fulfill their banking needs.

Decomposition of the balance sheet of the banking system highlights the prevalence of traditional instruments expected in a bank centric financial system. For instance, loans account for as much as 61% of the total assets as of December 2015. Investments, comprising of exposures to government securities, other fixed income instruments, equity investments and real estate investments, form the second major category with 15.6% share in total assets. On the liabilities side, deposits account for 59.2% of total liabilities, indicating a healthy deposit base to help Kuwaiti banks befittingly perform their intermediation role.

Growth in banking assets noticeably slowed down ….

After two years of double digit growth, consolidated banking assets posted significantly slower growth of 2.6% in 2015. Specifically, assets worth KD 1.7 billion were added to the banking system, putting total assets at KD 68.1 billion by December 2015. However, it was markedly slower expansion compared to the addition of KD 7.2 billion in 2014.

Flow data for the key components of banks’ assets reveals that slower asset growth was largely due to reduction in banks’ placements with both the central bank as well as other financial institutions. In particular, ‘Due from CBK’, which reflects banks’ placements with CBK, posted a substantial decline of KD 987 million in 2015; it was the first contraction since 2008 and suggests tightening liquidity conditions with reduced excess liquidity in the banking sector. Accordingly, CBK’s liquidity absorption (mopping up of the excess liquidity from commercial banks through interventions/tawarruq) noticeably tapered by the end of 2015 (see Chapter 4 for details). ‘Due from Financial Institutions’ which includes both interbank lending and placements, also posted much slower growth compared to 2014. Yet the growth in loans was healthy as non oil sector was able to grow well amid strong growth in capital expenditures and healthy trends in household borrowings, notwithstanding the drop in oil sector GDP.

…..yet domestic credit off-take remained strong

During 2015, banks’ consolidated loan portfolio expanded by another KD 2.9 billion, posting decent growth of 7.1%. While much lower compared to the growth recorded in 2014 (11.5%), credit off take was still fairly healthy. More significantly, domestic credit grew by an impressive 8.5% in 2015, compared to 6.3% a year earlier; it was encouragingly higher growth, particularly at a time when the Nominal GDP declined by 22% amid record low oil prices.

In terms of credit allocation to various types of borrowers, lending to large corporates accounted for around 71.7% of the total gross loans. A distant second was the households sector, with 23% share in overall credit and outstanding loans amounting to slightly above KD 10 billion as of December 2015. Though still limited, there has been a shift from corporates to households in terms of credit allocation as the share of household sector has marginally improved in the last few years.

On the other hand, share of SMEs in overall lending slightly decreased to 5.3% in 2015. To increase lending to SMEs, CBK has incentivized banks by using a preferential risk weight of 75% for SME finance. Moreover, at the national level, the Kuwaiti parliament approved a new law in March 2013 to establish the ‘Kuwait National Fund SMEs Development’.

The National Fund, in partnership with local banks will grant loans (under separate conventional and Sharia compliant schemes) up to a maximum of KD 500,000 to eligible SMEs by contributing 80% of the funding, while the remaining 20% will be provided by the partner bank(s).

Loans’ break up in terms of lending to the public and private sectors reveals that almost the entire lending was directed towards the private sector (99.2%), while the share of lending to the public sector further slipped to a paltry 0.8% during 2015. With huge accumulation of assets over the last decade, the need for public sector to borrow from the banking system have remained minimal. Strong financial profile of the public sector has also helped Kuwait avoid the issue of private sector crowding out that countries with frequent government borrowing from the banking sector typically experience.

Currency wise breakdown of the gross loans indicates that almost 70% of the overall lending was in the domestic currency, though the share of foreign currency (FC) loans improved from 26% in 2014 to reach 30% by 2015. Within FC loans, around 60% in 2015 were granted by Kuwaiti banks’ subsidiaries & branches abroad (FC out of Kuwait).

Geographical breakdown of banks’ lending portfolio reveals that out of banks’ 43.7 billion of gross loans as of December 2015, almost KD 32 billion (73%) have been granted within Kuwait. The remaining 27% of the gross loans have been distributed across various regions, with Europe and GCC accounting for around 10.2% and 9.5% respectively. Within GCC, banks’ greatest credit exposure is confined to Bahrain, followed by UAE and Saudi Arabia.

Credit growth was positive for all key sectors

Breakup of gross loans across various sectors indicates that all key sectors experienced positive growth in terms of credit off take. Noticeably, households became the major recipient of bank credit in 2015, surpassing the real estate segment that has traditionally been the top beneficiary of bank lending. The shift in banks’ lending away from real estate and towards households, while muted at present, underscores banks’ changing preference in favor of low risk areas.

Banks’ lending to investment companies also posted positive growth in 2015, thus bucking the trend of earlier years; however, its share in banks’ overall loan portfolio remained stagnant around 2.8%. Still, this marginal increase in lending to investment companies seemingly marks the reversal in the trend of deleveraging that the sector has been experiencing since 2009.

Notwithstanding the above mentioned shifts, the broader trend in loans over the years reveals that banks’ collective exposure to key sectors have remained largely stable, with little indication of a sudden surge in any specific sector. A relatively stable trend in credit allocation suggests that banks have avoided the boom and bust cycles in their lending practices, underlining a conservative approach towards credit allocation. However, concentration remains high as four sectors (real estate, households and trade and services) account for almost 64.5% of the entire credit portfolio.

Households & Real estate are leading recipients of bank credit

Banks’ credit to the households grew by 10.6% in 2015 to reach KD 10.1 billion, making household sector the top recipient of bank credit in Kuwait followed by the real estate sector (KD 9.4 billion). While growth in household credit was lower compared to 2014 (11.8%), it was still in double digits for the fifth consecutive year. Breakup of household loans reveals that around 83.8% of the household loans have been installment loans, which are long term personal loans for repair and purchase of private homes. These loans are repaid in monthly installments over a period not exceeding 15 years. Consumer loans, meant for purchase of consumer durables or to cover education/medical expenses, constituted the second major category of household loans with 13.8% share as of December 2015. Finally, credit card related loans made around 2.4% of overall household loans.

Banks’ lending to the real estate sector visibly slowed down in 2015 (2.2%) compared to much stronger growth in 2014 (8.4%). As a result, share of the real estate loans in banks’ overall credit portfolio marginally declined from 22.5% to 21.5% during 2015. Both conventional and Islamic banks had somewhat similar size of exposure to the real estate, with conventional banks’ accounting for a slightly higher share (51.2%) in 2015.

Given the fact that bulk of the household loans are being used for repair and purchase of private homes, banks’ overall exposure to the real estate is significantly greater than what appears from their direct lending of KD 9.4 billion. Banks’ combined exposure to the real estate can be viewed in terms of their lending to (i) real estate sector (ii) construction sector and, (iii) installment loans to the households. Adding up the lending under these three categories, banks’ exposure to real estate accounts for almost half of their entire lending portfolio. Yet the risk profile of installment loans is markedly different from banks’ direct lending to real estate and construction sector. Moreover, notwithstanding the apparent lack of diversification, non performing loan ratio in the household and real estate & construction sectors has been at low levels (2.5% and 2.4% respectively in 2015), indicating limited degree of infection (see Chapter 2). Additionally, as highlighted in Chapter 4, no major correction in real estate prices has been observed though sales values have significantly come down. This suggests the presence of genuine demand amid supply bottlenecks particularly in the residential segment.

Banks’ equity investments retreated amid falling stock prices

Banks’ investment portfolio posted a modest growth of 2.3% in 2015 compared to 2.1% in 2014. While investments in associates recorded a major contraction (down 11.5%) in 2015, investments in real estate and other fixed income went up by 8.5% and 8.2% respectively. Investments’ breakdown reveals that out of KD 10.6 billion of total investments, around KD 5.2 billion (49.2%) were placed in government securities as of December 2015. Banks’ equity investments formed the second major category with 22.8% share in total investments. In the last few years, banks’ exposure to other fixed income securities has been on the rise in particular; during 2015, it reached 19.6% of overall investments compared to 13.9% in 2012.

Geographical distribution indicates that banks’ investments within Kuwait marginally declined from 45.2% in 2014 to 43.3% in 2015. Moreover, a slight decrease in banks’ investments in Europe was also observed. On the other hand, banks’ exposure to all other regions went up, particularly in the countries within GCC, Africa, Asia etc. These trends collectively underscore the improving diversification of banks’ investment portfolios.

Growth in deposits markedly declined

During 2015, banking system deposits posted slower growth of 3%, compared to much stronger increase recorded during the earlier three years. Deposits raised through subsidiaries and branches abroad grew at an even slower pace (2.1%) compared to the growth in domestic deposits (3.3%), though the growth in both categories was significantly lower than in 2014. Overall, deposits reached KD 49.2 billion as of December 2015, with domestic deposits accounting for 76.8% of total deposits of the consolidated banking system. Over the years, the share of deposits from abroad has been slowly increasing due to the growing expansion of Kuwaiti banks abroad. Specifically, this share has gone up from 15% in 2007 to 23.2% in 2015 (though marginally lower than 23.4% recorded in 2014).

Around two-thirds of banks’ deposits are time deposits

Breakdown of deposits reveals that time deposits account for around 63% of the total deposits, highlighting the stable funding base of the banking system capable of providing stability under times of liquidity stress. Retail deposits are well diversified into three different categories (demand, saving and time), in line with the consumers’ transaction and precautionary demands for money. Finally, the deposits of other financial institutions (OFI) and government are overwhelmingly placed as time deposits. Given the strong fiscal profile of the government, presence of its deposits in the time deposit category further adds to the stability of banks’ funding base.

Islamic Finance: Past, Present and the Future

Your Excellencies, Distinguished guests, Ladies and Gentlemen,

A very good morning - it is a great pleasure for me to welcome you all.

I am deeply indebted to all the honorable ministers and governors of central banks and other distinguished guests for joining us today on this auspicious occasion. In particular, I would like to warmly welcome and thank Madame Christine Lagarde, Managing Director of the International Monetary Fund (IMF) for graciously supporting this endeavor and personally attending this conference.

I would also like to sincerely thank the staff of the IMF, the staff of the Middle East Center for Economics and Finance in Kuwait and my dedicated colleagues at the Central Bank of Kuwait (CBK) for their efforts in making this conference a success.

It is the first time that the IMF is cohosting a conference on Islamic Finance such as this, and the Central Bank of Kuwait is privileged to be a partner in organizing this historical event.

Taking this opportunity, I would like to share a few thoughts on the progress of Islamic finance in a historical context. My speech is set against three different times, covering the past, the present and the future. I will start with a very brief history of Islamic finance, particularly in the context of Kuwait, then turn to cover the present, and finally reflect upon its future. This broad sweep through history will hopefully help us see where we started from, how far we have reached and where we are heading next.

1-Islamic finance of the past; a humble beginning

Let me start with the past. Around 38 years ago, in the same city as we are meeting today, a pioneer, Sheikh Ahmed Al- Yasin, envisioned the possibility of establishing an Islamic bank. Back in the mid-1970’s, many would have considered it mere daydreaming. After all, there was hardly any role-model of Islamic finance to emulate. In the words of Sheikh Al-Yasin himself, thinking of establishing an Islamic bank was ‘like swimming against the tide’. It was a time when only conventional banks were in vogue; we ourselves had six of them in Kuwait. So it required a big leap of faith to establish an Islamic bank when there was virtually no example to learn from. Despite these challenges, Kuwait witnessed the establishment of Kuwait Finance House (KFH) - not only the first Islamic bank in Kuwait - but also one of the very first established anywhere in the world.

It was a humble start; with only four employees, KFH opened its doors to the public for the first time on August 31st 1978. I doubt anyone imagined that it would one day become a leading Islamic bank, with 8,000 employees and operations spanning across seven regions of the world.

The growth of Islamic finance as an industry is equally impressive. This is however hardly surprising, as the basic principles of Islamic finance deservedly have a universal appeal, irrespective of religious beliefs.

Adam Smith, the father of modern economics, argued that it is the pursuit of self-interest by individuals that leads, somewhat unintentionally, to the welfare of society as a whole. Islamic teachings, however, offer a more encompassing guide by making the broader interests of society central to our efforts. Fourteen centuries ago, the Prophet Muhammad (peace be upon him) said: Wish for the mankind what you wish for yourself.

This is the golden rule of a good society, a principle that has been conveyed by almost every major religion or ethical tradition. It goes beyond Adam Smith’s idea of an invisible hand in the sense that society’s welfare is not an accidental outcome. Rather, the golden rule requires that anything that harms a society is prohibited, even if it is beneficial for the individual.

And the golden rule epitomizes the concept of justice which is central to Islamic finance. Justice, in economic context, requires at least two things; proper allocation of resources for the welfare of the entire society, and sharing of risk and reward.

Since banks mobilize savings from a large group of people and lend to relatively fewer borrowers, there is an element of asymmetry in banks’ resource mobilization on the one hand, and resource allocation on the other. This necessitates that banks, in the world of Islamic finance, lend to those who can use these savings to benefit the whole of society – by making productive investments and creating more jobs.

However, in recent years, excessive liquidity amid unconventional monetary policies has mostly fueled asset growth, with limited impact on real economic activity. As Madame Lagarde rightly pointed out in one of her speeches last year, ‘there is too little economic risk-taking and too much financial risk-taking’.

Islamic finance, by establishing an inseparable link between finance and the real economy, encourages economic risk taking that helps improve growth and create jobs. It requires that credit must be provided for productive investments, not for conspicuous consumption or speculative activities.

To be continued tomorrow