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The Central Bank of Kuwait. Islamic banks in the country have a healthy funding base with a strong deposit franchise and healthy liquidity profile. Image Credit: Supplied

Dubai: Kuwait’s Islamic financial services sector is growing rapidly, with Islamic banking emerging as the most developed component of the industry, according to a recent study by the International Monetary Fund (IMF).

Kuwait’s Islamic banking industry has grown rapidly to become an important part of the domestic and global Islamic financial system. The country operates a dual system where Islamic and conventional financial institutions co-exist. The banking sector is the most developed part of the Islamic financial service industry and consists of full-fledged Islamic banks only, whereas Islamic windows are not permitted.

Other segments of the industry include investment companies, investment funds, insurance (Takaful), and reinsurance (ReTakaful) companies. The sukuk market has remained small and has been dominated by corporates issuing outside the country.

Islamic banks’ market share increased rapidly between 2005 and 2010 and has since then stabilised at around 38 per cent.

As of December 2015, Kuwait had the fifth-largest share of Islamic banking assets and the sixth-largest share of Islamic funds globally.

“Looking ahead, and notwithstanding challenges posed by the lower oil prices, the economic diversification effort could help drive further growth in Kuwait’s Islamic banking industry,” the IMF report said

Systemically important

Kuwait’s Islamic banking sector includes systemically important banks. The largest Islamic bank in Kuwait accounts for 23 per cent of total banking system assets, over 70 per cent of the Islamic banking assets and it has substantial cross-sector and cross-border operations. Some Islamic banks also have subsidiaries or associate companies with significant equity in financial and nonfinancial corporate subsidiaries and some of the subsidiaries or associate companies are incorporated abroad.

The assets of Kuwait’s Islamic banks are mainly debt-based instruments, thus their risk profile has broad similarities with those of conventional banks. Financing items, which are concentrated in real estate, personal loans and inter-bank lending, account for about 60 per cent of the total assets.

Investment activities are relatively moderate in magnitude, and they include management of direct equity and real estate investments as well as international leasing. Off-balance-sheet commitments, which range between 10 and 20 per cent of total assets, include LCs, acceptances and guarantees.

Key risks

Kuwait’s Islamic banks face some unique risks inherent in all Islamic banking models. Besides exposures to real estate sectors, through lending and collateral, these banks are allowed to establish subsidiaries or joint ventures in nonfinancial real estate corporations, thus their exposure to real estate is higher and more difficult to measure.

Even with strong supervision, the scale and complexity of corporate structures of the larger Islamic banks could present challenges for risk management, supervision and resolution, because of the presence of non-financial corporations and cross border operations in countries with diverse legal and regulatory frameworks. Such corporate structures, though central to the business model of Islamic banks, can create potential for related-party lending as well as contagion from other parts of the group.

The underdevelopment of Sharia-compliant financial markets and sukuk instruments continue to pose liquidity management challenges to Islamic banks. Like their conventional counterparts, Islamic banks in Kuwait have a healthy funding base with a strong deposit franchise and healthy liquidity profile. Over 60 per cent of the assets are funded by customer deposits, which include profit-sharing investment accounts (PSIAs).

Cost-to-income ratios have improved but remain higher than those for conventional banks.

Strong fundamentals

Kuwait’s Islamic banking sector is in a strong position to weather the challenges from low oil prices, but there are some downside risks. The capital adequacy ratio and Tier-1 capital remain above 15 per cent. Banks are also still highly liquid and provisioning ratios are high. However, the IMF note warns that with low oil prices persisting, deposit and asset growth for these institutions have, respectively, slowed down to 3.5 and 1.7 per cent in 2015 compared with the average of 9.5 and 10.4 per cent between 2010 and 2014. The real estate sector, to which Islamic banks have significant exposures through direct lending and indirectly through collateral, is also slowing down. Pressures in equity markets have also persisted and could contribute to non-performing assets.