Kuwait
Financial System Stability Assessment
Author: International Monetary Fund. Monetary and Capital Markets Department
Publication Date:
02 Apr 2019
eISBN:
9781498306409
Language:
English
Keywords:
ISCR; CR; banking sector; central bank; liquidity ratio; capital market; financial system; bank financing; insolvency framework
Download PDF (1.2 MB)

This Financial System Stability Assessment paper discusses that Kuwait’s limited economic diversification is directly reflected in the bank-centric financial sector. Banks have high concentrations to single borrowers, large depositors, and sectors, as well as significant common exposures. Risks to the financial sector are mostly external, stemming from oil price shocks, geopolitical tensions, and global financial developments. The risks are mitigated by sizeable sovereign financial assets, and by the ability of public entities to provide liquidity through large deposits. Stress tests suggest that banks are resilient to a wide range of shocks. The newly developed regulatory framework for capital market participants and products is an important step, but some gaps remain. The authorities have made important progress in strengthening the macroprudential framework. The crisis management framework and financial safety net arrangements should be strengthened and further operationalized. The diversification and resilience of the economy is expected to benefit from better financial inclusion of small-and-medium enterprises.

Abstract

This Financial System Stability Assessment paper discusses that Kuwait’s limited economic diversification is directly reflected in the bank-centric financial sector. Banks have high concentrations to single borrowers, large depositors, and sectors, as well as significant common exposures. Risks to the financial sector are mostly external, stemming from oil price shocks, geopolitical tensions, and global financial developments. The risks are mitigated by sizeable sovereign financial assets, and by the ability of public entities to provide liquidity through large deposits. Stress tests suggest that banks are resilient to a wide range of shocks. The newly developed regulatory framework for capital market participants and products is an important step, but some gaps remain. The authorities have made important progress in strengthening the macroprudential framework. The crisis management framework and financial safety net arrangements should be strengthened and further operationalized. The diversification and resilience of the economy is expected to benefit from better financial inclusion of small-and-medium enterprises.

Executive Summary

Since the 2010 FSAP, the financial system has withstood the real-life stress test of a severe drop in oil prices and the authorities have strengthened their framework. Banks, which constitute the largest part of the financial sector, have maintained high capital ratios, comfortable liquidity buffers, and high provisions, while nonperforming loans (NPLs) reached historic lows in 2017. The authorities proactively developed their regulatory and supervisory framework, notably by implementing Basel III for banks and establishing a regulatory and supervisory agency for capital markets, the Capital Markets Authority (CMA).

Kuwait’s limited economic diversification (characteristic of small oil-dependent economies) is directly reflected in the bank-centric financial sector. Banks have high concentrations to single borrowers, large depositors, and sectors, as well as significant common exposures. Risks to the financial sector are mostly external, stemming from oil price shocks, geopolitical tensions, and global financial developments. The risks are mitigated by sizeable sovereign financial assets, and by the ability of public entities to provide liquidity through large deposits.

Stress tests suggest that banks are resilient to a wide range of shocks. The banks follow simple business models, funding themselves through deposits and extending credit to the domestic private sector, with a large share of lending to government employees, and they have limited foreign exchange (FX) mismatches. Solvency stress tests, which assume—based on historical patterns—that government spending is sustained during periods of oil price correction, identify minor capital shortfalls in three banks under a severely adverse scenario, while banks would remain well above the regulatory floor under an adverse scenario. Interest rate and FX risks appear to be well managed and are unlikely to destabilize the banking sector. Single factor sensitivity analyses point to limited vulnerabilities, when compared to the current levels of bank capital, arising from single borrower and sectoral credit concentration. The abundance of liquidity allows most banks to comply with the prescribed liquidity ratios, even under severe stress, although buffers would be reduced.

The supervisory regime is effective, although there is room for improvement in certain areas. The Central Bank of Kuwait (CBK) updates its supervisory framework on an ongoing basis to incorporate international best practices, and the supervisory approach is appropriate. Further improvements could include enhanced integration of on- and off-site supervision, a strengthened consolidated supervision framework, and bolstered inspections of banks’ foreign-owned branches to improve the supervision of cross-border operations. Islamic banking—which accounts for 39 percent of assets—is exposed to specific operational risks, including regarding the interpretation of Shariah compliance, and would benefit from a centralized Shariah board at the CBK.

The recently developed regulatory framework for capital market participants and products is an important step, but some gaps remain. The CMA should establish a strict separation of commercial and securities market activities of licensed persons to isolate risks. On the supervisory front, the CMA should gradually shift from a comprehensive compliance-based approach towards risk-based supervision.

The authorities have made important progress in strengthening the macroprudential framework. The CBK has established a Financial Stability Office (FSO) to monitor systemic risks and has been publishing annual financial stability reports since 2012. The institutional setting should be further strengthened by assigning an explicit financial stability mandate to the CBK. The authorities should also establish a formal coordination mechanism between the agencies overseeing the financial sector—the proposed Financial Stability Committee (FSC) is a welcome step in this direction. To enhance the effectiveness of its macroprudential toolkit, the CBK should focus on filling data gaps and calibrating macroprudential tools.

The liquidity management framework has served the CBK well. The ample liquidity in the banking system provides comfort but limits banks’ exposure to—and potentially their ability to manage—normal fluctuations in liquidity. The CBK is well equipped to absorb the excess liquidity that stems from the country’s sizeable oil revenues. Improvements should include a refinement of the liquidity forecasting framework and a strengthening—and periodical testing—of both liquidity-absorbing and supplying tools.

The crisis management framework and financial safety net arrangements should be strengthened and further operationalized. Since the last FSAP, the CBK has been working toward strengthening the crisis management framework for the banking sector through several actions. A bank-specific insolvency framework has been incorporated into the draft commercial insolvency law; the framework for Emergency Liquidity Assistance (ELA) has been improved; and the CBK is contemplating the establishment of a stand-alone bank resolution unit, independent of supervision. While some elements are already in place, a more comprehensive, structured and formalized framework for corrective actions and bank recovery and resolution is needed. In addition, the existing blanket guarantee on deposits should be gradually unwound and replaced with a suitably structured Deposit Insurance Scheme (DIS), once pre-conditions are met. The large Islamic banking sector introduces an additional layer of complexity, as the authorities need to ensure the development and implementation of Shariah-compliant solutions for crisis management, recovery and resolution, and deposit insurance of Islamic banks.

The diversification and resilience of the economy would benefit from better financial inclusion of SMEs. The National Fund strategy should be adjusted to refocus activities from direct financing to leveraging financial intermediaries (e.g., through co-financing, on-lending, and risk sharing). Further efforts should focus on enabling the market for SME finance, including the adoption of a new insolvency law and of a secured transaction law, the establishment of an electronic registry for movable collateral, improvements in credit reporting on commercial lending, and a gradual relaxation of the interest rate cap. In addition, the authorities should encourage competition through alternative financial instruments and players.

Table 1.

Kuwait: FSAP Key Recommendations

article image

(ST) = within one year; medium-term (MT) = one to three years; long-term (LT) = three to five years.

Macrofinancial Setting

1. Kuwait is an oil-dominated economy that has proved resilient to shocks since the last FSAP in 2010. Prudent fiscal management allowed the country to record high fiscal and external surpluses and build strong financial buffers during periods of high oil prices. The resulting fiscal space allowed the authorities to smooth the impact of low oil prices after 2014 and to support growth through sizeable investment spending (Figure 1). Banks remained liquid throughout the period of low oil prices, and equity prices, after declining from 2014 through to 2016, have been recovering somewhat in 2017 and 2018.

Figure 1.
Figure 1.

Kuwait: Macrofinancial Environment

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Sources: Kuwaiti authorities; sovereign Wealth Fund Institute; and IMF Staff calculations.

2. The financial system is bank-centric, with Islamic finance playing a significant role. Financial system assets stood at 252 percent of GDP at end-2017 (Table 2) and are mostly held by the banking sector, which is itself dominated by two major banks. Foreign banks operate through branches, and account for less than four percent of consolidated banking assets. The non-bank financial sector, which is dominated by investment companies (ICs), has been declining in importance since the GFC. The insurance sector is under-developed: its assets account for less than one percent of GDP. While conventional finance dominates, the Islamic banking sector is one of the largest in the world in terms of its share in consolidated banking assets (40 percent), and 55 percent of assets held by investment companies (ICs) are managed according to Islamic finance principles.

Table 2.

Kuwait: Financial Sector Structure, End-2017

article image
Sources: Central Bank of Kuwait and IMF staff calculations.

Foreign branches do not include Ahli United Bank, which is already included in the top 10 banks. One of the foreign-owned branches is Islamic.

uA01fig01
Sources: World Bank Finstats Database, 2016 or latest available, World Bank Global Financial Development dataset, authority data, and IMF staff calculations.

3. Banks operate relatively simple business models and continued to see their activity grow despite the fall in oil prices. Assets are dominated by claims on the domestic private sector and by net foreign assets. Domestic credit is concentrated on the household sector (43 percent), where installment loans for home purchase and repair dominate, and on the real estate and construction sectors (28 percent). Funding is mostly originated through deposits (two-third of total). At the system level, the capital adequacy ratio (CAR) remained consistently well above the minimum requirement of 13 percent, hovering between 17.5 and almost 19 percent between 2011 and 2017. The liquidity ratio—supported by the large oil-financed government spending—remained comfortably above the 18 percent regulatory requirement, reaching 27.8 percent in June 2017 and further improving through September 2018. Asset quality improved steadily despite the slowdown in growth, with NPLs hitting a low of 1.9 percent at the end of 2017, with a provisioning coverage ratio of 230 percent. Despite conservative provisioning requirements, profits have been stable. In addition to prudent regulation and supervision, the banking sector benefited from general government support to the economy: an increase in public sector deposits partly offset a slowdown in private sector deposit growth, and countercyclical public spending supported credit growth, credit quality, and financial stability. Banks also proactively maintained the quality of their balance sheets by actively writing off non-performing assets against provisions (Figure 3 and Table 3).

Figure 2.
Figure 2.

Kuwait: Financial Sector Indicators

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Sources: CBK and IMF staff calculations.
Figure 3.
Figure 3.

Kuwait: Stress Test Scenarios and Results

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Sources: CBK and IMF staff calculations.1/ Estimations did not include the 1992–1993 war period.2/ Green bands represent individual banks’ maximum and minimum NPL ratios.
Table 3.

Kuwait: Selected Economic Indicators, 2014–24

article image
Sources: Data provided by the authorities; and IMF staff estimates and projections.

Calculated on the basis of real oil and non-oil GDP at factor cost.

Based on fiscal year cycle, which starts on April 1 and ends on March 31.

Starting FY2016/17, there has been a reclassification of expenditure items.

Excludes investment income and pension fund recapitalization.

Excludes debt of Kuwait’s SWF related to asset management operations.

Excludes SDR holdings and IMF reserve position.

For 2018, based on latest available data.

Does not include external assets held by Kuwait Investment Authority.

uA01fig02
Source: Central Bank of Kuwait.

4. The IC segment has shrunk significantly since the GFC, under challenging market conditions and tightened regulation. The business models of ICs vary widely. Since 2008, they have been shifting away from proprietary investment towards asset management and financial services. With the establishment of the Capital Markets Authority (CMA) in 2011, Is have also been subject to enhanced regulation and supervision. They have reduced their leverage, relying increasingly on own funds (48 percent of total funding in February 2018), while local bank financing declined from 40 to 23 percent of total funding between 2016 and 2018. The interconnectedness between ICs and banks—an important source of systemic risk at the time of the last FSAP—has declined substantially, as the exposure of banks to ICs fell from 12 percent of total banking assets during the GFC to 2.4 percent in 2017. On balance sheet, ICs are mainly exposed to foreign assets (about one third of total assets) and domestic financial investments (23 percent).

uA01fig03

Investment Companies: Assets

(In billions of KD)

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Source: Central Bank of Kuwait.
uA01fig04
Sources: Central Bank of Kuwait and IMF staff calculations.

5. Capital markets development is limited.

  • The bond market is nascent. Between 2015 and 2017, the government increased issuances of 2-to 10-year maturity bonds to cover its funding needs and extend the risk-free yield curve. The CBK issues 3- and 6-month bonds and Tawarruq for liquidity management purposes. Risk-free securities—around 20 percent of GDP in total—are almost entirely held by banks to maturity. Consequently, there is no secondary market or market yield curve.

  • By capitalization, the stock market is the second largest in the GCC in percent of GDP, but its liquidity is limited. At the end of 2017, 177 companies were listed, with banks, followed by other financial services, industry, telecom, and real estate, making up most of the listings. However, turnover was limited, representing 20 percent of a market capitalization equivalent to 80 percent of GDP.

uA01fig05

Domestic Government Bonds and Tawarruq Outstanding

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Sources: World Bank Finstats Database, Swiss RE, CBK, and CMA.
uA01fig06

Government Bonds and Tawarruq Outstanding by Maturity, May 2018

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

uA01fig07

Stock Market Capitalization

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Sources: World Bank Finstats Database, Swiss RE, CBK, and CMA.
uA01fig08

Stock Trading Volume by Sector, 2017

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Vulnerabilities and Risks

6. Oil-dependency and the small size of the economy define Kuwait’s financial vulnerabilities. Banks have high concentrations to single borrowers, large depositors as well as significant common exposures (Figure 2). They also have sizeable sectoral concentrations, notably in real estate. Banks have been looking for growth opportunities outside of the country and expanded foreign operations, increasing foreign assets to 20 percent of their assets. While FX mismatches appear negligible due to the small net open positions, the growth of foreign operations may pose a challenge to effective supervision.

uA01fig09

Top Three Exposures to Capital and Loans, 2017

(in percent)

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Source: Central Bank of Kuwait.

7. Islamic banks present a similar risk profile to conventional banks, but face additional operational risks related to Shariah compliance. The Islamic banking sector has for the most part a simple corporate structure, and its business model is very similar to the one of conventional banks: banks are mostly performing financing operations and rely essentially on deposits-like funding on the liability side. However, they face specific operational risks related to possible divergences of interpretation regarding the Shariah-compliance of their products.

8. Risks to the financial sector stem mostly from external shocks, but large buffers are major mitigating factors. Oil price shocks, geopolitical tensions and global financial developments are the main source of risks (Appendix I), and could affect credit quality, deposit growth, financial conditions, investor confidence and asset valuations. Large buffers in the banking sector and ample public-sector resources would however be available to mitigate financial sector risks.

Systemic Risk Assessment

9. The macro-financial scenarios used to stress the banking system reflect the risk assessment for Kuwait (Appendix I). The baseline scenario is in line with the April 2018 IMF World Economic Outlook projections. The hypothetical stress scenarios assume a gradual (“adverse”) and a sharp and permanent (“severely adverse”) shock to oil prices, equivalent to the 5th percentile of the distribution of prices between 1980 and 2017 (or a “once in 20 years” shock). The resulting negative impacts on output and market confidence in turn entail a deterioration of the real estate market and the quality of banks’ loan books. The model accounts for the historical behavior of government spending, which has tended to be sustained during periods of oil price correction, thereby supporting economic activity and, consequently, the resilience of the banking sector. Both the solvency and liquidity stress tests (performed on end-2017 data) covered the 10 largest banks by assets.

10. The banking sector appears resilient under the solvency stress tests, reflecting banks’ large capital buffers and high asset quality at the start of the stress test. While severe stress would affect the capital position of some banks, the recapitalization cost would be limited in comparison to the country’s ample financial resources.

  • Banks are resilient to both the adverse and the severely adverse scenarios. In the adverse scenario, the average CAR for all banks would remain well above the regulatory floor. Under the deep and protracted recession resulting from the severely adverse scenario, three banks would experience a limited shortfall (equivalent to 0.9 percent of GDP1), but the system-wide CAR would remain above the regulatory floor. A contingent claim analysis similarly underscores the resilience of the banking system (Annex III).

  • Vulnerabilities associated to sectoral and individual concentration risks appear manageable. Under the sensitivity analysis, assuming a hypothetical default of the five largest borrowers and a 50 percent recovery rate, five banks would not fulfill the regulatory capital requirements; the total shortfall would be limited, amounting to 0.5 percent of GDP. The household and real estate sectors constitute a sizeable part of bank exposures. A 20 percent default with zero percent recovery in any of the two sectors would leave four banks with capital deficiencies, albeit of small magnitude (0.3 percent of GDP).2

  • Market risk appears well managed. FX and interest-rate shocks have little impact on banks’ solvency, partly due to low net open positions.

11. Liquidity stress tests also point to the resilience of the banking sector. The liquidity tests used two different approaches: (i) a sensitivity check of banks’ liquidity coverage ratio (LCR) to potential funding outflows; and (ii) an analysis of the net stable funding ratio (NSFR). All banks would comply with the CBK Basel III transitioning requirement for the LCR (90 percent ratio in 2018) under both short-term funding stress and severe stress, and all but one would comply with the fully- loaded LCR ratio of 100 percent Transitioning arrangements were in place before the full implementation of the NSFR regime at the end of 2018. At the end of 2017, the average NSFR ratio for the entire system already reached 112.5 percent, with only one bank not reaching the Basel III fully-loaded NSFR levels of 100 percent3

Financial Sector Oversight

A. Regulatory and Supervisory Framework

Banking Sector

12. The supervisory framework, which the CBK updates regularly, is effective. The CBK has been proactive in incorporating best international practices, for instance by implementing the LCR (2017) and NSFR (2018), by developing guidance on Shariah supervisory governance for Islamic banks (2016), and consistently following up on FSAP recommendations (Appendix IV).

13. There would be merit in further strengthening the CBK’s autonomy and supervisory powers. Both the Ministry of Finance (MOF) and Ministry of Commerce and Industry (MOCI) are represented in the CBK Board. While the MOF is involved in certain supervisory decisions (e.g., issuance of regulation, issuance of bank license, and approval of certain enforcement actions), it does not interfere in the day-to-day operations of the CBK. Nevertheless, a clarification of the framework would be warranted, and the authorities should consider legislative changes to remove the MOF’s influence over the CBK’s decision on licensing, closure, and certain remedial actions.

14. The supervisory approach could be further refined to better assess the risk profile of banks, strengthen consolidated supervision, and enhance cross-border supervision.

  • Banks risk profile. The CBK has a well-developed supervisory approach (CAMEL-BCOM4), and both the on- and off-site supervision departments have a deep and granular understanding of banks. Further improvements could be achieved by better integrating the information from both departments; enhancing the forward-looking assessment of the banks’ risk profile; and supporting generalist supervisors with risk-specialists. Additionally, to further strengthen the resilience of the banking sector, the CBK could draw on the existing Supervisory Review and Evaluation Process to set bank-by-bank capital requirement targets, based on their risk profile and systemic importance.

  • Consolidated supervision. The group structure of parts of the Kuwaiti banking sector—Islamic banks can be at the heart of complex structure, and banks can be owned by a mixed group—can complicate the task of the supervisor. There is no clear framework to deal with banks that are part of a (banking) group. In addition to encouraging Islamic banks to simplify their group structure, the CBK has developed a practice of consolidated supervision of banks and relies on its de facto power to access information related to activities of parent and affiliated companies to satisfy itself that risks stemming from group structures are well monitored. It would benefit from seeing those powers to collect information on group entities formalized and enhanced.

  • Cross-border supervision. CBK communications with the host supervisors of Kuwaiti banks are mostly carried out on an ad hoc basis, although the CBK has one formalized Memorandum of Understanding (MOU) with the China Banking Regulatory Commission. There are no supervisory colleges, although for GCC counterparts, the GCC quarterly meeting provides a platform for supervisory authorities to exchange information. To strengthen cross-border supervision, the authorities should conclude MOUs with relevant foreign supervisory authorities, resume inspection programs as planned, and increase their frequency and depth.

15. The regulatory framework for Islamic banks is adequate and could be upgraded to clarify the respective role of the CBK and Shariah boards on issues related to Islamic finance.5 Conventional and Islamic Banks are subject to the same supervisory framework and follow International Accounting Standards. The framework is, however, adjusted for Islamic banks: the CBK has adopted the IFSB standards for capital requirements;6 it has developed liquidity management instruments based on Tawarruq contracts; and it has established fit and proper criteria for Shariah boards members and Islamic bank staff in charge of Shariah compliance. The respective roles of the CBK and Shariah boards on issues related to Islamic finance could, however, be clarified. Currently, cases of diverging opinions related to Shariah matters among members of the SSB are settled by the Fatwa Board in the Ministry of Awqaf and Islamic Affairs. This situation could expose the CBK to any final decision conflicting with financial stability. Current efforts to set up a centralized Shariah Board in the CBK, with the ability to expedite the resolution of divergences between bank Shariah boards, are commendable and could promote consistency across SSBs.7

Capital Markets

16. The CMA supervisory approach is effective but could be strengthened and would benefit from moving to an enhanced risk-based approach. The CMA joined the IOSCO in 2017; it has issued most of the regulations needed for market participants and capital market products, has active off- and on-site supervision programs and has taken enforcement action through its disciplinary panel and the external Capital Markets Court. It effectively fulfills all the essential regulatory and supervisory functions. Further developments should include stronger rules on licensing requirements, to limit licensed participants to activities within the purview of CMA; enhanced clarity regarding the perimeter of products that licensed brokers are allowed to offer to clients; and introduction of a regulation for local credit rating agencies. In addition, although the supervisory approach of the CMA is comprehensive in terms of the areas and entities to investigate, it should consider moving from a mainly compliance-based approach towards risk-based supervision. This would entail identification and management of systemic risks arising in the capital market, and regularly reviewing the perimeter of regulation.

B. Oversight and Management of Systemic Risks

17. The authorities have made considerable progress in strengthening the macroprudential policy framework since the 2010 FSAP. While there is no formal macroprudential authority, the CBK has been conducting macroprudential policy effectively: it has established an FSO, which has been publishing annual financial stability reports since 2012. In addition to implementing the Basel III regulations for capital and liquidity adequacy, it has broadened its macroprudential tools (Appendix II), actively used forward-looking loan loss provisioning, and introduced sectoral tools. In parallel, the CMA has been strengthening the oversight of ICs. Remaining on the CBK’s agenda is the finalization of the Counter Cyclical Buffer (CCB) and Domestic Systemically Important Banks (D-SIB) framework, including the publication of a buffer guide, and measures to ensure international reciprocity in CCB regulation. The CBK should also consider disclosing the identification methodology for D-SIBs, with a view to enhancing the communication of policy intention, strengthening its signaling effect, and increasing policy impact.

18. The responsibility of financial stability should be explicitly assigned, and a formal coordination mechanism established. The CBK does not have an explicit financial stability mandate, and though it has broad powers to collect information to monitor systemic risks, including from non-regulated entities, information sharing with other institutions is constrained by law. Given the multiple agencies overseeing the financial sector, and historically close relationship between financial stability and fiscal policy, a formal inter-agency coordination mechanism would be useful to foster collective policy actions. The planned FSC is a welcome step in that direction. It will be important to assign the CBK a clear financial stability mandate and a lead role in inter-agency information sharing, ensure that the FSC membership covers all relevant institutions, and grant it the power to recommend policies to committee members. A comply or explain mechanism would be useful to ensure transparency and accountability. The CBK should play a leading role in the committee, given the dominance of banks in the financial system.

19. Going forward, the CBK could focus on calibrating its macroprudential tools to enhance their effectiveness and should maintain its leading role in filling data gaps. The countercyclical capital buffer (CCB) stands ready to be activated, and the CBK has put in place targeted sectoral tools (cap on loan-to value (LTV), debt service-to-income (DSTI) ratios; and sectoral risk-weights). Calibration would require the authorities to continue their efforts to fill data gaps, including on the distribution of LTV and DSTI ratio over time and on household debt. The availability of a real estate price index would enhance transparency in the market, facilitate communications between the authorities and market participants, and strengthen market monitoring.

C. AML/CFT

20. Kuwait has made significant progress in enhancing its AML/CFT framework in recent years. Since its AML/CFT evaluation by the Middle East and North Africa Financial Action Task Force in 2011, main achievements have included the amendment of the AML/CFT Law in 2013, the adoption of a framework for implementing targeted financial sanctions in 2014, and the enhancement of the governance and operational capacity of the Financial Intelligence Unit (FIU). Kuwait’s assessment against the current AML/CFT standard is scheduled to take place in 2021.

21. The authorities should focus on the effective implementation of a risk-based approach to AML/CFT, and of a targeted financial sanctions regime. The 2012 Financial Action Task Force (FATF) standard puts greater emphasis on a risk-based approach to AML/CFT, including for supervision. Kuwait complies with TF-related targeted financial sanctions and should implement the existing framework. Going forward, the authorities should adequately mitigate the ML/TF risks identified. They should finalize an AML/CFT action plan based on the findings of the risk assessment and share it with relevant stakeholders, adopt a risk-based approach to AML/CFT supervision, effectively implement TF-related targeted financial sanctions, and enhance the operational independence of the FIU.

Financial Safety Nets, Bank Resolution, and Crisis Management Arrangements

22. The CBK has been strengthening the crisis management framework and financial safety net arrangements. The lack of a special resolution regime for banks and ICs, issues related to the blanket guarantee of deposits, and weaknesses in financial crisis framework were the main gaps identified in the 2010 FSAP. Since then, the authorities have worked toward strengthening the legal framework for bank insolvency, which is incorporated in the draft corporate insolvency law; they have improved the framework for ELA; and the CBK is contemplating the establishment of a dedicated unit for crisis management and resolution issues.

23. Formally designating the CBK as a resolution authority and attributing it an explicit responsibility to maintain financial stability would bolster the existing framework. The CBK has a de facto mandate to maintain financial stability. It has powers to impose restrictions on banks and require remedial actions when they fail to meet regulatory requirements or come under stress. Banks are also required to prepare contingency plans as part of annual Pillar II exercises.

24. The CBK should strengthen its powers to deal with troubled banks. In particular, the legal framework should clearly authorize the CBK to assume control of a non-viable bank and should allow it to address a range of bank distress situations. This should be supported by enhancements to the triggers system, including the establishment of explicit triggers for entry into resolution; and by requirements for all D-SIBs and medium-sized banks to maintain recovery plans. Finally, the ELA policy framework could be strengthened, through a clear definition of the terms and conditions of the ELA window, and by anchoring the ELA to a statutory objective of promoting financial stability in the CBK Law.8

25. The blanket deposit guarantee should, as a priority, be gradually unwound and replaced with a suitably structured DIS, once the pre-conditions are met. At the moment, all deposits are covered by a guarantee reintroduced in 2008. This arrangement contributes to financial stability, in a legal and constitutional environment that is not organized yet to accommodate swift corrective action or resolution for troubled financial institutions. However, it may generate moral hazard and reduce market discipline on bank; it is also costly to the government. The future DIS, which should be capped at a level that adequately protects retail depositors, could start as a simple “paybox” scheme—where the deposit insurer merely collects funds and pays out to depositors—and could in due time be expanded to include purchase and assumption transactions. Given the structure of the financial sector, it should also be designed with a component for Islamic Banks. There are challenges in developing Shariah-compliant solutions for both DIS and recovery and resolution framework, which could understandably delay the unwinding of the blanket deposit guarantee (Box 1).9

Financial Safety Nets and Islamic Finance

Sustaining Shariah compliance at every stage of recovery and resolution (RR) of an Islamic bank presents complexities. Those include notably (i) Shariah compliance of the sale of debt-type contracts (e.g., Murabahah) either at a discount or to non-Islamic entities; (ii) need to obtain the consent of the Investment Account Holders (IAHs) to carry out a range of actions that affect their rights and interests (e.g., identifying their share of assets); (iii) provisions to enable IAHs to exercise their rights; (iv) need to ensure Shariah compliance of liquidity support mechanisms and of various resolution tools (e.g., bail-in). In addition, resolutions require to harmonize creditor hierarchies with Shariah and to address the uncertainty over the treatment of profit-sharing investment accounts (PSIAs) based on Muḍarabah or Wakalah contracts, due to the conflict between their contractual terms and their actual risk-return profile.

Kuwait has achieved progress on a number of aspects of a RR framework for Islamic banks. The CBK allows the issuance of eligible Additional Tier 1 capital instruments with bail-in features based on Murabahah contracts. Kuwait also covers investment accounts under its blanket guarantee for all types of bank deposits.

The authorities should consider establishing a dedicated RR regime for Islamic banks. The key issues to be addressed include (i) determining the set of available recovery and resolution tools; (ii) ensuring Shariah-compliance of public declarations of insolvency by the resolution authority; (iii) formulating guidelines on the pre-positioning of contracts to facilitate the execution of recovery and resolution tools (e.g., the sale of Murabahah and Tawarruq contracts); (iv) achieving clear identification of the ownership of profit equalization and investment risk reserves in resolution, through disclosure requirements or by specific contractual terms of the investment account; (v) and, enabling potential avenues for group support in a Shariah-compliant manner.

It is important for the CBK to identify the necessary pre-positioning measures and provide guidance for implementing them. These pre-positioning measures involve: (i) the pre-approval of recovery and resolution plans of Islamic banks by their SSBs; (ii) issuing Basel III eligible capital using Mudarabah or Wakalah contracts; (iii) introducing disclosures on whether product-level requirements of an Islamic bank would continue to be maintained by a potential conventional buyer; (iii) identifying the types of contracts that need prior consent for a sale, and whether such consent can be sought at contract inception; (iv) taking the actions required to enable sales of assets in PSIAs as a recovery/resolution option, including contractual insertions into PSIA contracts that give IAHs consent to novate or transfer to a suitable new Muḍarib in the event of a predefined stress.

Managing Systemic Liquidity

26. The CBK monetary policy framework is oriented towards maintaining the exchange rate peg versus an undisclosed currency basket. The CBK sets a discount rate and offers facilities that establish an interest rate corridor (ranging from unremunerated deposits to the overnight lending facility). The overall excess liquidity generated by oil proceeds and government expenditure is reflected in banks’ balance sheets: banks easily meet the regulatory liquidity ratios and carry comfortable buffers, which has supported their resilience to recent shocks. Excess liquidity also explains the limited interbank activity and the CBK’s market operations, which are focused on banks meeting their prudential requirements.

27. The CBK has long-standing experience and is well-equipped to absorb the excess liquidity that stems from the country’s ample oil revenues. Several tools are available to manage liquidity, ranging from three- and six-month CBK bills, which are tendered regularly; to one-week and one-month time deposits offered by the CBK to banks, at its discretion, on a bilateral basis. The CBK also has facilities to provide liquidity via overnight, one-week or one-month repos; three-month FX swaps; a discount and rediscount system of commercial papers for terms up to one year; and overnight lending (the standing facility). These are seldom used, or tested, by the banks.

28. Improvements could include a refinement of the liquidity forecasting framework and a strengthening of both liquidity-absorbing and supplying tools. In due time, this would support a reduction in excess liquidity that will be needed for financial markets to develop and for banks to manage their liquidity in the interbank market. It would also help alleviate the heavy responsibility that is de facto put on the central bank, which is currently the first port of call in the event of non-emergency liquidity needs—a role normally assigned to money or bond markets. Regular testing exercises of both regular liquidity and ELA procedures with the banking sector could also help ensure the framework is operational at all times.

29. Further developments in the liquidity management framework could include a reserve requirement and a streamlining of the CBK’s monetary operations framework. At the moment, the CBK implements five liquidity ratios and one of these, the regulatory liquidity ratio, operates as a de facto reserve requirement. Should the CBK decide to rationalize those liquidity ratios, it could consider setting up a fully-fledged reserve requirement ratio. The CBK’s monetary operations framework has served the CBK well and could be streamlined in time, while meeting its objectives and retaining discretion. A streamlined framework would include a deposit rate, a discount rate and a lending facility, which would set the boundaries for market interest rates in support of the exchange rate peg. Introduction of a daily OMO could also be considered as part of the toolkit for short-term liquidity management.

Developmental Challenges

A. Developing Capital Markets

30. The CMA has launched an ambitious plan to support capital markets development. The first phase included T+3 settlement, delivery-versus-payment, segregated market tiers, standardized tick sizes and market makers. The completion of the first phase led to the elevation of Kuwait by FTSE Russell to Emerging Market status. Those measures, however, have yet to show their full impact; as an example, although a market maker framework has been created, no intermediaries have registered as market makers yet. Further success will require establishing appropriate market conditions and involving a broad range of stakeholders, beyond the CMA itself. To develop the government debt market, the authorities will need a regular issuance calendar, directed by an asset-liability management strategy, and a market-based auction process. Priorities in the corporate securities market should include developing market making and setting up an OTC market for listed corporate securities subject to appropriate governance and disclosure regulations. Finally, the authorities should facilitate a short-term commercial paper market based on a shelf registration program

B. Promoting Access to Finance for SMEs

31. The financial inclusion of SMEs is an important priority of Kuwait Vision 2035. SMEs represent an important source of job creation and economic diversification but in Kuwait, as in many countries, their access to credit is constrained. A 2017 WBG Business Confidence survey based on a sample including mostly mid-sized and small enterprises found access to finance to be the second largest constraint to business, after access to permits and licenses. This is reflected in the low share of bank credit to SMEs, around 2.5 percent of total bank loans in 2017.

32. Strengthening existing institutions, supporting the market for SME finance, and expanding financial instruments could support SME financial inclusion. A first step would be for the authorities to adopt a uniform national definition for SMEs, to support analytical and policy work. The National Fund for SME Development should refocus its activities away from direct financing, towards on-lending through financial intermediaries; it could also develop risk-sharing instruments, such as a partial credit guarantee scheme.

  • Policies to support the market for SME finance are needed. These include the adoption of a new secured transaction law and the establishment of an electronic registry of movable assets; enhancements to the credit bureau infrastructure, including the establishment of a fully-fledged credit bureau for commercial lending; and revamping the insolvency law. The authorities could also consider a gradual relaxation of the interest rate cap to unlock bank lending to SMEs.

  • The authorities may also want to consider fostering competition through alternative financial instruments and players, including fintech—provided they are appropriately regulated, notably to avoid consumer protection concerns. Other alternatives to bank finance include the expansion of leasing and the introduction of factoring. Finally, financial products and services should reflect SME’s changing financial needs throughout their life cycle, with the promotion of patient capital and venture capital addressing the needs of the smallest, newest SMEs, potentially with the support of the National Fund.

Table 4.

Kuwait: Financial Soundness Indicators, 2011–Sept 18

(In percent)

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Source: CBK.

Data are on consolidated basis.

Core liquid assets include: cash and cash equivalents, deposits with CBK, government securities, CBK bills, deposits with banks, certificates of deposit with other banks which mature within three months.

Appendix I. Risk Assessment Matrix

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Appendix II. Prudential Tools and Instruments

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Appendix III. Contingent Claims Analysis of the Banking Sector

1. For the 10 Kuwaiti banks that are publicly traded, equity prices can be used to derive measures of default risks. This information, provided by Moody’s CreditEdge database, can be used to provide additional background to stress tests. Estimates of expected default probabilities (EDF) and fair value CDS (FVCDS) from Contingent Claim Analysis (CCA) derivatives pricing model show that Kuwaiti banks are healthy and resilient. The results corroborate the conclusions of the stress-testing exercise.

2. The estimates are based on Moody’s EDF model,1 a structural credit-risk model which based on an option-pricing approach to credit risk. The three primary drivers of the model are asset value, default point, and asset volatility. Equity, equity volatility and default barrier information is used to derive a Merton-type risk indicator—a metric that summarizes all credit risk-related information. This “distance to distress” (DD) can then be mapped to the probability space to obtain the EDF metric for both corporates and financials.

3. The estimated EDFs for 10 Kuwaiti banks, for which data are publicly available, show that, following the spike in EDFs during the global financial crisis, the 1-year average EDF has declined for all banks and has remained very low for both large and medium-sized banks over the past 4 years. At end-March 2018, the average EDF for large, medium and small-sized banks stood respectively at 0.33, 0.54, and 0.5 percent. As investment grade or near investment grade ratings have EDFs of less than 0.8 percent, this implies that all of Kuwait’s banks in the sample are currently in a “safe zone.”

uA01fig10

Grouped Average 1 -Year EDF

(In Percent)

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

uA01fig11

Banks’s 1-Year EDFs and FV CDS

(as of March 2018)

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

4. Fair value credit default swaps (FVCDS) spreads can also be used to measure the “true” credit risk of financial institutions. The FVCDS derived using CCA by Moody’s Analytics are typically higher than market-based CDS spreads, reflecting the fact that default risk can be underpriced in market-based CDS due to the existence of either explicit or implicit government guarantees.

5. FVCDS, EDFs, and stress-test results all point to the same conclusion that Kuwaiti banks are resilient. They also provide broadly consistent relative ranking of their risk. Kuwaiti banks are becoming increasingly global, and while risks stemming from the potential default of their foreign associates and/or branches are small, those exhibit a level of volatility that warrants the attention of the supervisor.

uA01fig12

EDFs of Foreign Subsidiaries and Associates

(1-year EDF, in percent)

Citation: IMF Staff Country Reports 2019, 096; 10.5089/9781498306409.002.A001

Sources: CreditEdge and staff calculations.

Appendix IV. Previous FSAP Recommendations

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Appendix V. Top-down Stress Test Matrix (STeM) for the Banking Sector: Solvency and Liquidity Risks wait

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1

While capital in those banks would be below the Kuwaiti regulatory requirement, it would still be above the Basel III minimum requirement.

2

This would constitute an extreme shock, as household credit is mostly issued to public sector employees and backed by wages. In the absence of a housing mortgage market, real estate lending is limited to investment and

3

The NSFR requirement is applicable as of 2018, with a phase-in period.

4

Capital-Asset-Market Risk-Earnings-Liquidity and Business Strategy-Control-Organizational Depth-Management.

5

The regulatory framework for Islamic banks was assessed against the Core Principles for Islamic Finance Regulation

6

The framework distinguishes between profit-equalization reserves belonging to the shareholders and to investment account holders.

7

Since the FSAP, the authorities have proposed draft amendments to the CBK law establishing a centralized Shariah Board at the CBK.

8

Following the FSAP mission, the authorities have prepared a draft law assigning the CBK an explicit financial stability mandate and creating a Financial Stability Committee.

9

The IFSB’s has called regulators to allow conventional deposit protection schemes to cover deposits with Islamic banks, until a Shariah-compliant solution is identified.

1

See Moody’s “Credit Risk Modeling of Public Firms: EDF9” for the detailed description of modeling methodology. For further discussion of structural models based on option-pricing theory, see Crosbie and Bohn (2003), Ranson (2005), Caouette et. al. (2008), and Bohn and Stein (2009).

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Kuwait: Financial System Stability Assessment
Author: International Monetary Fund. Monetary and Capital Markets Department
Volume/Issue:
Volume 2019: Issue 096
Publisher:
International Monetary Fund
ISBN:
9781498306409
ISSN:
1934-7685
Pages:
38
DOI:
https://doi.org/10.5089/9781498306409.002