## _cr10239

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### Financial sector evolution and systemic importance
- Number of ICs more than doubled; on-and off-balance sheet assets of ICs reached more than 90 percent of the total banking system’s assets, making the sector systemically important.
- Drivers of IC growth: global trend toward nonbanks and search for yield, higher income with the oil boom, low barriers to entry, and strict regulations on banks’ investment activities.
- ICs’ asset share of total financial sector assets rose from 22.3 percent to 29.4 percent during 2004–08, declining to 27.7 percent in 2009.
- Number of ICs increased from 41 in 2004 to about 100 by end-2009.
- ICs’ asset composition (2009 baseline sample): Cash 7%; Stocks 35%; Bonds 1%; Real estate 20%; Private Equity 6%; Other 31%.
- Geographic concentration of largest 11 ICs’ assets: 43 percent in Kuwait and 43 percent in other GCC countries (sample-based).

### Banking sector developments, concentrations, and vulnerabilities
- Credit to the private sector grew at an average of 22 percent annually during 2004-08; growth subsided in 2008-09.
- Banks’ lending to ICs: 8.8 percent of total loans in 2006; 11.5 percent of total loans as of December 2009.
- Bank loans to individuals for investing in stocks: 11 percent of banks’ total loans.
- Installment loans: 18 percent of total credit; typically guaranteed by salary assignments.
- Banks’ credit to real estate, stock market, and distressed ICs: amounts to 49 percent of total credit and 2.5 times banks’ capital.1/
- Banking sector FSIs (end-2009):
  - CAR at 18 percent (all banks above the 12 percent regulatory minimum).
  - Leverage ratio (capital to assets) at 12 percent.
  - NPL ratio at about 9.7 percent in 2009 (up from 5.3 percent in 2008).
- Provisioning and asset-quality indicators:
  - Precautionary provisions increased to KD 470.3 million in 2009 (versus KD 385 million in 2008).
  - Specific and precautionary provisions accounted for 51 percent of NPLs.
  - Specific Provisions to Gross Non Performing Loans: 47.8 (2006), 48.2 (2007), 41.6 (2008), 38.5 (2009).
  - Non-performing loans to total loans: 3.9 (2006), 3.2 (2007), 5.3 (2008), 9.7 (2009).
  - Non Performing Loans net of provisions to capital: 14.3 (2006), 11.4 (2007), 26.0 (2008), 45.7 (2009).
  - Specific Provisions to gross loans: 1.8 (2006), 1.5 (2007), 2.2 (2008), 3.7 (2009).
- Liquidity and funding indicators (selected):
  - Core Liquid assets to total assets: 31.8 (2006), 28.7 (2007), 23.2 (2008), 20.2 (2009).
  - Liquid assets to total assets: 35.8 (2006), 33.3 (2007), 30.3 (2008), 26.1 (2009).
  - Liquid assets to short-term liabilities: 29.5 (2006), 39.0 (2007), 36.4 (2008), 34.7 (2009).
  - Deposits to assets: 66.7 (2006), 66.7 (2007), 70.3 (2008), 71.8 (2009).
  - Loans to deposits: 86.5 (2006), 89.1 (2007), 89.7 (2008), 91.0 (2009).
- Profitability (selected):
  - ROAA: 3.7 (2006), 3.6 (2007), 0.9 (2008), 0.8 (2009).
  - ROAE: 28.8 (2006), 29.4 (2007), 7.7 (2008), 6.8 (2009).
  - Net interest Margin to gross income: 55.9 (2006), 50.0 (2007), 58.8 (2008), 65.8 (2009).
  - Non-interest income to gross income: 44.1 (2006), 50.0 (2007), 41.2 (2008), 34.2 (2009).
- Market sensitivity:
  - Equity exposures accounted for 68.5 percent of shareholders’ equity capital in 2009.
  - Net open FX position to capital and reserves: -3.2 (2006), 0.6 (2007), 10.0 (2008), 10.0 (2009).

### Investment companies (ICs): structural weaknesses and crisis impact
- Structural vulnerabilities:
  - Highly leveraged positions; dependence on external financing (36 percent of liabilities).
  - Maturity mismatches (long-term assets financed by short-term liabilities).
  - Large exposure to equity and real estate markets; weak disclosure.
  - Fragmentation: average of KD 0.40 billion of assets per IC in the industry.
- Crisis outcomes:
  - Many ICs faced difficulties maintaining or renewing foreign lines of credit; some defaulted or were on brink of default.
  - Five large ICs defaulted on loans totaling about $10 billion.
  - ICs account for 13 percent of KSE market capitalization; deterioration in IC solvency would affect banks’ asset quality and equity prices.
- Stress-test outcomes (sample of 11 ICs):
  - Second scenario (15 to 33 percent default/loss rates): 3 ICs lose all capital; 7 ICs have capital-to-assets ratio below 10 percent.
  - Severe scenario (20 to 66 percent default/loss rates): 8 ICs lose all capital; only 1 IC will have capital-to-assets ratio above 10 percent.
  - Recapitalization needs under severe scenario (to 10 percent capital to assets ratio): 2 percent of GDP.
- Caveats: analyses indicative; liquidity and some market risks not fully covered; uniform PD/LGD assumptions used across ICs; market values may be lower than 2009 baseline.

### Macro-financial backdrop and crisis effects
- Pre-crisis growth and imbalances:
  - Real GDP growth averaged 7 percent during 2004-08.
  - Domestic aggregate demand grew at an average rate of 11 percent during 2004-08.
  - Inflation rose to double digits by 2008.
  - Fiscal and current account surpluses averaged 34 and 42 percent of GDP, respectively, during the boom period.
  - KSE lost KD27.2 billion or 51 percent in market capitalization from June 2008 to March 2009.
- Crisis impact (2008-09):
  - Real GDP estimated to have contracted by about 4½ percent in 2009.
  - Real oil GDP declined by more than 11 percent in 2009.
  - Real non-oil GDP estimated to have remained flat in 2009.
  - Growth in bank credit decelerated from about 19 percent in 2008 to 7 percent in 2009.
  - Banking profits declined by about 70 percent in 2008; one bank incurred losses of US$ 1.4 billion from a derivatives transaction on behalf of clients.
  - By end-2009, NPLs ratio close to 9.7 percent for Kuwaiti banks (up from 5.3 percent in 2008).

### Authorities’ response and policy measures
- Immediate measures:
  - Extension of blanket guarantees on all bank deposits.
  - Liquidity injections via CBK repo operations, swaps, direct collateralized placements, and government deposits at commercial banks.
  - Reductions in repo and discount rates; easing of prudential loan-to-deposit ratio.
  - Enactment of the financial stability law (FSL) allowing substantial financial sector guarantees.
  - Support to the KSE through a stabilization fund equal to 3 percent of GDP (utilization reportedly limited).
- Supervisory and regulatory actions:
  - CBK issued comprehensive regulatory guidance addressing banks’ risk management weaknesses and began migration from compliance-based toward risk-based supervision.
  - CBK encouraged banks to build precautionary provisions and increase capital; five of the 10 domestic banks were in the process of raising capital in 2010.
  - CBK has begun overhauling regulatory and oversight framework for ICs.
- Recapitalization outcomes:
  - Only one bank resorted to public funds for recapitalization (rights issue backstopped by KIA which injected one third of new capital).
  - ICs that restructured did not receive public financial support.

### Financial stability framework gaps and recommended enhancements
- Key gaps:
  - CBK macro-prudential framework needs major upgrade to better measure and anticipate systemic risks.
  - Financial safety net requires enhancement: contingency planning, crisis management, resolution framework, and ELA facility.
  - Blanket deposit guarantee lacks explicit funding arrangements and payout infrastructure; may undermine market discipline and create moral hazard.
  - Kuwait lacks a specific resolution regime for financial institutions; existing bankruptcy procedures are cumbersome.
- Recommendations (selected):
  - Clarify supervisory responsibilities among CBK, CMA, and MOCI; initiate coordination for transition to new oversight architecture.
  - Establish at the CBK a financial stability unit (FSU) responsible for macro-prudential supervision and consider issuing a financial stability report.
  - Replace blanket guarantee with a deposit insurance system that promotes market discipline, introduce a cap protecting depositors while incentivizing due diligence, and define a transition strategy with a timetable.
  - Improve ELA by broadening collateral acceptance and establishing valuation and haircut frameworks for non-standard collateral.
  - Overhaul bankruptcy framework to introduce a special resolution regime and facilitate debt rescheduling for viable ICs.
  - Formalize interagency cooperation with an MOU between CBK, MOF, KIA, and the future CMA and regularly test arrangements via crisis simulations.
  - Strengthen corporate governance rules and apply "fit and proper" tests for bank boards and management.
  - Lower maximum exposure limits on related parties and enhance legal framework to prohibit conflicts of interest.

### Stress testing, scenarios, and capital needs
- Stress-testing approach: single-factor shocks and macroeconomic scenarios; calibration guided by IMF (MCD) projections, equity market performance, historical distributions, expert judgment, and cross-country evidence.
- Macro scenarios:
  - Baseline: modest recovery in 2010; NPLs would increase by about two percentage points.
  - Intermediate and severe adverse scenarios: assume further global slowdown lowering oil revenues and non-oil GDP; assume haircuts ranging between 10 percent (baseline) and 50 percent (severe).
- Bank recapitalization estimates from scenario analysis:
  - Intermediate shock: recapitalization needed to restore CAR to 12 percent estimated at 0.9 percent of GDP; three of the largest banks fall below 12 percent.
  - Severe case: maximum recapitalization estimated at 3.8 percent of GDP; one medium-sized bank would lose entire capital; CAR of three largest banks would fall below 8 percent.
- Single-factor tests:
  - Assume 50 percent haircut on collateral; LGD estimated at 65.5 percent; average time to complete foreclosure estimated at 4.2 years.
- Liquidity stress test: banks could withstand a substantial deposit run over five days without external financing due to liquidity buffers.
- IC recapitalization under severe scenario: 2 percent of GDP to restore to 10 percent capital-to-assets ratio.

### Capital markets, insurance, housing finance, and market development
- Capital market and regulatory architecture:
  - Enactment of the capital market law is a key step toward creating a single, independent, and accountable CMA; clarify responsibilities and coordinate transition with CBK.
  - KSE displayed extreme imbalances during boom and correction; licensing institutional investors and improved oversight expected to enhance price discovery and reduce manipulation.
- Government securities market:
  - Secondary market for TBs and bonds virtually nonexistent; banks own majority of government bonds and roll over holdings.
  - Opportunity: issuance of government Sukuk could benefit Islamic banking market.
- Insurance sector:
  - Total gross insurance premiums in 2008: KD181 million (US$670 million), or 0.6 percent of GDP.
  - Regulatory regime focuses on compliance rather than financial/operational risk analysis; need to strengthen insurance supervision and increase technical capacity.
- Housing finance:
  - Prudential imbalances and interest rate limitations have led to concentration in volatile CRE lending rather than RRE lending.
  - Cap on lending rates and requirement to fix rates for at least five years create market price inflation risk and significant interest rate risk for banks.

### Risk Assessment Matrix — selected findings
- Banking sector exposure to real estate and stock markets and distressed ICs: Assessment: medium.
- IC sector structural vulnerabilities (leverage, external financing 36 percent, maturity mismatch, concentration, weak disclosure): Assessment: high.
- Sustained lower oil revenues could weaken public finances and investor confidence; impact assessment: high if realized, but likelihood of severe realization sometime in the next 3 years assessed as low given projected oil price recovery in medium term.

### Priority recommendations (summary by theme and timing)
- Financial sector oversight (Immediate and Short-Term):
  - Clarify responsibilities between CBK, CMA, and MOCI; initiate coordination for transition.
  - Establish FSU at CBK and enhance macro-prudential surveillance.
  - Perform periodic stress tests of real estate and major sectoral credit concentrations; review ICAAPs.
  - Extend viability assessment to all systemically important ICs.
  - Strengthen corporate governance and apply "fit and proper" tests.
  - Issue directives on conflict of interest; reduce limits for credit to related parties.
  - Continue migration to risk-based supervision; strengthen supervisory capacity; shorten on-site cycle; organize ICAAP on-site examinations.
  - Introduce quantitative and qualitative regulations to monitor ICs and develop new licensing regime; consider varying minimum capital depending on activities and risks (current minimum capital cited as KD 15 million).
  - Establish funding and operational arrangements for deposit insurance with an adequate cap; define transition timetable.
  - Establish an MOU on financial crisis management among CBK, MOF, CMA, and KIA.
- Contingency planning and crisis management (Medium-Term):
  - Broaden collateral acceptance and establish valuation/haircut frameworks for ELA.
  - Establish a special resolution regime with distinct bankruptcy procedures for financial institutions.
  - Implement remaining recommendations from 2004 FSAP.
- Liquidity management and market development (Medium-Term):
  - Formulate a long-term plan for debt/sukuk market development and start short-term market implementation.
- Real estate sector (Medium-Term):
  - Develop a real estate market information database.
  - Review and strengthen prudential regime for CRE lending.
- Insurance (Medium-Term):
  - Enhance visibility and capacity of insurance supervisory function; restructure MTPL insurance to be risk-based.

*Source: Executive Summary and selected sections from IMF staff report _cr10239.*

### Executive Summary ......................................................................................................

### _cr10239 - Executive Summary

### Financial sector evolution and systemic importance
- The number of ICs has more than doubled, with on-and off-balance sheet assets reaching more than 90 percent of the total banking system’s assets, making the sector systemically important.
- The growth of the ICs’ sector reflects a global trend (larger role for nonbanks and the search for yield), higher income with the oil boom, low barriers to entry, and strict regulations on banks’ investment activities.

### Banking sector developments and vulnerabilities
- Banks’ lending to the private sector grew at an average of 22 percent annually during 2004-08, funded mostly by robust growth in bank deposits.
- Important shifts in banks’ credit portfolios include greater financing of real estate activities and financing related to purchasing of securities by individuals and ICs.
- The banking sector is exposed (directly and indirectly) to real estate and stock market, and distressed ICs: credit to these sectors amounts to 49 percent of total credit and 2.5 times banks’ capital.1/
- Banks’ credit to ICs represents 11.5 percent of total credit to the private sector.
- Bank loans to individuals for investing in stocks represent 11 percent of banks’ total loans.
- Installment loans account for 18 percent of total credit; these are low-risk loans since they are guaranteed by salary assignments.
- Stress tests indicate the banking system could broadly withstand significant additional shocks. Under an adverse scenario of low oil prices and a deteriorating global environment, bank asset quality would worsen and solvency of some institutions could be undermined, but recapitalization needs under this scenario seem manageable.
- Mitigating factors for banks include: five of the 10 domestic banks are in the process of raising capital in 2010; banks are building precautionary provisions under CBK direction; and the relatively high current capital adequacy ratio (CAR).

### Investment companies (ICs): vulnerabilities and crisis impact
- IC sector structural characteristics that increase vulnerability:
  - Highly leveraged positions.
  - Significant dependence on external financing (36 percent of liabilities).
  - Maturity mismatches between assets and liabilities (long-term assets financed by short-term liabilities).
  - Large exposure to asset markets (equity and real estate).
  - Weak disclosure.
  - Fragmentation of the industry (an average of Kuwaiti dinar (KD) 0.40 billion of assets per IC).
- Many ICs faced difficulties maintaining or renewing foreign lines of credit; some have defaulted or are on the brink of default.
- ICs’ assets are concentrated regionally: 43 percent in Kuwait and 43 percent in other GCC countries (based on a sample for the largest 11 companies in Kuwait).
- The IC sector has limited capacity to withstand adverse shocks; solvency risk remains high and contingent on asset market developments.
- ICs account for 13 percent of the Kuwait Stock Exchange (KSE) market capitalization; deterioration in IC solvency would affect banks’ asset quality directly and indirectly by further pressuring equity prices.

### Crisis effects and authorities’ response
- The global financial crisis tightened liquidity and caused a sharp decline in asset prices, increasing banks’ NPLs and provisions—especially linked to ICs and real estate sectors.
- Authorities’ measures to preserve financial stability included:
  - Extension of bank deposit guarantee.
  - Bank liquidity injections.
  - Reductions in interest rates.
  - Adoption of a financial stability law.
- The CBK issued comprehensive regulatory guidance addressing banks’ risk management weaknesses and has begun migration from compliance-based toward risk-based supervision.
- The CBK has begun overhauling the regulatory and oversight framework for ICs.

### Financial stability framework gaps and required enhancements
- The CBK’s oversight for banks is well designed and effective in shielding the banking sector from direct consequences of the crisis, but insufficient to prevent turmoil in the IC sector.
- Key gaps and needs:
  - Strengthen CBK’s macro-prudential framework to better measure and anticipate systemic risks.
  - Enhance the financial safety net framework, including contingency planning, crisis management, resolution framework, and the emergency liquidity assistance (ELA) facility.
  - Improve ELA by broadening collateral acceptance policies and establishing a valuation framework with haircuts for non-standard collateral.

### Capital markets, insurance, and regulatory architecture
- Enactment of the capital market law is an important step toward creating a single, independent, and accountable CMA, which should improve KSE functioning and strengthen IC oversight.
- It is important to clarify regulatory and supervisory responsibilities between the CBK and the CMA and to coordinate the transition to the new oversight architecture.
- The regulatory regime for the insurance sector needs strengthening: current regulation focuses on compliance rather than on analyzing financial position risks or operational risks. Stronger insurance supervision would support liberalization and development of the insurance market.

### Risk Assessment Matrix — selected findings (summary)
- Banking sector exposure to real estate and stock markets and distressed ICs: Assessment: medium.
- IC sector structural vulnerabilities (leverage, external financing 36 percent, maturity mismatch, concentration, weak disclosure): Assessment: high.
- Sustained lower oil revenues could weaken public finances and investor confidence; asset and corporate sector vulnerability linked to oil prices: Assessment: high for impact if realized, but likelihood of severe realization sometime in the next 3 years assessed as low given projected oil price recovery in medium term.

### Priority recommendations (selected)
General
- The CBK, CMA, and the Ministry of Commerce and Industry (MOCI) should clarify supervisory responsibilities and initiate a coordination process for an efficient oversight architecture.
- Establish at the CBK a financial stability unit (FSU) responsible for macro-prudential supervision.

Banking supervision
- Perform periodic stress tests including for real estate and other major sectoral credit risk concentrations, and review assessments of how banks consider these concentrations in their ICAAPs.
- Lower the maximum exposure limits on related parties.
- Enhance the legal framework to prohibit conflicts of interest concerning related party transactions.
- Complete the migration from compliance-based supervision to risk-based supervision.
- Continue strengthening supervision capacity through further hiring and training.
- Shorten the on-site supervision cycle.
- Organize comprehensive ICAAP on-site examinations.

Investment companies
- Strengthen regulations on (a) licensing (in particular “fit and proper” criteria); (b) permissible activities; (c) corporate governance, including internal organization, internal control, risk management, external auditors, and accountancy rules; and (d) prudential limits on leverage and liquidity/maturity mismatch.
- Consider varying the minimum capital requirement depending on activities and risks assumed.

Financial safety net and resolution
- Replace the blanket guarantee with a deposit insurance system that promotes market discipline, including by introducing a cap that adequately protects depositors while incentivizing due diligence; define a transition strategy with a timetable.
- Improve ELA, including broadening collateral acceptance and establishing valuation and haircut frameworks for non-standard collateral.
- Overhaul the bankruptcy framework to adequately handle bankruptcies of banks and other financial institutions.

*Executive Summary — _cr10239 (IMF Financial Sector Assessment summary content)*

### 1.      The rapid expansion of the global economy and improvements in the regional

### _cr10239 - 1.      The rapid expansion of the global economy and improvements in the regional

### Pre-crisis expansion and macro-financial backdrop
- Real GDP growth averaged 7 percent during 2004-08.
- Domestic aggregate demand grew at an average rate of 11 percent during 2004-08.
- Inflation rose and reached double digits by 2008.
- Fiscal and current account surpluses averaged 34 and 42 percent of GDP, respectively, during the boom period.
- The KSE was the best performer among GCC states in this period; prices of apartments and commercial real estate (CRE) nearly doubled.
- Real estate and stock market prices rose strongly, supported by improved fundamentals and abundant liquidity.
- Credit to the private sector grew at an average rate of 22 percent annually during 2004-08. Credit growth subsided in 2008-09 (crisis period).
- Banks’ profitability: return on assets (ROA) averaged over 3 percent.
- Banking sector capitalization: banks’ CAR remained comfortably above the regulatory limit.

### Investment companies (ICs): rapid growth and emerging vulnerabilities
- Number of ICs increased from 41 in 2004 to about 100 by end-2009.
- Total IC assets more than doubled by end-2009 (see Figure 2 / Table 3 references in source).
- ICs’ asset share of total financial sector assets rose from 22.3 percent to 29.4 percent during 2004–08, declining to 27.7 percent in 2009.
- Banks’ direct exposure to the IC sector:
  - 8.8 percent of total loans in 2006.
  - 11.5 percent of total loans as of December 2009.
- ICs’ asset composition (Figure 2):
  - Cash 7%
  - Stocks 35%
  - Bonds 1%
  - Real estate 20%
  - Private Equity 6%
  - Other 31%
- Geographic concentration of IC assets highlighted large domestic and GCC exposures (figures and percentages provided in source figures).
- Sources of vulnerability in ICs: over-leveraging, maturity mismatches, high asset concentration, large exposures to domestic and regional equity and real estate markets.
- Structural and regulatory drivers of IC growth and weakness:
  - Low barriers to entry (capital requirement of only KD 15 million).
  - Segmentation of licensing and oversight (MOCI grants license; CBK has oversight).
  - Lack of clear international standards on IC regulation and supervision.
  - Broad permissible activities (ICs can engage in much the same activities as banks; only activity explicitly excluded is deposit taking).
  - Deficiencies in corporate governance and risk management: many ICs lack independent directors, minority shareholder representation, “fit and proper” tests for senior management and board members; internal audit, risk management and compliance functions often missing or understaffed.
- Systemic risk channels: ICs’ fire sales could depress asset prices, deteriorate banks’ balance sheets via direct exposures and increase NPLs through deteriorated household and corporate balance sheets.

### Aftermath of the global financial crisis (2008-09)
- Real GDP is estimated to have contracted by about 4½ percent in 2009.
- Real oil GDP declined by more than 11 percent in 2009.
- Real non-oil GDP is estimated to have remained flat in 2009.
- Growth in bank credit to the private sector decelerated from about 19 percent in 2008 to 7 percent in 2009.
- CPI inflation fell to 4 percent in 2009 (from double digits in 2008).
- Banking sector effects:
  - Profits declined by about 70 percent in 2008 (largest decline in the GCC region).
  - By end-2009, the NPLs ratio was close to 9.7 percent for Kuwaiti banks (up from 5.3 percent in 2008 as noted elsewhere).
  - Several banks’ ratings were downgraded.
  - One bank incurred large losses stemming from derivatives transactions on behalf of customers.
- IC sector effects:
  - Large losses due to exposure to domestic and regional asset markets (equity and real estate).
  - Five large ICs defaulted on loans totaling about $10 billion.
  - Many ICs restructured or rescheduled their debt to the banking sector.
  - Global deleveraging and reassessment of risk limited ICs’ ability to roll over external debt.

### Authorities’ response and policy measures
- Measures taken to maintain financial stability:
  - Extension of blanket guarantees on all bank deposits.
  - Liquidity injections via central bank repo operations, swaps, direct collateralized placements, and government deposits at commercial banks.
  - Reduction in repo and discount rates.
  - Enactment of the financial stability law (FSL) allowing for substantial financial sector guarantees.
  - Easing of the prudential loan-to-deposit ratio to facilitate credit growth.
  - Support to the Kuwaiti stock market through a stabilization fund equal to 3 percent of GDP. (Source notes: the utilization of this fund and the FSL loan guarantees have reportedly been very limited.)
- CBK actions to strengthen resilience and working environment:
  - Encouraged banks to book precautionary provisions and increase capital.
  - Maintained an expansionary monetary stance to limit pressures on corporate and household balance sheets.
- Fiscal policy:
  - Government adopted a medium-term expansionary fiscal stance with a focus on capital spending in the context of the newly approved development plan (DP).
- Recapitalization and support:
  - Only one bank resorted to public funds for recapitalization: capitalized through a rights issue backstopped by the Kuwait Investment Authority (KIA), which injected one third of the new capital.
  - ICs that restructured their debts did not receive public financial support.

### Financial sector vulnerabilities, stress testing, and scenarios
- Focus of vulnerability assessment: banks and ICs (other NBFIs relatively small; insurance companies underdeveloped).
- Stress testing approach:
  - Covered market, credit, and liquidity risks with single-factor shocks and macroeconomic scenarios.
  - Calibration guided by Fund’s (MCD) macro projections, equity market performance (for ICs), distribution tails from at least 10 years of Kuwait historical data, expert judgment, and cross-country evidence.
  - Market indicators and a macro-financial model were used to derive Kuwait-specific elasticities linking macro variables (including real non-oil GDP growth and oil prices) to NPL ratios.
- Macro scenarios:
  - Baseline: modest recovery in 2010 driven by higher oil prices and larger public sector expenditure under the DP; NPLs would increase by about two percentage points due to low private sector profitability and depressed asset prices.
  - Two adverse scenarios (intermediate and severe): assume further slowdown in the global economy lowering oil revenues and non-oil GDP, reducing confidence, constraining access to credit, and depressing asset prices; loan defaults and losses would increase.
  - Assumed haircuts to collateral range between 10 percent in the baseline scenario and 50 percent in the severe scenario.

### Banks: indicators and concentrated risks
- Banking sector aggregate FSIs (end-2009):
  - CAR at 18 percent (all banks above the 12 percent regulatory minimum).
  - Leverage ratio (capital to assets) at 12 percent.
  - NPL ratio at about 9.7 percent in 2009 (up from 5.3 percent in 2008).
- Asset composition and concentrations:
  - Banks’ assets are predominantly domestic (80 percent).
  - Main funding source: domestic deposits.
  - High sectoral concentration in credit to real estate, investment companies, and securities purchases (Figure 1 breakdowns referenced in source).
- Coverage ratio (specific provisions to NPLs) declined (source indicates decline but specific percentage not stated in provided excerpt).
- Key concerns:
  - Rising NPLs and large concentrations to volatile sectors endanger profitability and balance-sheet resilience.
  - Banks’ external exposures are limited, but liquidity tightening and asset price declines can materially affect asset quality.

*Source: IMF staff report content from _cr10239 - 1. The rapid expansion of the global economy and improvements in the regional (PDF chapter).*

### 38.5 percent from 41.6 percent in 2008, total provisioning (including precautionary)

### _cr10239 - 38.5 percent from 41.6 percent in 2008, total provisioning (including precautionary)

### Provisioning and Asset Quality
- Precautionary provisions increased to KD 470.3 million in 2009 (versus KD 385 million in 2008).
- Specific and precautionary provisions accounted for 51 percent of NPLs.
- Specific Provisions to Gross Non Performing Loans: 47.8 (2006), 48.2 (2007), 41.6 (2008), 38.5 (2009).
- Non-performing loans to total loans: 3.9 (2006), 3.2 (2007), 5.3 (2008), 9.7 (2009).
- Non Performing Loans net of provisions to capital: 14.3 (2006), 11.4 (2007), 26.0 (2008), 45.7 (2009).
- Specific Provisions to gross loans: 1.8 (2006), 1.5 (2007), 2.2 (2008), 3.7 (2009).

### Financial Soundness Indicators (selected, 2006-09)
- Capital Adequacy
  - Regulatory capital to risk-weighted assets (All Banks) (Local & Foreign Branches) 1/2: 21.2 (2006), 19.4 (2007), 17.1 (2008), 18.0 (2009).
  - Regulatory capital to risk-weighted assets (Conventional Banks) 1/2: 21.8 (2006), 18.4 (2007), 15.5 (2008), 18.9 (2009).
  - Regulatory capital to risk-weighted assets (Islamic Banks) 1/2: 9.9 (2006), 22.9 (2007), 21.8 (2008), 16.2 (2009).
  - Tier 1 capital to risk-weighted assets (All Banks) (Local & Foreign Branches) 1/2: 8.6 (2006), 17.4 (2007), 15.8 (2008), 16.8 (2009).
  - Capital to assets: 11.7 (2006), 12.6 (2007), 11.7 (2008), 12.1 (2009).
- Asset Composition (selected)
  - Real estate/Construction: 28.7 (2006), 30.6 (2007), 31.3 (2008), 32.2 (2009).
  - Households: 39.2 (2006), 33.6 (2007), 31.8 (2008), 31.8 (2009).
  - Mortgage loans: 3.5 (2006), 2.7 (2007), 2.5 (2008), 2.2 (2009).
  - Consumer loans: 19.9 (2006), 17.0 (2007), 15.2 (2008), 16.4 (2009).
- Liquidity and Funding
  - Core Liquid assets to total assets: 31.8 (2006), 28.7 (2007), 23.2 (2008), 20.2 (2009).
  - Liquid assets to total assets: 35.8 (2006), 33.3 (2007), 30.3 (2008), 26.1 (2009).
  - Liquid assets to short-term liabilities: 29.5 (2006), 39.0 (2007), 36.4 (2008), 34.7 (2009).
  - Deposits to assets: 66.7 (2006), 66.7 (2007), 70.3 (2008), 71.8 (2009).
  - Loans to deposits: 86.5 (2006), 89.1 (2007), 89.7 (2008), 91.0 (2009).

### Liquidity, FX and Market Sensitivity
- Liquid assets account for 26 percent of total assets and cover 35 percent of short-term liabilities (text statement).
- FX lending restricted to hedged borrowers with FX earnings and for trade financing purposes.
- Reported overall net open FX position is marginal; regulatory limit is 15 percent of Tier 1 capital.
- Equity exposures accounted for 68.5 percent of shareholders’ equity capital in 2009.
- Net open FX position to capital and reserves: -3.2 (2006), 0.6 (2007), 10.0 (2008), 10.0 (2009).

### Profitability and Bank Performance
- Return on Average Assets (ROAA): 3.7 (2006), 3.6 (2007), 0.9 (2008), 0.8 (2009).
- Return on Average Equity (ROAE): 28.8 (2006), 29.4 (2007), 7.7 (2008), 6.8 (2009).
- Net interest Margin to gross income: 55.9 (2006), 50.0 (2007), 58.8 (2008), 65.8 (2009).
- Non-interest income to gross income: 44.1 (2006), 50.0 (2007), 41.2 (2008), 34.2 (2009).
- Profitability decline driven by significant increases in NPLs and provisioning, and large losses incurred by one large bank in 2008 (losses amounted to US$ 1.4 billion as a result of a derivatives transaction on behalf of clients).

### Stress Test Results and Capital Needs
- Under the intermediate shock scenario:
  - None of the banks loses its entire capital.
  - Three of the largest banks fall below the minimum regulatory capital of 12 percent.
  - Recapitalization needed to restore the CAR to the 12 percent minimum requirement is estimated at 0.9 percent of GDP.
- Under the severe case scenario:
  - One medium-sized bank would lose its entire capital.
  - CAR of three of the largest banks would fall below 8 percent.
  - Maximum amount for recapitalization estimated at 3.8 percent of GDP.
- Single factor stress tests:
  - Highlight high exposure to the real estate and construction sectors.
  - Test assumes a 50 percent haircut on the value of the underlying collateral.
  - Loss given default (LGD) and average time to complete the foreclosure process estimated at 65.5 percent and 4.2 years, respectively (cited study).
- Liquidity stress test:
  - Banks could withstand a substantial deposit run over five days without external financing due to adequate liquidity buffers.

### Investment Companies (ICs): Vulnerabilities and Stress Tests
- Key risk factors for ICs:
  - Maturity mismatches between assets and liabilities.
  - Large exposure to asset markets (equity and real estate).
  - Highly leveraged positions with dependence on external financing.
  - Weak disclosure of risks.
  - Wide dispersion of the industry (many companies with small market share).
- Observed outcomes:
  - Substantial deterioration in ICs’ financial positions, defaults of a few large ICs, and large loan restructuring/rescheduling.
- Stress analysis for ICs:
  - Second scenario (15 to 33 percent default/loss rates): 3 ICs (out of 11) lose all their capital; 7 ICs have capital-to-assets ratio below 10 percent.
  - Severe scenario (20 to 66 percent default/loss rates): 8 ICs (out of 11) lose all their capital; only 1 IC will have capital-to-assets ratio above 10 percent.
  - Recapitalization needs under severe scenario (to 10 percent capital to assets ratio) would amount to 2 percent of GDP.
- Caveats:
  - Analyses are indicative; certain risks (liquidity risk) not explicitly covered or not fully covered (market risk).
  - Analysis applies the same PD, LGD, and loss rates in some asset categories to all ICs despite portfolio differences.
  - Market value for ICs’ assets could be lower than reported under the 2009 baseline assets values.
  - Analysis does not account for some companies' plans to increase capital in 2010 and other ICs not included in the sample.

### Regulatory and Supervisory Framework: Banks and ICs
- Current responsibilities:
  - Prudential regulation and supervision of banking and IC sectors primarily by the CBK.
  - Until establishment of the CMA, the KSE supervised brokerage firms, entities engaged in portfolio management, and the Kuwait Clearing Company for securities activities.
  - Supervision of the insurance industry, including brokers and agents, is responsibility of the MOCI.
- Creation of the CMA:
  - CMA Law grants broad regulatory and monitoring powers over most ICs activities, including licensing and prudential requirements.
  - Potential for regulatory and supervisory overlaps and gaps with CBK and MOCI; roles in prudential regulation and operational oversight are unclear.
  - CMA expected to take lead on market conduct-specific aspects of securities operations.
- CBK actions and needs:
  - Need for a major upgrade to CBK’s macroprudential framework.
  - CBK has begun steps including creating a FSU and could develop macro-financial models and consider issuing a financial stability report.
  - CBK amended law in 2004 to enable MOUs for consolidated supervision and to reject changes in significant ownership of a bank.
  - CBK can impose fines, limit activities, remove senior management, and appoint a controller/commissioner for problem banks.
  - Recommended CBK actions:
    - Perform periodic stress tests covering real estate and other major sectoral credit risk concentrations.
    - Review banks’ ICAAP treatment of concentration risks.
    - Lower maximum exposure on related parties.
    - Enhance legal framework to prohibit conflict of interest concerning related party transactions.
    - Complete migration from compliance-based to risk-based supervision; strengthen supervision capacity; shorten on-site supervision cycle; organize comprehensive ICAAP on-site examinations.
- Bank risk management and governance:
  - CBK issued comprehensive regulatory guidance to assist banks in identifying and managing risks and capturing them in the ICAAP.
  - Enhanced supervisory review process intended to ensure adequate capital and better risk monitoring/management techniques.
  - Move from compliance-based to enhanced risk-based supervision underway, including development of an early warning system.
  - Corporate governance improvements recommended: independent board members, enhanced minority shareholder representation, compensation linked to performance evaluation, and stronger board/senior management responsibility for risk and capital.

### Prudential Considerations for Investment Companies (Box summary)
- Key design considerations:
  - Regulations should reflect underlying business activities; differentiation by activity and asset-liability structure may be warranted but can increase supervisory burden and regulatory arbitrage risk.
  - Minimum capital requirement:
    - Current minimum capital cited as KD 15 million; some market participants consider this too low as an entry barrier.
    - Consider varying minimum capital depending on activities and risks.
  - Leverage and liquidity/maturity mismatch:
    - Justification for targeted prudential limits on leverage and liquidity for some IC types.
    - Arbitrary caps could cause distortions; design is complex given diverse IC activities.
  - Qualitative monitoring:
    - Strengthen licensing (“fit and proper” criteria), corporate governance, internal organization, internal control, risk management, external auditors, accountancy rules set by the supervisor, disclosure, and minimum contents of published accounts.

*Source: CBK and IMF staff estimates (content from IMF staff report).*

### 33.      Following the Gulf Bank crisis in November 2008, the CBK introduced a blanket

### _cr10239 - 33.      Following the Gulf Bank crisis in November 2008, the CBK introduced a blanket

### Deposit guarantee: assessment and recommended transition
- Finding: Following the Gulf Bank crisis in November 2008, the CBK introduced a blanket guarantee on deposits providing unlimited coverage for insured amount and deposit types (wholesale and retail, domestic and foreign creditors). Before that, no formal deposit insurance was in place.
- Shortcoming: The blanket guarantee is not backed by explicit funding arrangements, nor is the infrastructure in place for making actual pay-outs; in the event of a bank failure these factors "could potentially cause severe delays in providing compensation to depositors," which may undermine its effectiveness in preventing bank runs.
- Policy implications:
  - In the long term, the blanket guarantee can undermine market discipline and fuel moral hazard by eroding incentives for depositors (especially large-value wholesale depositors) to assess banks’ risk profiles.
  - Deposit insurance should be capped at a level that adequately protects retail depositors while preserving incentives for lenders to conduct due diligence.
- Recommendation:
  - Authorities need to decide their ultimate policy objective regarding deposit insurance and define a transition strategy with a timetable, potentially as part of an exit strategy from crisis support measures.
- Related exit-strategy elements noted:
  - Reversing the easing of the loan-to-deposit ratio from the current 85 percent back to the pre-crisis level of 80 percent.
  - The KSE stabilization fund.

### Emergency Liquidity Assistance (ELA)
- Legal and operational features:
  - The CBK Law (Art. 41) allows for extension of ELA to banks only.
  - Maximum tenure of ELA loans is six months.
  - Loans usually need to be backed by adequate collateral, commonly understood to be Kuwaiti treasury bills (TB) and bonds, although the law permits use of non-standard collateral.
- Recommendation:
  - The CBK could consider broadening collateral acceptance by establishing a valuation framework with haircuts for non-standard collateral.

### Contingency planning and crisis management
- Finding: Interagency coordination and cooperation during financial crises currently occur mostly on an informal basis, raising the risk of conflicts of interest, lack of preparation, and inadequate information sharing among regulators.
- Recommendation:
  - Formalize interagency cooperation with an MOU between the CBK, Ministry of Finance (MOF), KIA, and the future CMA, explicitly describing responsibilities in a financial crisis.
  - Regularly test the adequacy of interagency arrangements and crisis preparedness through crisis simulation exercises.

### Resolution framework and bankruptcy regime
- Finding: Kuwait lacks a specific resolution regime setting out distinct bankruptcy procedures for financial institutions (banks and ICs); existing bankruptcy procedures can be cumbersome with onerous court procedures. These issues are not addressed by the new FSL.
- Consequences:
  - Absence of a special resolution regime has slowed debt rescheduling for viable ICs; only one IC has sought debt rescheduling under the FSL.
  - Only ICs that use the FSL undergo a mandatory viability assessment (evaluation of asset quality and capacity of capital to absorb losses), conducted by consulting companies and extensively commented upon by the CBK.
- Recommendation:
  - Amend the bankruptcy framework to introduce a specific resolution regime for failing financial institutions and facilitate debt rescheduling for viable ICs.

### Development issues in the nonbank sector

Government securities market
- Finding:
  - Government has been issuing TBs and bonds for monetary operations, but the secondary market for government securities is virtually nonexistent.
  - Neither the MOF nor the CBK announces an issuance calendar.
  - Banks own the majority of government bonds and keep rolling over holdings, partly because government bonds are eligible for banks’ liquidity ratio requirement.
- Opportunity:
  - Considering the size and rapid growth of Islamic banking in Kuwait, issuance of government Sukuk could benefit the market.

Capital market (KSE)
- Finding:
  - During the precipitous fall from June 2008 to March 2009, the KSE lost KD27.2 billion or 51 percent in market capitalization.
  - The market displayed extreme imbalances during the boom and lacked trading mechanisms (e.g., short selling) to correct deviations from fundamentals.
  - Predominance of uninformed investors led to a one-way, low-volatility build-up and a highly volatile correction process.
- Policy implications and recommendations:
  - The CMA law is expected to streamline securities activity and strengthen governance of the KSE.
  - Better regulatory and oversight environment would enhance price discovery by licensing institutional investors and reducing price volatility from market manipulations.
- Operational note:
  - Planned issuances of government bills and bonds are announced by the CBK about one week in advance, and the KIA is informed.

Insurance and housing finance
- Insurance sector findings:
  - The Kuwaiti insurance sector is one of the smallest in the GCC.
  - Total gross insurance premiums in 2008 amounted to KD181 million (US$670 million), or only 0.6 percent of GDP.
  - Low insurance penetration is due to low awareness, low public confidence, and absence of a modern regulatory and supervisory approach.
  - Premia on motor third party liability insurance (MTPL) are not risk-based and are politically constrained, resulting in low quality service and lack of competition.
- Housing finance findings:
  - Prudential imbalances and interest rate limitations have led to concentration in volatile CRE lending rather than RRE lending.
  - RRE lending is subject to strict regulations (e.g., restrictions of property trading and prohibition of mortgaging residential properties), while CRE market regulation is far less stringent.
  - A cap on lending rates and obligation to keep them fixed for at least five years create risks:
    - Market price inflation via artificially low borrowing costs.
    - Significant exposure to interest rate risk for banks in absence of matched funding or hedging instruments.
- Recommendations:
  - Strengthen the regulatory regime for insurance supervision, focusing on risk analysis and operational risk assessment.
  - Review and rebalance prudential framework for housing finance to reduce CRE concentration and address interest rate and market risks.

### FSAP 2004 recommendations: implementation status (selected items)
- Deposit guarantee and bailouts:
  - Recommendation: Eliminate the blanket deposit guarantee, bank bailouts, and bailouts of investors in stock and real estate markets to reduce moral hazard.
  - Status: Largely implemented. The blanket deposit guarantee was removed but reinstated after the global crisis. Bank recapitalization in 2008 was designed to limit moral hazard. No bailout of ICs so far; a program to support distressed retail borrowers was introduced under parliamentary pressure.
- CBK independence and law amendments:
  - Recommendation: Enact amendments to enhance CBK independence.
  - Status: Not implemented.
- Interest rate flexibility:
  - Recommendation: Introduce greater flexibility in interest rates on lending.
  - Status: Not implemented; ceiling on lending rates remains as a legal requirement (removal requires amendment to the Commercial Law).
- Information sharing:
  - Recommendation: Seek authority to share confidential information for supervisory purposes with appropriate domestic and foreign authorities.
  - Status: Implemented.
- Capital markets law and market supervision:
  - Recommendation: Enact a new capital markets law creating a single independent authority.
  - Status: Implemented.
  - Recommendation: Prohibit insider trading and market manipulation; establish surveillance systems.
  - Status: Largely implemented; KSE installing a sophisticated market monitoring system.
- Insurance law and supervision:
  - Recommendation: Enact a new insurance law per Core Principles; strengthen insurance department capacity.
  - Status: Not implemented (new law); largely implemented for capacity building—insurance department has hired a senior advisor, but further capacity building needed.
- Liquidity management and secondary market development:
  - Recommendation: Reduce reliance on banks’ deposits with the CBK by issuing CBK bills or additional TBs; foster development of the secondary market.
  - Status: Implemented (issuance of treasury bonds began in 2005; maturity range lengthened through 2, 3, 5 and 7-year bonds; settlement facilitated by fungible, book-entry system).

### Main recommendations (Immediate, Short-Term, Medium-Term, by theme)
- Financial sector oversight (Immediate and Short-Term):
  - Clarify regulatory and supervisory responsibilities between CBK, CMA, and MOCI and initiate coordination for transition to new oversight architecture.
  - Perform periodic stress tests of real estate and other major sectoral credit risk concentrations; review ICAAP treatment of these concentrations.
  - Extend viability assessment to all systemically important ICs.
  - Enhance macro-prudential surveillance by establishing the FSU and initiate integrated supervision of systemically important sectors.
  - Strengthen corporate governance rules, apply "fit and proper" tests for board and management of new conventional banks.
  - Issue directives on conflict of interest and reduce individual and aggregate limits for credit to related parties.
  - Continue migration from compliance-based to risk-based supervision.
  - Introduce quantitative and qualitative regulation to better monitor ICs’ financial soundness and develop a new licensing regime for ICs.
  - Establish funding and operational arrangements for deposit insurance, including introducing a cap that protects depositors while preserving incentives for due diligence.
  - Establish an MOU on financial crisis management between CBK, MOF, CMA, and KIA.
- Contingency planning and crisis management (Medium-Term):
  - Consider widening collateral acceptance for ELA operations.
  - Establish a special resolution regime with distinct bankruptcy procedures for financial institutions.
  - Implement remaining recommendations from 2004 FSAP.
- Liquidity management and financial market development (Medium-Term):
  - Formulate a long-term plan for debt/sukuk market development and start implementing it with a short-term market.
- Real estate sector (Medium-Term):
  - Develop a real estate market information database.
  - Review prudential regime for CRE with a view to strengthening it.
- Insurance (Medium-Term):
  - Enhance visibility of regulatory and supervisory function to develop effective supervisory processes.
  - Increase technical capacity of the insurance department.
  - Restructure MTPL insurance to ensure sustainability, improve industry reputation, and appropriately cover liabilities.

### Focused review of Basel Core Principles — selected follow-ups
- CP 1 (Objectives, Autonomy, Powers and Resources):
  - 2004 recommendation: Adopt legislative changes to remove MOF influence over CBK decisions on licensing, closure, and remedial actions.
  - Status: No change.
- CP 1 (Cooperation):
  - 2004 recommendation: Amend law to allow sharing of supervisory information between domestic and foreign supervisors.
  - Status: Art. 78 (a) and Art. 82, § 3 of the CBK Law were amended in 2004.
- CP 3 Licensing Criteria:
  - 2004 recommendation: Give supervisor authority to reject banking license applications when owners do not meet "fit and proper" test.
  - Status: No change for conventional banks; Islamic bank owners are submitted to "fit and proper" tests.
- CP 4 Ownership:
  - 2004 recommendation: Give supervisor power to reject changes in significant ownership.
  - Status: Change of Art 57,§ 3 of the CBK Law in 2004 and executive circulars set a 5 percent maximum individual ownership for local banks and authorize CBK to reject ownership changes.
- CP 22 Remedial Measures:
  - 2004 recommendation: Establish a graduated formal framework for dealing with problem banks, transparent to stakeholders.
  - Status: Art. 64 and 85 of the CBK Law amended in 2004 to extend remedial measures; a special resolution system is still needed.
- CP 24/25 (Host Country Supervision/Foreign Banks’ Establishment):
  - 2004 recommendation: Approve legislation allowing confidential information sharing and enter into MOUs.
  - Status: Art. 78 (a) and Art. 82, § 3 amended in 2004; MOUs have not been concluded, but CBK shares information and collaborates with foreign authorities for consolidated supervision.

*Source: IMF staff report content provided in the supplied document.*

### Appendix Table 2. Summary of the Principal Recommendations and Priorities

### _cr10239 - Appendix Table 2. Summary of the Principal Recommendations and Priorities

### CP 1 (1) Objectives, Autonomy, Powers and Resources
- Adopt legislative changes that would remove the MOF’s influence over the CBK’s decisions on licensing, closure, and certain other remedial actions.

### CP 3 Licensing Criteria
- Create a level playing field with Islamic banks and submit the major shareholders of conventional banks, including their ultimate beneficial owners and others that may exert significant influence, to the fit and proper test.

### CP 8 Credit Risk (and supervisory capacity)
- Migration of compliance-based supervision to risk-based supervision.
- Address staffing issues by hiring additional experienced staff.
- Shorten on-site supervision cycle (12-18 months instead of current 30 months).
- Organize comprehensive ICAAP on-site examinations.

### CP 10 Large Exposures Limits
- Refer to recommended action for CP 8.
- Perform periodic stress tests of real estate and other major sectoral credit risks concentrations and review existing assessment of the way banks consider these risk concentrations in their ICAAP.

### CP 11 Exposures to related parties
- The supervisor should reduce the individual and the aggregate maximum limits for bank exposure to related parties.
- Enhance the legal framework to prohibit conflict of interests.

### CP 13 Market Risk
- The four recommendations under CP 8 regarding credit risk are also relevant for market risk.

### CP 14 Liquidity Risk
- The four recommendations under CP 8 regarding credit risk are also relevant for market.

### CP 15 Operational Risk
- The four recommendations under CP 8 regarding credit risk are also relevant for operational risk.

### CP 16 Interest Rate Risk in the Banking Book
- The four recommendations under CP 8 regarding credit risk are also relevant for interest rate risk in the banking book.

### CP 20 Supervisory Techniques
- The four recommendations under CP 8 regarding credit risk are also pivotal for the supervisory techniques.

### CP 23 Corrective and Remedial Powers
- The existing framework for dealing with problem banks has to be completed by a special resolution system for financial institutions.

*Source: _cr10239 - Appendix Table 2. Summary of the Principal Recommendations and Priorities*

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