Outlook for Kuwaiti banking system shifting to negative, according to Moody's reports

This reflects, on the one hand, the still good operating environment and the sector's good financial fundamentals, but on the other hand, Kuwaiti banks' high exposure to the weakening domestic real estate market, some earnings quality concerns, the banks' indirect exposure to local equity markets and tightening conditions on international credit markets, says Moody's Investors Service in its new Banking System Outlook for Kuwait.

Moody's credit outlook for the Kuwaiti banking system expresses the rating agency's view on the likely future direction of fundamental credit conditions in the industry over the next 12 to 18 months. It does not represent a projection of rating upgrades versus downgrades.

Stathis Kyriakides, a Moody's Assistant Vice-President/Analyst and author of the report, explains:

"The operating environment for Kuwaiti banks remains strong thanks to high oil prices in the booming local and regional economies. This, together with healthy net interest margins and excellent cost efficiency, results in superior profitability."

However, Kuwait's economy remains relatively undiversified, with half of GDP generated from oil-related activities. The modest size of the non-oil and private sectors means good lending opportunities are relatively scarce, leading to large exposures and industry concentrations at many banks, particularly to the commercial real estate and construction sectors. Moody's believes its previously expressed concerns over these large exposures have been justified by the sharp upsurge in real estate prices in recent years, giving rise to fears over possible asset bubbles.

"On the one hand, we recognise that the correction in residential real estate prices during 2008 has yet to translate into any evident deterioration in the quality of Kuwaiti banks' loan portfolios. However, if market pressures were to persist, non-performing loans would likely start to rise from their still low levels. Bank lending is over-collateralised but this is not in itself sufficient to provide adequate comfort in the event of protracted market weakness. In addition, foreclosure procedures remain largely untested," says Mr Kyriakides.

Most Kuwaiti banks still have modest risk profiles, in Moody's view, as they tend to offer relatively plain vanilla products, while open positions in different currencies or direct exposures to market risk are limited as a result of the central bank's instructions. Nonetheless, recent events at Gulf Bank, which has announced potentially sizeable losses, have cast some doubts on control and risk management practices, particularly in relation to banks' capacity to identify and manage risks.

Overall system profitability has remained strong despite some one-off write-downs by conventional banks during 2007, boosted to some extent by market-related gains and other extraordinary gains. However, the quality of earnings varies significantly.

Despite some upward pressure on funding costs, the liquidity of Kuwaiti banks remains good, although this is largely the result of central bank regulation rather than management initiative. Nor is system liquidity a major concern. Moody's notes that, following the run on deposits at Gulf Bank -- which appears to have been modest to date -- the central bank has acted promptly not only to provide Gulf Bank with access to liquidity (as and if needed) but also to guarantee customer deposits at all Kuwaiti banks. Depositor sentiment appears to have been calmed as a result, but Moody's continues to monitor the situation closely.

"Kuwaiti banks continue to display some of the best cost-to-income ratios in the world, ranging from 20% to 40%. Increased operational and marketing costs have resulted in some weakening but we do not expect any significant change in operating efficiency over the near term," Mr Kyriakides adds. Forthcoming shareholder support in the form of capital increases has traditionally resulted strong capital adequacy levels for Kuwaiti banks -- nearly all of which is core equity capital.