Kuwait Finance House Case-Study: Financial Reporting as a Method of Risk MitigationBY: CAMILLE PALDI

Introduction

In this financial analysis of Kuwait Finance House Group (KFH), I have conducted a ratio analysis of key liquidity, profitability, and efficiency ratios and compared KFH to one of its main competitors, Gulf Finance House (GFH) in order to illuminate the financial health of KFH.

I have also examined the accounting and business practices, disclosure, corporate and Shari’ah governance mechanisms, and Notes to the Financial Statements .

I conclude with recommendations to KFH and the industry for the best way forward in terms of financial reporting practice.

Aim

Through financial analysis of Kuwait Finance House, I aim to show the current state of financial reporting in the Islamic finance industry and make recommendations for improvement.

Objective

By examining KFH accounting, disclosure, and reporting practices and their suitability for an Islamic bank, remuneration practice, corporate and Shari’ah governance, strategy and their possible financial impact, and through discussing risk mitigation and capital structure, I plan to provide a snapshot of the financial and nonfinancial health of the institution for the benefit of a potential investor/depositor and also the state of financial reporting for the Islamic finance industry.

Kuwait Finance House

KFH is organized into three major business segments including treasury, investment, and banking (KFH 2011: 78).

In 2011, KFH had 54 branches and was ranked among the best Islamic banks in the world.

KFH activities are conducted in accordance with the Shari’ah as approved by the Bank’s Fatwa and Shari’ah Supervisory Board (SSB) (KFH 2011: 51).

Ratio Analysis: Current Ratio

Kuwait Finance House (KFH) has a fairly consistent current ratio for 2009 (.73:1), 2010(.73:1), and 2011(.70:1). Although the ratio is below 1:1, this doesn’t necessarily indicate that KFH is headed for a financial disaster, however, it does mean that KFH is working with negative working capital.

The current ratio for Gulf Finance House (GFH) gives a gloomy outlook for this international financial institution in 2009 (.48:1), 2010 (.08:1), and 2011 (.01:1). In 2011, GFH only had .01 cents of assets for every $1 of liability. Both banks are relying heavily on the fact that depositors do not withdraw their deposits, however, GFH seems to be in a more vulnerable position.

Earnings Per Share

In terms of Earnings Per Share (EPS), initially, a potential investor may feel uncomfortable with KFH as KFH starts in 2009 with (18. 1 cents), 2010 (15.4 cents), and ends in 2011 at (10.8 cents).

However, the reason for the sudden decline in EPS may be due to a bonus share issue.

Earnings Per Share

GFH starts out in 2009 with an EPS of 272.17 cents, 2010 (76.84 cents), and ends in 2011 with .04 cents.

This is an alarming rapid decline and also means that for every 1$ invested, the return for GFH is only .04 cents, indicating very low profitability for GFH.

Debt-to-Equity

KFH has a debt- to- equity ratio of 5.9 in 2009, 6.5 in 2010, and 7.3 in 2011. GFH’s debt-to-equity ratio is 2009(2.7), 2010(7.7), and 2011(2.53).

It seems that KFH has been more aggressive than GFH in financing its growth with debt in 2011 and appears to be a credit risk.

If the cost of debt-financing becomes greater than the return, this could negatively impact KFH’s business.

Therefore, KFH should seek the right balance of debt and equity finance so as to leverage its assets correctly, especially with a declining EPS and turbulent economic conditions.

Return- on- Equity

Return on equity for KFH amounts to 2009(22%), 2010(4%), 2011(9%) and for GFH 2009(13%), 2010(7%), 2011(31%).

It appears that in 2011, GFH has a better ROE than KFH.

Furthermore, KFH’s ROE steadily declined from 2009 to 2011.

This is a worrying signal for potential KFH investors.

Return- on- Assets

Return on assets for KFH in 2009 is 6.4%, 2010(5.7%), and 2011(.01%) and for GFH in 2009(.03%), 2010(7.96%), and 2011(.09%).

Once again, GFH is more efficient in terms of return on assets although GFH also has a low figure and KFH sees a rapid decline in ROA from 2009 to 2011, possibly worrying investors.

Moody’s

In fact, in 2011, Moody’s was reviewing a downgrade for KFH due to the fact that the overall coverage level of provisions to problem loans remained relatively low, approximately 73%.

Provisioning needs also continued to weigh down KFH's profitability, with the bottom-line only stabilizing through relatively volatile investment income.

Moody’s cited inefficient reporting as one KFH’s key problems in addition to weak asset quality, financing, and loan books, and problems in management and internal controls.

Moody’s

Moody’s stated that the poor asset quality was due to concentrated exposures to non-banking financial institutions, real estate, and underperforming investments.

In fact, in May 2013, Moody's downgraded KFH’s long term ratings by one notch to A1 from Aa3. Moody's also downgraded KFH's baseline credit assessment (BCA) and bank financial strength rating (BFSR) by two notches to ba1/D+ from baa2/C- respectively.

Moody’s

The Prime-1 short term rating was confirmed.

All ratings assigned to KFH in 2013 carry a negative outlook.

Moody’s reported that the rating actions reflect (1) continued asset quality pressures; (2) an increasing reliance on volatile investment income; and (3) the current organizational complexity and overall risk profile inconsistent with global peers.

Overextension and Wrong Direction

The exposure from excessive derivatives trading most likely added to the poor asset quality.

In addition, the bank may be overextended in real estate and investment.

Overextension and Wrong Direction

In 2011, KFH launched a one billion KD real estate portfolio in collaboration with the Kuwait Investment Authority and KFH initiated several real estate and special purpose financial funds including a gold traded fund and introduced investment portfolios.

KFH also partnered with Grosvenor Fund Management to invest up to £380m in US healthcare real estate, having a combined investment capacity of £900m (Gassner 2011).

Perhaps KFH should redirect some of these efforts towards its banking section.

Accounting Practices

Although an Islamic bank and an associate member of AAOIFI, KFH Group does not officially adhere to the AAOIFI standards in its financial reporting.

KFH financial statements are prepared in accordance with IFRS, however, KFH selectively and unofficially follows FAS guidelines in some areas of reporting.

Accounting Practices

IFRS does not equip KFH with the necessary degree of disclosure and transparency in light of Islamic modes of finance, as risk exposures of assets vary according to different types of contracts and the mode may be used for sale or finance, which would result in different reporting implications.

Accounting Practices

Furthermore, there are many rules in the Shari’ah, which the IFI must abide by, which may affect reporting requirements.

General disclosures unique to IFI’s are information about the Shari’ah Advisory Board, policies on zakat, policies of profit distribution with IAHs, disclosures on prohibited earnings and disclosures of concentration of asset risks involving unrestricted investment accounts.

Many gaps in disclosure occur due to use of conflicting standards.

Accounting Practices

For example, in regards to investment accounts, some IFIs treat such accounts as equity or liability, while others report them as off-balance sheet items.

Jordan Islamic Bank, Bahrain Islamic Bank and Qatar Islamic Bank treat investment accounts that are based on mudarabah contracts as liabilities and report them on- balance sheet.

Other banks treat investment accounts as fiduciary investments and report them off-balance sheet (Al Rajhi Bank and Shamil Bank of Bahrain)(Sarea 2012:27).

Accounting Practices

KFH reports restricted investment accounts off-balance sheet and discloses joint financial assets and percentages of funds involving unrestricted investment account funds, which mitigates agency risk involved with the commingling of funds (FAS1).

Accounting Practices

Furthermore, in terms of FAS1, KFH discloses compensating balances as balances with banks and financial institutions - exchange of deposits, both on the assets and liabilities sides of the balance sheet (Shabbir, 2012).

According to Abdel Karim, reporting off balance sheet allows IFI’s to hide negative information such as losses because of misconduct or negligence (Safiddiene 2007:144).

Accounting Practices

Under mudarabah investment management, the IFI is not liable for loss arising from investments according to Shari’ah.

In IFRS, this would be presented as a liability along with other deposits, however, under AAOIFI, unrestricted investment funds are to be presented as a separate item between liabilities and owners’ equity.

Accounting Practices

In terms of Ijarah, AAOIFI requires both operating ijarah and ijarah muntahia bittamleek to be treated as an operating lease.

In IFRS, both operating ijarah and ijarah muntahia bittamleek are classified as finance leases.

Due to Shari’ah requirements, Ijarah contracts cannot be accounted for as finance leases.

The leased assets are recognized in the books of the bank and not capitalized in the customers books.

Accounting Practices

The leased assets are then depreciated in the books of the bank, contravening IAS 17 (Ibrahim 2007).

The 2011 KFH Annual report states that capitalized leased assets are depreciated over the estimated useful life of the asset (KFH 2011:54).

Accounting Practices

It is required for leasing with gradual sale that the inventory be valued at fair values, not lower of historical cost or net realizable value. Hence, IAS2 cannot be followed (Ibrahim 2007).

The 2011 KFH Annual report states that finance leases are capitalized at inception of the lease at fair value, or if lower, the present value of the minimum lease payments (2011:54).

Accounting Practices

The special nature of Islamic banking requires tailored standards in order to promote full disclosure and transparency of the IFI (See Table on Next Slide).

Disclosure Requirements for Islamic Finance (AAOIFI)

Capital Based on trust, profit sharing contract with no executive involvement.

Performance of fund (net asset value) and/or dividend return.

State outstanding balance, change in value and profit distributed (FAS 6).

Commingling of Funds

IFI can utilise the funds and pool for financing or investment.

Funds utilised are to be identified visà-vis shareholders and other deposit funds.

Disclose joint financial assets and percentages of funds involving unrestricted investment account funds (FAS 1).

Investment Policy

IFI can adopt a flexi investment policy in utilising IAH funds.

Decisions should be taken in the interest of an IAH.

Provide adequate disclosure on basis of investment policy when mobilizing IAH funds.

 Disclosure Requirements for Islamic Finance (AAOIFI)

Profit and Loss Distribution

Mutually agreed profit distribution ratio and basis to be specified.

Mechanisms are specified and effectively communicated.

State PSR, income determination method, allocation basis and reserve management policy (FAS 5).

Reasonable Return

Effective return to IAHs is realised.

Smoothing of rate of return to IAHs.

Report policies, amount, and movements within PER (FAS 11).

Capital Recovery

Fund is safeguarded by ensuring capital is recovered prior to profit distribution.

Accrued profit not distributed until assurance provided that capital is not depleted.

Report policies, amount and movements of Investment Risk Reserve IRR (FAS 11).

Accounting Practices

Capital adequacy and the use of regulatory capital are governed by the Basel Committee on Banking Supervision (KFH 2011: 87) rather than the standards issued by AAOIFI and the IFSB.

However, Islamic finance standards are required to regulate deposits based on Wadi’ah (guaranteed safe custody) or Qard Hassan (interest free loan) contracts, which are reported as liabilities in the balance sheet.

Accounting Practices

At 31 December 2011, the total Capital Adequacy ratio for KFH was 13.73% and Tier (1) 13.51% (2010: 14.22% and Tier (1) 14.15%) compared to the ratio required by the regulatory authorities of 12% (KFH 2011 Annual Report, 31).

However, as KFH does not use the IFSB and AAOIFI standards for capital adequacy, this may not truly reflect KFH’s capital structure and stakeholders cannot truly assess whether capital structure decisions were made to maximize shareholder equity.

IFSB Capital Adequacy Standard

The IFSB has issued a capital adequacy standard, which is based on the Basel II standardized approach with a similar approach to risk weights. However, the minimum capital adequacy requirements for both credit and market risks are set out for each of the Shari’ah compliant financing and investment instruments (Van Greuning and Iqbal 2008:83).

AAOIFI Statement on Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks

The AAOIFI Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks takes into account the differences between deposit accounts in conventional banking and investment accounts in Islamic banking (Van Greuning and Iqbal, 2008:59) recommending not including the risk-sharing account deposits in capital (Van Greuning and Iqbal 2008:81).

Accounting Practices

The 2011 KFH Annual Report states that no changes were made in respect to capital management objectives, policies, and processes from the previous years, however, the dividend pay- out to shareholders significantly decreased from 2010 to 2011, while directors’ salaries increased.

Furthermore, profits distributed to investment account holders (IAH’s) decreased from 2010 to 2011 as seen in the table on the next slide.

Profits Distributed to Investment Account Holders (IAH’s) Decreased from 2010 to 2011

Deposit Type 2011% of Profit Distribution to IAH’s

2010 % of Profit Distribution to IAH’s

Khumasia: 2011 (1.920%)

Mustamera: 2011(1.728%) 2010 (2.378%)

Sedra: 2011(1.344%) 2010(1.850)

Tawfeer: 2011(1.152%) 2010(1.585%)

Investment Accounts

The Bank receives deposits from customers as part of several unrestricted investment accounts “On Balance Sheet” and restricted “Off Balance Sheet.” In Unrestricted Deposits, these are invested by the bank as Mudarib investing funds for limited or renewable periods at various investment ratios.

Investment returns are distributed among the bank as a Mudarib and investment account holders on proportionate basis for each type of these accounts and the elapsed investment period (KFH 2011).

Investment Accounts

Investors’ capital is not guaranteed and they incur losses if the bank does (Van Greuning and Iqbal 2008:35).

KFH acts as an investment agent in restricted deposits.

Investment Accounts

In terms of depositors’ accounts, non-investment deposits in the form of current accounts are not entitled to any profits nor do they bear any risk of loss as the Bank guarantees to pay the related balances on demand. Accordingly, these deposits are considered Qard Hasan from depositors to the Bank under Islamic Shari’ah.

Investment deposits comprising of Khumasia, Mustamera, and Sedra deposits are for an unlimited period, initially valid for one year, and are automatically renewable for the same period unless notified to the contrary in writing by the depositor.

The Tawfeer savings accounts are investment savings accounts valid for an unlimited period. In all cases, the investment deposits receive a proportion of the profit as the board of directors of the Bank determines or bear a share of loss based on the results of the financial year.

Investment Accounts

The bank generally invests approximately 100% of investment deposits for an unlimited period (Khumasia), 90% of investment deposits for an unlimited period (Mustamera), 70% of investment deposits for an unlimited period (Sedra) and 60% of investment saving accounts (Tawfeer).

The bank guarantees to pay the remaining un-invested portion of these investment deposits. Accordingly, this portion is considered Qard Hasan from depositors to the Bank under Islamic Shari’ah.

Investing such Qard Hasan is made at the discretion of the Board of Directors of the Bank, the results of which are attributable to the equity-holders of the Bank (KFH 2011:71).

Investment Accounts

According to the AAOIFI Shari’ah Standard No. 40 Distribution of Profit in Mudarabah-based Investment Accounts, section 4/1, the method of profit distribution should be well-known so that no room is left for uncertainty and dispute.

Distribution of profits should also be in terms of ratios and not at all by specifying a lump sum amount or a percentage of the capital for any party or any other method that could lead to avoidance of sharing of the profit between the two parties (2004: 723).

KFH has not specified in its annual report the method of profit distribution, however, has listed the concerned ratio.

Investment Accounts

According to section 5/1, Distribution of Profit, Application of Scoring Method of Profit Distribution, the scoring method for distribution of profit among the participants of general investment accounts should be used.

From the 2011 report, we cannot deduce the method used, however, all we can see is that the ratio of profit decreases from 2010 to 2011 due to a decision of the Board of Directors (AAOIFI 2004: 723).

The dilemma currently experienced in terms of the divergence of accounting standards and their implementation poses a great threat to the sustainability of Islamic financial institutions.

Investment Accounts

Appropriate management of PSIA, with proper measurement, control, and disclosure of the extent of risk sharing and IAH’s can be a powerful risk mitigant in Islamic finance (Van Greuning and Iqbal 2008:59).

The AAOIFI and the Islamic Finance Supervisory Board recommend that Islamic banks accurately disclose the returns on IAH and shareholder funds, the bases and the percentages for the allocation of assets, and profits and expenses in a way to enhance transparency and enable investors to monitor the performance of their investments (Safieddine 2009: 144).

Remuneration Committee

The Board of Directors of the Bank proposed a cash dividend of 15% for the year ended 31 December 2011 decreasing from 20% in 2010. At the same time, Directors’ fees increased to KD 260 thousand in 2011 from KD 160,000 in 2010 (KFH 2011: 74).

As the Annual Report does not contain a remuneration committee report, we cannot see how and why these decisions were made.

Shari’ah Governance Board

A transparent financial institution would ideally reveal the duties, decision-making, competence, and composition of the Shari’ah Board, as well as publish all fatwa issued by the Board.

However, in a one page report, KFH merely certifies that most decisions made were Shari’ah compliant and for those that were not, the funds have been donated to charity and provides the names and pictures of the members (Van Greuning and Iqbal, 2008:36).

KFH unofficially adheres to FAS 1 in terms of zakat and qard-hassan reporting. In 2011, zakat was calculated at 2.5777% and charged to the consolidated statement of income (KFH 2011:59).

Corporate Governance

KFH lacks any meaningful corporate governance structure to address potential agency problems concerning investment accounts nor for the organization as a whole, except through unofficial compliance with minimal FAS standards.

Disclosure

Although the statements have been certified by Ernst and Young as a true and fair representation and KFH compliance with capital adequacy regulations, if KFH does not adhere to the standards set out specifically for Islamic banking, the statements may not in reality be a true and fair representation of the position of KFH and the capital structure management may not have been carried out in a manner to truly maximize shareholder’s equity and this would remain unknown to the stakeholder.

Risk Mitigation

KFH slightly reduced liquidity risk even though credit risk increased, indicating effective capital structure management in the advent of business expansion and a slightly increasing ability to meet demand deposit withdrawals.

One cause for concern is the use of derivatives by KFH, which is not Shari’ah compliant and which exposes the assets of its business to a whole new set of risks, potentially resulting in loss of profits in the long-run.

Risk Mitigation

KD000’s 2010 2011

Credit Risk Exposure

KD11941780 KD12588420

Liquidity Risk 23% 22%

Equity Price on

Kuwait Stock

Exchange

KD2740 KD2920

Notes to Financial Statements

As KFH Group adheres to IFRS, gaps in disclosure may occur and there runs a risk of non-Shari’ah compliance.

Notes to Financial Statements

Standard Yes No

FAS No.1 requires that restricted investment accounts should be reported off balance sheet in the statement of the changes in restricted investments.

x

FAS No.3 disclosure should be made in the notes to the financial statements for a financial reporting period if the Islamic bank has made during that period a provision for decline in the value of Mudarabah assets.

x

FAS No.4 disclosure should be made in the notes to the financial statements for a financial reporting period if the Islamic bank has made during that period a provision for a loss of its capital in Musharaka financing transactions.

x

Notes to Financial Statements

FAS No.5 requires bank to disclose percentages for profit-allocation between investment account holders and the bank.

x

FAS No.6 disclosure should be made, in the notes on significant accounts, of the percentage of the funds of unrestricted investment. Distinguishes reporting requirements of unrestricted (on balance sheet item) and restricted (off balance sheet item) investment accounts.

x

Fas No. 9 on Zakat x FAS No.10 requires that the Islamic bank shall disclose in its financial statements revenues and profits of Istisna’a contracts recognized for the financial period.

x

Notes to Financial Statements

FAS No.11 requires that the Islamic bank shall disclose in the notes any deductions, either as a percentage or an amount, from mudarabah income. Introduces the Profit Equalisation Reserve (PER) and Investment Risk Reserve (IRR) to protect IAHs’ interests by ensuring stable distribution rate of return to IAHs as well as ensuring capital recovery prior to realisation of distributable profit.

x

Fas No. 14 on Investment Funds x FAS No. 17 on Investments x FAS No.20 requires that the bank shall disclose in the notes to the financial statements the policy adopted in financing deferred payment sale transactions.

x

Notes to Financial Statements

FAS No.21 require that disclosures shall be made of the accounting policies adopted in the transfer of assets from unrestricted investment accounts to restricted investment accounts.

x

FAS No.23 requires consolidated financial statements shall be prepared by combining the financial statements of the IFI.

x

Conclusion

It appears that KFH follows the basic disclosure requirements of AAOIFI even though it officially adheres to IFRS, however, there is a gap in relation to the more detailed requirements of the AAOIFI standards.

However, all of these requirements appear to have been met in the KFH (Bahrain) B.S.C.(c) Public Disclosure Report, as AAOIFI standards are officially followed in Bahrain prepared in accordance with the Central Bank of Bahrain’s requirements outlined in its Public Disclosure Module, Section PD 3.1.6 Additional Requirements for Semi Annual Disclosures, CBB Rule Book, Volume II for Islamic banks.

Conclusion

Concerns for investors include the worrying debt-to-equity, ROE, and ROA ratios, overextension in the real estate and investment businesses, the declining dividend pay-outs and increasing salaries along with the decreasing percentage of profits to investment account holders, and the Moody’s downgrade.

Another destabilizing factor could be the use of derivatives to hedge risk and/or speculate and the lack of transparency in the reporting of the investment accounts, remuneration committee, Shari’ah Board, and the Group as a whole.

Agency problems involving the investment accounts can be mitigated if KFH Group opted to adopt the structure of the KFH Bahrain Public Disclosure Report in its financial reporting, which adheres to AAOIFI standards.

Conclusion

My recommendation to KFH is to utilize the Bahrain Public Disclosure Report in the KFH Group consolidated financial statements either as a separate additional report or included in the Notes to the Group consolidated financial statements.

Conclusion

Furthermore, I recommend KFH to issue a Remuneration Report and to develop a comprehensive corporate governance structure as well as issue a more substantial Shari’ah Supervisory Board Report so as to ensure Shari’ah compliance.

KFH should also consider taking the lead as one of the first Islamic banks to introduce a system of guaranteeing deposits in order to attract greater clientele and ensure industry-wide stability.

Otherwise, KFH remains the best Islamic bank in Kuwait and the Middle East.

Conclusion

Bibliography Available Upon Request.

Full Report and Bahrain Disclosure Report for KFH available on my Academia Profile.

https://durham.academia.edu/CamillePaldi