KBA Workshop - Euromoney Conferences

The Finance-Development Nexus:
The Need for a Performing
Banking Sector
Ali Arifa
Department of Economics
College of Business Administration
Kuwait University, P. O. Box 5486
Safat-Code 13055, Kuwait
Telephone: (965) 2498-8408
Fax: (965) 2483-6237
Email: ARIFA@cba.edu.kw
Presented at the Euromoney Kuwait Conference,
Financing Development, Developing Finance
April 11-12, 2011, Kuwait City, Kuwait

What is being Discussed?
Background information on the causal link
between economic growth and development
on one side and financial development on the
other side.
Should the banking sector be a major
contributor in the process of financing growth
(as related to the development plan) in the
state of Kuwait?
Should the State of Kuwait create a
“Development Bank” to assist in financing the
development plan?
The pre-requisites for a successful process of
financing growth in the state of Kuwait.

Financial Development and Economic
Growth, the Direction of Causation:
Theoretical Background
The relationship between financial
development and economic growth has
been the subject of extensive research for
a long time.
This debate has intensified since, the
1980’s with the emergence of the
endogenous growth theory.

The “supply leading” hypothesis:
The argument is that financial deepening
is indeed an engine of economic growth.
In fact, financial deepening is a vital precondition
for tangible growth and
development.
It contends that the development of the
financial system and in particular its
evolution into a market oriented sector
would provide an efficiency stimulus to the
process of capital accumulation in a way
that promotes economic growth.

How does the “supply leading”
hypothesis work?
Both the quantity and quality of
investment are enhanced as a result of
financial development whereby household
real supply of funding increases and
holdings of unproductive tangible
decreases.
Technological innovations as promoted by
financial deepening makes financial
institutions more productive, with a
positive effect on economic growth.

The policy implication the “supply
leading” hypothesis work?
The financial activity is considered as a
major determinant of the real activity
where well functioning financial systems
are crucial for economic growth.
Countries should systematically adopt
appropriate macroeconomic policies,
encourage competition within the financial
sector, and develop a strong and
transparent institutional and legal
framework for financial sector activities.

The “demand following”
hypothesis:
Inspiring economic growth and high levels of
development ultimately create demands for
particular types of improved financial systems.
That is, as the economy becomes more
sophisticated, increased demand for many
services and increasingly adept settings are
inevitable, among which is an increased demand
for financial deepening. The financial system
would eventually respond to this increased
demand.

Policy Implications of the
“demand following” hypothesis:
Financial activity, is the result of economic
growth.
Financial development has very little effect on
economic growth. It simply follows economic
growth as opposed to creating it.
On this ground, any planned efforts to promote
financial development is plainly an unnecessary
use of resources given that a resulting
improvement in the financial sector will have
little effect on growth.

Which direction of causation in
the current context of Kuwait?
Almost irrelevant in light of the current plan and its
vision (“Kuwait 2035”):
"Transforming Kuwait into a financial and trade
center, attractive to investors, where the private
sector leads the economy, creating competition
and promoting production efficiency, under the
umbrella of enabling government institutions,
which accentuates values, safeguards social
identity, and achieves human resource
development as well as balanced development,
providing adequate infrastructure, advanced
legislation and inspiring business environment".

The current status, and the
opportunities for the banking
sector?
The country is implementing a four-year plan (the
biggest in the history of Kuwait), signaling a clear
change in direction for the nation’s economy.
It is a plan with a KD31 billion investment target and
with mega projects.
It is an ambitious plan, specially in relation the role of
the private sector. In line with this, 50 per cent of the
investments required under the plan should come from
the private sector.
Clearly, the banking sector should see an opportunity
with provision of credit lines for the projects of the
plan as long as government support is there.

Commonly cited “worries”:
The nation can not put all of the various
elements of the plan in place.
The private sector could not handle the 50
per cent of the investments required
under the plan.
Funding by commercial banks would not
be sufficient.

So what is being proposed?
Supplement the funding of the plan by a
“state fund”, ie through:
The creation of a state-run national “development bank”
Expanding the role of the Kuwait Fund for Arab
Economic Development to become a provider of credit
(perhaps subsidized credit) to the private sector. (It has
even been proposed to increase the capital of this
institution from KD2 billion to KD 10 billion).

Is “state-run funding” the way to
go?
No, for a number of objective considerations:
1. Strategic consideration:
This represent a clear form of government intervention,
(that gives the public sector even more weight and more
power), which is at odds with the second strategic goal
of the plan:
“The private sector leads the development in
accordance with stimulating mechanisms”

Is “state-run funding” the way to
go?
2. Opportunity cost consideration:
The banking sector will be deprived from a significant
share of the credit market, with a negative effect on the
profitability of this sector. It would lure away investors
and new projects from the Kuwaiti commercial banks.
The banking sector will be subjected to unfair
competition, given that the state fund would not
necessarily be subject to Central Bank regulation. That is
no interference from the Central Bank despite the fact
that banking services are provided (Asymmetry of
regulation).
More importantly, this will result into a missed
opportunity in relation to financial deepening.

Is “state funding” the way to go?
3. Efficiency consideration:
The increase in supply of credit might lead commercial
banks to ease the screening process for loan approval,
(and therefore the violation of safe standards for credit).
The tendency for credit being granted based on “other”
considerations. That is, there is a risk of “soft
conditions” the state-run funding will bring.
Interest rates will be put under pressure causing the
Central Bank of Kuwait to lose one of its most important
monetary policy intervention tools in the saving and
consumer market, which is harmful to the economy as a
whole.

Is the banking sector able to handle
the task?
To start with, there is no evidence to suggest that the
banking sector in the State of Kuwait is not able to
handle the funding for development challenge, in
accordance with the credit policy in place in each bank,
and in accordance with the guidelines of the Central
Bank of Kuwait.
There are 21 domestic and foreign banks are currently
operating in Kuwait, and they do not seem to have
liquidity problem. In fact, judging by 2010 data as
revealed by the Central Bank, the minimum ratio for
liquidity was 18%, and this ratio was at 28.9% at the
end of 2010. This is a strong indicator on the
robustness of the commercial banks position, and
evidence of their capacity to meet the funding
requirements of the development plan.

Is the banking sector able to handle
the task?
Judging by the ratio of loans to deposits in the
Kuwaiti banking sector, there is potential for
additional lending, and for the increase in the
financing capacity of the banks.
Judging by the indicator of capital adequacy
ratios, Kuwait commercial banks are well above
the minimum, even as stipulated by Basel III.
This is an indication of a strong capital base that
allows commercial banks to safely expand their
loan granting activities.

Is the banking sector able to handle
the task?
The funding capacity by commercial banks
is expected to increase in light of the
expected improvement in economic
conditions domestically and externally,
and the associated increase in their ability
to attract deposits, and strengthen their
capital bases.