Last Tuesday, Kuwait Finance House K.S.C.P. (KFH, A1 stable, ba11) disclosed that it is studying a merger with Bahrain-based Ahli United Bank B.S.C. (AUB, unrated). Although the merger would present significant integration challenges owing to the banks’ geographically dispersed asset bases, it would be credit positive for KFH. The merger would strengthen and diversify KFH’s business, support its profitability and overall credit quality, and offer benefits from potential economies of scale and increased lending opportunities in a slowing economic environment. If successfully completed, the transaction would create the sixth-largest bank in the Gulf Cooperation Council (GCC), with approximately $85 billion in total assets as of year-end 2016 (see exhibit). The merger is at an early stage of evaluation, with financial analysis underway.AgreeIf successfully concluded and the banks agree on a price, the transaction would require approvals from relevant authorities and the banks’ respective shareholders before starting the integration process. The merger study comes as low oil prices slow economic growth across the GCC and subdue credit growth.If successful, the merger would expand KFH’s banking operations, which are primarily focused in Kuwait and Turkey, and include relatively small operations in Malaysia and Bahrain. In addition to Bahrain, AUB has principal subsidiaries in the UK, Kuwait, Iraq, and Egypt, and has an associate in Oman. The merger has the potential to provide economies of scale and synergies in the markets where both banks have operations. A merger would result in KFH becoming Kuwait’s largest bank, leapfrogging over the current leader, National Bank of Kuwait S.A.K.P. (Aa3 stable, a3), but would remain the world’s second-largest Islamic bank behind Saudi Arabia-based Al Rajhi Bank (A1 stable, a3).ConversionWe would expect the merged entity’s enhanced franchise to benefit from the growth of Islamic assets in the GCC. In Kuwait, that share has increased to around 40% as of the end of 2016 from around 35% as of the end of 2010, and ranks second in the GCC behind Saudi Arabia. Although Islamic asset growth is occurring throughout the GCC, the conversion of conventional banks to fully Shariah-compliant Islamic banks is aiding the growth in Kuwait. We expect Islamic banks’ credit growth to exceed that of conventional banks, notwithstanding an overall moderation of GCC credit growth because of lower oil prices. We expect that there would be considerable integration challenges with this merger, given the banks’ geographically dispersed operations. Other risks include how the structure and strategy of the merged entity could change KFH’s overall risk profile, both in terms of solvency (capital and profitability) and liquidity (liquid assets and access to funding).By Moody’s Investors Service