ABANA Review on Middle East Financial Centers
February 2008

Time to Call The Sheriff? - Financial Regulation in the Gulf

By Katya Madison, Kendall Miller and Chris Martin of the Arab Financial Forum (www.arabfinancialforum.org)

The Gulf Cooperation Council (GCC) countries are enjoying massive financial surpluses thanks to record oil prices.  Alongside the sovereign wealth funds of the Far East, the GCC’s investment vehicles have made waves in world markets to an extent not seen since the 1970s.  The legacy of those particular good times was a cycle of boom and bust in the Gulf region’s markets.  But more than three decades later, the absorptive capacity of GCC economies has increased and we are witnessing significant regional investment in infrastructure, and market growth within a considerably more sophisticated regional financial sector.  The challenge now is to develop the right type of regulation that will provide a solid foundation for growth while protecting against fall out from some of the recent excesses that have shaken Gulf markets.

Progress is being made to fit in with global frameworks.  For instance, a Bank of International Settlement survey of seven of nine Middle East jurisdictions shows that 89% of banking assets in the Middle East are expected to be covered by Basel II during the period 2007-09, the majority of which are locally incorporated.  In countries such as those in the GCC, the banking sector is well developed and profitable with efficient back office systems.  This is in contrast to most of the MENA region. In many of these countries, the banking sector is dominated by public sector banks, which are characterized by government intervention in credit allocation, losses and liquidity problems, and wide interest rate spreads (or spreads in rates of returns).  Sector reforms launched in countries including Egypt will take time to feed through to the local financial operating culture.

Discussions of the development of the regulatory frameworks in Arab markets focus on the need to raise accounting standards and strengthen reporting mechanisms.  These inappropriate systems and the improper classification of non-performing loans stand out as perceived inadequacies. Another concern with Arab markets is the disparate and sometimes inconsistent application of law. This diminishes clarity and increases the potential for conflict between regulators and those operating a, sometimes, confusing legal framework. Property rights enforcement also tends to be weak. All of these factors hinder commercial investment and hence growth, thus improvements in these areas are the building blocks with which the architecture of successful regulation will be built.  Sadly, the rate of change in these basic systems has sometimes been desperately slow in the Arab world – despite a generally perceived awareness of the need for change.  Fortunately, the Gulf countries are clearly ahead and leading the way in raising standards.

Progress has been most visible in the development of the regulatory institutions themselves. Growth in the finance sector, the birth of new markets and the introduction of greater foreign intermediation in old ones, have brought with them a heightened awareness of the need not only to keep up with events, but to be proactive.  The rapid expansion of sophisticated new financial centers in the region and the consequent competition has resulted in a greater emphasis on effective regulation.  The creation of new regulatory bodies, such as Saudi Arabia’s Capital Markets Authority, and the streamlining of market regulators, such as is occurring in Qatar, demonstrates the increased focus on developing effective bodies.  In Dubai, the DIFC has introduced what law firm Clifford Chance describes as “a radical departure from local procedural rules,” a more accessible court system with new regulation operating in English to help litigants to pursue claims. At the end of last year, the Dubai Financial Services Authority (DFSA) issued its Hedge Fund Code of Practice – the first of its kind to be issued by a financial market regulator and an indication of the level of excellence sought.  Regulators are growing in size, re-organizing and are taking time to train with and strengthen links with their regional and international counterparts.

Effective implementation of reforms requires careful consideration of the appropriate pace, timing and sequencing.  In a number of industrial countries, financial liberalization occurred only in the 1970s.  By comparison, the required pace of change is accelerated in the case of the GCC countries with huge earnings from high oil prices.  The regional intention is to implement the best elements of the Combined Code in corporate governance and Basel II for banks’ capital requirements.  Progress in this direction will bring greater stability and transparency resulting in higher volumes of business.  Gulf regulators have taken great strides in a relatively short time frame. They now stand reasonably well-equipped to operate at a world standard level but they face a range of varied demands. The recent strong emergence of Islamic banking requires adapted supervisory skills. Bahrain’s BMA/CBB has developed rigorous standards for the regulation of Islamic financial institutions and, with Malaysia, is the world leader in this area. Increased development within the insurance industry will bring its own challenges.  Greater technological sophistication and forensic skills by regulators are also needed to stop fraudsters with dubious investment schemes seeking to move into one of the world’s most capital rich region.

John Wright, a former Chief Executive of the Oman International Bank and a member of the advisory board of the Arab Financial Forum, believes “the biggest weakness in bank regulation in the GCC is the laws which allow individuals or groups of individuals to own large stakes in banks.”  One of the consequences of this is the high proportion of board members who may be shareholder appointees, running the risk that board members will prefer the attractions of quick returns over other possibly more prudent business growth targets.  Where the blocks of shares change hands, the management changes, and there is potential for discontinuity in operational procedures. The restraining role that can be played by the independent non-executive director is fairly non-existent in the region.

Wright’s proposed solution is to adopt the Hong Kong banking ordinance that restricts individuals or groups of individuals owning more than ten per cent of the shares.  Likewise, stable management would lead to better compliance with regulators.  Increased use of the new generation of local management trained to international standards rather than a revolving door of expatriate management would also strengthen through stability. 

It is a mixed picture in the Gulf at present, with some regulators being further along than others in the implementation of Basel II directives.  Plans for a Gulf Cooperation Council common currency and the creation of a common market in the GCC have been long talked about but are finally moving closer to realization – at least with regard to the free movement of goods, labour and capital flows.  Such opening of markets and harmonization of regulations means that regulators will need to work closely together to ensure a common approach.  Saudi Arabia’s move to open up its banking sector to GCC investment represents a first step along the way but progress, as ever when dealing with six sovereign states, is slower than intended.

Having said that, regulation is continuing to strengthen in the Gulf countries; the DIFC, Saudi’s CMA, Bahrain’s CBB, UAE’s Central Bank as well as their equivalents in Qatar, Kuwait and Oman are now reasonably well-equipped to operate a world-standard regulatory regime. The DIFC has done this in a relatively short time-frame while Bahrain’s BMA/CBB has developed rigorous standards over decades and is now a world leader on the regulation of Islamic financial institutions. When the British government wanted to change the rules to allow Islamic retail and wholesale banking it turned to the framework developed in Bahrain as guidelines.

Similar progress is being made in other parts of the Gulf.  Among the benefits offered to participants in the Dubai International Finance Centre (DIFC) are a zero tax rate on income and profits, no restrictions on foreign exchange or capital/profit repatriation, internationally accepted laws, and 100 percent foreign ownership.  The Dubai Financial Services Authority (DFSA) serves as the regulatory body for the DIFC, and was the first to establish regulations on hedge funds in the latter part of 2007.  Hedge funds are categorized as specialist funds that must adhere to specific eligibility requirements, demonstrating explicit separation of asset pricing and total value.  As risk management is crucial to a hedge fund’s success, the DFSA has mandated that all these financial vehicles state both their normal and exceptional risk to potential customers and traders.

Saudi Arabia is the biggest player in the region.  The Saudi Government established the Capital Market Law (CML) in July 2003 which created the Saudi Arabian Capital Market Authority (CMA) for applying the law and issuing its rules, regulations and instructions related to the capital markets.  Elsewhere, the regulatory arm of the Central Bank in Oman is not government controlled, but still operates under the title of the Central Bank, and Qatar introduced the Qatar Financial Centre Regulatory Authority in 2005. Likewise in 2006, Bahrain created a regulatory arm for the Central Bank of Bahrain, which has issued the CBB Rulebook progressively since 2004 and will ultimately comprise five separate volumes corresponding to the five licensing categories.  Rulebooks pertaining to conventional banks (Vol. 1), Islamic banks (Vol. 2), insurance (Vol. 3), and investment business (Vol. 4) have already been issued, while work is underway on Volume 5, governing specialized services, and on a further rulebook governing capital market regulations.

All commercial banks incorporated in the United Arab Emirates must be established as shareholding companies under the UAE Companies Law and must be majority owned by UAE nationals with a majority of directors also being UAE nationals. The regulatory framework for banking in the UAE is based on Federal Law No. 10 of 1980 and stipulates that banks must have fully paid-up capital of at least AED 40 million and must place 10% of their net annual profits in a special reserve until the fund amounts to half the capital.

Despite this, George Morton, who has been a commercial banker in the Gulf for more than two decades, has a concern about the underlying strength of current systems.  He worries that any significant adverse political event in the region or the deflation of the Gulf-wide property “bubble” could bring a much less forgiving environment with potential systemic difficulties in the banking/financial intermediary sector. This would put Gulf financial regulation to a new test as local liquidity tightened or evaporated and asset values imploded.  The resulting strain on bank solvency, not just liquidity or profitability, could well place unsustainable burdens on regulators as well as the financial institutions themselves. 

So while much progress has been made, the regional financial architecture is very much untested and its underlying fragility could be exposed in such a scenario. Further development and improvements in regulatory bodies will come with confidence in the financial sector, following freer markets and more foreign interaction. Looking ahead, further challenges for the regulators come with the World Trade Organisation (WTO) accession initiatives and International Monetary Fund (IMF) financial sector assessment programs. Although financial sectors were left out of the initial agreements, the industry is now steadily being opened up to foreign investment which should benefit the local economies. Opening the markets to foreign capital regulators will however broaden the field across which the burden of risk is carried.  A further likely consequence will be the deepening of the investor base and the creation of real liquidity in the regional stock and capital markets.  This should result in additional, independent judgment systems that are essential to allow markets to function at true value.

This article has been prepared by the Arab Financial Forum (www.arabfinancialforum.org) which is a not for profit organization bringing together policy-makers from the public and private sectors concerned with the development of Arab financial markets. The AFF contributes studies to the OECD-MENA financial reform programme and holds expert roundtables. To find out more please contact Ian Walker, the AFF’s executive director, on inquiries@meconsult.co.uk.

 

“I believe that the Gulf regulatory environment has never been healthier and is moving ably in the right direction.  It has won the respect not only of market practitioners subject to its guidance and regulation but also international counterparties, rating agencies and fellow regulators such as the FSA in the UK and MAS in Singapore.  What Gulf regulators now require is time and experience to bed down and ride the full economic cycle.”

 

George Morton, director, European Islamic Investment

 Macro-Political & Economic Studies

MEC carries out  periodic reviews of the politics and economies of the Gulf states, the Middle East and Central Asia. Running to 50 pages, these papers are client specific and review recent events and assess future prospects and factors which may influence the stability and likely future developments of these sensitive regions.

Clients Commissions

MEC Publications Group prepares bespoke studies and market surveys on behalf of corporate and government clients. Such studies are client specific. Copies are available for MEC clients only and the product is not normally available in the public domain. Lists of some of the more generalised major studies prepared by the MEC Publications Group are shown on the MEC International Ltd website at www.meconsult.co.uk.

Central Asia

The Windsor Energy Group is going to present a new study on Central Asian Gas Markets in Almaty on the 1st of October of 2007. This is a study on the request of the government of the Republic of Kazakhstan, which is a follow up on last year’s study on Central Asian and Caspian Pipelines. Please see the Central Asian Gas Markets report description for more information.

European Energy and Diplomatic policies Towards the Arabian Gulf Countries

In January 2003 MEC International was commissioned by a client to prepare a series of reports on the subject of "European Diplomatic and Energy Policies Towards the Arabian Gulf Countries and Yemen 2003-2005." The joker in the pack was the prospect of imminent regime change in Iraq. The project analysed the changing fundamentals of Euro political and economic policies toward the Gulf states in the light of the forthcoming regime change war in Iraq.

Project Upstream

Commissioned by a regular international client, this study covered the reasons for the invitation from Saudi Arabia to the super majors to bid for entry into the gas project of the Saudi energy sector and the reasons underlying the enthusiastic response of the world energy companies to this proposal.

Project Samarkand

MEC International created for a regular client a major study some 250 pages in length on a series of integrated political risk/energy related briefs. MEC has worked with this client for some 12 years. The methodology employed was to break down the brief into its component parts and to recruit up to 25 or more analysts to address the appropriate part of the brief where the individual strength of the analyst lies. Project editors then checked the final text for errors and edited the final report. Delivery to the client took place in late December 2004.

Country Export Guides Project

MEC was invited by the Brazilian Government to complete twelve Middle East country guides for businessmen exporting to Arab countries. The countries concerned were Algeria, Tunisia, Libya, Lebanon, Syria, Jordan,Kuwait, UAE, Qatar, Bahrain, Oman Yemen. The 12 reports were to be practical guides to assist Brazilian commercial companies and businessmen to do business in the respective countries of the study. They had to be prepared in time for the Middle East Heads of State summit which took place in Brasilia in early  May 2005. The information provided needed to be current, comprehensive and freely available without restrictions in its use.

MEC established twelve individual country project teams to undertake

A total task force of some 30 - 36 consultant analysts and 4

editors each of whom was responsible for the final report of 3 of the countries.

This project Leader was Robin Kealy, a former British Ambassador in Tunisia.

The task was simple in concept but complex in execution – the collection of commercial data to provide Brazilian businessmen with an adequate briefing on their individual target country markets. The project was completed on time and within budget.

Newsletters

At times of tension and crisis, MEC offers its clients up-to-date information and serious analysis of events and their implications by tailor made newsletters delivered by IT technology.

MEC Analytical Group

An interactive analytical group working through IT and the world wide web the group operates with some 240 respondents and is delivered privately to readers by emai only. The MAG addresses issues of the day including terrorism, stability of the Gulf and Central Asian countries, the politics of energy, the ongoing crisis in Iraq, negotiations for membership of the WTO, and environmental issues. Membership of the group is by invitation only. 

Sector Studies

These reports are entirely client-driven and are prepared by MEC project task forces briefed to meet the specialist requirements laid down in client briefs. The reports completed for clients include:

• .A Review of the Export potential into the Islamic States of West Africa
• A Study of the Saudi and Kuwaiti Ophthalmic Market.·       A Survey of the Ambulance Market in Saudi Arabia.
• A Study of Satellite and Telecoms Markets in the Gulf.
• A Review of the D-I-Y market in Turkey
• A Study of the Telecoms market in six Maghreb and West Med countries
• A study of Ports and Shipping Lines in the Mediterranean
• A Study of e-commerce in the Arab & Gulf countries.

 For Further Information

Please contact Ian Walker or Geoffrey Hancock at MEC International, Granville House, 132-135 Sloane Street, London SW1X 9AX; tel: 020 7591 4816; fax: 020 7591 4801; e-mail: queries(at)meconsult.co.uk