Information about Middle East Oriente Medio

II. Structure of the GCC Financial Sectors

International Monetary Fund
Published Date:
November 1997
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A. Banking Intermediation

The GCC countries have a fairly large number of banks with extensive networks of branches. Banks are also, with few exceptions, financially strong and well capitalized, with total assets ranging between 70 percent of GDP for Saudi Arabia and 280 percent for Oman, levels that are high by international standards (Chart 1). In 1995, the region boasted 9 banks with assets exceeding US$5 billion each, of which three had assets of more than US$10 billion each. Moreover, in most GCC countries, the value added of financial services currently accounts for about 10 percent of non-oil GDP.

Chart 1.GCC Countries: Banking Sector Indicators

Sources: Data provided by the authorities; Middle East Economic Digest (MEED); MEED MONEY.

1/ Assets are not risk-weighted.

Most of the region’s banks were originally branches of major international banks until the mid-1970s when foreign banks were required to transfer ownership to domestic residents; at present, foreign banks are permitted only minority ownership of local banks. All GCC countries have moratoria on the licensing of new banks. They have recently agreed to permit local banks to establish branches in other GCC member countries. Although private ownership of banks is predominant in many GCC countries, government equity participation in financial institutions is widespread and a large number of banks and specialized financial institutions are fully controlled by the public sector. Moreover, in many cases, private sector ownership tends to be concentrated in a few shareholders.

Licensing and foreign ownership restrictions may have resulted in a relatively high degree of banking concentration. In Saudi Arabia (1996) and Oman (1994), the three largest banks accounted for approximately one-half of total bank assets, equity, and loans, with one bank accounting for approximately one-fifth of assets and equity. These ratios are even higher in Kuwait, where the three largest banks accounted for nearly 80 percent of the banking sector’s total assets and equity in 1995, while the largest single bank accounted for one-third.

By traditional measures of financial deepening, the region is well monetized. In most countries, the ratio of money supply to GDP is high, ranging between 50 percent and 90 percent, and has been relatively stable over the years reflecting the banking sector’s ability to attract increased deposits (Chart 2). The extent of monetization and the banks’ success in mobilizing longer-term financial assets are also evidenced by low ratios of currency and short-term deposits to broad money (27 percent on average in 1996), and of ratios of currency-to-deposit (average of 10 percent in 1996). The high degree of monetization is a testament to the increased confidence in banks and the ability of the latter to utilize advanced consumer banking technologies. Usage of automated teller machines and point-of-sales technologies is widespread; tele-banking services and the usage of credit and debit cards are expanding. Such technologies have been supported by advanced computerized payment and settlement mechanisms.

Chart 2.GCC Countries: Financial Indicators, 1990-96 1/

Sources: Data provided by the authorities; International Monetary Fund, International Financial Statistics; and World Economic Outlook.

1/ All indicators are regional averages.

2/ Interest rate differential between domestic interest rate and similar maturity U.S. dollar LIBOR rate.

* Newly industrialized economies of South East Asia.

Reflecting the relatively limited—albeit expanding—share of the private sector in economic activity in the GCC countries, bank lending to the nongovernment sector has remained modest in most countries.3 Notwithstanding problems of private/public sector distinctions in the statistical accounts (especially in monetary data), credit to the nongovernment sector averages less than 40 percent of GDP for the GCC countries and less than two-thirds of total credit, shares that are lower than those in the G-7 industrial countries and the fast growing economies of East Asia (Chart 3). By contrast, the region’s banks have been generally active lenders to the government sector, with Kuwait and Qatar having the highest shares.

Chart 3.GCC Countries: Credit Indicators, 1990-96 1/

(Ratios to GDP)

Sources: Data provided by the authorities; International Monetary Fund, International Financial Statistics; and World Economic Outlook.

1/ All indicators are regional averages.

* Newly industrialized economies of South East Asia.

The relative importance of lending to the government sector reflects the increased recourse to bank borrowing to finance the large fiscal deficits that emerged as a result of the Gulf crisis and the subsequent decline in oil prices, as well as other factors such as the floating of government bonds to finance payments to farmers in Saudi Arabia, the taking over of bad debts by the Kuwaiti government under the Debt Collection Program (DCP), and the financing of large gas and petrochemical projects in Qatar, to mention only a few examples. While the share of credit to the private sector has been increasing since 1990 in all GCC countries, part of the private sector’s financing needs (especially for investment) has been met either through liquidation of private assets held abroad, or through borrowing from foreign banks and off-shore banking units.

Bank lending continues to be of a predominantly short-term nature and is heavily concentrated in traditional sectors, such as trade, and construction and real estate activities, which together, account for about 30-45 percent of the total, while the industrial sector’s share has generally been less than 10 percent. However, the GCC banking sector has recently experienced a marked increase in personal credits, the share of which in total credit has reached 30-40 percent in some countries. This reflects high demand for consumer loans by an increasingly young and wealthy population, as well as a rising demand for bank loans to finance equity purchases.

B. Framework and Instruments of Monetary Policy

The GCC countries have open economic systems with free movements of capital and fixed exchange rate arrangements. This institutional setting has implications for the conduct and the effectiveness of monetary policy, which is geared toward maintaining stability of the exchange rate arrangements.4 In this framework, demand pressures, created mainly through fiscal deficits, have tended to be absorbed through the balance of payments, thus mitigating the monetary impact of deficits. Thus, during 1985-90, money supply grew by only an average 2.9 percent a year, despite relatively high fiscal deficits. Since then, government deficits have been reduced in all the GCC countries through fiscal consolidation efforts, which have eased the pressures on the balance of payments while permitting money supply to continue to grow at moderate rates (averaging 4 percent a year over the past five years). Under these conditions, the scope of monetary policy is limited to primarily regulating short-term liquidity and smoothing out volatility arising from exogenous shocks, while the burden of adjustment falls on fiscal policy.

The use of instruments of monetary policy by GCC central banks has varied in recent years with increasing reliance being placed on market-based instruments. In Bahrain and Kuwait, the authorities use open-market operations (purchases and sales of government securities, repos of government securities); open-market-type operations (outright sales in the primary market); and central bank-lending operations (overdraft window, overnight lending). The Central Bank of Kuwait also has a “liquidity scheme” in the form of one-month deposits with the central bank at a competitive interest rate, which is used when the ceiling on treasury bills and bond issues is reached. The U.A.E. Central Bank relies mainly on purchases of foreign exchange, although it uses a swap facility and transactions in central bank certificates of deposit. The Qatari authorities also operate a discount window facility. The main instruments used by the Saudi Arabian Monetary Agency (SAMA) to smooth out liquidity and interest rate movements are repo operations in government bonds. Other instruments used by SAMA include foreign exchange swaps and the placement of government deposits in different banks. However, in all countries, the lack of deep and well-structured secondary markets for government paper has hampered the further development and effectiveness of open-market operations. Finally, recourse to certain direct instruments of liquidity management has been maintained mainly for prudential purposes, in the form of mandatory loan-to-deposit ratios, and ceilings on consumer credit and interest rates.

Owing to the existing fixed exchange rate arrangements and the freedom of capital movements, interest rates in the GCC region have usually closely tracked interest rates on U.S. dollar-denominated assets—except for temporary deviations in response to exogenous shocks, and upward deviations explained by transaction costs and risk factors. The recent strengthening of the region’s macroeconomic balances has led to a further decline in interest rate differentials in most countries (Charts 2 and 4). While most GCC countries had maintained restrictive regulations on interest rates in the early 1970s, since then, there has been a progressive easing, with interest rates now largely determined by market forces in most countries. Nevertheless, some restrictions remain in a few countries, such as ceilings on deposit rates and caps on lending rates or on consumer loans. Some of these ceilings are either nonbinding or affect a small share of overall financial transactions. Because of the region’s low rates of inflation, interest rates have generally been positive in real terms, with real rates ranging in most countries between 3 percent and 5 percent. Most GCC banks have a deposit interest rate yield structure with rates that fluctuate across maturities and provide a premium for longer-term deposits; however, the term structure of lending rates has remained generally less wide.

Chart 4.GCC Countries: Macroeconomic Indicators, 1990-96 1/

Sources: Data provided by the national authorities.

1/ All indicators are averages for the region.

C. Banking Soundness, Regulation, and Supervision

Since the early 1980s, the GCC financial sectors faced a number of difficulties, including the 1982 crash of the informal stock exchange (Souk Al-Manakh) in Kuwait, and the property market collapse of the 1980s. With the drop in international oil prices and the cut in government expenditures in the mid-1980s, a number of banks faced difficulties as sizable loans turned nonperforming. However, since then, banks have increased their “general” provisions and capitalization in response to the introduction of stricter prudential regulations, and also partly reflecting improved management practices and higher profits. Banking problems have also been resolved through mergers and closures and, in some cases (notably Kuwait), government assumption of bad debts.

A key factor behind the improvement in the region’s bank soundness indicators has been the strengthening of prudential regulations and central bank supervision. All GCC countries have established provisioning and capital adequacy requirements that are generally stricter than those prescribed under the Basle rules. Moreover, all central banks carry out on-site inspections and off-site analysis of banks. While prudential regulations vary across countries (e.g., foreign currency exposure limits; credit concentration ratios; limits on consumer lending; and liquid asset ratios), few countries have guidelines for bank management standards, and only a few systematically regulate and supervise nonbank financial activities (e.g., derivatives; Islamic banking; mutual funds; and brokerage houses). International accounting and risk evaluation standards and early warning systems for the identification of bank difficulties exist in only a few countries. Some countries have introduced a deposit insurance scheme, while others are preparing the necessary regulations.

Partly as a result of the strengthened regulatory and supervisory standards, the GCC banks tend to be well capitalized (in absolute terms and when measured against the Basle requirements). For instance, the region’s (simple) equity-to-asset ratio ranges between 7 percent in Bahrain and 13 percent in the United Arab Emirates. When assets are risk weighted, the capital adequacy ratios reach levels that are among the highest in the world (22 percent in Saudi Arabia and 21 percent in the United Arab Emirates); these ratios partly reflect the large share of lending to government, which has a low risk weight. However, the situation of individual institutions with regard to capitalization varies substantially.

D. Nonbank Financial Intermediation

Despite the moratoria on new (and foreign) banks, the financial structure of the GCC countries has diversified over time with most of the expansion accounted for by branching activities, money changers, and investment offices. Most GCC countries are home to investment banks, insurance companies, foreign exchange- and money-brokers, representative offices of foreign banks, and general “financial service units.” Investment banks engage primarily in securities underwriting, investment advice, and portfolio management. Money brokers are typically affiliates of established international firms and facilitate transactions in financial instruments (primarily, negotiable certificates of deposit and foreign exchange). Representative offices are essentially agencies set up by foreign financial institutions to gather economic, financial, and commercial information for their principals and to provide general assistance to local and regional customers of these principals. Some countries (e.g., Bahrain) have recently licensed mutual funds that are separate from banks.

Government securities issued by GCC countries are mostly held by banks, pension funds, and specialized institutions. There are no active secondary markets in these securities and there are usually limits on bank purchases of treasury bills. With the aim of strengthening secondary markets, some GCC commercial banks have been allowed to issue negotiable certificates of deposit (CDS) (Oman in 1994, and the United Arab Emirates—dollar-denominated CDS—during 1993/94).

All GCC countries possess large public sector specialized banks focused on sectoral lending at below market interest rates (e.g., agriculture; industry, and small- and medium-sized companies). Their operations are financed by budgetary transfers rather than deposit-taking activities.

One area that has recently experienced rapid growth relates to Islamic financial operations. Islamic banks and Islamic investment institutions have now over US$70 billion of assets worldwide. The origin of such activities in the GCC countries dates back to the early 1970s when institutions were set up with the objective of recycling the oil-related surplus in accordance with the Islamic Sharia. Early operations focused on trade-related financing and leasing operations and tended to mobilize funds of individuals who shunned interest-bearing bank accounts. By the early 1990s, many GCC commercial banks (as well as nonregional institutions) had started Islamic banking operations. A number of new Islamic investment funds have been launched during the past two years to manage wide-ranging portfolios of shares in companies whose activities are compatible with Islamic principles. Returns on Islamic operations have, so far, been high. A major policy issue in this regard is how to strengthen regulation and supervision of such activities (Box 1).

Equity markets in the region are expanding as the scope for private enterprise is increasing and demand for equity investment is rising (Chart 5 and Box 2). Saudi Arabia’s equities market is by far the largest in the Arab world in terms of capitalization, but transactions are exclusively handled by the banks and trading is relatively modest. The Kuwait Stock Exchange is the most active in the GCC area and one of the largest in the Arab world in terms of volume of trading. Stock exchanges in Oman, Qatar, and the United Arab Emirates are relatively new. In general, the GCC stock markets are well capitalized with ratios to GDP (1996) ranging between a high of 98 percent in Kuwait and a low of about 24 percent in Qatar. However, both the number of traded companies and the turnover ratios are considered low compared with stock markets in industrial countries and in rapid growing emerging markets. The number of listed companies is also relatively low.

Box 1.Regulation and Supervision of Islamic Banks

The growing size of Islamic finance raises the important issue of how best to regulate and supervise Islamic banks.1 In general, depositors in such banks share in the risk of the investment that their deposit is financing; neither the deposit’s principal nor its return is guaranteed. This mode of operation suggests that Islamic banks need close supervision and regulation.

  • Islamic banks are subject to the same risks facing conventional banks (adverse shocks; mismanagement; etc.). These risks have effect on solvency and profitability and could have a systemic impact on the economy.
  • Since Islamic banks are under no legal requirement to safeguard the depositors’ base, they have no incentive to hold collaterals. This suggests that such banks can be more risk-prone than conventional banks.
  • Islamic banking operations involve complex modes of financing, which are accentuated by shortages of relevant skills, and the absence of uniform accounting and tax standards.

Most “best practices” developed by the Basle Committee are broadly appropriate for regulating and supervising Islamic banks. In addition, such banks could conceivably be subject to lower liquidity requirements than conventional banks. However, there are three areas where stricter rules may be required.

  • Islamic banks’ incentive to engage in risky activities and the absence of an incentive to use the “security buffer” of a collateral suggest the need for higher risk-weighted capital asset requirements.
  • Stricter information disclosure requirements and close monitoring are also important since deposits are not protected and depositors tend to allocate funds across banks according to their risk preferences.
  • Islamic banks face a strong “investment risk” since projects are the main source of return for depositors and given banks’ reduced use of collateral. Regulators need to ensure that banks have adequate capabilities for project evaluation, appraisal, selection, auditing, and monitoring.
1This box draws on Errico (forthcoming).

Chart 5.GCC Countries: Equity Market Capitalization (1996)

Sources: Data provided by the authorities; International Finance Corporation, “Emerging Markets Factbook;” and Middle East Economic Digest.

* Newly industrialized economies of South East Asia.

Box 2.The Main GCC Equity Markets

Bahrain. Capitalization in the Bahraini Stock Exchange amounts to 100 percent of GDP; however, the number of traded companies stands at only 37. Limited trading in the market by non-Bahrainis is sanctioned (especially GCC residents and by non-Bahraini residents in Bahrain).

Kuwait. The Kuwait Stock Exchange (KSE) has existed since the early 1970s. Its capitalization amounts to slightly above 80 percent of GDP with 66 companies traded; bonds are also traded on the market, but in low volumes. The volume of trading at the KSE is twice as large as in other GCC countries taken together, but is second to Saudi Arabia in terms of capitalization. In 1996 and early 1997, activity on the KSE expanded, as large shares of government enterprises were sold to the private sector. About 60 percent of transactions are executed by institutional investors. The KSE is supervised by the Stock Exchange Commission consisting of 11 members appointed by the Ministry of Commerce, the Kuwait Investment Authority, the Central Bank of Kuwait, and the chamber of commerce. To facilitate transactions and encourage participation of foreigners, the KSE has established two international clearing schemes (Kuwait-Egypt-Lebanon and Kuwait-Bahrain-Oman).

Oman. The Muscat Securities Market (MSM) was established in 1989. Its capitalization in 1996 stood at 172 percent of GDP with nearly 100 companies traded. The removal of restrictions to GCC investment in 1992 contributed importantly to the increase in capitalization of the MSM. Recently, Omani companies were allowed to take in foreign investors without jeopardizing their tax status.

Saudi Arabia. Saudi Arabia’s equity market is over the counter (OTC) where commercial banks have been granted the exclusive right to trade for their clients. At end-1996, total capitalization was about US$40 billion—a level larger than all of the Arab stock markets put together—although only 70 companies are traded. There is a large concentration of holding of shares and of market capitalization, with the 10 largest companies accounting for 60 percent of total capitalization in 1993 compared to 15-20 percent in developed economies and 30 percent in emerging markets. While GCC nationals can trade in the Saudi equity market, restrictions apply to foreign (non-GCC) participation. However, non-GCC residents can invest in the stock market through mutual funds. In March 1997, the Saudi American Bank launched the Saudi Arabian Investment Fund (SAIF), a closed-end fund that is listed on the London Stock Exchange and is open to institutional investors.

The region’s equity markets face a number of important constraints: there is a lack of brokers and market makers; foreign access to the markets is generally restricted to GCC nationals; a number of large corporations remain under government control; and there is a general weakness in transparency requirements and the provision of information. Also, private shareholders have been reluctant to move away from traditional bank financing and open their companies’ capital to new investors. These issues are discussed in Section IV.

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