Monday 05, March 2018 by Jessica Combes

Telescopes and governance of Arab banks


Alissa Amico, Managing Director at GOVERN discusses the corporate governance regulations and culture of financial institutions in the Arab world.

In the wake of the financial crisis that started unravelling a decade ago, banks were perceived as the major culprits of corporate misconduct. A decade later, they have been subjected to volumes of regulations ranging from the Dodd-Frank Act, to the Volker Rule, to MIFID and the Basel Committee requirements. There is, seemingly, no end in sight of the regulatory wave that has focused on bank governance generally, and conflicts of interest in particular. That regulators mean business was demonstrated by hefty fines handed to major banks for practises ranging from trading irregularities to distribution of toxic financial products to manipulation of interbank rates.

Regulatory zeal
The message behind these regulations and enforcement actions—delivered not by a white dove, but rather by a watchful eagle—signalled to bank executives and boards that the velvet gloves have come off. The main focus of this effort was on corporate governance failings in developed markets, where governments in the United States, United Kingdom, Greece and Spain have emerged as white knights in shining armour, injecting swaths of capital in failing banks such as Lloyds, Goldman Sachs and the Royal Bank of Scotland, to the dismay of the general public.

Regulators and banks in emerging markets, on the other hand, have begrudgingly inherited the consequences of this newfound regulatory zeal, while the health check of most emerging market-domiciled banks has not revealed the same compensation excesses or conflicts of interest targeted by the new global regulations. Indeed, when the supervisory wave hit the shores of emerging markets, protests by both growth market regulators and banks regarding their relevance were palpable.

While emerging market regulators and banks pointed out the irrelevance of these regulations to their national circumstances, they begrudgingly complied in order to avoid compromising their integration in the global financial architecture. This is certainly how this story has played out in emerging markets such as the Middle East, where banks have always been rather strictly supervised, and where due to the concentrated ownership structure of banks, similar abuses and excesses did not occur.

Bank regulation in the Arab region
Over the past decade, all countries in the Arab region have developed specific corporate governance codes or guidelines for banks, reflecting the new Basel Committee and OECD recommendations, which were revised in 2015. In most jurisdictions in the region, governance codes have been reviewed and have gradually been imposed as mandatory regulations. Jordan, Bahrain and Qatar continue operate on a 'comply-or-explain' basis, reflecting the Central Banks’ desire to provide scope for governance scalability. A decade later, Arab Central Banks’ interest in evolving governance regulatory frameworks remains unabated: Morocco revised standards in 2014, Qatar in 2015, Kuwait and Jordan in 2016, Saudi Arabia and the UAE are doing so this year. Although with some exceptions, these standards are largely in line with global practices.

However, their adoption by the banking community is questionable. Even more questionable is the suitability of these standards—which at the time of their development reflected global bank governance failings—to organisations in emerging markets—as well as the Arab world. Indeed, in the Middle East—considering the critical role of banks in national economies—bank governance has been a priority for regulators well before the financial crisis knocked on the door. Historically, the sector has been the largest contributor to the financial services industry and today, it continues to account for more than 54 per cent of the industry in the region, while equity and bond markets contribute to only 33 per cent and 13 per cent respectively.

In Jordan and Kuwait, the banking sector accounts for a whopping 80 per cent of the financial sector and in Bahrain and Lebanon, bank assets exceed the GDP by several multiples. Banking regulators are not the only supervisors interested in good governance of banks. For most countries in the region, banks are the most important sector represented in public equity markets. According to our recent research, of the 100 largest listed companies in the region, 42 are banks, far higher than any other sector. Banks are therefore key to attracting capital to the region’s equity markets and indeed, bank shares tend to be the among the most actively traded in the region where liquidity is scarce. For instance, in Qatar, five of the largest 10 listed companies that account for 70 per cent of market turnover, are banks.

Driven by revisions of banking governance standards and principles for listed companies over the past decade, Arab banks and their regulators have formally aligned with international governance standards, making their boards more independent and reinforcing risk management. However, considering that the regulations emanating from the global standard-setters were not targeted at specific risks in the Middle East, these were adopted more for the form than for their substance. In private, board chairs concede that independent directors serve a decorative role and do not dare to challenge the majority shareholder, who is often also the chair or the CEO.

In recent years, the tables have turned: the symbolic application of international governance practises by Arab banks sector will no longer suffice. Their governance is now of critical importance not only as a signal of the acceptance of the global rules of the game, but also to protect banks from a range of international and domestic risks.

National and international developments over the past three years have highlighted the need for a home-grown regulatory overhaul of bank governance in the Middle East to address specific domestic economic threats and opportunities that require robust risk management and oversight. The fact that Arab banks had survived the financial crisis with minimal battle scars offers little consolation at this juncture. They were neither allowed to structure potentially toxic financial products nor had an issue with excessive remuneration of executives, given that the separation of management and ownership in the region is symbolic.

Perhaps more importantly, while the concentrated ownership of some banks by families and other state protected banks during the crisis also carry specific governance risks, it also need to be examined going forward. In Lebanese family-owned banks for example, boards, management and the shareholders are often one and the same, impeding the necessary separation between the CEO and Chair roles. State-owned banks, whose market share ranges from 20 to 40 per cent in individual Arab countries, have their stability and governance concerns primarily linked to challenges of maintaining an arm’s length relationship to other state-owned enterprises. In Egypt, this has, in the 1990s, resulted in high non-performing loans and difficulties in restructuring banks prior to their privatisation.

Broad challenges
Domestically, banks in the Middle East are operating in an uncertain environment as economies of both oil-exporting and importing countries have been negatively affected by the decline in the price of natural resources and political instability in some countries of the region. This has accentuated the existing risks, notably raising questions around structure of loan books, where credit concentration both to specific borrowers and sectors remains relatively high.

For instance, the five largest borrowers are equivalent to 35 per cent of the total capital of Omani banks. Arab banks remain mostly domestically concentrated which further contributes to their risk profile. In Saudi Arabia, net foreign assets account for just over 10 per cent of banks’ total assets and in Qatar, domestic credit comprises 88 per cent of the total outstanding credit, according to the latest available data. While their loan book is concentrated, it is also dominated by short-term lending such personal and real estate loans, which represent, on average, 40 per cent of the total banking assets in a number of Arab countries.

Internationally, Arab banks have been under pressure due to concerns around money laundering and illicit financing, forcing Central Banks to actively engage with international organisations and standard setters in Washington, Brussels and London for a more nuanced and better informed regulatory approaches. The pressure on central banks to dispel these perceptions have increased considering the potential negative repercussions on the integration of Arab banks in the global financial architecture if doubts around their integrity linger. For instance, the classification by the European Commission of the UAE, Bahrain and Tunisia in December 2017 as tax heavens has put further pressure on the national regulators to demonstrate that the sector is transparent and adequately overseen.

At the same time, the de-risking by global banks has put enormous pressure on correspondent banking relationships with Arab banks, with CBR withdrawals affecting 39 per cent of MENA banks, affecting both commercial clients and even NGOs operating in the Middle East. While it is debatable as to what extent these concerns and measures are well founded, examples of legal battles such as the Arab Bank case (which will be decided in the US Supreme Court this year), further fuel concerns around the linkages of Arab banks to illicit activities.

Emerging examples such as the recent Turkish Halkbank case, where earlier this month one of its senior employees was convicted of assisting to evade sanctions against Iran, highlight the risk of a spillover of political tensions on the banks. Together, these national and international developments imply that the traffic light at the current juncture where Arab banks find themselves has turned from green to yellow. Last month’s bank country risk assessment by Standard and Poor’s classified a number of countries in the region as high risk, including Morocco, Tunisia and Egypt. While Arab banks remain highly capitalised, strict prudential regulation and conservative approaches to lending and product distribution will not suffice in the Aldous Huxley-like 'brave new world' of banking. The bank governance culture, especially at the level of boards, needs to be re-thought considering the dynamics in the sector regionally and internationally.

This re-thinking is occurring while the sector is sitting on shifting sands both domestically and internationally. Domestically, the banking sector is starting to witness significant structural changes with the consolidation of banks in the Gulf (e.g. NBAD and the FGB merger in 2017 in the UAE). This might, in the long-term, lead to the emergence of clear national champions operating cross-border and hence needing to reckon with governance standards in multiple jurisdictions. Globally, the banking sector is poised for significant disruption. Tech titans have the potential to unsettle the sector in a way WhatsApp and Skype have with the highly protected telecommunications sector in the region. Regulators and policymakers will no longer be in a position to shield local banks from the winds of change as they previously have from foreign competition because the status quo has increasingly become about fintech and innovation as opposed to size and scale. The days that Arab banks can continue dealing with clients through tellers and faxes seem numbered.

Future outlook
To remain integrated in the financial system, their boards will be required to demonstrate commitment to integrity and transparency principles, where bare-bones governance disclosure will not assuage foreign and supranational regulators. To a large extent, the responsibility for this lies with the Central Banks which will need to coordinate with peer regulators and facilitate cross-border transparency. At the level of individual banks, a re-thinking of transparency, especially for banks with foreign shareholders or dual listings, will likewise be important.

At the same time, bank boards will be put under pressure not only to improve transparency, but perhaps more importantly, to adjust to the forthcoming threat to their brick and mortar business model. Just as Careem has brought ‘creative disruption’—as Schumpeter would have it—to the transportation industry, fintech will render the traditional business models of Arab banks largely obsolete in the longterm. Already in other emerging markets such as China, the mobile payment sector has reached $5.5 trillion.  

Role of boards
A key question is whether boards of Arab banks stand ready to face the simultaneous multiplication of risks, including global compliance, domestic lending and global industry disruption. Due to the concentrated ownership that previously shielded banks from the financial crisis, boards of most Arab banks continue to be composed of family and state nominated representatives, and as a result of the low turnover of board members, lack the diversity and fresh blood that can help them navigate the risks, but also the opportunities, offered by fintech innovation.

While boards and C-suits of banks are cognisant of the domestic economic context and political risks, they are less prepared for the technological forces set to disrupt the industry. Many bank boards have not conducted an evaluation and generally speaking, do not possess critical skills such as information technology due to the lack of refreshment of boards linked to their stable ownership structure. Board evaluations and measures to foster diversity in the management and board ranks are certainly welcome. It is a new dawn not only for bank boards but also for the banks regulators in the region.

The transposition of international regulations (which in some ways are ill-suited to the reality of Middle Eastern economies) that has occurred over the past decade is no longer a sine qua non condition to protect the reputational capital of Arab banks. Local regulations and their implementation will be needed to address the ownership structures and specific economic risks in the region. The practises of the bygone era where banks were exempted from governance standards that were applicable to other listed companies will need to be reconsidered as well as regulations for listed companies and banks streamlined.

Regulators will also need to critically re-assess the supervisory approaches such that governance is explicitly considered as part of the prudential supervisory framework as opposed to a separate pillar of oversight. In doing so, they will need to integrate the concerns that arise in the case of family and state-controlled banks, while aiming to ensure that all banks—irrespective of their ownership—compete on a level playing field. In the coming years, bank regulators in the Middle East will need a stethoscope to diagnose the ability of institutions to withstand the macro-economic and political risks, by identifying and focusing on systemically important banks, while at the same time assuring the viability of smaller banks. They also need a telescope to foresee and integrate in their regulatory frameworks looming industry risks to ensure that boards and C-suites are positioned to withstand broader shifts in the industry that may render the traditional banking industry obsolete in the coming years.  



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