The world's financial markets have been turned upside down, with many wondering just how it was possible.
Re-thinking Gulf financial regulation
The world's financial markets have been turned upside down, with many wondering just how it was possible for international regulators to have let so many down, and some seriously questioning the virtues of unfettered capitalism. The story is universal, with investors running for cover and governments stepping in to stem the rot through massive bailout funding and outright takeovers of institutions and bank assets. The Gulf was not immune, as one GCC central bank after another either made pronouncements about the robust health of its national banking system, or outlined commitments to guarantee deposits and pump in liquidity to ease a creeping credit crunch that is now threatening to derail some Gulf projects. Gulf investors also ran for cover from investment banking products and "clever" instruments such as short-selling, derivatives and options, opting for the safe havens in gold, commodities and property. The Gulf banking sector is still relatively young when compared with "developed" financial markets, and it was not too long ago that a favoured shelter of wealth in the region was keeping cash stashed at home. Given current market uncertainty, some might be tempted to emulate their grandparents' prudence. The most important lessons to learn from the unfolding crisis are that markets must have effective risk management and that regulatory authorities must understand the basic risks that financial institutions are taking if they are to effectively regulate the sector. Managing and mitigation of risk must be paramount, and the system should not be overexposed to any one sector. In much of the Gulf, and particularly in Dubai, banks are heavily exposed to the construction and related sectors, some of which appear highly vulnerable, especially if the anticipated foreign demand evaporates. The outflow of foreign capital from the Gulf indicates that some foreigners are taking profits to shore up shaky financial positions back home. For Gulf regulators, the -western financial model was going to be the template to follow, but that blind faith has been shaken. Again, due to the relative infancy of Gulf central bank regulation, most risk management models copied western counterparts. Short selling, for example, which is illegal in regional markets, was tolerated by western regulators until both the UK and US took action to suspend it, but it was also contemplated by some Gulf regulators. The massive financial turmoil has caused a Gulf rethink as regional regulators now look for stability and traditional banking products. The urgency for tougher controls will be felt the most by Gulf regulators in places such as Dubai and Qatar, which closely track the regulatory environment of the UK, and Saudi Arabia, which traditionally follows US regulatory changes. Whichever model is tracked for local adaptation, the mood worldwide is certainly for a more resurgent and effective regulatory regime. There is a danger, however, that the crisis will hamper liberalisation and innovation. For the Gulf, this could be both a blessing and a long-term problem. It is a blessing in trying to restore public confidence - that most fragile of commodities - with regional regulators concerned that markets are not ready to manage derivatives and other exotic financial instruments. It could be a problem if the region wishes to remain at the cutting edge in financial services and compete against other financial hubs. The general feeling is that Gulf regulators are going to play it safe and be cautious. They will take incremental steps to improve the market at the expense of some of the more sophisticated products. While some sectors such as banking and real estate are likely to see a slowing as a direct result of the global crisis, there are also fears that growth could slow in areas such as the sukuk, or bonds, market. The sukuk market has matured enough to start experimenting with new derivations such as Islamic credit swaps, but that trade will stall as issuers go back to basics. International banks were behind much of that innovation, but as they cut their losses and concentrate on core products, they are less likely to push new Islamic derivative products. This could be an opportunity for Gulf banks to fill the gap, but again this will happen in regulatory jurisdictions that have relevant expertise in Islamic banking supervision, and this is where Bahrain has an edge. Corporate governance, transparency and the protection of shareholder interest are other areas for Gulf regulators to concentrate on to regain public confidence, and it is heartening to see that some serious action is being taken. A veritable who's who of executives are under investigation, but unless there is effective transparency and people actually go to jail for fraud, opacity will depress markets, as has been most noted in Dubai. There is probably going to be increased emphasis by Gulf regulators on encouraging regional fund managers to focus more on domestic investors. The Gulf retail market is still one of the most lucrative in the world, and providing opportunities to this sector could be an important way of building regional financial stability. The world regulatory environment is going to change, and it might still be nervous over the coming few months before that elusive confidence comes back. In the end, it will be those regulators that best understand the environment and products in which their financial systems operate, as well as the risks being taken, that will be the models to follow. This could ultimately determine which of the Gulf's regulators comes out pre--eminent and shapes the future of its -financial hub. Dr Mohamed Ramady is a former banker and a Visiting -Associate Professor, Finance and -Economics Department, at King Fahd -University of Petroleum and Minerals