Generic Risks of Gulf Banks

Despite the relatively benign operating environment, GCC banks remain susceptible to systemic risk and potentially disruptive credit conditions. The systemic risk is embedded in: the adoption of new financial reporting standards; changes in regulatory regimes; exposure to conglomerates with less transparent governance practices; and impending execution of public policy reforms.

A comprehensive set of International Financial Reporting Standards (IFRS), which was promulgated by the International Accounting Standards Board (IASB) came into effect in 2005. IFRS requires that most securities held by banks in their portfolios should be measured at fair value, with gains or losses on re-measurement recorded either in the income statement (for securities that are classified as trading or designated as being measured at fair value through profit or loss) or in equity (for those securities classified as available-for-sale). The only exceptions are debt securities, which are deemed to be held until their maturity and measured at amortized cost.

The Standard also requires the use of the consolidation of strategic equity participations and private equity interests, which were previously recognized on the basis of equity accounting. IFRS requires that a controlling interest in a special purpose vehicle should be consolidated, with the exception of those which are acquired and held exclusively with a view to their subsequent disposal within 12 months. This has an immediate consequence for those banks which have been actively engaged in private equity, as they will now have to consolidate those private equity investments which they controlled – even though they may plan to sell them in a few years’ time.

Two Challenges
Adoption of IFRS has presented the banks with two challenges: first, the increased complexity of IFRS; and second, a new standards and accounting model focused squarely on the asset/liability recognition and measurement. Until recently, accounting practice was generally based on historical cost and focused on accounting for transactions, underpinned by the concepts of ‘realization’, under which profits were not recognized until they were realized, and ‘matching’, under which revenues were matched with costs. The inadequacy of these accounting concepts became evident as companies smoothed their profits using creative accounting or created excessive provisions and reserves. The IASB is now demanding a clear focus on asset/liability approach to recognition, and a ‘fair-value’ basis of measurement of assets and liabilities.

According to IAS, fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. The best indicator of fair value is quoted market price of instruments in an active market. If a market for a financial instrument is not active, an entity establishes fair value by using a valuation technique that makes maximum use of market inputs and includes reference to recent arm’s length market transactions. This means that financial reporting under IFRS involves a process of: initial measurement (at fair value), re-measurement (at fair value), and de-recognition (at price). For financial institutions with focus on private equity or less liquid securities, there could be a significant difference between fair market value determined in a notional market context, and the price at which assets are de-recognized. Departures from fair value could possibly occur as parties to a transaction may not always act at arm’s length or are not necessarily knowledgeable. Even when following a thorough due diligence exercise, it cannot be expected to uncover all details about a prospective acquisition. Valuing non-controlling interest in a special purpose vehicle could even be a more challenging task as it may require the use of a minority discount. The ability to determine fair valuation of assets for banks pursuing Shari'a compliant activities is also critical. Islamic financial institutions either acquire the asset or in the absence of open market transaction, notionally determine market valuation.

Value determination requires a degree of skill and experience to justify selections of cap rates, projected cash flows and adjustments. Expressing opinion on the carrying value of assets is outside the scope of audit work. Managements’ value estimates of assets and liabilities could be construed as subjective. To add a degree of objectivity to the value of assets, value cross checks or estimates should be sought from valuation professionals.

Fairness opinion is another tool which offers more legitimacy to an acquisition or a disposition price. When providing a fairness opinion, a professional valuator comments on the fairness of the price in an arm’s length transaction. Getting the acquisition price substantiated in the form of a fairness opinion provides the acquirer an assurance that payment does not exceed the price paid in any arm’s length transaction.

In principle, fair value measurement was intended to reduce volatility in earnings of the financial institutions, but its unintended consequence seems to have increased concerns over banks’ equity. The potential of arbitrary assignment of value or element of subjectivity could over or under value the true worth of a bank. The impact of unrealized capital gain or loss on a bank’s equity now warrants more scrutiny.

Basel II
As of 2006, banks need to start complying with a new regulatory scheme, Basel II, which regulates capital adequacy rules. The Basel Committee on Banking Supervision (the Committee) proposed a New Basel Capital Accord (Basel II) that consists of three mutually reinforcing pillars, which together should contribute to increasing the safety and soundness of the financial system. The Committee is seeking to implement a more risk-sensitive and flexible approach to bank capital requirements than that established by its 1988 Capital Accord. At the same time, the Committee aims to align supervisory review more closely with the way in which banks manage their risks, including encouraging the use, and further development, of internal risk and capital management systems. One of the most notable changes in Basel II is the introduction of a capital charge for operational risk. Due to the extensiveness and complexity of Basel II, Gulf banks are now facing many challenges in implementing the requirements for operational risk and internal ratings.

Although many GCC banks already use internal risk rating models, most would not be able to conform to the Basel II requirements readily due to the lack of detailed and reliable data for every asset’s probability of default. As a first step towards reaching compliance, banks need to improve their data gathering and retention capabilities. Banks must have three years’ worth of data. The collection of which seems difficult as GCC lending markets lack depth in loan populations. New businesses and small-medium enterprises will be particularly severely disadvantaged as banks are most likely not to have statistics for these mid-tier companies.

Under the present regime banks have to provide the full 8% own capital backing for all corporate lending − regardless of the quality of the debtor. For example it costs a bank just as much to lend to a double-A rated company as it does to lend to a triple-B rated company.

However banks that can prove their internal credit rating process meets certain criteria will be able to take advantage of the Basel II rules. They will be allowed to hold less capital to back lending to strong companies, but will have to provide more capital to cover the weak. This would lead to a significant increase in the cost of borrowing even for investment grade companies in the triple-B category. Many companies − those rated by their banks as below investment grade − may well no longer be able to receive loans at old rates.

Complex Challenge
The challenge is more complex for small banks, especially for those pursuing lending as a non-core activity. In the absence of a viable internal rating system, the banks might be required to allocate more regulatory capital to their loan book than at present. Even after making huge investments in technology and risk systems, the effect of utilizing internal models on small banks’ capital cannot be predicted with certainty. Regulatory approval is not necessarily contingent upon huge investments in IT infrastructure. Prior to making commitments and allocating resources for technology acquisitions, the banks should assess their existing IT infrastructure capabilities. At times even existing IT capabilities could be modified to determine regulatory capital and its adequacy. Such cost-effective solutions are best suited for banks which do not have resources to make the necessary investments or possess a diverse balance sheet.

Credit mitigation techniques proposed in the Accord are necessarily stringent. Banks tend to compromise credit quality if they lend to companies with weak governance record. Limited economic diversification in the Gulf region has also put constraints on the banks to diversify their loan books. The Gulf is dominated by few business power-houses. These business families have been the recipients of grants, quotas and licenses from governments. They have also been the primary beneficiaries of loans from banks. While the quantitative aspect of the ratings might be strong, a risk assessment of corporate governance practices should also be carried out to integrate governance and quantitative ratings. The integration of qualitative and quantitative measures has already progressed to an advanced stage in North American banks, driven mainly by new legislation. Internal ratings of borrowers by banks in a manner consistent with credit rating agencies' methodologies will also help standardize economic capital allocation.

Rating Assessments
Qualitative rating assessments should include ownership and control, management quality, succession planning, executive incentives, internal controls and corporate culture. The initiative should also include the role of an independent board of directors in implementing prudential oversight and management accountability. Financial analysis should also include means to determine the true cost of the board’s participation in enforcing accountability and transparency. And finally, banks should share and encourage their clients to implement industry best practices.

The role of guarantees in credit enhancements should also be reviewed. The banks need to re-examine their loan book to determine the true value of posted collateral. To limit single name losses, banks investing in family businesses can also seek additional protection by incorporating cross-default and lockbox type arrangements. The cross default concept is usually invoked in a syndicated credit arrangement. Cross default means if a borrower defaults on its obligations with one lender, a simultaneous default is triggered with the other lender. Despite bilateral borrowing arrangements and due to the lack of a fully developed syndication market, inserting a cross-default would serve as an early warning mechanism.

In a lockbox arrangement, the borrower is instructed by the lender to cause all of the borrower's present and future account receivable collections to be sent directly to the lockbox at the bank. All account receivable collections that are received by the bank in the lockbox are deposited by the bank into a collateral reserve account to reduce the line of credit. In the event that the borrower receives any account receivable collections, cash, checks or other proceeds, the borrower is required to deposit all such funds into the collateral reserve account at the bank. Until such time as all indebtedness owed to the bank under the loan documents has been paid in full, all account receivable proceeds are deposited into collateral reserve account to reduce indebtedness.

Lockbox arrangement significantly enhances the operational capability and credit quality of the borrower's credit receipts. Lockbox helps maintain the continuity of payments to the collateral reserve account. Lockbox arrangement also helps avoid co-mingling of assets in asset-backed securitization arrangements. As conglomerates continue to borrow from different financial institutions, the adoption of such program will ensure that all receivables collected are initially deposited in a designated account. Such arrangement also reduces the likelihood of cash leakages or inappropriate inter-company loans to relatively weak entities of the group.

These pre-emptive risk mitigation measures will help regionally focused banks meet the challenges of impending public policy reforms. The pressure to undertake reforms on GCC governments is being exerted from several fronts. Reforms are needed to create jobs for a booming population of young graduates. The growth in GCC population, which doubled in size in the past 20 years, has outstripped the GDP growth. Gulf countries rely heavily on oil exports to earn their foreign exchange.

Need For Reforms
At the regional level, reforms are required to create a GCC single market by 2007 and Gulf monetary union by 2010. In their last meeting in March 2005 in Riyadh, the Gulf central bankers agreed on five criteria of convergence as a part of their monetary and financial policy integration. These criteria are similar to those applied in the EU. The five key benchmarks established are: budget balance, foreign reserves, public debt, interest rates on deposits and inflation rates.

The Gulf central bankers agreed to cap the budget deficit to 3% of GDP for each member state. Although the agreement on foreign reserves is not final yet, the foreign reserves criterion was initially set to cover at least four-to-six months of total imports. GCC members have also sought to align their public debt, which must not exceed 60% of GDP. An important prerequisite for economic integration is the issuance of a single currency. This will require the alignment of interest rates. The Gulf central bankers stressed that the interest rate on deposits should not be more than the interest rate average of the lowest three countries, which is estimated at about 0.94%. Gulf central bankers also agreed on a criterion on inflation, which was capped at 1.5%.

At present, only one criterion (budget balance) is met by all GCC countries. Significant efforts are required to reach alignment in other areas. Among them, reduction in public debt is considered as the most important. Saudi Arabia, the region’s largest economy, will be required to retire approximately $60bn of public debt by 2007 to achieve the target of debt below 60% GDP. Saudi Arabia’s 2004 public debt was at 75.9% of GDP. Other states with debt levels over 60% of GDP are: Bahrain (62.9%) and Qatar (61.8%). With large idle manufacturing capacity in the private sector, it is also in the Saudis’ best interest to expedite economic integration. Rapid reduction in public debt could be achieved by encouraging FDI, privatizing state-owned companies or services and increasing taxation.

Interest Rates
The steps required to accomplish monetary union also include unifying interest rates policy and meeting inflationary targets. The twin challenges of simultaneously reducing interest rates and inflation call for structural adjustments of some national economies. Current estimated rate on deposits in Saudi Arabia (1.94%), Bahrain (1.81%), Oman (1.26%) and Qatar (1.123%) are higher than those of UAE (0.94%) and Kuwait’s (0.66%) which are at or below the maximum limit of 0.94%. In 2004 inflation was above the benchmark rate of 1.5% in: Qatar (3.9%), UAE (3.2%), Kuwait (2.3%) and Bahrain (2.2%). The countries below benchmark inflation rate were: Saudi Arabia (0.7%) and Oman (0.2%).

If core deposit or lending rates are reduced then demand for private and corporate debt could increase further. While verifiable data with respect to household indebtedness in GCC is not available, the increase in borrowings per household to unsustainable levels could trigger personal, household or corporate bankruptcies. As economic integration proceeds and borders disappear, banks need to be cognizant that in certain jurisdictions where the legal system is grounded in Islamic Shari'a, there is no certainty of foreclosing or liquidating the collateral in the event of a bankruptcy. In a Shari'a jurisdiction, all rights and obligations relating to the collateral will be finally and authoritatively determined by the application of Shari' law. Under this law previous decisions may not be recorded, and are therefore not generally regarded as a biding precedents for later court cases.

Even though the GCC central bankers have laid down the criteria for economic and monetary integration, important issues relating to the alignment of financial and legal systems also need attention. So far the delivery of public policy reforms has been incremental to avoid disruption in social and cultural order. Yet, all economic participants recognize the urgency for such reforms. The roll-out of such reforms will have a direct impact on local businesses. It could either prop up local heroes or inflict casualties. Banks also need to foresee the consequences of such reforms.

In their relationship reviews, the banks need to clearly assess the competitiveness of their clients. This requires a candid industry analysis, understanding the implications of public policy agenda and increased foreign competition. GCC banks could adopt a voluntary structured early intervention and resolution system to mitigate these risks. Opening up the dialogue amongst banks, regulators and public policy managers is equally important in assessing and managing these generic risks.