Can Arab Financial Institutions Rise to the Challenge?
Can Arab Financial Institutions Rise to the Challenge?
Potential investments in the Arab world are huge. The World Bank estimates that Morocco, Algeria, Tunisia, Egypt, Jordan, Lebanon, Yemen and West Bank and Gaza require investments of $60-$100 billion in their infrastructure over the 1997-2006 period. The Gulf countries also have to pump up large amounts of investments, especially in their energy sectors. The Arab Petroleum Investments Corporation estimates that between 2002 and 2006 new investment requirements in the oil and gas sectors will reach around $84 billion.
Faced with large public deficits and mounting public debts, Arab governments are no longer in a position to finance these huge investments outlays out of their coffers. In principle, this should have provided regional financial institutions with an opportunity and the challenge to play a more active role and to develop their expertise in financing large projects. So far, this has failed to materialize. It is also unlikely that the region's banks will play that role in the near future. To understand why, we need to look at some features of the current Arab banking system and its links with the major international financial centers.
The financial sector in the Arab world is excessively dominated by banks. Despite stock-market reform, banks remain at the heart of the financial sector. But if the banks are supposed to pull the Arab economies, their performance is still far from satisfactory. Illustrative in this respect is that Arab banking represents a small part of global banking. Thus, according to The Banker's top 1000 banks list in 2002, the combined Tier One capital of the top 20 Arab banks stood at only $28.5 billion, representing less than 1.5 percent of the combined total capital of the top 1,000 banks. With $58 billion Tier One Capital, Citigroup - the largest bank in the world - had more capital than the combined capital of the largest 86 Arab banks in the Banker's top 1000 in 2002.
The small size of the average Arab bank is due to various reasons. Consolidation within national markets, even in over-banked markets such as Egypt, Lebanon, and Bahrain, has been very slow. This is compounded by the fact that the Arab banking industry is scattered in small markets with little integration across national markets. Due to regulatory restrictions, cross-border banking consolidation is still at its infancy. This has prevented the emergence of an Arab bank with strong regional presence. Fragmentation and modest size of Arab banks limit their ability to pursue financial innovation and raise sufficient capital for financing large projects which are currently being arranged through foreign banks.
Another major feature of the Arab banks is related to their ownership structure. Arab banks, if not state-owned, are mainly family owned. This structure of banks has some important implications. First, it reinforces the problem of small size. Family-owned banks are reluctant to raise the capital needed for expansion through financial markets. They also tend to resist calls for consolidation because consolidation means sharing or losing control over decision making. These banks will also resist any attempts of being completely acquired as this will indicate loss of social and political power for the family. Second, family ownership of banks affects the quality of bank management where control and decision making processes are highly centralized in a few people, mainly the owners, affecting banks' attitude toward the return-risk matrix and lending behavior, which is based mainly on relationships rather than risk assessment.
Banking systems in the Arab world also have a peculiar asset structure. Although banks are no longer required to fund government financing requirements, the exposure of the banking sector in most Arab economies to the public sector is still quite considerable. This is in fact puzzling. According to the financial reform advocates, financial liberalization should induce greater shift of financial resources toward the private sector. This reallocation toward the private sector has not occurred even in countries with declining public debt such as Morocco.
Another interesting feature is the large percentage that foreign assets comprise out of Arab commercial banks' total assets. For instance, in Jordan foreign assets represent around 30 percent of commercial banks' assets, in Lebanon and Saudi Arabia they stand at 20 percent. Interestingly, foreign assets in Syria represent over 50 percent of banks' assets. The large holding of foreign assets highlights an interesting point. Despite the region's large investment needs, substantial amounts of funds continue to flow out of the region's financial institutions. A substantial part of these funds are deposited by Arab banks into the major international financial centers. This indicates the global links of Arab banks remain mainly limited to recycling surplus funds away from the region. For instance, consider Arab banks' links with London's international financial center. Bank of England statistics show, at the end of 2003 the external liabilities from the Arab world deposited at banks operating in the U.K. amounted to over $80.5 billion. On the other hand, external loans of banks in the U.K. to the region amounted only to around $23 billion. This indicates substantial amounts of money have migrated to the U.K., with very little flowing back into the Arab world.
Due to these weak features, Arab banks are most likely to be overtaken by giant international banks. Although in the short run, this is unlikely to affect Arab banks' profitability, it will certainly have long term adverse consequences in certain crucial aspects of banking. At the moment, Arab banks are pampered by the opportunity of lending to the public sector achieving banks' ultimate dream: low risk and high return. However, since this type of funding requires little or no risk assessment, Arab banks are losing an opportunity to upgrade their risk assessment techniques, diversify their investments and develop new and expand their expertise in new areas. This does not only apply to the area of project finance. In the Euromoney Awards for Excellence for 2002, in the Middle East category global banks reaped all the main awards. The best debt house award went to Merrill Lynch; the best equity house award went to UBS Warburg; the best mergers and acquisition house award went to Duestche Bank; the best bank for custody, risk management and treasury operations went to Citigroup; while the best house for cash management went to HSBC. This should make Arab bankers worry of the competition they are likely to face once markets are open.
Regarding their global links, Arab banks' main challenge will always be how to play an active role in channelling money and funding investments into the Arab world and not how to recycle funds away from the region. Arab banks have a significant opportunity in assuming this role given their local knowledge of Arab markets, historical links, similar business cultures, their networks, and geographical proximity. But weak structural features suggest that Arab banks will not only likely fail to reap their home-market advantages, but once the public-financing bonanza comes to an end, there will be very few investment opportunities to turn to.
Dr Bassam Fattouh is a lecturer in financial studies at the Department of Financial and Management Studies, SOAS, University of London. A version of this article appeared in the September 2004 issue of The Middle East in London.