The Financial Markets of the Arab Gulf

Power, Politics and Money

Jean Francois Seznec, Samer Mosis

• Publisher: Routledge
• Year: 2018
• Print ISBN: 9780815380801
• eBook ISBN: 9781351059695
• Edition: 1
• Topic: Économie
• Subtopic: Audit

Financial markets across the Arabian Peninsula have gone from being small, quasi-medieval structures in the 1960s to large world-class groupings of financial institutions. This evolution has been fueled by vast increases in income from oil and natural gas. The Financial Markets of the Arab Gulf presents and analyzes the banks, stock markets, investment companies, money changers and sovereign wealth funds that have grown from this oil wealth and how this income has acted as a buffer between Gulf society at large and the newfound cash reserves of Gulf Cooperation Council states (Saudi Arabia, the United Arab Emirates, Qatar, Kuwait, Oman and Bahrain) over the last fifty years.

By assessing the development of institutions like the Abu Dhabi Investment Authority, the Saudi Arabian Monetary Authority, the Public Investment Fund and the National Bank of Kuwait, The Financial Markets of the Arab Gulf evaluates the growth of the markets and provides a detailed, critical, snapshot of the current form and function of the Gulf's financial markets. It argues that the markets have been controlled by various state institutions for socio-political reasons. In particular, the Saudi state has used its sophisticated regulatory regime to push for industrialization and diversification, which culminated in the Vision 2030 plan. The UAE, Qatar, Kuwait, Bahrain and Oman have also been strongly involved in establishing modern markets for similar purposes but have done so through different means, with varying results, and each in line with what has been considered their respective comparative advantages.

Along with critically surveying these institutions and their role in global finance, the book also presents case studies depicting transactions typical to the region, including the highly profitable documentary credits of commercial banks, the financial scandal of certain financiers and their regulatory arbitrage between Bahrain and Saudi Arabia, a review of the Dubai's trade miracle, and an assessment of the value and importance of the privatization of Saudi Aramco.

1 A Short History of the Financial Markets in the GCC States

The evolution of the Gulf’s modern financial markets began in the 1970s in parallel with the exponential growth of hydrocarbon revenues. Prior to this, local financing needs were met through an amalgamation of money changers, some of which had grown substantially in size and sophistication, local branches of foreign banks and directly through the intermediation of bankers from global hubs in New York and London.

In Saudi Arabia in particular, in the 1970s, there was a major effort to diversify the burgeoning economy away from crude oil. Some of the leading civil servants of the time, such as Mr. Aba Al Khail, Khalid al Gosaibi, Ahmed Zaki Yamani, or Hisham Nazer were strongly pushing for modernization of the Kingdom’s economy. They felt that the banking system needed to join the 21st century in order for the Kingdom to have a chance at developing beyond crude oil. One of the primary initiatives in this regard was their push for a well-regulated market under the leadership of a strong central bank, the Saudi Arabian Monetary Agency (SAMA). At the time the Saudi financial and capital markets were just beginning to take shape, while Kuwait was already much more sophisticated with both an official stock market and an unregulated stock market called the Souk Al Manakh. Kuwait and the United Arab Emirates (UAE) had an established Islamic Bank, while Saudi Arabia had none. Nearby, Bahrain was becoming a major financial hub for the region, providing services which Beirut-based financial institutions could no longer offer due to civil war. In the UAE, a series of disparate stories were at play across the country’s Emirates, with Dubai capitalizing on its position along major trade routes to supplant its waning hydrocarbon revenues, while Abu Dhabi established the framework for what would be one of the world’s largest financial institutions, the Abu Dhabi Investment Authority, in an effort to insulate itself from financial volatility.

These institutions established in the mid-1970s have evolved greatly. The volume and type of transactions they host have grown exponentially. Their exposure and openness to foreign markets has been transformed while their role in global markets has grown in prominence and shifted in substance. The Gulf’s modern market structure and function, which will be presented in later chapters, has been built upon the foundations that are described in this chapter, which focuses on the developments between the mid-1970s and 1980s in key financial markets in the Gulf.

The Commercial Banks

The first commercial banks of the Gulf were established by the colonial powers to service their local needs or that of their traders on their way to the Far East or India. The Bank of the East, which ultimately became Standard Chartered, was first established in Bahrain in 1920 and primarily served British companies and civil servants in their relations with both London and the Indian Empire, which was managing Britain’s affairs in the Gulf. Driven by similar dynamics, the British Bank of the Middle East was established in Jeddah to serve the subcontinent trade from England and the Indian pilgrims to Mecca. The British also established The Imperial Bank, now HSBC, in Kuwait in 1943, to service the substantial British presence in Kuwait at the time. The French established the Banque de l’Indochine in Jeddah very early on to service the trade and ships from France to Indochina. This branch proudly claimed that its address was P.O. Box 1. By the same token, Dutch Algemene Bank established a branch in Jeddah for their trade to Indonesia as well as the numerous pilgrims from Indonesia to Mecca.

The branches of foreign banks were very important to the region’s early development. Many merchants used them to trade with Asia, Europe, or the US. They opened cash accounts, which would help them dealing with the bank’s worldwide networks. They also provided short-term loans usually linked to trade. However, in the 1950s, some local merchants decided they could go into banking for themselves. They wanted to have the capacity to deposit funds locally, and in general take their business to locally owned institutions rather than be dependent on what they perceived as the whims and decisions of foreign banks in New York, London or Paris. In Saudi Arabia, this gave birth to the National Commercial Bank, established in 1953 by two Hadrami families in Jeddah, the Al Mahfouz and the Kakis.¹ Very rapidly they opened branches in numerous towns in Saudi Arabia, which allowed them to build large local deposits and provide local banking services. The Sharbatly family, also in Jeddah, established the Riyadh Bank in an analogous pattern of events.

Driven by very similar dynamics, leading merchant families in Kuwait and Bahrain started the National Bank of Kuwait in 1952 and the National Bank of Bahrain in 1957, respectively. NBK was established with the full support of then ruling Sheikh Abdullah al Salem al Sabah, who underwrote the bank with an interest-free deposit of 1 million British pounds. In doing so he looked to placate prominent merchant families who felt that British-owned banking interests were unjustly eroding their money-lending and money-changing enterprises.² Some of these families were among the founding members of NBK, most notably the Al Kharafi, the Al Sagr, the Al Hamad and the Al Sayer, all of whom continue to have members represented across NBK’s board of directors and executive management.³ After its founding, NBK quickly took on many of the country’s central banking functions, expanded its lending operations and opened new branches throughout the country. By the late 1950s, NBK had surpassed its British counterpart as the dominant bank in Kuwait.

The United Arab Emirates saw the modern history of its banking sector start with UAE Federal Law No. 10 of 1980. Known as The Banking Law, it established the Central Bank of the UAE (CBU) and gave it legal authority to issue and ensure the stability of the official currency (the dirham), organize, promote and supervise the banking sector, oversee credit policy, advise the government on economic matters, maintain foreign reserves and act as the bank for banks in the UAE.⁴ As part of these authorities, the Banking Law also provided the CBU with oversight over the registration, licensing and operation of commercial and investment banks, financial institutions and money changers, most of which is carried out by the CBU’s Banking Supervision and Examination Department. That stated, as stipulated in the Banking Law’s Article 77, a number of important institutions are outside the CBU’s jurisdiction including public credit institutions other than commercial banks, governmental development funds, private and pension funds and insurance and reinsurance agencies, effectively placing the country’s various sovereign wealth funds outside of its oversight.

Before 1980, there had been no central regulatory actor for the UAE’s burgeoning banking and finance sector. The CBU’s predecessor, the Currency Board, had been established in 1973 not for regulatory reasons, but with the primary purpose of establishing a new UAE currency. Until then, the prevalent currencies used in the recently formed country were the Qatari Riyal and the Bahraini dinar. The lack of regulatory oversight was not due to lack of foresight, but instead due to the ruling Emirs’ reluctance to grant regulatory power over domestic banks, including many which royal family members held financial interest in, to the Currency Board’s mainly foreign management.⁵ In a time of massive oil-driven financial growth, this lack of regulation led to significant troubles including rampant real estate speculation, bank proliferation and credit expansion, eventually leading to a run on the currency and multiple bank failures in 1977.⁶ It is in this sense that the Banking Law fundamentally changed the banking sector, forcing banks to be established as national shareholding companies and binding them to capital and ownership structure limitations.⁷ Once in place, the CBU was quick to act, issuing regulations expanding audits and inspections, expanding reporting requirements, establishing a computerized loan risk department, setting minimum capital requirements and limiting loans to bank executives to 5% of the bank’s total capital.⁸

In Saudi Arabia, after the first oil boom of 1973, the government, like most other oil-producing countries, started programs to establish physical infrastructure on par with that of Europe or the US. It signed hundreds of billions in contracts for harbors, roads, airports, schools, entire new cities—all at the same time. This level of expenditure brought about a new role for the young domestic banking sector.

To ensure efficiency in the financing of these infrastructure projects, the Ministry of Finance (MoF) supervised the issuance of contracts. It demanded that all contractors involved in this effort provide bid bonds, followed by performance bonds and advance payment guarantees. These performance bonds, which were often written in favor of SAMA, ensured that the Saudi central bank would recoup any losses stemming from incomplete projects, either due to unforeseen circumstances or contract bankruptcy. From 1974 to 1983, the Saudi market required US$1 billion dollars of performance bonds and between US$2 and US$4 billion of advance payment guarantees each year. The bonds and guarantees required were drafted to the same standards of the documentary credits used in the United States. The banks also had to provide letters of credits to contractors for the import of goods related to the contracts, as well as cash advances to tie the contractors over between the time the work was done and the time the government actually paid; all told these financial instruments amounted to roughly US$30 billion per year.⁹

This activity provided an opportunity for the local banks not only to expand their portfolios, but arguably more importantly, to interact with, and learn from, more advanced international banking outfits. This was underpinned by the fact that many of the banking facilities needed for the larger contracts were so large that the local banks had to share their risks with other banks locally and abroad. Since most of the income of the Saudi government was in USD from the sale of oil, the government drafted and paid all contracts over in USD US$100 million and not Saudi Riyals (SAR). Hence, for larger contracts, the banking facilities needed were in the hundreds of millions of USD. On a US$100 million contract, such as road or an airport, which was a substantial amount in the 1980s, contractors needed to provide a 1% bid bond, a 5% performance bond and a 10% advance payment guarantee. The contractors also normally would require about 10% for letters of credit and a similar amount in short-term advances. Thus a contract of the size mentioned would require a total facility of US$46 million, a large sum at the time. Accordingly, banks tried to share the risks with other banks through syndication arrangements, with the largest portion of syndicated risks consisting usually of performance bonds and advanced payment guarantee facilities. A more detailed discussion of this process is discussed in Chapter 6.4.

As such, syndications of large lines of credits for contractors became a major activity between banks in the Middle East, as well as leading international banks, and became a major source of income for many of these banks. This active exchange and spreading of risk was one of the first modern financial activities carried out regularly across the Gulf. In the early 1970s, to ease the strain on local banks, SAMA agreed to accept bonds issued directly by certain well-vetted large foreign banks. These banks consisted of the largest Western banks (Citibank, Chase, Morgan Guarantee, Barclays, Indosuez, Sumitomo, Bank of Tokyo) as well as some of the more established banks from developing countries. All other banks were required to either co-issue with approved banks or local Saudi banks, with which the smaller banks could have a traditional correspondent relationship. The limitation on the number of foreign banks able to issue bonds directly gave SAMA substantial leverage in dealing with the foreign banks.

By the late 1970s, SAMA grew fearful that the still quasi-embryonic local banking sector could lose its dominant role in arranging these various financial facilities to a massive flow of banking services from abroad. It also feared that local banks would grow to seek more lucrative, and less risky, use of their funds by providing facilities to non-Saudi companies active outside Saudi Arabia. To avoid this SAMA took a number of measures. In 1978, SAMA forbade all Saudi banks from participating in foreign led syndications. SAMA also required that Saudi banks request its approval prior to participating in syndications not floated for the Saudi market specifically. In great part, these actions were also driven by SAMA’s watchful eye on the problems many banks were having with syndicated loans and facilities in Latin America. It was there that some of the largest banking outfits were facing major defaults, a development which SAMA wanted local banks to avoid.

Until the early 1970s the branches of foreign banks operating in Saudi Arabia were not regulated by SAMA, but instead were technically under the jurisdiction of regulators in their home jurisdiction. SAMA had very little say on what the local branches of these foreign banks could or could not do outside of its ability to limit the amount of local deposits they could take. By and large, the branches of foreign banks were small and unable to cope with a large increasing demand for banking services, some due to lack of infrastructure and some due to lack of capital. Even though the capital of the branches was technically the same as that of the parent bank, facilities to local merchants would have to be approved by remote head offices, which de facto limited the amount of business that was actually done with local merchants. With the inflow of oil income and significant growth in infrastructure expenditures, the potential for business was growing rapidly, especially given the numerous infrastructure projects active during the period, all of which required significant financial facilities.¹⁰ To tap in to the post-1973 booming market, it was important for the foreign banks to obtain more deposits. Getting SAMA’s approval to do so proved problematic though, as the Saudi central bank was uncomfortable with them taking the local deposits while practicing outside the Kingdom’s direct regulation. It was in light of this environment that SAMA felt it had the leverage to establish a new regulatory environment, one in which these foreign branches would be forced to come under its jurisdiction.

In 1978, SAMA informed the foreign banks that they would be permitted to expand and open more branches, but only if they became locally registered Saudi corporations and increased their capital, but with the proviso that the new capital structure had to give Saudi citizens a 60% majority. Hence, the banks were not nationalized per se, but were “Saudi-ized,” which in turn put these foreign entities under the supervision of SAMA rather than under the supervision of their home central banks. The Saudization requirement started lengthy negotiations between the foreign banks and SAMA. The parent banks in Europe and the US feared that Saudization would hinder their ability to manage their overseas branches and control their own banking risks. Moreover, minority ownership positions, even with management control, was against the corporate policy of some banks, such as Citibank, which held out to the longest prior to accepting its new status.

SAMA was able to persuade the banks to go along with the plan because the foreign banks realized that they could increase their deposits, their loans and their fee instruments. More importantly, the banks realized that by moving forward with new regulatory structures they would remain on the good side of SAMA, who at the time had reserves of US$180 billion, which had to be placed somewhere. Thus, in the eyes of these foreign banks, the potential increase for business and profit was strong despite the potential loss of 60% of the new profits to Saudi shareholders. In the end, the foreign banks were still able to maintain a 40% interest, and their fear of being dominated by Saudis shareholders was somewhat assuaged by the fact that no Saudi was allowed to own more than 5% of the outstanding shares, a stipulation that allowed the foreigners to keep effective control of management.

The perception that there was money to be made in Saudi was not wrong. In conjunction with the large increase in oil revenues, the Kingdom’s bank deposits increased from US$1.09 billion in 1973 to US$47.49 billion in 1991.¹¹ However, the larger deposits were not matched by a proportional increase in loan activity. The ratio of bank loans to deposits in the Kingdom went from 61% in 1980 to 46% in 1991.¹² If banks do not lend money to businesses or individuals, they must place their money with other financial institutions or buy corporate or government securities. At the time Saudi banks did not trade in government securities and did not place funds with one another. Hence, the Saudi banks became little more than intermediaries between small Saudi depositors and large Western and Japanese banks.

The declining loans to assets ratio was largely due to the problems banks had collecting bad loans from rich and powerful borrowers. At the time, Shari’a law, which acted as the law of the Kingdom, applied to everyone, including banks and business. The Saudi interpretation of Shari’a, especially the Hanbali interpretation, specifically forbade the giving and receiving of interest.¹³ Mortgages that bore interest or that were on movable assets were not acceptable in court and floating liens were specifically forbidden in the Qur’an. The court’s conservative interpretation of the Shari’a meant that judgments where usually rendered against banks. Consequently, banks justifiably felt that they could not credibly obtain redress in court, which in turn limited the banks’ desire to lend, let alone take risky debt. Further, even in the unlikely event that bank receive...

Table of contents

• Cover
• Half Title
• Series
• Title
• Copyright
• Dedication
• Contents
• List of Figures, Maps, Tables
• List of Abbreviations
• Introduction
• 1 A Short History of the Financial Markets in the GCC States
• 2 The Financial Markets of the United Arab Emirates
• 3 The Financial Markets of Saudi Arabia
• 4 The Financial Markets of Bahrain, Qatar, Kuwait and Oman
• 5 The Gulf States in Global Financial Markets
• 6 Case Studies
• 7 Conclusion
• Index