governance challenges in the financial sector an overview...

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XIIth Euro-Mediterranean Conference on Economic Transition

Governance Challenges in the Financial SectorGovernance Challenges in the Financial Sector

An Overview of the Lebanese and Arab Banking An Overview of the Lebanese and Arab Banking Industry visIndustry vis--àà--vis ofvis of

Recent International Financial StandardsRecent International Financial Standards

Dr. Makram SaderSecretary General

Association of Banks in Lebanon

Brussels - Belgium20 - 21 February 2008

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Outline

I – Local and Regional Financial Services : Financial Industry Structure, Size and Performance

II – Local and Regional Compliance With Recent International Financial Standards and Trends

III – Local and Regional Financial Services and the “IT Productivity Paradox”

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• Industry Structure Indicators

• Industry Size

• Industry Performance Indicators

I –Local and Regional Financial Services : Industry Structure and Performance

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Selected Indicators on the Size of the Financial Markets, 2006- Billion USD

Source: Global Financial Stability Report/ IMF, October 2007, IFS/IMF, BDL, BSE.* 2007 figures

GDP Stock Market Capitalization

Public and Private Debt

SecuritiesBank Assets Total in % of GDP

World 48,204 50,827 68,734 70,861 190,422 395EU 13,644 13,069 23,203 36,642 72,913 534Euro area 10,589 8,419 18,768 25,838 53,025 501US 13,195 19,569 26,736 10,205 56,510 428Japan 4,366 4,796 8,719 6,415 19,930 456UK 2,395 3,794 3,298 9,213 16,305 681

Emerging market countries 14,079 11,692 6,056 11,271 29,020 206o/wEmerging Asia 6,260 6,857 3,518 7,487 17,862 285Latin America 2,942 1,454 1,557 1,434 4,445 151Arab countries 1,234 1,262 200 1,235 2,697 219Lebanon* 24 11 7 82 100 417Africa 920 851 141 500 1,492 162Europe 2,631 1,873 742 976 3,592 136

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Financial Assets Structures- 2006Equity

SecuritiesPrivate Debt

SecuritiesDebt

SecuritiesBank

DepositsShare, % Share, % Share, % Share, % USD trillion %

World 32 26 16 27 167 100% of GDP 112 89 54 93 346%USA 35 36 11 18 56.1 100% of GDP 147 155 47 76 424%Euro zone 23 32 17 27 37.6 100% of GDP 81 115 62 97 356%Japan 24 10 35 31 19.5 100% of GDP 108 45 155 138 446%Emerging Asia 33 19 17 31 4.3 100% of GDP 82 48 44 76 250%China 30 5 10 55 8.1 100% of GDP 92 16 30 169 307%

MENA*, USD billion 1100 100 100 1000 2300MENA struct., % 48 4 4 43 100% of GDP 69 6 6 63 144%

Lebanon, USD billion 11.2 0.6 6.3 71.0 89.1Lebanon struct., % 12.6 0.7 7.0 79.7 100% of GDP 47 3 26 296 371%

Total

Sources: Mapping Global Capital Markets, 4th Report, January 2008, McKinsey & Company (MGI) MENA, McKinsey Global Institute Lebanon, ABL calculations

* Including: Algeria, Bahrain, Djibouti, Egypt, Iran, Iraq, Israel, Jordan, Kuwait, Lebanon, Libya, Morocco, Oman, Qatar, Saudi Arabia, Syria, Tunisia, United Arab Emirates, Yemen.

MENA Fin.assets CAGR 1996-2006 = 15.5%MENA GDP CAGR 1996-2006 = 12.1%

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Mena Countries : Financial Development Indices, 2002/03 1

(Based on Qualitative and Quantitative Data Scale 0-10)2/

Source : Authors' calculations.1/Original ":Subjective" Weighted index2/ Scale : Very Low=Below 2.5, Low=2.5-5.0, Medium=5.0-6.0, high=6.0-7.5, very high=above 7.5Source : IMF WP/04/201

Nonbank Financial

SectorBahrain 7.7 7.3 5 9.3 7.8 8 8.9Lebanon 7 8.7 3.3 7.7 8.3 7 5.2Jordan 6.9 7.1 6.3 8.7 6.5 8 5.4Kuwait 6.8 7.4 5 8 6.6 8 5.9United Arab Emirates 6.6 7.9 5 6.7 5.8 8 5.9Saudi Arabia 6.4 7.8 3.3 8 6.4 8 4.2Oman 5.9 6.1 5 8.3 4.2 8 4.8Qatar 5.7 6.8 0.7 6.7 5.7 8 6.3Tunisia 5.6 7.7 4.7 5.3 4.5 5 5Morocco 5.5 5.6 4.7 7.3 6.8 4 3.8Egypt 5.4 6 6.3 5.3 5.6 6 3.2Sudan 4.7 5.7 0.7 3.7 6.2 7 4.5Djibouti 4.1 3.8 1.3 5 6 7 2Yemen, 3.9 4.1 0.7 3.3 5 9 2.2Republic of M i i

3.5 3.8 0.7 3 3.9 5 4.5Algeria 3.2 2.5 3 3.5 4.4 4 2.3Syrian Arab Republic 1.1 1.9 0.7 0 0.9 0 2.4Libya 1 1.3 0.7 2 0.5 0 1Average 5 5.5 3.3 5.7 5.1 5.9 4.2

Financial Development

Index

Banking Sector Regulation and Supervision

Monetary Sector and

Policy

Financial Openness

Institutional Environment

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Stock Markets in Arab Countries

* as of February 11, 2008.Sources: Arab Monetary Fund, Arab Stock Exchange Markets, specialized reports.

Market nameMarket

capitalization* (million $)

Share, (%) Turnover ratio (06), %

P/E ratio (latest available)

P/BV ratio (latest

available)Abu Dhabi Securities Market 116,465 9.2 23.8 16.6 3.0Amman Stock Exchange 42,241 3.3 72.7 29.0 3.1Bahrain Stock Exchange 27,753 2.2 6.6 13.6 2.1Beirut Stock Exchange 10,703 0.8 24.5 11.7 1.4Casablanca Stock Exchange 20,525 1.6 18.4 33.2 -Doha Securities Market 104,051 8.2 33.8 16.4 4.2Dubai Financial Market 132,661 10.5 109.0 16.0 2.8Egypt Capital Market 143,160 11.3 52.3 18.1 -Kuwait Stock Exchange 208,971 16.6 56.3 13.0 2.8Muscat Securities Market 23,604 1.9 17.0 15.0 2.9Palestine Securities Exchange 2,691 0.2 39.1 - -Saudi Stock Market 424,078 33.6 429.2 19.3 3.6Tunis Stock Exchange 5,116 0.4 13.3 15.3 1.6Total 1,262,020 100.0 - - -

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Assets Structure of Arab Banks million USD

Source: IFS/IMF, December 2007.* Covers only Deposit Money Banks and does not include fixed assets and unclassified assets.

Reserves% of total

AssetsClaims on

private sector% of total

AssetsClaims on

public sector% of total

AssetsForeign

assets% of total

Assets Total Assets*

Share of each country,

%

Algeria 27,410 37.4 16,889 23.1 28,274 38.6 660 0.9 73,233 5.9Bahrain 1,886 4.8 9,855 24.9 1,402 3.5 26,357 66.7 39,500 3.2Djibouti 10 1.6 148 23.1 13 2.0 469 73.3 640 0.1Egypt 40,373 26.2 59,448 38.5 30,462 19.7 23,966 15.5 154,249 12.5Jordan 5,804 17.0 15,615 45.7 3,380 9.9 9,389 27.5 34,188 2.8Kuwait 12,746 12.7 59,197 59.0 11,562 11.5 16,838 16.8 100,343 8.1Lebanon 19,802 24.8 17,752 22.3 21,508 27.0 20,710 26.0 79,772 6.5Libya 11,853 59.6 3,918 19.7 2,187 11.0 1,918 9.6 19,876 1.6Mauritania 16 3.9 350 86.2 19 4.7 21 5.2 406 0.0Morocco 8,071 10.5 55,047 71.6 10,128 13.2 3,644 4.7 76,890 6.2Oman 1,431 6.6 14,348 66.2 971 4.5 4,920 22.7 21,670 1.8Qatar 1,923 3.0 29,779 46.5 11,511 18.0 20,895 32.6 64,108 5.2Saudi Arabia 18,741 7.5 146,192 58.4 42,365 16.9 43,216 17.3 250,514 20.3Sudan 1,185 13.5 5,566 63.3 1,113 12.7 925 10.5 8,789 0.7Syria 2,548 10.3 4,798 19.4 6,217 25.1 11,222 45.3 24,785 2.0Tunisia 1,756 6.6 21,266 79.9 2,201 8.3 1,404 5.3 26,627 2.2United Arab Emirates 33,293 13.1 130,051 51.2 25,814 10.2 64,784 25.5 253,942 20.6Yemen 1,363 23.8 1,633 28.5 1,260 22.0 1,469 25.7 5,725 0.5Total Arab 190,211 15.4 591,852 47.9 200,387 16.2 252,807 20.5 1,235,257 100.0

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Arab Countries Deposits at Non Resident Banks Oustanding Amount

(all sectors) Share, % Non Bank Sector1- Bahrain 35,840 6.7 5,6772- Lebanon 31,038 5.8 11,9213- Algeria 10,612 2.0 3,1294- Djibouti 626 0.1 2425- Egypt 41,812 7.9 14,2946- Iraq 1,832 0.3 6667- Jordan 16,835 3.2 4,6128- Kuwait 46,403 8.7 19,7539- Lybia 73,670 13.8 5,094

10- Mauritania 622 0.1 31211- Morocco 12,452 2.3 3,56212- Oman 12,723 2.4 7,25313- Palestine Territory 657 0.1 17814- Qatar 10,007 1.9 3,92015- Saudi Arabia 101,878 19.1 55,13316- Somalia 51 0.0 1617- Sudan 1,830 0.3 81918- Syria 24,564 4.6 2,34119- Tunisia 7,097 1.3 1,35220- UAE 93,747 17.6 37,04621- Yemen 7,968 1.5 1,093Total Arab Countries Deposits 532,264 100.0 178,413

1- Total Arab Countries 532,264 178,4132- Africa & Middle East 742,268 255,6723- Developing Countries 2,315,044 715,3644- All Countries 24,240,804 6,808,786

(1) / (2) (%) 71.71 69.78(1) / (3) (%) 22.99 24.94(1) / (4) (%) 2.20 2.62

5- GCC 300,598 128,782

Source: BIS Quarterly Review, December 2007.

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Industry Structure Indicators

Arab (2006) Lebanon (2007)

Assets/GDP 120% 341%

Credit to private sector / GDP 58% 85%

Capital / Assets 11% 7.6%

BIS capital ratio 23% 25%

Credit to private sector / customer deposits 80% 30%

Stock market capitalization / GDP 85% 45%

Sources : AMF, UAB, BDL.

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58.1%35.5%Cost/income

1.1%2.6%Return on assets (ROAA)**

16.3%24.1%Return on equity (ROAE)**

LebanonArab*

Industry Performance Indicators

* Top 100 Arab Banks** Pre-tax profits

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Performance Indicatorsin Percent

ROA ROECapital to Risk-Weighted Assets

Non Performing Loans to Total

Loans Cost to income*Western EuropeBelgium 1.1 17.7 12.0 1.8 62.22France 0.6 11.9 11.4 3.2 63.94Italy 0.8 11.5 10.7 5.3 58.25Spain 1.0 19.9 11.9 0.6 53.22Switzerland 0.9 17.7 13.4 0.3 53.26United Kingdom 0.5 8.9 12.9 0.9 50.2Middle East and Central AsiaEgypt 0.9 17.4 16.3 24.7 -Jordan 1.7 15.9 21.4 4.3 -Kuwait 2.6 21.6 22.0 3.9 23.74Lebanon 0.9 9.8 24.7 13.3 58.1Morocco 1.3 17.4 12.3 10.9 -Saudi Arabia 4.3 30.5 21.8 2.0 31.44Tunisia 0.2 9.1 11.8 19.2 -UAE 2.3 18.0 16.6 6.3 30.58

Source: Global Financial Stability Report, IMF, October 2007.* Sources: The Banker, Banque du Liban.

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World 2806

Sovereign FundsUSD billion

Source: Regional and International medias.

Arab Countries 54%Non Arab Countries 45%

N.B. Could grow by USD 1200 billion yearly Could reach at 2011 more than USD 11000 billion. Diversify from government bonds & bank deposits to private bonds

from securities to derivatives.from US dollar to other currencies

Arab countries 1512 Non Arab countries 1294o/w: o/w:Abu Dhabi 897 Singapore 438Saudi Arabia 259 Norway 329Kuwait 213 China 200Qatar 50 Russia 148Libya 50 Australia 49Algeria 43 Alaska 40

Brunei 35Korea 20Kazakhstan 19Malaysia 16

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II – Local and Regional Compliance With RecentInternational Financial Standards and Trends

► Corporate Governance

► Anti Money Laundering and Combating the Financingof Terrorism

► Risk Management : Risk mitigation and risk allocation

► Capital Allocation under Basle II

► HR , IT capital, IT labor

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II -1 Recent International Financial Standards (IFS)

RecentIFSCapital Allocation

Under BaselII

AML/CFT

Corporate Governance

Risk Management

- Capital adequacy ratio- Lending to related parties- Loans to one borrower- Liquidity ratios- Foreign exchange exposure- Others

Traditional

ITITHRHR

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High×The exchange should be independent from industry and government

There should be independence between industry and government

4-Regulatory Environment -Independence from industry and government

HighDisclosure3-Transparency of Ownership and Control -Related-party ownership

Top×At least 1/3 of the board should be non executive, a majority of whom should be independent

At least 1/3 of the board should be non executive, a majority of whom should be independent

2-Structure and Responsibilities of the Board of Directors-Independence

HighProxy voting should be available to all shareholders

×1-Minority Shareholder Protection -Proxy systems

PrioritySecurity and Company

Law

Exchange Rules and Listing Requirements

Company By-laws

II-2 Corporate Governance: International Standards (Institute of International Finance – IIF)

Source: Institute of International Finance, Inc., Policies for CorporateGovernance and Transparency in Emerging Markets, February 2002.

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Steps to bridge the gap

II-2 Corporate Governance (continued)

- No independent members on the board of directors (family businesses or family controlled businesses)

- No separation between ownership and management

- Intersection between private and public interests

- Adapt international standards to meet the needs of our markets and their specificities.- Incorporate the new standards in our laws and regulations.- Translate laws and regulations into policies and procedures.- Implement and start practicing.- Adopt transparency and disclosure.

- Independent non executive board members

- Separation between ownership and management

- Separation between private and public interests

Prevailing inArab Countries International Standards

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II-2 Anti Money Laundering and Combatingthe Financing of Terrorism (AML / CFT)

Group of StandardSetters

World Bank, IMF, BISFATF, IOSCO, IAIS, EGMONT…

Action plan

Reporting(mostly under taken by World Bank and IMF

Conditionality (loans and financial

assistance)

ROSCFSAR

(Separate and under Article IV)

AML/CFT assessment methodology

based on 40+8 FATF recommendations

Assessment implementation

Technicalassistance

(FIUs)

Surveillanceand policydialogue

Research

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At the present stage: Where do we stand vis a vis theseinternational standards?

As Arab Banks

Most Arab countries enacted the necessary laws.Most Arab central banks and monetary agencies issued andcirculated the required regulations covering mainly:

II-2 Anti Money Laundering and Combating the Financing of Terrorism (AML / CFT) (continued)

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- Know Your Customer (KYC) and all related matters.- Watch, collect and trace all unusual (suspicious) incoming

and outgoing funds transactions.- Survey funds transactions undertaken by real persons or

physical entities listed on the black lists circulated by concerned authorities to banks.

- Disclose, report, notify and sometimes publish as a part of the obligations of internal audit towards the bank management and as a part of the obligations of the external audit in its detailed reports submitted to supervisory authorities and general assemblies of shareholders.


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Moving forward:

- Train and educate employees at different levels for AML/CFT to become a part of daily operations and work culture.

- To reaffirm the strong commitment of top management and allocate proper resources to AML/CFT.

- Move from disclosure and reporting to making information available to the market.


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1-To enact more elaborated/sophisticated or detailed corpus of laws and regulations.

2-To reaffirm management commitment and engagement byallocating adequate resources.

3-To enhance cooperation with the international communitythrough IFI and within FATF.

4-To develop training and market discipline.

II-2 Best strategies for Corporate Governance and AML/CFT

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Same Risks

Different structureof balance sheet

Different macroeconomicoperating environment

Large exposure to sovereign risk: 1/5 ofassets•Low credit rating⇒ High risk• A narrow taxation base• Fluctuation of other publicrevenue sources ⇒ Low creditworthiness

Large exposure andconcentration on both sides of the B/S:• Few big corporations• Few big depositors

Heavy dependenceon deposits(> 80% of liabilities)• Short term deposits• Lack of stable longterm funding (pensions, middle class savings, bancassurance,…)

Large exposure to credit risk:main not to say unique

source of financing.• Family business: continuousinterference between relatedbusinesses, no separation between corporate/family financials• Lack of or low quality

financial statements• Lack of corporate governance,Audit, Disclosure, Transparency…• Narrow capital funds base and heavy dependence on debtrather than equity financing.

Built-in volatility, mismatch and liquidity risk

II-3 Risk Management

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Risk Management

Limited by socio-economicdeterminants:• un-diversified economies• un-favorable income distribution

Retail banking:limited by narrow wagesbase and income levels

Risk mitigation

Lack of appropriatehedging instrument

and liquid and dynamicmarkets

Risk allocation/ Diversification

Lack of domestichedging capabilities:•Underdeveloped primary capital markets.•Insignificant underlying primary and secondary securitiesmarkets to develop derivatives

and hedging instruments.• All players move in the samedirection (one way market).

On the internationalmarkets:• The recourse to hedging

techniques throughinternational markets is often very costly.• This is because most of us (Lebanon, Egypt,…) operate"out of range".

Diversification in credit risk from sovereignand corporate to :

Private banking:• limited by lack of middleclass savings.• upper and high income earnersdeal directly with internationalprivate bankers

II-3 Risk Management (continued)

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Sovereign Risk Classification of The Arab Countries

*OECD adopts a scale from 1 (best rating) to 7 (worst rating).Sources: OECD, Participants to the Export Credit Arrangement as of February 1st 2008,and Standard & Poor's (latest rating).

S&P's Rated (R), Unrated (UR) ECA Risk Scores*

Corresponding Risk Weight (Basel II)

Algeria UR 3 50Bahrain R 2 20Djibouti UR - -Egypt R 4 100Iraq UR 7 150Jordan R 5 100Kuwait R 2 20Lebanon R 7 150Libya UR 6 100Mauritania UR 7 150Morocco R 3 50Oman R 2 20Qatar R 2 20Saudi Arabia R 2 20Sudan UR 7 150Syria UR 7 150Tunisia R 3 50United Arab Emirates UR 2 20Yemen UR 6 100

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II-4 Allocation of capital under Basle II

A - We expect the minimum required capital of Arab banks to almost double in implementing the Basle II agreement. This is because:

- Sovereign risk accounts for 1/5 of our total assets. The attributed risk weights of zero or very low percentages on average until now should be dramatically revised and linked to the rating of sovereigns in the coming years.

- We have to take into consideration capital requirements for operational risk.

- We have to account for the mismatch risks not taken or partially taken into account in capital allocation.

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B - This can be achieved through a balanced capital allocation

- Tier-one capital still represents more than 90% of total capital funds.

- Tier-two: under-represented, under-developed: preferred shares, convertible bonds, subordinated long term notes, and many other hybrid instruments.

II-4 Allocation of capital under Basle II (continued)

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C - Pre-requisites

- Develop capital markets and meet all the necessary relatedrequirements (corporate governance…..).

- Build market confidence.• Balanced options for Issuers and Investors.• Disclosure in line with most recent IAS 39 standards:

• Transparency of Management intentions.• Well defined redemption policy (classified as debt/equity?).• How to deal with hybrid instruments at maturity: dilution of earnings/share.


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D - From hedging the risks by only increasing the capitalto a well integrated strategy

Combining

Capital (tier-two) raisingReallocation

of risks (on and off balance sheet)

Lobbying toaddress macroeconomic

inbalances

Develop primarymarket and

have a balancedfinancial system (banks/markets)

Shift in the structureof bank income from interest income to non

interest income(commissions and fees)

More short termlending

?

More foreign liquidassets

?

Limit lending to thepublic sector to debt in

domestic currency?

More lendingto small

and mediumenterprises

?


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1 -To accelerate the development of capital markets toward a more balanced financial system and stability (enough underlying supports)

2 -To build market confidence among issuers and investors

3 -To develop instruments and techniques of hedging

4 -To enhance training and management commitment and to allow for adequate resources

II-4 Best strategies for Risk Management and Capital Allocation Under Basel II Agreement

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III – Local and Regional Financial Services and the “IT Productivity Paradox”

Investments in IT

Hardware

Software

Communications

Internal Staff

Services

Goals

Cost cutting

Cross-sell

Enter new markets

Improve customerservice

Risk management

Compliance with new rules and regulations

Basle IIInternational Accounting

Standards (IAS)

Anti-Money laundering

(AML)

Corporate Governance

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Investment in IT and non -IT Capital and Labor(International experience)

IT Capital : ► May have no real benefits in terms of productivity and Profitability

► But strategic necessity for competition purposes

IT Labor : ► May contribute to high returns

⇒ Need to shift emphasis from IT capital to IT labor

IT Capital investment is relatively better than non-IT capital investment

IT Labor investment is relatively better than non-IT labor investment

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Investment in IT: Limitations

1- Socio-cultural limitationIT needs to be well integrated into the banking operating environment

2- Business requirements (Banking applications)

3- System of policies and proceduresFull integration of the IT to the system of policies and procedures

Decision making processHierarchyFlow of information

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4- Over investment in non-IT capital and in non-IT labor at theexpense of IT labor

IT labor most profitableIT labor improves efficiency

► Hire more IT-focused employees► More spending on maintaining existing systems v.s

development of new IT systems► Aligning existing systems to business processes rather than

bringing newer systems► In-house maintenance and development could be better than

outsourced maintenance and development

Investment in IT: Limitations

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Conclusion : Euro-Arab Cooperation in Financial Industry

Levels of cooperation desired by Arab banks and which can be met efficiently by the European partner.

►First, at the macro level of the financial industry & market: structure & operating environment.

►Second, at the micro level: Bank-to-Bank cooperation.

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Desired Support/ Assistance

Very High

High

Medium

Low

High

Non-bank Financial Sector

Regulation & Supervision

Institutional Framework

Monetary sector & Monetary policy

Financial Openness

-Stock market, financial markets-Mortgage market-Diversification of institutions and products: Mutual funds, Hedge funds

-Introduction and implementation of Standards & Codes:IAS/IFRS,AML/CIF, Basle II, Corporate governance-NPL's policies-Resources, legal protection& Independence

-Judicial system, loan recovery, conflictResolution (arbitrage…), property rights, bureaucracy……

-Remove exchange and credit control-Liberalize interest rate policies & markets:Activate Interbank market -Government securities market:Activate the secondary market

-Multiple rates/ parallel market-Restriction on R/FC & NR/financial assets

E

AMix of support:

Technical Financial Organizational Human resources training and development

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Strategic Alliances

Business

Know how, internationalstanding,

financial strength

Investment Banking

Area of Activity

Specific Agreements

IT/Training Network

Market & Distribution

Retail & Bancassurance

Correspondent BankingL/C's

L/G's…

Business

Cost issue (rating, ECA's)Business

Corporate &Trade Finance

Strategic Partnership

Business (savings)

Know how, Expertise, innovation, products

Asset Management & Private Banking

Required Cooperation/ Mutual Interest

Form of Cooperation

A E A EA E A E

governance challenges in the financial sector an overview...

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