Global Financial Reform: What are its Implications for the Middle East?
A Commentary by Masood Ahmed, Director, IMF Middle East and Central Asia Department, and José Viñals, Director, IMF Monetary and Capital Markets Department
Published in Al Hayat, July 13, 2010
In the wake of the global financial crisis, policymakers around the world are working to build a financial system that is both innovative and stable in support of sustainable economic growth. Broad consensus has formed around the need for significant enhancements to the regulation and supervision of banks and other financial institutions—with a view to tracking and regulating risk-taking more effectively—and to strengthen crisis resolution mechanisms.
Middle East banks were less affected by the crisis than their counterparts in advanced economies: they were more focused on traditional lending and savings mobilization, and generally less integrated into global financial markets, so contagion was less. Prompt and forceful policy action, along with a range of financial reforms and initiatives already in place, helped contain the impact of the crisis. Prudent fiscal policies and the accumulation of reserves in many countries during the pre-crisis boom years have also helped reduce macroeconomic vulnerabilities and provided the needed fiscal space for government support.
Nevertheless, as elsewhere, the crisis uncovered a number of vulnerabilities across the region, highlighting the need for further reforms. Some of these are old shortcomings, including excessive dependence by banks on name lending without adequate due diligence and risk management practices, inadequate supervisory powers to take early remedial action, and deficiencies in consolidated supervision. Addressing these problems requires better regulation and hard-nosed supervision. It cannot be emphasized enough that a sound financial system needs active oversight and the willingness to act quickly to discourage excessively risky activity.
But in addition, the recent crisis has prompted a host of global regulatory initiatives, four of which are particularly germane to the region: reducing cyclicality, establishing stronger liquidity standards, finding ways to address systemically important financial institutions, and improving bank resolution frameworks—including cross-border.
Reducing cyclicality in financial markets—boom and bust cycles—is particularly relevant for Middle Eastern financial sectors that are vulnerable to swings in oil prices and capital inflows. In these countries, financing exuberant demand for real estate and equity during the 2003–08 oil price boom created vulnerabilities. The subsequent sharp decline in asset prices resulted in large losses for many banks and possibly excessive caution in extending credit, even for potentially sound projects. While good macroeconomic policies—such as using countercyclical fiscal policies—should be the first line of defense, the prudential policies being considered in the global debate could help commodity exporters and others exposed to shifting capital flows. These tools, such as capital, liquidity, and provisioning requirements, could be used to encourage financial institutions to build buffers in good times to be drawn down in bad times.
And as financial intermediation across the region continues to deepen, it will be crucial to ensure that financial institutions build adequate liquidity management systems and buffers. Many emerging markets in the region and elsewhere have seen episodes of rapid credit growth not matched by rising stable retail funding. Banks turned to foreign funding sources, and several systems were hit hard when these were not rolled-over. This is not to say that international financial flows are to be discouraged but, rather, that the risks need to be appropriately distributed and hedged. Of interest to the Middle East are evolving international discussions surrounding liquidity standards proposed by the Basel Committee.
A few countries in the region host banks that appear large relative to the ability of authorities to provide support. The crisis has brought to light the risks posed by systemically important intermediaries in advanced economies, and global regulators are debating ways to mitigate these risks. Options include imposing a capital surcharge, demerging riskier activities, or developing “funeral plans” whereby a bank continuously satisfies its regulators that any failing part can be separated from the parent structure and resolved in an orderly fashion.
A number of banks in the region have operations in various countries. Although these may not be that large in any given jurisdiction, supervisory authorities need to strengthen cross-border cooperation to ensure a consolidated overview of risks. One immediate focus is to put in place a more comprehensive legal framework that is dedicated to government intervention in financial institutions that provides for speedy restructuring options, both locally and across borders.
Some countries that were less affected by the crisis may not see the need for implementing some of the new reforms. However, these reforms are meant to deal with future vulnerabilities that may emerge in all countries. Furthermore, in a financially globalized world, differing regulations across borders could lead to a migration of risky activities to those countries with the lowest regulatory requirements. Certainly, in formulating new best practices, a degree of national discretion will be necessary and policy recommendations will need to be adjusted to local conditions. To that end, with efforts to reshape the global financial architecture still at a discussion phase, the views of policymakers in the Middle East should form part of the international debate. A coherent global approach to these issues offers the best chance of limiting the risk of uncoordinated policies, distorted investment flows, and regulatory arbitrage.