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---

### Executive Summary — Macroeconomic Context and Risks
- Growth drivers:
  - Oil production has risen.
  - Nonoil activity, including construction, trade and tourism, contributed to the strong growth performance, the highest among GCC countries.
- Inflation and overheating:
  - CPI inflation is estimated to have increased to about 9.3 percent in 2006.
  - Other signs of overheating emerged, especially in the booming real estate and construction sectors.
- Main domestic risk:
  - Possibility of a sharp cyclical correction.
- Key macro statistics (selected, 2003–2006):
  - Current account surplus: about US$36 billion in 2006, equivalent to 22 percent of GDP.
  - Fiscal surplus: almost 29 percent of GDP in 2006.
  - Gross official reserves: US$28 billion in 2006.
  - Real GDP growth: 2004: 9.7; 2005: 8.2 percent; 2006: 9.4 percent.
  - CPI inflation (average): 3.2, 5.0, 6.2, 9.3 (2003–2006).
  - Total exports of oil and gas (US$ billions): 29.6, 38.0, 55.0, 70.2 (2003–2006).
  - Average crude oil export price (US$ per barrel): 28.1, 36.3, 53.6, 63.5 (2003–2006).
  - Nominal GDP (AED billions): 325.3, 381.1, 488.4, 599.7 (2003–2006).
  - Nominal GDP (US$ billions): 88.6, 103.8, 133.0, 163.3 (2003–2006).
  - Memorandum: Quota: SDR 611.7 million; Population-2006: 4.23 million; Per capita GDP-2006: $38,600.

### Banking Sector: Structure, Performance, and Competition
- Role and credit expansion:
  - Banking sector dominates financial intermediation and enabled rapid credit expansion to households, corporations, and public and quasi-public enterprises.
  - Major construction projects for hotels, apartments, commercial and entertainment properties and infrastructure dominate Dubai and Abu Dhabi.
  - Demand for credit driven by rapid population growth and interest rates in domestic currency that are negative in real terms.
- Market composition and concentration:
  - Sector assets equivalent to 130 percent of GDP in 2005.
  - Five largest banks account for about 44 percent of system assets.
  - Number of banks (2002–2006): total banks: 47, 46, 46, 46, 46.
  - Islamic banks asset share rose from 8.8 percent at end-2002 to 12.6 percent at end-2006 (14.2 percent of deposits).
  - State-related institutions account for 63 percent of total bank assets.
  - Foreign banks' share in total banking assets declined from 25 percent in 2001 to 22 percent in 2006.
- Soundness indicators (selected):
  - Total regulatory capital to risk-weighted assets: 18.6, 16.9, 17.4, 16.6 (2003–2006).
  - Regulatory Tier I capital to risk-weighted assets: 18.2, 16.3, 16.9, 15.0 (2003–2006).
  - Nonperforming loans to total gross loans: 14.3, 12.5, 8.3, 6.3 (2003–2006).
  - Return on assets: 2.3, 2.1, 2.7, 2.3 (2003–2006).
  - CAR rose to 17.4 percent at end-2005 but declined to 16.6 percent at end-2006.
- Market opening:
  - After long moratorium, CBU authorized three foreign GCC banks and two local Islamic banks in 2006 (have yet to commence operations).
  - Recommendation: liberalization be extended to non-GCC foreign banks.
- Ownership and taxation:
  - Foreign banks face a 20 percent tax on profits (not applied to domestic banks).
  - Recommendation: further relax constraints and open up banking sector to non-GCC banks.

### Real Estate, Mortgages, and Vulnerabilities
- Exposure and size:
  - Construction (excluding mortgages) share of loans (2002–2006): 16.3, 8.3, 8.5, 6.9, 4.8.
  - Real estate mortgage loans share of total loans (2002–2006): 7.2, 5.3, 4.4, 5.0, 6.6.
  - Mortgage loans are 6.6 percent of bank loans (Table 3).
  - Bank mortgages represent about a fifth of household debt; household debt to GDP: 6.6, 6.1, 6.9, 5.2 (2003–2006).
  - Anecdotal: Dubai property prices increased by about 200 percent in 2002–06.
- Lending practices and risks:
  - Typical loan-to-value ratios (LTVs): 70 to 80 percent; observed relaxation to 90 or 100 percent in some segments.
  - Mortgages initially developed by Islamic finance companies; provided at floating rates.
  - Final use of personal loans for business purposes not well captured, implying household real estate exposure may be higher than mortgage stock suggests.
  - Lending standards may be weakening as institutions compete for mortgage business.
- Policy recommendations:
  - CBU to issue prudential regulations to limit risks associated with mortgages and other real estate lending by banks and finance companies.
  - Enhance prudential regulation and monitoring of banks’ exposure to real estate.
  - Continue improvements in sectoral classification of loans.
  - Enhance oversight of nonbank financial institutions involved in real estate financing.
  - Introduce maximum LTV and debt-to-income ratios.
  - CBU aims to create a federal credit bureau.
  - CBU proposed framework for real estate finance subsidiaries by banks.

### Stress Tests and Systemic Resilience
- Scope and methodology:
  - Stress tests conducted for all 46 U.A.E. commercial banks based on end-September 2006 data.
  - Focus on credit risk, with attention to real estate market developments; liquidity, exchange, and interest rate risks also assessed.
- Key stress-test results (selected, all figures preserved):
  - Doubling of substandard, doubtful, and loss loans would reduce overall CAR from 16.3 percent to 11.5 percent.
  - A strong shock affecting corporate borrowers, contractors, and mortgage loans would leave CAR at 14.6 percent.
  - The same real estate shock plus deterioration of personal loans quality would drive CAR down to 11.6 percent.
  - In that latter scenario, five locally incorporated banks, accounting for one-quarter of bank assets, would have CAR < 10 percent, with two becoming insolvent.
- Table 7 pre-shock CAR (selected):
  - Domestic banks: 17.3
  - Foreign banks: 12.7
  - Large banks: 16.0
  - Medium Sized banks: 15.7
  - Small banks: 18.2
  - State owned: 18.3
  - Islamic banks: 15.8
  - All banks: 16.3
- Example shock outcomes (Table 7):
  - A. Credit risk — Real estate (mortgages, construction loans and personal loans; 20% and 15% NPLs): All banks: 12.1.
  - A. Credit risk — Real estate (property developers, corporates, contractors, mortgages): All banks: 14.6.
  - A. Credit risk — Real estate + indirect credit risk: All banks: 11.6.
  - A. Credit risk — General shock: Increase of NPLs by 100 percent: All banks: 11.5.
  - B. FX risk — Appreciation of the AED/USD by 10 percent: All banks: 15.9.
  - C. Interest rate risk — Increase of interest rates by 300 basis points: All banks: 16.1.
  - D. Combined credit and interest rate risks — External shock + interest rates +300 basis points: All banks: 13.0.
- Liquidity stress simulations (Table 7):
  - Liquidity ratio (pre-shock) — All banks: 49.9.
  - After 16% customer deposit withdrawal: All banks: 30.6.
  - After 35% decrease in government deposits: All banks: 43.6.
  - After 30% decrease in non-resident deposits: All banks: 40.7.
  - After 30% decrease in foreign interbank funding: All banks: 45.1.
- Liquidity vulnerability:
  - Pre-shock liquidity ratio: 50 percent (rounded context).
  - A 16 percent withdrawal of customer deposits would lower liquidity ratio to just over 30 percent, disproportionately affecting medium-size and Islamic banks.
  - A 35 percent decline in government deposits would have greatest effect on publicly owned banks without threatening system liquidity.
  - A 30-percent decline in foreign interbank funding confirms less favorable liquidity buffers for small and medium-sized banks and Islamic banks.

### Supervision, Regulation, and Legal Framework
- Progress and changes:
  - ESCA fully operational as securities regulator; issued new Code of Corporate Governance in May 2007.
  - Responsibility for oversight of IPOs transferred from Ministry of Economy to ESCA in January 2007.
  - CBU introduced a comprehensive risk assessment approach and preparing for Basel II; banks expected to implement the standardized approach under Basel II by December 31, 2007.
  - Several key laws approved in AML/CFT; new Insurance Law promulgated on February 28, 2007 (comes into force six months after promulgation).
- Remaining weaknesses and recommendations:
  - Expand enforcement powers of the CBU and introduce explicit legal protection of supervisors exercising duties in good faith.
  - CBU to implement MOUs with ESCA, DFSA, and Insurance Commission for formal cooperation and exchange of supervisory information.
  - Build supervisory capacity for Basel II and for Islamic banking; develop necessary skills and specialized staff within banking supervision.
  - Consult more regularly with banking profession ahead of regulatory changes and publish draft regulations for public comment.
  - Introduce and enforce an aggregate limit for commercial bank lending intended for an IPO subscription.
  - Introduce more transparent procedures for emergency financial support to banks and consider limited deposit insurance.
- Banking supervision specifics (Core Principles):
  - Recommendation to formalize contacts between supervisors and enhance information exchange.
  - CBU should be informed and given approval power over proposed changes of significant ownership; explicit review procedures recommended.
  - Loan classification: recommend classify loans as impaired when payments have fallen 90 days in arrears and introduce minimum provisioning percentages and general loan-loss reserves.
  - Large exposures: include off-balance sheet items and interbank exposures with maturities < 12 months in definition of large exposures.
  - Basel II implementation timeline and requirements:
    - CBU announced intention to implement Basel II by December 31, 2007 (Circular 3735/2006 of August 27, 2006).
    - Standardized approach mandatory for credit risk in Pillar 1; market risk to adopt 1996 amendment to Basel I.
    - All banks expected IRB compliant by January 1, 2011.
    - Parallel run planned from June 30, 2007.
  - Capacity constraint: shortage of skilled personnel, including for Islamic banking specifics; training and salary packages recommended.

### Islamic Banking and Liquidity Instruments
- Increasing importance:
  - Islamic banks have become an increasingly important part of the UAE system.
- Liquidity and supervisory gaps:
  - CBU lacks an instrument for providing short-term liquidity to Islamic banks; supervisory capacity in this area has lagged.
- Recommendations:
  - Develop a market for government, or CBU-backed, shariah-compliant instruments to provide Islamic banks with instruments for liquidity management.
  - Enhance CBU supervisory capacities in Islamic banking.

### Capital Markets, Exchange Performance, and Insurance Sector
- Capital markets structure and performance:
  - Exchanges: ADSM, DFM, DIFX; number of exchange-listed companies: 110; overall market capitalization: about US$170 billion.
  - ADSM and DFM indices had dropped by 52 percent and 68 percent, respectively, from their 2005 peaks (as of December 2006).
  - Fixed-income securities traded on ADSM and DFM: less than 2 percent of exchanges’ market capitalization.
  - Sukuk listings on DIFX exceeding US$7 billion in market value.
- Market governance and recommendations:
  - Open capital markets more fully to foreign investors by removing restrictions on stock ownership and board membership.
  - Encourage public listing of large, quasi-public companies; CBU and ESCA to form a working group to encourage public listings.
  - Enact an accounting law to adopt IFRS for public companies and create a national accounting standard for other companies.
  - Strengthen disclosure, corporate governance, and IPO pricing/oversight (transfer IPO oversight to ESCA; revise Companies Law).
- Insurance sector:
  - Total premium revenue: about US$2.2 billion in 2005 (about 1.7 percent of GDP).
  - Comparative benchmarks: emerging markets average 3.5 percent of GDP; OECD 9 percent of GDP.
  - New insurance law promulgated on February 28, 2007; scheduled to take effect August 31, 2007.
  - Recommendation: prompt issuance of implementing regulations, recruit specialized supervisory personnel, consider placing insurance supervision under the central bank, and over time grant greater autonomy to the Insurance Commission and its Director.

### Payments, Liquidity Management, and Financial Safety Nets
- Payment systems:
  - Fund Transfer System (FTS) is an RTGS in use since 2002.
  - Check Clearing System (CCS) scheduled for upgrade in 2007 to an Image CCS to allow settlement within 2 to 4 hours.
  - SWITCH system used for ATM transactions; project to create a GCC-wide SWITCH network.
- Reserve requirements and instruments:
  - Reserve requirements: 14 percent of demand deposits and 1 percent of time deposits (dirham), unchanged since 2001.
  - Average reserve requirement at end-December 2006: about 7.2 percent.
  - Aggregate commercial bank reserves: 8.1 percent of M2 and 4 percent of total bank assets.
  - Certificates of Deposit (CDs) issued by CBU: maturities one week to 18 months; outstanding value as of December 2006: about US$8.8 billion (about 4 percent of total bank assets).
  - CDs rate of return closely tracks LIBOR; absence of sovereign debt securities means CDs are the only government-backed instruments; secondary market in CDs has not materialized.
- Recommendations:
  - CBU to initiate working group on sovereign debt issuance to foster corporate bond and short-term debt markets and form a yield curve (Time Frame: Short Term, within 12 months).
  - CBU to develop market for government—or CBU—backed shari’a-compliant instruments for Islamic institutions.
  - Make bank intervention strategy and emergency financial support more transparent; consider limited deposit insurance funded by bank premia.

### Dubai International Financial Centre (DIFC) and DIFX
- Purpose and status:
  - DIFC established in 2004 as first Federal Financial Free Zone; characterized as a future regional financial center.
  - DIFC mission: be “a catalyst for regional economic growth, development and diversification.”
- Activity and scale:
  - As of January 2007, seven banks authorized to accept deposits or provide credit in DIFC; three operational.
  - As of December 2006, DIFC banks held total assets of around $518 million (tiny fraction of US$200 billion total U.A.E. banking assets).
  - DIFX market capitalization as of January 2007: about US$21 billion; 45 percent of DIFX capitalization from bond instruments (including sukuk).
  - DIFX listings: seven equity securities (three ordinary shares) market cap about US$6.7 billion; 23 securities listed total.
  - DIFX specialization in Islamic finance; sukuk listings noted (e.g., Nakheel US$3.52 billion sukuk).
- Legal, regulatory, and institutional features:
  - DIFC comprises DIFCA, DFSA, and Dubai Judicial Authority (DJA).
  - Under Free Zone legislation, institutions licensed in DIFC: may conduct business with residents and nonresidents; prohibited from transacting in the U.A.E. Dirham and from taking deposits when conducting “financial banking activities.”
  - DFSA is an independent regulator with robust rule-making, licensing, supervision, inspection and enforcement powers; DFSA is signatory to IOSCO Multilateral MOU.
- OFC characterization:
  - DIFC would not be characterized as an offshore center based on benchmarks: domestic lending in foreign currency permitted, residents accounted for 44 percent of DIFC bank assets, and DIFC does not provide lighter supervision or bank secrecy.
  - Exception: foreign banks in DIFC receive tax advantage (not subject to 20 percent profits tax applied to foreign banks elsewhere in U.A.E.).
- Recommendations and observations:
  - Clarify competence and remit of “Competent Authorities” under Federal Law No. 8 to avoid regulatory overlap.
  - DFSA and other authorities to coordinate supervisory arrangements; transfer securities oversight outside the DIFC to ESCA recommended.
  - Note: actual banking activity in DIFC is small; regulatory and judicial structures remain to be tested as activity grows.

### Securities Market Regulation and Collective Investment Schemes
- Key findings:
  - Capital markets laws lack provisions related to collective investment schemes.
  - Interim Central Bank resolution attempted to fill gap but lacks depth and specificity.
  - DIFC framework for collective investment schemes in place; DFSA licenses fund operators; distribution restriction: funds can only be distributed to investors with liquid capital of at least US$1 million.
- Recommended actions (selected):
  - Centralize securities market regulation in one regulatory body with clear legislative mandate (P1–P5).
  - Improve operational independence of ESCA (e.g., chairman not a minister; majority of board private citizens with financial sector expertise).
  - Provide ESCA with explicit powers to fine and suspend brokers in law (P8–P10).
  - New securities law to set procedures for MOUs and cooperation (P11–P13).
  - IPO process and disclosures to be formally transferred from MOE to ESCA; revise Companies Law (P14–P16).
  - Promulgate comprehensive regulations for collective investment schemes (Ps 18–20); consider separate Collective Investment Law in medium term.
  - Adopt accounting law to mandate IFRS for public companies and strengthen auditing regulation (P16).

### AML/CFT and Judicial Capacity
- AML/CFT assessment:
  - Assessment initiated in March 2007; draft mutual evaluation report expected for MENAFATF and FATF plenaries in November 2007 and February 2008, respectively.
  - Preliminary findings: basic framework in place but legal framework needs strengthening to align with 2003 FATF Recommendations.
  - FIU needs more powers and staff to conduct analysis of suspicious transaction reports.
  - Regulatory structure uneven: CBU and DFSA more developed than other agencies.
  - National coordination needs improvement as AML/CFT expands to other sectors.
- Judicial and accounting frameworks:
  - Enact an accounting law to adopt IFRS for public companies and create national accounting standards for others.
  - Ministry of Justice to establish and fund financial education for judiciary.

### Main Recommendations (selected, with time frames)
- Financial sector legislation:
  - Amend ESCA legislation and transfer securities oversight from CBU and MOE to ESCA. Time Frame: Short Term.
  - Issue supporting regulations and implement new Insurance Law promulgated on February 28, 2007. Time Frame: Short Term.
  - Update Banking Law (1980) and Companies Law (1984). Time Frame: Medium Term.
  - Enact accounting law adopting IFRS for public companies. Time Frame: Medium Term.
- CBU banking actions:
  - Issue prudential measures to reduce real estate lending risks. Time Frame: Short Term.
  - Continue Basel II preparations; issue guidelines and build supervisory capacity. Time Frame: Short Term.
  - Seek expanded enforcement powers and legal protection for supervisors. Time Frame: Short Term.
  - Enter into MOUs with ESCA, DFSA, and Insurance Commission. Time Frame: Short Term.
  - Introduce and enforce aggregate limit on bank lending for IPO subscriptions. Time Frame: Short Term.
  - Introduce transparent emergency support procedures and consider limited deposit insurance. Time Frame: Short Term/Continuous.
- Liquidity management and capital markets:
  - CBU to initiate working group on sovereign debt issuance to foster corporate bond and short-term debt markets and form a yield curve. Time Frame: Short Term, within 12 months.
  - CBU to develop government—or CBU—backed shari’a-compliant instruments for Islamic institutions. Time Frame: Short Term.
  - CBU and ESCA to initiate working group to encourage public listings of large, quasi-public companies. Time Frame: Short Term.
  - Ministry of Justice to establish and fund judiciary financial education. Time Frame: Short Term.
  - Ministry of Economy to open capital markets to foreign investors by removing restrictions on stock ownership. Time Frame: Medium Term.

*Source: IMF 2007 FSAP Update for the United Arab Emirates — Executive Summary—Main Findings; IMF staff report excerpts from the supplied PDF content unit.*

### Executive Summary—Main Findings........................................................................................5

### Executive Summary—Main Findings

### Macroeconomic Context and Risks
- Growth drivers:
  - Oil production has risen.
  - Nonoil activity, including construction, trade and tourism, contributed to the strong growth performance, the highest among GCC countries.
- Inflation and overheating:
  - CPI inflation is estimated to have increased to about 9.3 percent in 2006.
  - Other signs of overheating emerged, especially in the booming real estate and construction sectors.
- Main domestic risk:
  - Possibility of a sharp cyclical correction.

### Banking Sector: Structure, Performance, and Competition
- Role and credit expansion:
  - The banking sector dominates financial intermediation in the U.A.E. and has enabled rapid credit expansion to households, corporations, and public and quasi-public enterprises.
  - Major construction projects for hotels, apartments, commercial and entertainment properties and infrastructure dominate Dubai and Abu Dhabi.
  - Demand for credit is also driven by rapid population growth and interest rates in domestic currency that are negative in real terms.
- Soundness indicators:
  - Banking sector shows comfortable levels of capitalization and profits, benefiting from rapid economic expansion and a steady decline in the ratio of NPLs to total loans.
- Market opening:
  - After a long moratorium on licensing new banks, three foreign banks from GCC countries and two local Islamic banks were authorized in 2006 (have yet to commence operations).
  - Recommendation: liberalization be extended to non-GCC foreign banks.

### Stress Tests and Vulnerabilities
- General resilience:
  - Stress tests found the banking system would be resilient to a variety of shocks.
  - Banks absorbed the 2006 decline in stock market prices with little effect on their balance sheets, and rapid increase in overall lending helped offset a drop in fees and commissions.
- Real estate risk:
  - Some banks are vulnerable to a severe correction in the real estate market which would leave banks accounting for one quarter of total bank assets with their capital seriously impaired.
  - Although mortgages still account for a relatively small part of bank loan portfolios, indirect exposure could be significant due to rapid development of property markets in Abu Dhabi and Dubai and new legislation allowing expatriates to own real estate.
  - Turnaround in real estate could affect quality of consumer and other loans.
  - Lending standards may be weakening as institutions compete for mortgage business.
- Policy recommendation:
  - CBU to issue prudential regulations to limit risks associated with mortgages and other real estate lending by banks and finance companies.

### Supervision, Regulation, and Legal Framework
- Progress made:
  - ESCA has become fully operational as a regulator for the securities markets.
  - ESCA issued a new Code of Corporate Governance in May 2007.
  - Responsibility for oversight of IPOs transferred from the Ministry of Economy to ESCA in January 2007; pricing of IPOs now left to the private sector.
  - CBU introduced a comprehensive risk assessment approach and has been preparing since late 2004 for implementation of Basel II; banks expected to implement the standardized approach under Basel II by December 31, 2007.
  - Several key laws approved in AML/CFT.
- Remaining weaknesses and recommendations:
  - Expand enforcement powers of the CBU and introduce explicit legal protection of supervisors exercising duties in good faith.
  - CBU to implement MOUs with ESCA, DFSA, and the Insurance Commission for formal cooperation and exchange of supervisory information and oversight of financial institutions.
  - CBU to build supervisory capacity for Basel II and for Islamic banking (develop necessary skills and a core set of specialized staff within banking supervision).
  - Consult more regularly with banking profession ahead of regulatory changes and publish draft regulations for public comment.
  - Introduce and enforce an aggregate limit for commercial bank lending intended for an IPO subscription.
  - Introduce more transparent procedures for provision of emergency financial support to banks and consider introducing limited deposit insurance.

### Islamic Banking
- Increasing importance:
  - Islamic banks have become an increasingly important part of the UAE system.
- Liquidity and supervision gaps:
  - CBU lacks an instrument for providing short-term liquidity to Islamic banks, and its supervisory capacity in this area has lagged.
- Recommendation:
  - Develop a market for government, or CBU-backed, shariah-compliant instruments to provide Islamic banks with instruments for liquidity management.
  - Enhance CBU supervisory capacities in Islamic banking.

### Capital Markets and Insurance
- Capital markets:
  - U.A.E. capital markets are underdeveloped relative to the banking sector but gaining in depth and sophistication.
  - Staff recommendations:
    - Open capital markets more fully to foreign investors by removing restrictions on stock ownership and board membership.
    - Encourage public listing of large, quasi-public companies on the stock exchanges to help widen the market; companies would need to improve corporate governance and reporting prior to listing.
    - CBU and ESCA to initiate a working group with other relevant public parties to encourage public listings of large, quasi-public companies.
    - Ministry of Economy to open capital markets to foreign investors by removing restrictions on stock ownership.
- Insurance sector:
  - Growing rapidly but not yet systemically important.
  - To meet foreign competition, domestic insurers need to enhance asset management capabilities and supervision must keep up with oversight of risk management.
  - Recommendation:
    - Establish a more independent insurance supervisory agency, possibly within the Central Bank.

### Payments, Liquidity Management, and Financial Safety Nets
- Payment systems:
  - Payment system fully automated and computerized; an RTGS system for large value payments has functioned smoothly since 2002.
- Sovereign debt and market development:
  - Recommendation: CBU to initiate a working group with relevant parties (Federal Government, Emirates, large state-owned enterprises) on issuance of sovereign debt instruments (despite the fiscal surplus) to foster development of the market for corporate bonds and short-term debt and form the basis for a yield curve.
- Liquidity instruments for Islamic institutions:
  - Recommendation repeated: CBU to develop a market for government—or CBU—backed, shari’a-compliant instruments for deposit-taking Islamic institutions.

### Dubai International Financial Centre (DIFC)
- Purpose and status:
  - DIFC established in 2004 as the first “Financial Free Zone” in the U.A.E., best characterized as a future regional financial center rather than an offshore center.
  - Part of Dubai Emirate’s drive to diversify its economy by attracting international business and developing a wholesale banking center and institutional investor base.
- Activity and infrastructure:
  - Actual banking activity in the center has been small.
  - DIFX has begun to compete successfully with other UAE and GCC stock markets.
  - Physical and legal infrastructure of the DIFC is impressive.
  - Dubai Financial Services Authority (DFSA) is well staffed with experienced banking, insurance, and securities market supervisors.
- Recommendation:
  - DFSA and other authorities to coordinate supervisory arrangements; transfer of securities oversight outside the DIFC to ESCA recommended (see below).

### Institutional Responsibilities and Legislative Reform
- Current fragmentation:
  - Federal-level responsibility for securities market supervision spread between CBU, MOE, and ESCA, creating inefficiencies and overlap (DFSA regulates securities within the DIFC).
- Recommended consolidation:
  - Transfer all responsibility for oversight of securities markets (other than in the DIFC) to ESCA in line with draft ESCA legislation.
- Urgency for legal reform:
  - Need for public and industry support and implementation of major updates to key financial sector legislation:
    - The Banking Law
    - The Companies Law
    - The Insurance Law (note: following the mission, a new law on insurance was promulgated on February 28, 2007, which will come into force six months after its promulgation)
    - The ESCA Law
  - Enact an accounting law to adopt IFRS for public companies and create a national accounting standard for other companies.
  - Ministry of Justice to establish and fund an education program on financial issues for training the judiciary.

### Main Recommendations (selected from Box 1) with Time Frame
- Financial Sector Legislation:
  - Amend the ESCA legislation to strengthen supervision and transfer responsibilities of CBU and MOE for securities markets oversight to ESCA. (Such legislation was in draft form as of May 2007.)
    - Time Frame: Short Term
  - Issue supporting regulations and implement the new Insurance Law, promulgated on February 28, 2007.
    - Time Frame: Short Term
  - Update and implement major revisions to the Banking Law (1980) and the Companies Law (1984).
    - Time Frame: Medium Term
  - Enact an accounting law that would adopt IFRS for public companies and create a national accounting standard for other companies.
    - Time Frame: Medium Term
- Banking Sector (CBU actions):
  - Issue prudential measures to banks and finance companies to reduce risks in real estate lending.
    - Time Frame: Short Term
  - Continue preparing for banks’ implementation of Basel II, including issuing guidelines and building supervisory capacity.
    - Time Frame: Short Term
  - Seek expanded enforcement powers for prompt corrective action.
    - Time Frame: Short Term
  - Introduce explicit legal protection of bank supervisors exercising official duties in good faith.
    - Time Frame: Short Term
  - Enter into MOUs with ESCA, DFSA, and the Insurance Commission for cooperation on oversight.
    - Time Frame: Short Term
  - Consult more regularly with the banking profession ahead of regulatory changes and publish draft regulations for public comment.
    - Time Frame: Short Term
  - Introduce and enforce an aggregate limit for commercial bank lending intended for an IPO subscription.
    - Time Frame: Short Term
  - Introduce more transparent procedures for emergency financial support to banks and consider limited deposit insurance.
    - Time Frame: Short Term/Continuous
- Liquidity Management and Capital Markets:
  - CBU to initiate a working group on sovereign debt issuance to foster corporate bond and short-term debt markets and form a yield curve.
    - Time Frame: Short Term, within 12 months.
  - CBU to develop a market for government—or CBU—backed, shari’a-compliant instruments for Islamic financial institutions.
    - Time Frame: Short Term
  - CBU and ESCA to initiate a working group to encourage public listings of large, quasi-public companies.
    - Time Frame: Short Term
  - Ministry of Justice to establish and fund judiciary financial education.
    - Time Frame: Short Term
  - Ministry of Economy to open capital markets to foreign investors by removing restrictions on stock ownership.
    - Time Frame: Medium Term

*Source: IMF 2007 FSAP Update for the United Arab Emirates — Executive Summary—Main Findings.*

### 3.      An outward-oriented development strategy and prudent financial policies have

### 3.      An outward-oriented development strategy and prudent financial policies have

### Macroeconomic performance and external assets
- Oil export revenues pushed the current account surplus to about US$36 billion in 2006, equivalent to 22 percent of GDP.
- Fiscal surplus reached almost 29 percent of GDP in 2006.
- Gross official reserves reached US$28 billion in 2006.
- The dirham was officially pegged to the SDR from November 1980 to February 2002; since then it has been pegged to the U.S. dollar.
- Real GDP growth:
  - 2004: 9.7 8? (table shows "9.7" in row header formatting); 2005: 8.2 percent; 2006: 9.4 percent (highest rate among GCC countries).
- Inflation accelerated to 9.3 percent in 2006 (officially reported inflation, which is likely to be underestimated).
- Table 1 selected figures (2003–2006):
  - Total exports of oil and gas (in billions of U.S. dollars): 29.6, 38.0, 55.0, 70.2 (2003–2006).
  - Average crude oil export price (U.S. dollar per barrel): 28.1, 36.3, 53.6, 63.5.
  - Crude oil production (millions of barrels per day): 2.26, 2.33, 2.38, 2.57.
  - Nominal GDP (in billions of AED): 325.3, 381.1, 488.4, 599.7.
  - Nominal GDP (in billions of U.S. dollars): 88.6, 103.8, 133.0, 163.3.
  - Real GDP (at factor cost, annual percent change): 11.9, 9.7, 8.2, 9.4.
  - Real oil and gas GDP (annual percent change): 13.6, 2.9, 1.6, 6.5.
  - Real nonoil GDP (annual percent change): 11.2, 12.6, 10.8, 10.4.
  - Domestic demand (annual percent change): 12.1, 16.8, 17.7, 18.9.
  - CPI inflation (average): 3.2, 5.0, 6.2, 9.3.
  - Gross domestic investment (percent of GDP): 23.4, 22.5, 20.4, 21.3.
  - Gross national saving (percent of GDP): 31.9, 32.5, 38.7, 43.3.
  - Public saving (percent of GDP): 7.9, 14.0, 24.5, 33.4.
  - Private saving (percent of GDP): 24.1, 18.4, 14.2, 9.9.
  - Revenue (percent of GDP): 30.7, 35.4, 41.7, 50.5.
    - Oil revenue (percent of GDP): 23.2, 26.1, 31.3, 38.4.
    - Nonoil revenue (percent of GDP): 7.5, 9.3, 10.4, 12.1.
  - Expenditure and net lending (percent of GDP): 28.2, 24.9, 21.4, 21.7.
    - Current (percent of GDP): 22.8, 21.4, 17.2, 17.1.
    - Capital (percent of GDP): 4.9, 3.3, 3.9, 4.5.
  - Budget balance (percent of GDP): 2.6, 10.5, 20.3, 28.8.
  - Non-hydrocarbon balance (percent of non-hydrocarbon GDP) 1/: -29.3, -22.6, -17.1, -15.3.
  - Non-hydrocarbon balance (excluding investment income) 1/: -32.4, -27.9, -25.0, -24.3.
  - Net foreign assets (annual percent change): 2.5, 10.2, 14.8, -6.7.
  - Net domestic assets (annual percent change): 59.4, 49.8, 62.2, 54.9.
  - Credit to private sector (annual percent change): 13.5, 24.7, 44.5, 36.9.
  - Broad money (annual percent change): 16.1, 23.2, 33.8, 23.2.
  - Exports of goods and services (in billions of U.S. dollars): 67.2, 90.2, 117.2, 142.6.
  - Nonoil exports of goods (in billions of U.S. dollars): 14.1, 18.3, 22.4, 26.4.
  - Imports of goods (in billions of U.S. dollars): -45.8, -63.4, -74.5, -86.1.
  - Current account balance (in billions of U.S. dollars): 7.6, 10.3, 24.3, 35.9.
  - Current account balance (in percent of GDP): 8.6, 10.0, 18.3, 22.0.
  - Gross official reserves (in billions of U.S. dollars): 15.1, 18.7, 21.3, 27.9.
  - Reserves in months of next year imports of goods and services: 2.3, 2.4, 2.3, 2.8.
  - Real effective exchange rate (1990=100): 122.4, 118.1, 121.4, 127.7.
  - Average exchange rate (AED per U.S. dollar): 3.67253.67, 3.67253.67, 3.6725 (table formatting preserves "3.67253.67253.6725 3.6725" as in source).

- Memorandum items:
  - Quota: SDR 611.7 million.
  - Population-2006: 4.23 million.
  - Per capita GDP-2006: $38,600.

### Monetary and financial sector developments
- Credit and money growth (annual percent change):
  - Growth of claims on the private sector: 2005: 44.5 percent; 2006: 37 percent (year as a whole).
  - Broad money growth: 2005: 33.8 percent; 2006: 23.2 percent.
- Given the pegged exchange rate, domestic interest rates closely tracked U.S. dollar rates, but real interest rates were negative due to inflation acceleration.
- Stock markets: sharp correction starting in late 2005 across U.A.E. and GCC; price gains prior to correction were driven by optimistic earnings expectations and easy credit; volatility exacerbated by investors liquidating positions to fund IPO subscriptions.
- Cross-border flows and funding:
  - U.A.E. banks increased borrowing from abroad over the past three years.
  - Banks issued Euro Medium-Term Notes (EMTNs) typically with five-year tenor and interest spreads in the range of 30 to 50 basis points over LIBOR.

### Banking system structure and market composition
- Banking sector size and concentration:
  - Sector assets equivalent to 130 percent of GDP in 2005 (second largest among GCC countries after Saudi Arabia).
  - Five largest banks account for about 44 percent of system assets.
- Number and type of banks (2002–2006):
  - Total banks: 47, 46, 46, 46, 46 (2002–2006).
  - Private banks: 32, 31, 31, 31, 31.
    - Local private banks: 6, 6, 6, 6, 6.
    - Foreign private banks: 26, 25, 25, 25, 25.
  - State-owned banks: 15, 15, 15, 15, 15.
  - Islamic banks: 2, 2, 4, 4, 4.
  - Non-Islamic banks: 45, 44, 42, 42, 42.
  - Branches of foreign banks: 11, 11, 11, 11, 11.
- Asset and deposit shares (percent):
  - Private commercial banks asset share: 35.2, 35.9, 36.1, 35.8, 36.4 (2002–2006).
    - Local private asset share: 11.4, 11.8, 12.6, 14.1, 14.5.
    - Foreign private asset share: 23.8, 24.1, 23.5, 21.8, 21.9.
  - State-owned banks asset share: 64.8, 64.1, 63.9, 64.2, 63.6.
  - Deposits share private commercial: 39.3, 39.7, 38.8, 38.5, 40.1.
    - Local private deposits: 13.0, 13.6, 13.8, 14.9, 15.6.
    - Foreign private deposits: 26.3, 26.1, 25.0, 23.7, 24.5.
  - State-owned deposits share: 60.7, 60.3, 61.2, 61.5, 59.9.
  - Islamic banks asset share rose from 8.8 percent at end-2002 to 12.6 percent at end-2006 (14.2 percent of deposits).

- Ownership and market entry:
  - State-related institutions account for 63 percent of total bank assets.
  - Foreign banks' share in total banking assets declined from 25 percent in 2001 to 22 percent in 2006.
  - Moratorium on licensing new foreign banks exists since 1981; CBU authorized three new GCC banks in 2006 (Qatar, Kuwait, Saudi Arabia) with reciprocal treatment understanding.
  - Foreign banks face a 20 percent tax on profits (not applied to domestic banks).
  - Recommendation: further relax constraints and open up banking sector to non-GCC banks.

### Real estate, mortgage market, and vulnerabilities
- Real estate and construction exposure:
  - Construction (excluding mortgages) share of loans: 16.3, 8.3, 8.5, 6.9, 4.8 (2002–2006).
  - Real estate mortgage loans share of total loans: 7.2, 5.3, 4.4, 5.0, 6.6 (2002–2006).
  - Mortgage loans are 6.6 percent of bank loans (Table 3).
  - Bank mortgages represent about a fifth of household debt in the U.A.E.; household debt to GDP: 6.6, 6.1, 6.9, 5.2 (2003–2006).
  - Anecdotal evidence: Dubai property prices increased by about 200 percent in the period 2002–06.
  - Many large real estate projects are undertaken by state- or ruling family–owned developers.
  - Several large property developers own or are closely related to the biggest nonbank financial institutions active in mortgages; two largest such institutions had total assets of AED 6.6 billion at end-2006.

- Mortgage market practices and risks:
  - Mortgages initially developed by Islamic finance companies; provided at floating rates.
  - Typical loan-to-value ratios (LTVs): 70 to 80 percent; observed relaxation to 90 or 100 percent in some segments.
  - Demand for credit fueled by high population growth and low interest rates (in real terms and relative to rental yields), contributing to speculative behavior and rising asset prices.
  - Final use of personal loans for business purposes is not well captured in data, implying household real estate exposure may be higher than mortgage stock suggests.

- Policy recommendations on real estate exposure:
  - Enhance prudential regulation and monitoring of banks’ exposure to the real estate sector.
  - Continue improvements in sectoral classification of loans.
  - Enhance oversight of nonbank financial institutions involved in real estate financing.
  - Introduce more adequate prudential regulations, such as maximum LTV and debt-to-income ratios.
  - The current CBU regulation limits a bank’s real estate exposure to 20 percent of its customer deposits; staff notes this is not adequately linked to market expansion and evolving funding structures.
  - CBU aims to create a federal credit bureau to enhance credit information infrastructure.
  - CBU proposed framework for creation of real estate finance subsidiaries by banks.

### Financial soundness indicators and stress tests
- Capital and asset quality (2003–2006, in percent unless otherwise indicated):
  - Total regulatory capital to risk-weighted assets: 18.6, 16.9, 17.4, 16.6.
  - Regulatory Tier I capital to risk-weighted assets: 18.2, 16.3, 16.9, 15.0.
  - Nonperforming loans net of provisions to capital: 7.7, 3.5, 1.8, 0.6.
  - Nonperforming loans to total gross loans: 14.3, 12.5, 8.3, 6.3.
  - Return on assets: 2.3, 2.1, 2.7, 2.3.
  - Return on equity: 16.4, 18.6, 22.5, 18.0.
  - Interest margin to gross income: 59.5, 64.6, 49.3, 29.3.
  - Noninterest expenses to gross income: 43.6, 40.3, 26.9, 20.9.
  - Liquid assets to total assets: 22.7, 23.2, 26.9, 16.4.
- Encouraged indicators:
  - Capital to assets: 11.4, 11.1, 11.9, 12.6.
  - Personnel expenses to noninterest expenses: 29.5, 38.6, 41.8, 54.6.
  - Customer deposits to total (non-interbank) loans: 125.0, 113.6, 112.4, 96.5.
- Other indicators:
  - Loan loss reserves/non-performing loans: 88.5, 94.6, 95.7, 98.2.
  - Deposits as percent of M2: 92.7, 93.2, 94.1, 94.1.
  - Commercial banks loans to private sector as percent of total deposits: 69.9, 69.5, 69.1, 66.6.
  - Number of commercial banks (end-of-period): 46, 46, 46, 46.
  - Number of banks with C.A.R. above 10 percent: 46, 46, 46, 46.
  - Spread between 3-month interest rate on local currency deposits and loans (percentage points): 5.1, 6.2, 6.2, 5.1.
  - Foreign currency deposits as percent of M2: 24.4, 25.8, 22.8, 24.1.
  - Foreign currency denominated lending/total lending: 23.9, 20.7, 19.7, 22.8.
  - Earnings per employee (in millions of AED): 0.40, 0.50, 0.70, 0.71.

- Sector performance and profitability:
  - CAR rose to 17.4 percent at end-2005 but declined to 16.6 percent at end-2006 due to growth of risk-weighted assets.
  - Ratio of NPLs to total loans fell from 12.5 percent at end-2004 to 6.3 percent at end-2006; gross NPLs stock grew modestly.
  - Banking sector remained profitable despite slowdown in noninterest income after 2005; returns on assets and equity declined somewhat in 2006 but remained at comfortable levels.
  - Personnel expenses increased due to higher cost of living and competition for qualified professionals.

- Stress tests:
  - Stress tests conducted for all 46 U.A.E. commercial banks based on end-September 2006 data.
  - Analysis focused on credit risk with particular attention to real estate market developments; liquidity, exchange, and interest rate risks were also assessed.
  - Oil price shocks were tested indirectly via effects on government deposits (direct asset-quality effects limited because banks have little direct credit exposure to oil and gas sector).
  - Appendix I contains a more complete description of stress test methodology and subgroup results (large, foreign, domestic, Islamic banks).

*Source: IMF staff report (United Arab Emirates), selected excerpts from chapter "An outward-oriented development strategy and prudent financial policies have", including Table 1, Table 2, Table 3, Figure 1, and Table 4.*

### 21.      Stress tests suggest that the banking system as a whole would be generally

### Stress tests suggest that the banking system as a whole would be generally resilient to an across the board and significant deterioration of asset quality.

### Banking system resilience and stress-test results
- Doubling of the level of substandard, doubtful, and loss loans would reduce the overall capital adequacy ratio from 16.3 percent to 11.5 percent (Appendix III, Table 7).
- A strong shock affecting corporate borrowers, contractors, and mortgage loans would leave the capital adequacy ratio of the banking system at 14.6 percent.
- The same real estate shock plus a deterioration of personal loans quality would drive the capital adequacy ratio down to 11.6 percent.
- In the latter scenario, five locally incorporated banks, accounting for one-quarter of bank assets, would see their capital adequacy ratios reduced to less than the regulatory minimum 10 percent, with two of them becoming insolvent.
- Exposures to interest rate and foreign exchange risks appear modest, though significant assets held abroad and large net foreign exchange positions in U.S. dollars expose banks to the effects of an appreciation of the domestic currency (Appendix III).

### Liquidity resilience and simulated liquidity shocks
- Pre-shock liquidity ratio: 50 percent.
- A 16 percent withdrawal of customer deposits (the decline experienced in the U.A.E. during the 1990 Gulf War) would lower the liquidity ratio to just over 30 percent, with a disproportionate effect on medium-size and Islamic banks.
- A 35 percent decline in government deposits (as occurred when oil prices fell during 1995–96) would have the greatest effect on publicly owned banks without threatening the liquidity position of the system.
- A 30-percent decline in foreign interbank funding was simulated; results confirmed a less favorable liquidity buffer for small and medium-sized banks and Islamic banks.
- Definition note: The liquidity ratio referenced is the ratio of liquid assets to liquid liabilities, both with maturities of less than 3 months.

### Capital markets: market structure and depth
- Exchanges: Abu Dhabi Securities Market (ADSM), Dubai Financial Market (DFM), Dubai International Financial Exchange (DIFX).
- Financial derivatives traded on the Dubai Gold and Commodities Exchange (DCGX) established in November 2005.
- Dubai Mercantile Exchange (DME) planned to be launched following a joint venture with the New York Mercantile Exchange (NYMEX).
- Number of exchange-listed companies: 110.
- Overall market capitalization: about US$170 billion.
- Fixed-income securities traded on ADSM and DFM: less than 2 percent of the exchanges’ overall market capitalization.
- Sukuk listings on DIFX exceeding US$7 billion in market value.
- Recommendation: Issuing government securities would catalyze development of money and interbank markets and encourage formation of a yield curve for fixed income products; revisions to the Companies Law are needed to enable development of corporate debt instruments.

### Equity market performance and governance
- As of December 2006, ADSM and DFM market indices had dropped by 52 percent and 68 percent, respectively, from their peaks in 2005.
- Contributing factors to the 2003–05 rally and subsequent correction: speculative demand, abundant regional liquidity, narrow market leadership, concentration of trading in a few stocks, weak participation by non-GCC investors, absence of international institutional investors, and speculative retail trading that pushed prices faster than earnings.
- Policy recommendations:
  - More stringent disclosure requirements and corporate governance laws to foster international confidence and attract large institutional investors.
  - Encourage listings of large, quasi-public enterprises to increase market depth and stimulate mutual fund development.
  - ESCA’s issuance (May 2, 2007) of a code of corporate governance for listed companies noted as a welcome development.
- IPO mispricing issues:
  - IPOs priced through a process validated by the Ministry of Economy (MOE), which sets a nominal value based on assessment of acceptable market value.
  - During the boom, some IPOs were undervalued and heavy subscription often encouraged investors to unwind positions in established companies, increasing volatility.
  - By cabinet decree, oversight responsibility for IPOs was transferred from the MOE to ESCA as of January 7, 2007; Companies Law revision will be needed to validate the transfer.

### Market access, shareholder protection, and regulatory gaps
- Foreign ownership limits: foreigners may not own more than 49 percent of the voting shares of a company; the Chairman of the Board and the majority of the Board of Directors must be U.A.E. nationals.
- If a shareholder wishes to increase holdings to as much as twenty percent of a company’s shares, it must notify the exchange; the exchange can prevent acquisition on grounds of prejudice to the national economy.
- Many companies restrict ownership to U.A.E. nationals; recommendation: relaxation and eventual removal of these restrictions.
- Accounting and shareholder protection gaps:
  - No accounting law mandating accounting standards for public companies (ADSM requires IFRS for its listings).
  - Companies Law provides basic shareholder protection but lacks some provisions, e.g., a prohibition against related-party transactions except under full disclosure and approval by shareholders.

### Insurance industry: size, potential, and supervision
- Total premium revenue for insurance: about US$2.2 billion in 2005 (about 1.7 percent of GDP).
- Comparative benchmarks: emerging market economies average 3.5 percent of GDP; OECD countries 9 percent of GDP.
- Growth drivers: mandated health coverage for expatriate workers, growing private sector, opening real estate markets, rising income levels, growing expatriate population.
- Industry needs: enhanced asset management and risk underwriting capacities, higher levels of risk retention.
- Supervision capacity: insurance supervision carried out by a small section in the Ministry of Economy with about fifteen professional staff; supervision has focused on regulation and compliance rather than on risk.
- New insurance law promulgated on February 28, 2007, scheduled to take effect August 31, 2007:
  - Establishes a more independent Insurance Commission, remaining under the Minister of Economy as Chairman of the Board of Directors.
  - Staff recommendations: prompt development and issuance of implementing regulations, recruitment of additional specialized supervisory personnel, consider placing insurance supervision under the central bank, and over time grant greater autonomy to the Insurance Commission and its Director.

### Coordination and collaboration of financial sector supervisors
- International cooperation: CBU and ESCA have MOUs with home country supervisors; ESCA is an original signator of a regional organization of securities market regulators; DFSA has MOUs with key home country regulatory authorities.
- Domestic coordination gaps:
  - ESCA and the DFSA have a formal MOU and have exchanged enforcement information.
  - No formal MOUs between CBU and ESCA, the Insurance Commission, or the DFSA.
  - Recommendation: put in place formal arrangements such as MOUs to ensure systematic coordination, information sharing, and consolidated supervision of financial conglomerates.

### Liquidity management, financial safety nets, and payment systems
- Reserve requirements: banks required to maintain reserves (in dirham) equivalent to 14 percent of demand deposits and 1 percent of time deposits, regardless of currency of denomination.
  - Note: Deposits with maturity of more than one week are considered time deposits.
  - There has been no change in reserve requirements since 2001.
- Average reserve requirement at end-December 2006: about 7.2 percent.
- Aggregate commercial bank reserves equivalent to 8.1 percent of M2 and 4 percent of total bank assets.
- Certificates of Deposit (CDs) issued by CBU:
  - Maturities: one week to 18 months.
  - Aggregate value of outstanding CDs as of December 2006: about US$8.8 billion, or about 4 percent of total bank assets.
  - CDs rate of return closely tracks LIBOR; issued on demand by CBU, rates set based on prevailing market conditions.
  - Absence of sovereign debt securities means CDs are the only available government-backed financial instruments; secondary market in CDs has not materialized.
  - Recommendation: CBU should develop a market for government or CBU backed shariah compliant instruments (since CDs are not available for Islamic banks).
- Overdraft facility and lender-of-last-resort (LOLR) operations:
  - Fee determination: overdraft first deducted from institution’s reserves at CBU; interest fee equivalent to the three-month inter-bank rate plus 5 percentage points levied on any shortage in minimum reserve requirements over a six-day moving average.
  - Special LOLR overdrafts: maturity of one week to six months; terms (maturity, interest rate, collateralization) decided case-by-case by the CBU Board; interest rate usually set around market rates; collateral criteria fixed by CBU Board.
  - Use of overdraft facilities has been infrequent; no special LOLR overdrafts outstanding in January 2007.
- Historical government interventions: forced consolidations, direct cash injections, and extension of overdraft facilities have been used over the past 25 years to limit systemic fallout from bank failures.
- Deposit insurance:
  - U.A.E. does not have an explicit deposit insurance system.
  - Authorities have been reluctant to impose such a system on moral hazard grounds.
  - Staff recommendation: CBU should make its bank intervention strategy and emergency financial support more transparent; within this strategy, consider a limited deposit insurance arrangement funded by premia from banks.

### Payment systems and infrastructure
- Legal basis: Under the Banking Law, the CBU operates and oversees the payment system (Chapter Two, Article (5), paragraph (4) and Article (18), paragraph (9)).
- Account structure: Licensed commercial banks required to maintain three separate accounts with the CBU: a dirham current account for settling financial transactions, and two reserve accounts (one in dirham and one in U.S. dollars). Banks and moneychangers recently allowed euro and U.S. dollar current accounts.
- Fund Transfer System (FTS):
  - Replaced Testkey Telex Transfer System (TTTS) in 2001.
  - FTS is a Real-Time Gross Settlement (RTGS) system based on a secure intranet network; all U.A.E. banks have used it since 2002.
- Check Clearing System (CCS): labor intensive CCS scheduled for comprehensive upgrade during 2007; authorities aiming to introduce an Image CCS to allow settlement of checking transactions within 2 to 4 hours (improving on current paper-based system that clears in T+1).
- SWITCH system used to settle ATM transactions; project underway to create a GCC-wide SWITCH network.

### AML/CFT assessment and preliminary findings
- An AML/CFT assessment was initiated by the Fund’s Legal Department during a mission to the U.A.E. in March 2007.
- A draft mutual evaluation report expected to be considered for adoption by MENAFATF and FATF Plenaries in November 2007 and February 2008, respectively; once adopted, a ROSC will be circulated to the Board for information.
- Preliminary findings:
  - Basic framework is in place but legal framework needs strengthening in some areas.
  - AML law needs amendment to bring it more closely in line with the 2003 FATF Recommendations by providing more powers for the Financial Intelligence Unit (FIU) and expanding the number of predicate offences for money laundering.
  - FIU should increase staff to conduct analysis of suspicious transaction reports within the FIU rather than relying on CBU Supervision Department resources.
  - Regulatory structure for AML/CFT compliance is varied; CBU and DFSA have significantly more developed procedures and resources than other regulatory agencies.
  - Coordination at the national level could be improved, particularly as the AML/CFT system expands to other parts of the financial and nonfinancial sectors.

*Source: IMF staff.*

### 49.      The level of banking activity in the DIFC is small compared with the domestic

### _cr07357 - 49.      The level of banking activity in the DIFC is small compared with the domestic

### Banking activity in the DIFC
- As of January 2007, seven banks were authorized to accept deposits or provide credit in the DIFC, and three of them were operational.
- In addition, 20 firms regulated as banks in other jurisdictions are authorized to provide investment banking services.
- As of December 2006, DIFC banks held total assets of around $518 million, a tiny fraction of the US$200 billion in total U.A.E. banking assets.
- U.A.E. banks establishing a presence in the DIFC are required to obtain approval from the Central Bank.

### DIFX performance and market structure
- As of January 2007, the total market capitalization of DIFX was about US$21 billion.
- 45 percent of DIFX market capitalization originated from bond instruments (including sukuk).
- Seven equity securities are listed on the exchange (3 of which are ordinary shares) with a market capitalization of about US$6.7 billion.
- Twenty-three securities have been listed on DIFX (Box 2 notes DIFX’s specialization in Islamic finance).

### The Dubai International Financial Centre (Box 2): structure and features
- Established in 2004 as the first Federal Financial Free Zone in the U.A.E.
- Permitted activities include banking services, capital markets, asset management, reinsurance, Islamic finance, ancillary services, and business processing operations.
- Under Free Zone legislation, financial institutions licensed in the free zone:
  - May conduct business with residents and nonresidents.
  - When conducting “financial banking activities,” are prohibited from transacting in the U.A.E. Dirham and from taking deposits (regardless of currency).
- DIFC comprises three independent authorities under the Office of the President of the DIFC:
  - Dubai International Financial Centre Authority (DIFCA): sets development strategy, acts as registrar of securities and companies; its subsidiary DIFC Investments houses DIFX and Hawkamah.
  - Dubai Financial Services Authority (DFSA): independent financial services regulator; activities include rule-making and policy development, licensing and registration, supervision of DIFC participants, and enforcement.
  - Dubai Judicial Authority (DJA): independent judicial system for civil and commercial matters within the DIFC; legal system based on common law.
- As of end-January 2007:
  - DIFC had attracted more than 330 companies benefiting from 0 percent taxation and no restrictions on the level of foreign ownership.
  - Close to half of the institutions registered by DIFC are financial and ancillary service companies.
- DIFC mission: to be “a catalyst for regional economic growth, development and diversification.”
- Facilities and governance emphasize industry best-practices, world-class infrastructure, and state-of-the-art technology.

### Offshore financial center (OFC) characterization
- Benchmarks for OFC attributes include:
  - Offshore activities constitute the bulk of financial services offered.
  - Aggregate external assets and liabilities at the center are out of proportion to intermediation for the domestic economy.
  - Firms in the center benefit from: (i) lower taxation; (ii) moderate or light financial regulation; and (iii) banking secrecy and anonymity.
- Based on these benchmarks, the DIFC would not be characterized as an offshore center because:
  - Companies established within the DIFC are legally able to lend to the domestic market in foreign currency.
  - Residents accounted for 44 percent of the small amount of bank assets at the DIFC at end-2006 and the bulk of individual loans.
  - The DIFC does not offer benefits of less demanding supervisory oversight or bank secrecy laws; the legal framework is well developed with highly-skilled supervisors and a strong monitoring system.
- Exception: foreign banks operating in the DIFC do receive a tax advantage because they are not subject to the 20 percent profits tax applied to foreign banks operating elsewhere in the U.A.E.

### Regulatory and legal issues and recommendations
- Federal Law No. 8 provides that “Competent authorities in the Federal Government may conduct inspections of a Financial Free Zone to ascertain its compliance with the provisions of this Law...” (for example the restriction on conducting banking business in dirham), but the Law is silent on identifying or defining who are the “Competent Authorities.”
- Staff recommendation: clarify who are the “Competent Authorities” and the nature of their remit to help avoid regulatory overlap or gaps.
- DIFC is described as a future regional financial center with regulatory and supervisory systems on par with other regional centers (such as Singapore and Hong Kong) and is likely to generate positive spill-over effects on the rest of the U.A.E. financial sector (e.g., impetus for a new U.A.E. securities law, greater transparency, and better corporate governance).
- Hawkamah Corporate Governance Institute (within DIFC) is promoting better corporate governance standards and practices across the region.

### IOSCO/FSAP observations and summary assessments (U.A.E. and DIFC distinctions)
- The regulatory and supervisory regime for the DIFC is entirely separate and independent from that for the U.A.E.; separate assessments were carried out for regulation of securities market activity in the U.A.E. and for the DIFC.
- FSAP update assessment conducted in January 2007 used IOSCO Methodology for Assessment of the IOSCO Principles (2003).
- Key market and regulatory facts:
  - U.A.E. securities markets include Dubai Financial Market (DFM), Abu Dhabi Securities Market (ADSM), and Dubai Gold & Commodities Exchange (DGCX), all regulated by ESCA.
  - DFM: 43 listed companies (largely property holdings), five listings of bonds or sukkuk; only about one-third trade frequently; DFM declared status as an “Islamic financial market” and went partially public by floating twenty per cent of its shares.
  - ADSM: 61 companies listed with a low level of trading.
  - DGCX: only one active derivatives contract being traded—gold futures.
  - Investment advisers, independent brokers and banks participate; asset management products such as mutual funds are growing.
- Institutional/regulatory observations and recommendations:
  - ESCA is the regulator of the securities markets but is not fully independent from the executive branch; operational independence could be improved by ensuring the chairman is not a minister, senior executive or employee of the government and by specifying that the majority of the board be private citizens with financial sector expertise.
  - Regulation is somewhat fragmented (ESCA regulates IPOs and secondary issues; CBU regulates investment funds and investment advisers). Recommendation to consolidate securities market supervision in one agency, such as ESCA, as proposed in draft legislation.
  - Exchanges act as de facto SROs; relationships between ESCA and exchanges should be clarified in a new securities law, establishing ESCA as overall regulator and exchanges as formally designated SROs operating under delegated authority.
  - ESCA has extensive enforcement powers and uses them regularly; recommendation that the new securities law provide statutory authority for regulation of investment funds and advisors and give ESCA statutory authority to issue warnings and fines.
  - In the medium term, a new separate Collective Investment Law should be considered to provide a more robust framework for collective investments, asset management, and custodial activity in securities markets.
  - ESCA can communicate with foreign regulators and has entered into MOUs; more explicit authority and procedures are needed for cooperative enforcement, including collecting, safeguarding and distributing information.
  - Disclosure regime weaknesses: required disclosure for IPOs is limited and should be replaced with a comprehensive prospectus; absence of a legally mandated accounting standard regime weakens disclosure—IFRS is used by default in practice, but only ADSM requires IFRS for listed companies.
  - General preconditions: U.A.E. generally has preconditions for effective regulation, but needs improvement in accounting law (no accounting law or legally mandated accounting standards) and in the judiciary’s experience adjudicating financial disputes.

*Italic: IMF staff report content (excerpts) from the provided PDF content unit.*

### 71.      The capital markets laws do not contain any provisions related to collective

### _cr07357 - 71.      The capital markets laws do not contain any provisions related to collective

### Collective investment schemes
- Finding: "The capital markets laws do not contain any provisions related to collective investment schemes."
- Interim measure: "A resolution of the Central Bank has attempted to fill in the regulatory gap, but does not contain the depth and specificity that is normally associated with the regulation of mutual funds."
- Recommendation: "Specific provisions in law applying to collective investment schemes need to be adopted to support growth of the industry."
- DIFC specific: "The framework for collective investment schemes has recently been put in place. Fund operators must be licensed by the DFSA and are subject to a comprehensive framework including disclosure obligations, valuation standards, and internal control and risk management requirements."
- DIFC distribution restriction: "Funds, which can only be distributed to investors with liquid capital of at least US$1 million, must be in the form of an investment company, limited partnership or trust."
- DIFC private funds: "Operators of private funds, which have a limited distribution, are subject to fewer requirements but are still licensed and supervised."
- DFSA powers over funds: "DFSA has powers to issue a stop order and wind up a fund."

### Market intermediaries (Principles 21–24)
- Finding: "The ESCA Law and regulations provide for extensive regulation of brokers."
- Exchange oversight: "the exchanges also approve brokers for membership on the exchange and closely monitor their activity."
- Limitation identified: "The permitted activity of brokers is limited to taking and transmitting orders and should be expanded so that they can participate more fully in market activity and development, such as investment banking, underwriting and providing investment advice."
- DFSA in DIFC: "The DFSA has full power to license and supervise market intermediaries. Intermediaries are subject to capital requirements related to the risks in their particular business and activities. DFSA rules contain a full set of internal control, risk management and business conduct standards."

### Secondary market (Principles 25–30)
- Finding for UAE exchanges: "The three exchanges in UAE are well organized and managed. ESCA, as their supervisor, has a good working relationship with them. They have good infrastructure and technology systems to carry out their activity which are constantly being reevaluated and upgraded."
- Surveillance: "Up-to-date surveillance programs in use by the exchanges and ESCA provide for good market surveillance practices."
- ESCA authority gap: "P26 ESCA under the existing law does not have the authority to require amendments to the rules of the exchange or impose a range of conditions on the operator of the exchange. The new securities law should address the relationship between ESCA as the regulator and the exchanges as SROs to clarify their relationship. The law should give ESCA the complete authority to regulate the securities markets and should delegate that power as needed to the exchanges."
- DIFX specifics: 
  - "The DIFX began operating as an exchange in September 2005; it has 9 equity listings all dual listed on another exchange. There are also 4 listings of sukuk (Shari’a compliant) bonds."
  - "In December 2006, Nakheel Development Ltd., a property development subsidiary of Dubai World, listed US$3.52 billion dollars worth of sukuk bonds on the exchange, making the DIFX the world leader in sukuk bond listings."
  - "Trading volume on the exchange is low, particularly for bonds, which tend to be bought and held."
  - "All clearing and settlement on the DIFX takes place in U.S. dollars."
  - "There are no transparency rules in place for over-the-counter trading but there does not appear to be an OTC market at this time."
  - "There is a full set of market abuse rules and effective market surveillance systems in place."

### Recommended actions (selected items from Table 5 and Table 6)
- Principles Relating to the Regulator (P 1–5)
  - P1. "The regulation of the securities markets needs to be centralized in one regulatory body with a clear legislative mandate to regulate the securities markets in their entirety."
  - P2. "Improve operational independence of ESCA by providing: (a) that the Chairman may not be a minister, senior executive or employee of the government; and (b) a majority of the Board should be experienced persons who are not government employees."
  - P4. "ESCA should have a formal procedure for taking the costs of compliance into account in formulating its regulatory policy."
  - P5. "ESCA should implement a formal Code of Conduct for its staff, setting forth rules for conflicts of interest"
  - DIFC actions: "Complete Memorandum of Understanding with the Central Bank of the UAE" and "Consider lengthening the comment period for new rules."
- Principles for the Enforcement of Securities Regulation (P 8–10)
  - P9. "Authority to fine and suspend brokers should be in the law giving ESCA its powers."
- Principles for Cooperation in Regulation (P 11–13)
  - P11. "The new securities law should provide for more specific provision setting out the procedures for establishing MOUs and their specific characteristics."
- Principles for Issuers (P 14–16)
  - P14. "The IPO process and requisite disclosures should be formally transferred from MOE to ESCA (by revision of the Companies Law) and should follow international best practice."
  - P15. "The proposed new law on Commercial Companies should be passed and the new Code of Corporate Governance should be adopted."
  - P16. "A new law regarding the regime for accounting in the UAE should be adopted"
  - P16 (audit): "The existing law on the auditing profession should be modified to improve regulation of the auditing profession."
  - DIFC consideration: "Consider stipulating audit standards in DIFX rules"
- Principles for Collective Investment Schemes (P 17–20)
  - Ps 18, 19 and 20. "Promulgate comprehensive regulations for the structure and operation of collective investment schemes. (This is not adequately covered in the new draft ESCA legislation.)"
  - DIFC consideration: "Consider more detailed rules for valuation and redemption should the regulatory regime be extended to retail products"

### Authorities’ response (UAE federal/ESCA and DFSA responses)
- ESCA reaction (paragraphs 74–77):
  - "ESCA broadly agrees with the assessment done by the FSAP Update team observers..."
  - Anticipated improvement: "we believe, after taking into account the new laws which will be passed shortly, our compliance with IOSCO principles would further improve."
  - Regulatory moves taken:
    - "the authorities have immediately shifted the regulation of IPOs to ESCA"
    - "The Code of Corporate Governance for listed companies was promulgated in May 2007."
    - "The process of cross border information sharing is being formalized while a new Staff Code is being implemented for ESCA's staff members to avoid any potential conflicts of interest."
    - "The process of consultation for setting up a suitable body for implementation of accounting and auditing standards has been put in place and human resources are continuously upgraded."
  - Assertion: "We are sure that these changes, when fully implemented, would make us fully compliant with IOSCO's principles of securities regulation."
- DFSA reaction (paragraph 95): "The DFSA considers the document to be a fair and well articulated assessment of the DFSA’s conformity with IOSCO’s Objectives and Principles of Securities Regulation and has no additional comments."

### DIFC institutional and market background (key facts and dates)
- Legal/jurisdictional:
  - "In 2004 the UAE constitution was amended to allow an emirate to establish a 'financial free zone,' a separate legal, geographic and judicial jurisdiction."
  - "Federal Decree No. 35 in 2004 established the DIFC, with an accompanying resolution delineating the 110 acre area of Dubai within which the DIFC is located."
  - "The DFSA is a separate and independent regulatory agency established in 2004 under Dubai Law No. 9."
- Market structure and activity:
  - "As of January 2007, there were 104 firms registered with the DFSA."
  - "Forty percent of these are financial institution primarily regulated by home supervisors; the majority are subsidiaries of large financial institutions and only a few operate solely within the DIFC."
  - "The DIFX began operating as an exchange in September 2005; it has 9 equity listings all dual listed on another exchange. There are also 4 listings of sukuk (Shari’a compliant) bonds."
  - "The operation of collective investment schemes is very recent in the DIFC, as a framework law was put in place in April 2006. Seven fund operators have been licensed by the DFSA, and seven private funds are domiciled in the DIFC."
  - "The DIFC also established a separate court, with both a trial and appeal level..."
  - "All clearing and settlement on the DIFX takes place in U.S. dollars."
- Regulatory powers and practice:
  - "The DFSA has full authority to license and supervise regulated persons and the authority to make rules, form policy and issue interpretations."
  - "The DFSA has authority to inspect and investigate regulated persons. It can require production of documents and records and compel testimony. It has a range of enforcement powers including the power to give direction to regulated persons, to issue stop orders to investment funds, and to halt trading on the DIFX. The DFSA can withdraw or refuse licenses."
  - "The DFSA has emphasized international cooperation and information sharing as part of its enforcement and supervision activities. It has signed a number of MOUs and is a signatory to the IOSCO Multilateral MOU."

### Observations and caveats
- Implementation stage: "Because the DIFC and DFSA were established very recently and because activity within the DIFC is still new and somewhat limited, it was difficult to assess in-depth the effect of the new regulatory structure in practice."
- Supervision readiness: "The DFSA has shown a commitment to bring action against those in violation of the law and its rules and has established robust licensing processes. It has established systems of information sharing and supervisory cooperation necessary to supervise international financial services."
- System testing: "However, the robustness of the system remains to be tested as activity within the center increases. Similarly, the strength of the DIFC court system and judicial framework for the DFSA’s work will be tested as challenges to the law and regulation arise in future. It is noted that the Court recently issued injunctive orders on the application of the DFSA."

*Source: _cr07357 - 71.*

### 98.      To comply with this core principle the team confirms the 2001

### _cr07357 - 98.      To comply with this core principle the team confirms the 2001

### Core Principle 1(6). Cooperation
- Findings
  - "There is no regular contact with other supervisors of financial companies, such as insurance companies, and no exchange of prudential returns (2001 FSAP)."
  - "There are no formal arrangements in place for cooperation and information sharing between the insurance supervisor, the securities markets’ supervisor or the banking supervisors."
  - Existing working relationship between the CBU and ESCA is noted; reinforced by the Governor of the CBU being a member of the board of ESCA.
  - Start-up of ESCA operations was facilitated by seconding CBU investment examiners to ESCA; contacts take place rarely and no prudential information is exchanged.
  - A working arrangement transfers operational supervision of brokers licensed to deal in local shares to ESCA; ESCA will also assume supervision of brokers dealing in foreign shares on a date still to be determined. These arrangements do not result from an amendment to the legal statutes of the CBU or ESCA.
  - "The U.A.E. insurance industry is not well developed at present and that only two banks are part of a group containing an insurance company."
- Recommendation
  - "Formalize the contacts between the different supervisors and enhance the process of information exchange."
  - "ESCA should take full supervisory responsibility of brokers and the relevant laws should be amended accordingly."

### Core Principle 4. Transfer of significant ownership
- Findings
  - Securities legislation (Article 19 of Cabinet Resolution 12/2000) requires the CBU to pre-approve holdings exceeding five per cent in stock listed banks.
  - "No procedures have been established to examine the fit and proper character of the shareholders."
  - Draft banking law intends to extend the pre-approval requirement of holdings exceeding five per cent to nonlisted shares.
  - "Only three of the 21 local banks are not listed on the stock exchange."
  - Holdings in excess of one percent are to be reported annually to the CBU (Letter BSD 64/84 of 16/1/85) and additional information is gathered during on site supervision.
- Recommendation
  - "The CBU should be informed of proposed changes of significant ownership, including beneficial ownership of all banks, and explicit review and approval procedures should be established."
  - "The supervisor should also be given the power to take action to modify, reverse or otherwise address a change of control that has taken place without the approval of the supervisor."

### Core Principle 9. Problem assets, provisions and reserves
- Findings
  - "The classification of advances as substandard at 180 days in arrears is too long and there is no explicit restriction that would prevent an advance from being declassified because it has been rescheduled (but otherwise its recoverability was unchanged)."
  - Circular 313/84 requires banks to establish and maintain a regular procedure for classifying advances to identify accounts as impaired (based on adverse credit features).
  - Classification into sub-standard, doubtful, and loss is based primarily on subjective criteria; advances in default for 180 days would normally be classified as at least sub-standard.
  - Provisions for sub-standard and doubtful advances are based on a subjective assessment of expected losses.
  - Provisions for advances classified as loss should be for 100 percent of exposure (net of realizable value of collateral).
  - "The definition of ‘default’ and the matter relating to the period being reduced to 90 days is being studied and a decision will be taken in the light of the projected introduction of Basel II."
  - "Banks in general already apply a more detailed system of categorizing credits."
- Recommendation
  - "The CBU tighten the present classification of impaired credits in light of the more demanding practice of banks in the U.A.E"
  - "Specifically, the CBU should classify loans when payments have fallen 90 days in arrears."
  - "Introduce a required minimum percentage of provisions for each category" and "Consideration should also be given to the introduction of a general loan-loss reserves."

### Core Principle 10. Large exposures
- Findings
  - Large exposure limits and definitions:
    - "The large exposure limit for a single borrower or a group of related borrowers is 7 percent of the bank’s capital."
    - "Aggregate large exposures are subject to a limit of 800 percent."
    - "The large exposure limit is 20 percent for each parents, subsidiaries, and affiliates (which in aggregate should not exceed 60 percent)."
    - "The limit is 30 percent for interbank exposures."
  - "Exposures to banks within the U.A.E. for maturities of less than 12 months and off-balance exposures with maturities of less than 12 months are not yet included in the definition of large exposures."
- Recommendation
  - "Off-balance sheet items and inter-bank exposures to U.A.E. banks with maturities of less than 12 months should be included in the definition of large exposures."

### Capital adequacy, Basel II implementation, and risk management (CP13, CP15)
- Findings
  - CBU Circular 13/93 section 3 sets a minimum solvency ratio (Basel 1) of 10 percent for banks; ratio is calculated only for credit risk and certain off–balance sheet items.
  - Present regulatory capital requirements differ from Basel I: "all exposures on GCC countries are weighted at a zero rate whereas, with the exception of Saudi-Arabia a 100 per cent weighting ratio should have been applied."
  - "Applying the 100 per cent weighting increases the required minimum capital ratio for a number of banks thus substantially reducing their existing capital margin."
  - "On a total of seven banks having a capital ratio lower than 16,5 per cent at the end of 2005 four banks would suffer from this change."
  - CBU intends to use discretionary powers given by Basel II to maintain the zero weighting for GCC exposure.
  - Timeline and actions:
    - "In 2005 the CBU formed a working group to prepare the implementation of the Basel II Accord (CP6)."
    - "A detailed analysis and a diagnostic review of each bank was completed by the CBU and external consultants in February 2006."
    - "The CBU has announced to the banking industry its intention to implement Basel II by December 31, 2007. (Circular 3735/2006 of August 27, 2006)"
    - "Regarding Pillar 1, the standardized approach will be mandatory for credit risk, while for market risk banks are expected to adopt the 1996 amendment to Basel I."
    - "All banks will be expected to be Internal Ratings Based compliant by January 1, 2011."
    - "Pillar 2 and Pillar 3 will also have be observed by December 2007."
  - Implementation preparations:
    - CBU conducting an impact study for selective Basel II criteria and drafting guidelines covering the three pillars.
    - "Banks will have to file formal implementation plans and to obtain supervisory approval for their approach."
    - "A parallel run of the present capital adequacy system and the standardized approach for credit risk is planned from June 30, 2007."
  - Capacity constraints:
    - "Basel II is very demanding on the supervisors as well as on the supervised financial institutions."
    - Shortage of skilled and qualified personnel with respect to Basel II requirements.
    - Additional difficulty due to Islamic shariah–compliant contracts and operations requiring special expertise.
    - Concern about supervisory capacity and resources to organize and maintain adequate control of Basel II implementation across banks.
- Recommendation
  - "Pursue and finalize the planned implementation of Basel II, including the issuance of the necessary guidelines."
  - "Continue training of staff to prepare for the introduction of the IRB approach and put in place a salary package allowing to attract and maintain the required specialized staff."

### Core Principle 18. Abuse of financial services
- Finding
  - Article 20 of Federal Law No(4) of 2002: "bank staff and money changers who report suspicious transactions in good faith to the compliance officer or to the CBU cannot be held liable."

### Core Principle 23. Corrective and remedial powers of the supervisor
- Findings
  - Existing administrative penalties under Article 112 of the Union Law No 10 should be amended to include the power to:
    - "To impose fines;" (footnote: "The only fine the CBU is presently allowed to impose is for delays in submitting prudential reports and data to the Credit Risk Bureau. The fine amounts to AED 200 per day of delay (Article 107 of the Banking Law).")
    - "To suspend an individual bank manager;"
    - "To appoint managers;"
    - "To apply to the U.A.E. Court for injunctions, freeze orders, compulsory winding up orders;"
    - "To initiate civil procedures to obtain damages against wrongdoers and obtain compensation from them for their victims;"
    - "To refer the matter to the appropriate authorities in the U.A.E. responsible for enforcing the U.A.E. penal laws;"
    - "To bar the distribution of dividends;"
    - "To give orders to the bank;"
    - "To order the bank to implement a regularization program within a certain period;"
    - "To appoint an official administrator."

### Appendix II. Initial Public Offerings (IPOs) — Box 3. Public Offerings: Separating Policy Functions
- Findings and guidance
  - Privatization: "Decisions involved in privatization should be taken separately for each issue." Government (Ministry of Economy) as issuer should specify terms and seek advice from a skilled neutral third party.
  - Pricing: "Market mechanisms should be used for the pricing of new offerings in the market." Additional objectives for privatization (e.g., redistribution) should be separated from pricing.
  - Allocation of shares: Allocation in oversubscription is complex; "For private companies, the underwriter would normally influence allocation substantially."
  - Regulation: "An independent regulator (in this case, ESCA), should be charged with the regulation and oversight of offerings." Regulator’s role should be separate from issuance and pricing.
  - Subscriptions: IPOs in the U.A.E. have been partly financed by large bank loans at substantial cost; "Leverage was also excessive, with some IPOs being more than 800 times oversubscribed."
  - Recommendation for CBU: "Restrict the aggregate level of credit that a bank is allowed to extend for the financing of an individual IPO."

### Appendix III. Stress tests for the banking system
- Data and scope
  - Stress tests based on data for end-September 2006 on the 46 U.A.E. commercial banks; based on current loan classification system for nonperforming loans.
  - Staff noted additional data needed: (i) household and corporate balance sheet data; (ii) data on large exposures in the banking system; and (iii) a more precise breakdown of personal loans and estimate of real estate exposure.
  - Seven scenarios under different assumptions were used to test credit risk. "An assessment of the impact of a move to the 90-day norm for NPLs was not possible due to data limitations."
- Key stress-test findings
  - "Stress tests suggest that the banking system would be generally resilient to an across the board and significant deterioration of asset quality."
  - Doubling of current level of substandard, doubtful and loss loans:
    - Overall capital adequacy declining from 16.3 percent to 11.5 percent.
    - "Large banks and foreign banks would be the most affected."
    - Under extreme conditions, 11 of the 21 locally incorporated banks would exhaust their Tier 1 capital (vs. 6 in the initial FSAP stress tests).
  - Real estate shock:
    - A strong shock affecting property developers, corporate borrowers, mortgages and contractors would drive capital adequacy ratio from 16.3 percent to 14.6 percent.
    - Combination of real estate shock plus indirect deterioration of personal loans for business and consumption would drive capital adequacy ratio down to 11.6 percent.
- Table 7. Summary of Stress Test Results (selected figures; all figures preserved exactly as presented)
  - Capital adequacy ratio (pre-shock)
    - Domestic banks: 17.3
    - Foreign banks: 12.7
    - Large banks: 16.0
    - Medium Sized banks: 15.7
    - Small banks: 18.2
    - State owned: 18.3
    - Islamic banks: 15.8
    - All banks: 16.3
  - Capital adequacy ratio after shocks — examples:
    - A. Credit risk — Real estate (mortgages, construction loans and personal loans; 20% and 15% NPLs)
      - All banks: 12.1 (breakdowns: Domestic banks 12.6; Foreign banks 10.2; Large banks 10.1; Medium Sized banks 12.3; Small banks 15.2; State owned 13.1; Islamic banks 10.8)
    - A. Credit risk — Real estate (property developers, corporates, contractors, mortgages)
      - All banks: 14.6
    - A. Credit risk — Real estate + indirect credit risk
      - All banks: 11.6
    - A. Credit risk — General shock: Increase of NPLs by 100 percent
      - All banks: 11.5
    - B. Foreign exchange risk — Appreciation of the AED/USD by 10 percent
      - All banks: 15.9
    - C. Interest rate risk — Increase of interest rates along the yield curve by 300 basis points
      - All banks: 16.1
    - D. Combined credit and interest rate risks — External shock + increase of interest rates along the yield curve by 300 basis points
      - All banks: 13.0
  - Liquidity ratios
    - Liquidity ratio (pre-shock) — All banks: 49.9
    - Liquidity ratio after shock — Customer deposit withdrawal (16%) — All banks: 30.6
    - Liquidity ratio after shock — Decrease in government deposits (35%) — All banks: 43.6
    - Liquidity ratio after shock — Decrease in non resident deposits (30%) — All banks: 40.7
    - Liquidity ratio after shock — Decrease in foreign interbank funding (30%) — All banks: 45.1
  - Note: "1/ Defined as assets of maturities of less than 3 months in domestic and foreign currency on liabilities of less than 3 months in domestic and foreign currency. 4 other liquidity ratios were used."

*Italic: IMF staff and Central Bank of the U.A.E. data and assessments as presented in the supplied content.*

### 124.      Because of the uneven development of the exposure to the real estate sector,

### _cr07357 - 124.      Because of the uneven development of the exposure to the real estate sector,

### Real estate exposure and capital adequacy
- Because of the uneven development of the exposure to the real estate sector, banks would be diversely affected.
- In the most exceptional scenario:
  - Five locally incorporated banks would see their capital adequacy ratios reduced to less than the regulatory minimum 10 percent, with two of them in negative territory.
  - Large banks show the largest deterioration but their capital adequacy ratio stays within prudential requirements.
  - Islamic banks and foreign banks appear the most vulnerable.
- Observations on bank types and exposures:
  - Foreign banks traditionally work with less capital in the U.A.E., and most of them have recourse to their head offices for additional capital.
  - Because of the prominent role of Islamic financing mechanisms in real estate purchases, Islamic banks tend to be more exposed to the real estate sector.
  - The extent to which Islamic financing mechanisms such as Ijara (leasing) would protect the lenders and mitigate those risks has not been significantly tested.
  - One conventional bank appears more vulnerable under the test as it is particularly exposed to personal loans for both business and consumption purposes.

### Resilience to external shocks and credit quality
- Overall, the banking system would be resilient to a deterioration of credit quality caused by external shocks.
- Effects of world oil price fluctuations:
  - Predominantly affect the banking sector through banks’ liquidity.
  - Effects on asset quality are difficult to estimate because banks have little direct credit exposure to the oil and gas sector.
- Simulated external deterioration affecting trade and related services:
  - The banking system would weather the shock relatively well: capital adequacy would decline to 13.2 percent.
  - Four locally incorporated banks would see their capital drop below the minimum required 10 percent.
  - Foreign banks and Islamic banks would be most affected—the former because of an active involvement in trade finance.

### Bank liquidity profiles (selected indicators, September 2006)
- Notes on groupings (based on individual bank data):
  - domestic banks (77 percent of total bank assets)
  - foreign banks (23 percent)
  - large banks (37 percent, each representing at least 8 percent of total bank assets)
  - medium-sized banks (42 percent)
  - small banks (21 percent, each with less than 2 percent of assets)
  - publicly owned banks (43 percent)
  - Islamic banks (14 percent)
- Selected Liquidity Ratios 1/ (values as reported)
  - Domestic banks: L/D 118.1, LR 30.1, LA/A 14.4, LA/LL 44.3, FCLA/FCLL 29.9
  - Foreign banks: L/D 88.1, LR 54.1, LA/A 31.3, LA/LL 76.7, FCLA/FCLL 70.4
  - Large banks: L/D 138.5, LR 42.6, LA/A 14.4, LA/LL 74.8, FCLA/FCLL 47.4
  - Medium sized banks: L/D 93.7, LR 30.2, LA/A 18.7, LA/LL 35.7, FCLA/FCLL 32.0
  - Small banks: L/D 104.0, LR 43.7, LA/A 24.4, LA/LL 46.3, FCLA/FCLL 33.1
  - Publicly owned domestic banks: L/D 140.3, LR 42.0, LA/A 15.4, LA/LL 58.5, FCLA/FCLL 37.2
  - Islamic banks: L/D 102.5, LR 21.1, LA/A 14.1, LA/LL 36.8, FCLA/FCLL 24.0
  - All banks: L/D 110.7, LR 36.5, LA/A 18.3, LA/LL 49.9, FCLA/FCLL 36.9
- 1/ Definitions:
  - L/D: net loans to total deposits
  - LR: cash, assets with the CBU and due from banks on sum of customer deposits and due to banks
  - LA/A: cash, assets with the CBU and due from banks on total assets
  - LA/LL: assets with a maturity of less than 3 months on liability of less than 3 months
  - FCLA/FCLL: assets with a maturity of less than 3 months on liability of less than 3 months (foreign currency only)

### Domestic liquidity shock simulations
- Customer deposit shock:
  - A 16-percent shock to customer deposits was simulated.
  - The 16-percent magnitude mirrors the largest deposit shock the U.A.E. has faced: deposits fell 16 percent from July to end-August 1990.
  - A general run on deposits would disproportionately affect medium-sized and Islamic banks.
  - For Islamic banks, no distinction was made on the types of Islamic deposits affected due to data limitations.
- Government deposit shock:
  - Government deposits are correlated with oil price developments and tend to be quite volatile.
  - A 30-percent decline in government deposits was simulated (between 1995 and 1996 government deposits dropped by 34 percent).
  - Publicly owned banks would be most affected but without threatening significantly the liquidity position of the system.
  - Foreign banks would be the least affected.

### External liquidity shock simulations
- Non-resident deposit and external funding risks:
  - Although a significant share of non resident deposits is stable and the U.A.E. appears to be a “safe haven” in situations of regional instability, large withdrawals of non resident deposits cannot be ruled out.
  - Given the increasing reliance of commercial banks on external funding, a shock on foreign interbank funding was simulated (a 30-percent decrease in both cases).
  - Results confirm the less favorable liquidity buffer of some institutions: small and medium sized banks and Islamic banks.

### Interest rate risk
- Banks appear relatively protected against interest rate risk:
  - Internal stress tests on interest rate risk are conducted regularly in most banks.
  - Large maturity gaps appear to be well managed with a matching of interest sensitive assets and liabilities.
  - Islamic banks (and finance companies) have the possibility of repricing frequently.
  - Most lending is based on floating interest rates, including for mortgages—borrowers bear most of the risk of rising interest rates.
- Simulated interest rate shocks:
  - 300 basis points along the yield curve, and 400 basis points of short-term interest rates (with an inversion of the yield curve due to the temporary nature of the shock) appear to have a relatively limited impact on banks’ capital.
  - However, banks may be taking on additional credit risk; combined shocks (simultaneous rise in interest rates and NPLs) were also simulated to test this.

### Foreign exchange risk
- Exposure to foreign exchange risk appears well contained:
  - Most foreign exchange operations by U.A.E. banks are in U.S. dollars, and the peg to the U.S. dollar has been maintained successfully since 1980.
  - Net foreign exchange positions in U.S. dollars at end-September 2006 were equivalent to 28 percent of bank capital, with most banks holding significant positive foreign exchange positions.22
  - Consequently, an appreciation of the domestic currency against the US dollar would affect negatively the capital ratios of most banks.
  - For all banks, a 10-percent appreciation of the dirham with respect to the US dollar would result in a decline in the CAR from 16.3 percent to 15.9 percent.
  - Banks’ net foreign exchange positions in other foreign currencies are relatively small (equivalent to 6.5 percent of capital), with negative positions in euros and positive positions in other currencies.
- 22: Additional notes from the source:
  - Net foreign exchange positions in U.S. dollars are declining and represented 44 percent of capital in December 2005.
  - Medium sized and Islamic banks hold the largest positive foreign exchange positions in U.S. dollars as of September 2006 (equivalent to 78 percent and 182 percent of their capital, respectively), and would therefore be most affected by an appreciation of the dirham.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07357.pdf_