Gulf of governance

The Middle East has no shortage of capital, but limited attention to good governance has hampered the economies in realising their full potential. Could this be about to change?

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By  Vikas Kaul Published  April 4, 2005

|~||~||~|In Bahrain, an Islamic bank is financing a premium real estate development project, the Durrat Al Bahrain. To ensure the project is executed properly, the bank has picked up a 50% equity stake in the company. “Now, banks are entering into these types of contracts,” says Shaharuddin Zainuddin, director of banking operations at the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). “Five years ago, only 5% of the deals were of this type. Now, they are around 10%, and in the future, these types of contracts are likely to grow even more,” he says. Banks pushing for equity holdings or positions on the board is a pointer to a new mindset that is demanding greater accountability. Be it financial markets, financial services providers, or companies, there is a growing awareness that global capital mandates an environment that is open, transparent and encourages accountability. There are many factors driving these changes: Arab money — much of which used to go out to the West — is finding its way back into the region in a big way, post-September 11. These investors are however used to high levels of transparency and disclosure offered in the world’s more developed markets, and now, they expect the same environment back home, and this is pushing the issue of corporate governance to the forefront. Also, many countries in the region have joined the World Trade Organisation (WTO) and are opening up their financial markets. Madhukar Shenoy, director, PriceWaterhouseCoopers (PWC), Bahrain, says: “Eight out of 10 countries in the Gulf region have committed to implementing Basel II conventions (the toughest regulatory rules yet for the financial services industry) in the next couple of years. This will bring about more demanding regulators who will, in turn, ask for greater transparency and risk management norms.” At the same time, some countries in the region are seeking global financial support for their development plans. Take Egypt, for example. Banks rarely lend to small or medium sized firms even though such firms generate the bulk of the employment in the country. International credit rating agencies estimate non-performing loans for the four national banks to be around 30% of their total loan portfolio. To attract global investors to invest in Egyptian companies, Egypt needs to overhaul its financial system. The Central Bank of Egypt has now begun to push for reforms. Elsewhere in the Middle East, the banking system is largely inefficient with huge non-performing assets. “The more these regional markets look towards international players to participate in their development plans, the more they acknowledge and apply international standards and norms of corporate governance. The last thing an emerging economy needs is a reputation for not learning from the mistakes of others,” says Dubai-based Matthew Smith, regional chief operating officer, HSBC Bank, Middle East. Many of these emerging economies, particularly member-states of the Gulf Cooperation Council (GCC), are consciously trying to work together — and even this has an implication on governance norms. “As companies from one country in the region try to raise money in another country, they will need some form of homogenisation of governance norms,” says Yezdi Karai, president, K Solutions, a firm that helps closely held family-owned companies go public. HSBC’s Smith adds: “In general, as the number of stakeholders — such as banks and other lenders, shareholders, customers and staff — increases, and they find themselves in an increasingly competitive environment, they will look at corporate governance, and corporate social responsibility in a more self-interested way.” What has been missing so far is the push to change the system, especially in Middle East countries, such as Egypt, Jordan and Lebanon, where knowledge of governance issues are barely traceable. “Parliamentarians, industrialists and even economists are not aware of corporate governance. When I talk about it, they say ‘what are you talking about?’” Says Mowafak Al Yafi, managing partner of a leading financial advisory firm in Lebanon, Grant Thornton. The lack of understanding in these parts of the Middle East can be traced back to two sources, according to Yafi: the region inherited French laws that tend to protect family owners at the expense of everybody else (as opposed to the Gulf countries which inherited British laws). He also blames the culture that teaches people to operate on their own rather than working as a team. Charles Neil, secretary to the board of directors, Dubai International Financial Centre, points out other problems as well: “Some countries do not have proper bankruptcy laws while others have no take-over codes. The majority of firms have traditionally been family-owned and there was little protection for minority shareholders. Only a small proportion of shares are actually tradable. Even in the larger public companies, the shareholding is dominated by one or a few key shareholders,” he says. “The idea of independent directors is still alien to most,” says PWC’s Shenoy. Although some countries do have regulations that mandate independent directors on the board, the enforcement is weak. Some of the more basic requirements, such as disclosure of conflict of interests by directors, are often missing. “In practice what happens is that there is no independent process for selecting these directors,” says Neil. “The issue is that the regulations, in this respect, are not enforced.” “Disclosure norms in this region are relatively weak in comparison to the more developed markets.” he adds, citing accounting , conflict of interest , directors interests, risk analysis, concentration of exposures , disclosure of material adverse events as areas that all need to be properly addressed. “There are a lot of good quality regulations in place, but the issue is a lack of enforcement,” he explains. “However, you have to remember that corporate governance is still evolving even in the USA. In the Gulf countries, elements of corporate governance are there and most institutions follow international accounting standards. Company laws in many countries in the region do define many things pertaining to good governance but I don’t think it’s really well understood,” points out Shenoy. This might be beginning to change now. “What you are seeing is that things are getting codified and brought into limelight,” says Karai of K Solutions. Oman is bringing out its own corporate governance code. In Qatar and Egypt, the central bank is pushing for change. “DIFC is a manifestation of Dubai’s commitment to ensure that financial institutions that operate there can count on the highest standards of regulation and professionalism,” says HSBC’s Smith. DIFC, through its regulatory arm, Dubai Financial Services Authority (DFSA) aims to bring in best practice from across the world. “What they are doing is very interesting. They have looked at best practices, and then chosen the ones that are most suitable for the region. They are kind of localising best practices, which is good,” says Karai. Moreover, DIFC has articulated clear take-over codes, bankruptcy and liquidation procedures to offer exit to investors, proxy voting and protection for minority shareholders. The stock exchange that is being promoted by DIFC, the Dubai International Financial Exchange (DIFX), intends to insist on a higher float percentage for companies that list on the exchange, so that external investors have a greater say in how companies are run. In Saudi Arabia, which is currently the region’s biggest initial public offering (IPO) market, the Capital Markets Authority (CMA) has taken some important steps towards ensuring good governance. It now requires companies to create and publish a ‘statement of ethics and business practices’ that must be signed by the CEO, CFO and all the directors. The Sarbanes-Oxley Act that was framed in the US to toughen governance norms post-Enron collapse inspired this move. The act requires companies to articulate and put down on paper a clear governance framework they intend to follow. As Karai points out, “In large part, it is a state of mind…a behavioural issue.” In Bahrain, the Ministry of Commerce has endorsed the recommendations of the first Basel committee on banking supervision, the Basel 99. And the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), which deals with Islamic banking and financial principles, has also gained importance as the number of Islamic financial institutions has grown rapidly in the last five years. Today, there are over 180 financial institutions worldwide that follow Islamic banking principles. These institutions, spread over 45 countries, are grappling with issues that arise from applying Islamic banking principles. “For instance, western standards deal adequately with the economic substance of a transaction but do not lay enough emphasis on the procedures involved. However, these procedures are at the heart of Islamic banking,” says Zainuddin of the AAOIFI. Take the example of a financial lease. Under the western accounting norms, the assets are carried off the balance sheet of the lessor. However, in the case of Islamic banks, the assets, by virtue of generating a rental, must remain on the lessor’s balance sheet. So standards outlined by the AAOIFI help in setting a reporting framework consistent with sharia principles. “For any Islamic bank, there is a risk of loss of reputation due to non-compliance with sharia. Earlier, banks had an internal sharia advisor who would define the norms as well check if those norms were being met. This obviously was flawed,” says Zainuddin. Now, the AAOIFI has issued clear standards, and an external supervisory board is being put in place by banks. In some countries, such as Malaysia and Sudan, a single supervisory body has been created by the central bank. In other countries, these supervisory bodies are external organisations just like any other accounting and auditing firms. The AAOIFI standards are also designed to bring greater uniformity in the way such institutions prepare their accounts. Take the example of the money Islamic banks raise from their investors. Almost 90% of this money comes in the form of Investment Accounts. It doesn’t carry a fixed interest rate. Instead, these accounts operate on a profit-sharing mechanism. Hence, they do not constitute a fixed liability and are akin to mutual fund investments. Some banks would show this as quasi capital while others would show it as liability. (It is much simpler for the conventional bank where most money comes in the form of deposits. The bank pays a fixed rate of interest on it. As a result, this is shown on the liability side of the balance sheet.) In these investment accounts, there is a further categorisation – there are restricted accounts and unrestricted accounts. In the former, the account holder defines where his money should be invested (say, in real estate). In this case, the responsibility of the bank is largely fiduciary in nature. So the bank does not own that money but manages it like a sector-specific mutual fund. In the case of unrestricted investment accounts however, the bank has the freedom to invest as it deems fit. So this has been defined as quasi capital (invested with the bank) and those who make such investments are in a situation similar to minority shareholders. The new AAOIFI standards unambiguously clarify how the money should be reported in the banks’ books. “Without these standards, there was no clarity and you couldn’t compare two banks,” says Zainuddin. Currently, four countries, Bahrain, Sudan, Qatar and Jordan, have made standards formulated by the AAOIFI mandatory. Several others like the UAE, Malaysia, Indonesia, Kuwait, Lebanon and Pakistan have either incorporated some of its ideas or are examining them for implementation in the near future. It is a good beginning. As financial institutions embrace corporate governance norms, they will also begin to push companies they invest in towards better governance practices. And this will provide the confidence and certainty that will ultimately encourage and attract more investors to the region.||**||

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