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GCC Economic Monthly

Source: NCB Capital

Rebuilding the financial system

Summary

Amid signs of relative economic stabilization and consequently, the diminished focus on economic emergency measures, the policy debate is once again shifting to regulatory reform. Shortcomings of the pre-crisis regulatory framework are widely viewed as a main culprit for the troubles that ensued. In spite of several proposals to address the problems, little concrete progress has materialized to date as political inertia and lack of international coordination remain key obstacles toward implementation. Moreover, some of the most heatedly debated issues — notably bonuses — are in part motivated by political populism and may well distract attention from other areas.

• The ‘light touch’ approach to financial regulation over the past two decades not only fueled unprecedented growth of financial services, but also left several gaps in the regulatory framework. In addition to the problem of high leverage, banks consolidated into institutions deemed “too big to fail” and innovated new instruments outside the purview of formal regulation. With persistent low interest rates and unprecedented innovation, systemic risks built up to extraordinary levels, partly because their perceived costs remained low

• While the initial policy response to the downturn rightly focused on crisis control, the focus is now shifting to attempts of modifying the regulatory framework substantially. The most important proposals include: creation of systemic risk councils to oversee large; interconnected financial firms; excess capital and liquidity requirements for banks; and regulation of over-the-counter (OTC) derivatives and the shadow banking system. If converted into legislation, these measures promise to revamp the system significantly

• However, political differences and lack of international coordination remain key obstacles to progress of regulatory reform. Policymakers in the US and UK have divergent views over the multiplicity of regulators and their roles in times of crisis. Unless these differences are resolved and the proposals morph into concrete regulations, the opportunity for establishing a new regulatory order, besides restoring confidence in regulatory mechanisms, could well be lost. This could have serious consequences for further growth of the financial system and leave open the risk of a future relapse.

• Apart from severe turbulence among Kuwaiti investment houses, the GCC financial sector has remained relatively insulated from the current turmoil. Unlike their western counterparts, no financial institution has failed in the GCC region while authorities have focused on reviving confidence in the economy
• The GCC’s corporate sector performance points toward gradual economic stabilization. Especially, large-cap companies in the banking and petrochemicals sectors posted robust performances in 2Q-09, although it may be too soon to conclude that this represents a sustainable trend

• Global equity markets recovered in July following losses in June, as positive economic numbers from China and a robust 2Q-09 corporate sector performance in the US boosted investor optimism. The G7 markets returned positive numbers ranging 4.0%–10.9% while the leading emerging markets gained 3.1%–15.3%. In the GCC, Saudi Arabia’s TASI gained 3.2% during July

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