A 'third-generation' set of reforms may be needed down the road for Egypt's financial sector, Doha Abdel-Hamid* argues Despite arduous government efforts invested so far in instituting a modern system of regulation in a free-enterprise economy, Egyptian financial markets remain far from being truly open. There remains a need for further deregulatory reforms that would seal the genuine integration of domestic financial markets with the outside world. This would pave the way for true laissez-faire competition on a level-playing field among developed nations and surrounding MENA region counterparts. Several challenges loom ahead. First, a clearly defined vision with measurable outcomes as regards where Egyptian financial markets are headed is required. Medium and long-term strategies should be designed with an eye on where Egyptian financial markets could stand vis-à-vis other centres in the MENA region and among the emerging and developed world. A comprehensive programme that is strategic in nature would assess strengths and vulnerabilities and would be able to define targeted implementation plans, set required resources, time lines, monitoring and evaluation mechanisms and commensurate outcomes. The involvement of the public, including financial regulators, academics, researchers, consumer advocacy associations and specialist think tanks, will have to be secured to avoid implementation problems and ensure stakeholders' consensus. Ample research needs to be concluded beforehand to set acceptable assumptions and related viable scenarios. Second, the quality of disseminated data, level of detail and timeliness are backbones to the efficiency of (and key to investment decision making in) financial markets in the Western world. One of the pillars of the reform programme, is to ensure that financial institutions and regulators are accountable to the public, the administration, the press and legislative bodies. Information disclosure and dissemination are essential prerequisites for an efficient market that is able to allocate resources to their optimum use, select potential investment opportunities and carry out informed decision-making. Without meeting this precondition, Egyptian financial markets will continue to suffer from being unable to attract acclaimed financial institutions (FIs), financial service providers (FSPs) and institutional investors (IIs) so as to maintain a presence on the international financial map. Reporting requirements should be defined, periodic, timely, enforceable and in compliance with international norms for all FIs. This leads to the following issue of concern. Functional regulation is a third challenge. Since the 1970s, world financial markets have witnessed a tangible growth in financial conglomerates through synergies. The evolution of such an institutional structure has brought about economies of scale and scope, which have, in turn, led to expanding the capacity of FIs in offering competitive and diversified products in banking, securities and insurance. In addition, the phenomenon inspired the growth of mega-banks along the lines of the German model (gross bank or universal bank). The transformation caused a shift from functional to institutional regulation. Under functional regulation, the dividing lines between banking, securities and insurance activities are clear-cut and a single regulator has distinct responsibilities in each activity. Conversely, institutional regulation is built on the de facto truism that the functional lines of regulation have become blurred since the emergence of mushrooming financial conglomerates in the developed world. This has burdened banking regulators, being the first to introduce deposit protection schemes, with the responsibility of trying to draw dividing lines between banking risks and those pertaining to other types of activities undertaken by mega financial firms. The UK's Financial Services Authority and the US' federal "umbrella" regulator (dubbed as "millennium regulators") are bodies whose raison d'être lie in the existence of this new hybrid regulatory approach. Hence, should Egypt work on streamlining its regulatory structure to face the upcoming challenges of the GATS 2005, developing an institutional regulator, or to put it differently, defining the exact duties of each functional regulator, will have to be incorporated within the letter of law until an institutional regulator is created when time is ripe. There have been recent calls for detaching financial regulators in Egypt from the government due to the need for regulatory autonomy and to preclude political influence over regulatees. However, developed nations' experiences -- particularly the UK's, where the country's financial markets have been influenced by a culture of peer pressure until the resurgence of its first formal regulatory structure in the 1980s -- has shown the system of self-regulation as sub-optimal in a number of respects. Although self-regulated organisations (SROs) were independent of the government and the national budget, financial failures and scandals were not uncommon, particularly in the era of deregulation, in which many large mobile players adopted a short-termist, self-interested vision to investments channelling in recyclable financial markets. Financial regulators tended to ignore regulatory closures to delay the exposure of regulatory failure to the public eye in the hope that FIs might employ self-corrective measures and for the sake of the widely known "revolving door phenomenon". Not only that, if self-regulation mutatis mutandis does not contain some obvious measures to curtail regulatory capture to the industry (as is the case at present in Egypt with the formation of financial regulators' board of directors), a cartelistic regime will be created and closed market ideological strictures will prevail. A deliberately-tailored incentive mechanism for self-regulatory organisations is required that is based on private incentives. Punitive measures may be utilised as deterrents for regulatory forbearance and for capture to the industry's FSP groups. Although the above measures sound rather austere, they are likely to lead to some positive results. Challenges related to implicit safety mechanisms also exist. Till now, Egypt lacks systemic safety measures. Both the US and the UK established their explicit deposit protection schemes since the early 1930s and 1980s respectively, fine tuning the systems over the years as economic circumstances changed. The dilemma that faces the CBE, despite its strengthened independence, is that banks in Egypt are not allowed to fail for political, rather than economic, reasons. The prevalent belief is that should a single bank be allowed to fail, a possible run on other banks will ensue. Of course, this proposition is not built on valid free market grounds, whereby firms would be allowed free entry and exit based on healthy competition. This has led to a serious incentive problem that culminated in large amounts of non-performing loans in public banks' portfolios from the 1980s till today. The presence of incorrect competitive incentive mechanisms will lead to non-economic measures of systemic, market and institutional risks. Risk measurement and management and scenario analyses are crucial areas worthy of the attention of the Egyptian regulator. Meanwhile, the regulator should be empowered to enforce such measures and the CBE should be given the authority to excise deposit protection premiums on all banks that free-ride the lender-of-last-resort (LOLR) system. Better supervision is a sixth challenge. Is the number of examiners a dependent variable on the increase in the number of new market players during first and second-phase competitive deregulation and onwards? Are they sufficiently trained, incentivised and compensated? Do they have properly tested and functioning early-warning mechanisms hooked to their offices via automated networks? Do examiners have "what, if" scenario-manipulation gadgets to handle potential financial crises at their earliest stages? Do examiners exchange information on recent supervisory topics of interest with global regulatory associations, such as the Bank for International Settlements, the International Organisation for Securities Commissioners and the International Association for Insurance Supervisors? Do examiners have a clear mandate and law enforcement powers? Is the Ombudsman concept, widely known in the West, being considered for application? Are punitive measures within the letter of law sufficiently deterring renegades? Are there any periodic surveys undertaken by regulators or other stakeholders to answer the above queries? Should the answer be "no" to any of these questions, there should be room for future supervisory improvement in that area. Financial instruments and market efficiency are a seventh challenge. A closed market would represent the natural habitat for oligopolistic behaviour. In such a restricted market, competitive market pricing, product choice and consumer rights are nonexistent. First-phase (1970s and 1980s) and second-phase (1990's economic reform and structural adjustment programme) deregulation have shown mixed features of closed and open economics prevailing in Egyptian financial markets. Despite the increase in the number of firms, the market is still concentrated, FIs are relatively low in capitalisation, information dissemination is lacking and, most importantly, product diversity is severely constricted. Although primary markets were reinvigorated by the flotation of some privatisation candidate stocks, the necessary regulatory infrastructure for market operation has not yet been completed. With restricted entry and exit and the presence of market players with limited capitalisation, there was heavy reliance on the products supplied through government privatisations. The government took upon itself the burden of being the main supplier of financial market products during the deregulation eras. This has slowed down remarkably despite the passage of a number of laws in 1998 enabling the privatisation of public-sector banks and insurance companies, among others. The challenge ahead is to revive the government's privatisation programme and to allow local and foreign market players to introduce innovative products that were introduced in the US and the UK decades ago, such as negotiable orders of withdrawals, commercial papers, revolving underwriting funds, convertibles, options, swaps, futures, junk bonds, and mortgage and asset-backed securities. The new announcement of establishing a secondary market for local government bonds is a strongly commended step along the same direction of reform. Some day, when the government's privatisation programme has ended, the ingression of new financial markets will be needed in third-generation financial reforms. The challenges laid above are immense, particularly when considering Egyptian cultural specificities. The roots of Egyptian laws are Roman and French, therefore they comply with the spirit of international norms as a minimum threshold. The social culture is built on authoritative decision-making -- a legacy of decades of central planning and strong state grip over the lives of citizens. However, this is rather a top- bottom approach to public management and does not sufficiently address much of the challenges ahead. Empowerment, involvement and delegation of authority represent the new management approaches in developed economies -- a prerequisite for successful public administration and governance in the new millennium. Other challenges rest with the able definition, interpretation and efficient institutional mechanisms that would dictate the enormous tasks of carrying out the judicial implementation of law. Furthermore, human resource development issues related to regulators and market players' operations are of paramount importance. Assistance from the developed world and from donors is to be sought, as this would entail mutual strategic benefits to both sides. If Egyptian financial markets are aligned to international standards, this would open new markets for mega financial firms suffering from developed markets' overcapacity, secure that systemic risk containment measures are codified and unified worldwide, insure consumers acquire financial products at lower competitive cost and prudent risk and reinforce co- operation between local and foreign regulators on issues addressing hazardous financial activities and investor protection. Should the great challenges ahead be given the attention of the government, business sector, independent research institutes and the donor community, Egypt will most likely be a capable global player in open financial markets in the not too distant future. * The writer is a professor of finance at Hye-Watt University, Edinburgh, Scotland. * This is an abridged policy brief of a conference paper presented in "The Institutional and Policy Challenges Facing The Egyptian Economy", by the Center for Economic, Financial Research and Studies (CEFRS) and the United States Agency for International Development (USAID), Cairo, May 2002. ** The arguments expressed in this article represent the sole personal view of its author and therefore do not reflect those pertaining to any of the institutions she is affiliated with.
